The Fantastic Four: * TOUSA, General Growth Properties, Yellowstone and Yano-Horoski: Portents of Calamity?

A series of recent court opinions have precipitated ominous warnings that we may be witnessing the erosion of secured creditors’ rights, an erosion that some have argued may herald substantially increased borrowing costs and a further dissipation of the credit markets as a whole.

In TOUSA,[2] the bankruptcy court, finding fraudulent conveyance, not only avoided the liens that arose from the fraudulent transfer, but also ordered the disgorgement of all funds received by the senior lenders plus nine percent in prejudgment interest, a result aggregating more than $480 million. In General Growth,[3] a case involving the debtor and 337 of its 750 subsidiaries, affiliates and joint ventures, the bankruptcy court, in denying several motions to dismiss for bad faith, and notwithstanding the special-purpose entity (SPE) structure of the group as a whole, concluded that the interests of the entire group must be taken into account in determining whether an individual SPE should be dismissed.

In Yellowstone Mountain Club,[4] the bankruptcy court, again in a fraudulent-transfer context, found the lender’s actions to be a product of overreaching, characterizing them as predatory, and thereafter subordinating Credit Suisse’s first lien on a $232 million secured claim. In Yano-Horoski,[5] a state court in Suffolk County, N.Y., citing a lender’s “unconscionable, vexatious and opprobrious” conduct, canceled the mortgage on the borrower’s residential property.

Meanwhile, federal borrowing currently stands at $6.671 trillion, constituting 47 percent of the GDP. The deficit stands at a record $1.43 trillion, equal to 10 percent of the GDP, the highest shortfall relative to the GDP since 1945. The credit markets have lost much of their liquidity, and the global economy still suffers from a shortage of credit. “When set against projected demand for credit by the public and private sectors’…forecast supply could ‘fall short of even anemic private sector demand.’”[6] At least $1.3 trillion of debt will come due between now and 2013, $160 billion of which was securitized, and $50 billion in securitized commercial real estate loans are due to be refinanced in the next year alone.

Recognizing these figures in the Nov. 19, 2009, edition of Forbes, Stuart Saft, a partner at Dewey & LeBoeuf LLP, wrote: “In the last few weeks there have been a series of court decisions that will have repercussions in the credit markets for years to come making an already cautious lending community absolutely paranoid, and restricting credit even if available.” Citing, among others, the General Growth and TOUSA opinions, Saft further said, “The recent court decisions demonstrate how courts can override the words and intent of loan documents and lenders’ remedies notwithstanding the widespread concern about the fiscal health of our lending institutions and the need for them to recover to unfreeze the credit markets and permit economic growth to resume.”

Are these cases mere, albeit large, anomalies, or do they portend something larger, something more ominous, something fundamentally at odds with and that may undermine the larger credit market’s recovery? Even though some, like Saft, have claimed that these cases will lead to disastrous results in the credit market, in reality these cases are not likely to have this effect. It is submitted that while these cases may be extraordinary in their scope, given the relative size of the judgments involved, they are uniformly based on extraordinary, sometimes quite egregious, facts. As a result, and as it becomes apparent after a review of the decisions themselves, the holdings in these cases are likely of limited future applicability.

TOUSA
In TOUSA, the bankruptcy case of a Florida-based home builder, the court was called upon to decide a fraudulent-transfer action under §§544 and 548 of the Bankruptcy Code. In 2005, a TOUSA subsidiary became a party to a joint venture for which TOUSA guaranteed the unsecured debt incurred in connection with the subsidiary’s participation. When the housing market began its decline, the venture defaulted on its obligations. Litigation ensued and, in an effort to settle the litigation, TOUSA, together with some of its subsidiaries that were not parties to the joint venture, borrowed $500 million from Citicorp and other lenders. To secure the loan, TOUSA and its subsidiaries granted the lenders liens on substantially all of the assets of the subsidiaries, including a $207 million tax refund. TOUSA thereafter paid the venture lenders, which included Bank of America, JPMorgan Chase and others.

A 13-day trial was held in the summer of 2009 on the fraudulent transfer claims, and Hon. John K. Olson issued a 182-page decision, holding that the TOUSA subsidiaries were insolvent, both before and after the granting of the liens, and that the subsidiaries were left with an unreasonably small amount of capital to continue the operation of their businesses. The judge voided the liens, including the liens on the tax refund, and ordered the lenders to return $403 million previously paid to them plus prejudgment interest, all of which amounted to more than $480 million. The judgment has been taken to the district court on appeal.

