The COVID-19 pandemic has caused the filing of many Chapter 11 bankruptcy proceedings in industries such as consumer retail, restaurants and movie theaters. While the commercial real estate industry has been dramatically impacted by the pandemic, thus far, not many commercial single-asset real estate borrowers have filed for bankruptcy. If and when such borrowers start filing Chapter 11 bankruptcy, lenders will have to navigate the legal landscape that has developed over the past several years. This article addresses certain of the issues likely to be raised in the Chapter 11 proceedings.
A central tenet in the structure of senior real estate lending documentation is the prevention of the borrower, in the event it files for Chapter 11 bankruptcy, from re-writing the essential provisions of