General Growth
In General Growth, the debtor and its subsidiaries, affiliates and joint ventures, filed for chapter 11 protection on April 16, 2009. The debtor’s subsidiaries were generally structured as bankruptcy-remote SPEs. They required independent directors or managers whose approval was required for certain actions, including filing for chapter 11 relief. The SPEs had their own cash-management systems, and the loans to the SPEs did not require parent-company guarantees.

At the first-day hearings, the court granted the debtors’ cash-collateral motion and allowed the debtors immediate access to the cash generated by each SPE, wherever located, in order to preserve the going-concern value of the enterprise as a whole. Virtually all of the lenders had objected on various grounds, principally complaining that the debtors’ use of their respective cash collateral would vitiate the SPE structure and the bankruptcy-remote protections within that structure. The court, in assuaging the lenders, granted them various forms of adequate protection, and ultimately the final DIP order substantially improved the terms that the debtors had first proposed. Several of the lenders thereafter filed motions to dismiss certain of the chapter 11 cases as to specific borrowers.

In filing the motions to dismiss, the lenders argued that they were being forced to assume the credit risk of the General Growth enterprise as a whole—a risk for which they had not bargained. They further argued that many of the SPEs were not in default and produced sufficient cash flow to service their individual obligations.

Recognizing that the SPE structure had been used by the debtors to shield the lenders and their collateral from the impact of a bankruptcy filing by the borrowers’ parent and/or siblings, the court nevertheless held that the interests of the entire enterprise had to be taken into account when determining a discrete dismissal of any one entity. The court concluded that even though specific borrowers were not in default, the disarray in the credit markets was sufficient to create uncertainty as to the prospect of refinancing when the debt did mature in the future. The court further noted that, in failing to dismiss any discrete case, the court’s order did not adversely affect the lenders’ fundamental rights inherent in the SPE structure.

Yellowstone
In Yellowstone Mountain Club, the bankruptcy court, faced with an allegation brought by the creditors’ committee that a syndicated loan characterized by the lender’s counsel as “a fairly standard syndicated loan transaction”[7] concluded that the loan was anything but. The court found that Credit Suisse had engaged in a systematic sale of a syndicated loan product that would benefit the developers and the lender, but would leave all the risk of loss on the creditors of the developments. The court found that 94 percent of the loan proceeds of the original $375 million loan was utilized “for purposes unrelated” to the business of the borrower and indeed had gone directly to the principal of the borrower for his personal use, the transfer of which was not memorialized by any documentation, but was merely reflected on the debtor’s books with a journal entry. The court further found that the due diligence was “all but nonexistent,” that the projections utilized by the lender in advancing the loan “had no foundation in historical reality,” and that the only plausible explanation for the lender’s action was the fees that it would garner in the event that the loan was booked.

Remarkably, the court found that the lender, unable to syndicate a loan with a ninety percent loan-to-value ratio, had developed a new appraisal methodology, which it termed “total net value.” As a result, the loan failed to conform to the Financial Institutions Reform Recovery and Enforcement Act (FIRREA), so it was funded through the lender’s Cayman Islands branch, which is not subject to FIRREA, thus resulting in a total net value of $1.16 billion and a 35 percent loan-to-value ratio. “While [the] new loan product resulted in enormous fees to Credit Suisse in 2005,” wrote the court, “it resulted in financial ruin for several residential resort communities. Credit Suisse lined its pockets on the backs of the unsecured creditors. The only equitable remedy to compensate for Credit Suisse’s overreaching and predatory lending practices in this instance is to subordinate Credit Suisse’s first lien position.”

While the court agreed to allow Credit Suisse to credit bid its debt in an upcoming auction of the debtor’s assets, the court also required that Credit Suisse provide sufficient funds as part of its bid to pay the debtor-in-possession financing, administrative fees and other costs of the bankruptcy, inclusive of the allowed unsecured claims of certain unsecured creditors.

Yano-Horoski
Most recently, on Nov. 19, 2009, Judge Jeffrey Arlan Spinner of the Supreme Court, Suffolk County, N.Y., decided a case involving IndyMac Mortgage Services (Indymac), a division of OneWest Financial FSB. Indymac, as the court said in its opinion, “purport[ed] to be the servicer of” a loan that was secured by a residential mortgage on Diana Yano-Horoski’s home, in which she lived with her husband and her working daughter. Indymac was the servicer for the benefit of Deutsche Bank, which claimed to be the owner and holder of the adjustable-subprime note and mortgage, though, as the court notes, the record-holder of the note and mortgage was IndyMac Bank FSB, an entity that is no longer in existence.

A judgment of foreclosure was granted to Indymac on Jan. 12, 2009, and thereafter, in accordance with New York law, the borrower requested a settlement conference. The settlement was continued five times “in a series of unsuccessful attempts by the Court to obtain meaningful cooperation from the [lender].” The court thereafter ordered an officer of the lender to appear, and at that appearance the officer “celeritously made clear to the Court that [the lender] had no good faith intention whatsoever of resolving this matter in any manner other than a complete and forcible devolution of title from Defendant.”

Compounding the lender’s problems with the court was a revelation that, although a forbearance agreement had been entered into by the parties and thereafter breached by the borrower, the forbearance agreement had not been sent to the borrower until after its stated first payment due date. Thus, the lender had caused the borrower to breach the forbearance agreement before she had even received it. Further, the court, utilizing the lender’s calculations, was unable to determine the balance due, noting that “it now appears that the elusive principal balance is either $290,687.85, $285,381.70 or $283,992.48.”

The lender had further refused a number of offers that would have resulted in the lender’s being paid in full, “aside from some tinkering with the interest rate,” and according to the opinion, the lender’s representative, throughout the settlement conference, held an “opprobrious demeanor and condescending attitude that no proffer by Defendant (short of consent to foreclosure and ejectment of Defendant and her family) would be acceptable to Plaintiff. Even a final and desperate offer of a deed in lieu of foreclosure was met with bland equivocation. In short, each and every proposal by Defendant, no matter how reasonable, was soundly rebuffed by Plaintiff.”

The court, in conclusion, found the lender’s conduct “inequitable, unconscionable, vexatious and opprobrious…wholly unsupported at law or in equity, greatly egregious and so completely devoid of good faith that equity cannot be permitted to intervene on its behalf.” The court further determined that ordinary punitive actions, including dismissal of the case at bar or monetary penalties, would have been ineffective in addressing the lender’s behavior. As a result, the court ordered that the note be cancelled and voided, that the mortgage be vacated, that the lender was barred from attempting to enforce the note in the future and finally that the judgment of foreclosure be vacated.

What Is the Real Impact of These Cases?
By and large, these cases represent a business arrogance that, if the media reports can be trusted, seemed all too common among some lenders in the run-up to the recession. General Electric’s CEO Jeff Immelt recently described the era as one characterized “by meanness and greed.” Each party to a securitized transaction foisted the responsibility of failure onto the next, taking out large fees in the process, often failing to appropriately document which entity even owned the loan. Large loans were made, often on the basis of the fees generated, instead of the viability of the underlying transaction or the value of the collateral.

The moral of the story does not lie in a diatribe against the courts’ holdings as sowing speculative fear for the broader credit markets. Fraudulent transfers demand appropriate remedies; vexatious behavior mandates appropriate legal and equitable responses. Indeed, it is the independence of the courts that is the strength of our judicial system.

Instead, the moral of the story can be found with the simple understanding that in every transaction, someone will ultimately be determining its reasonableness. While the courts may occasionally get it wrong, they generally make a good-faith attempt to assess the relative merits of the parties’ respective positions and issue their decisions accordingly. In those cases where there has been overreaching, where loans are seemingly designed to impose the losses occasioned by default on others, and where reasonable offers are rebuffed without regard to economic reality, courts can and should take appropriate measures. Lenders, not only to guard against adverse oversight but because it is right, should ensure that the value of the collateral upon which the loan is based is appropriate, that accurate measures are in place to assign loss appropriately, and that borrowers are able to compete honestly and fairly for appropriately priced financing.

Most importantly, it is appropriate to ensure accountability on those responsible for unreasonable loans and the losses that they create. If the courts get it wrong, there are remedies on appeal. If the judgments and the appeals raise the cost of doing business because business was undertaken carelessly or fraudulently, it is appropriate that the lenders bear the risk of loss. If, on the other hand, it is the borrowers who were careless or fraudulent in their actions, it is the borrowers who should bear that loss. However, if only as a check on the behavior of those who try to game the system, someone, sooner or later, will be watching.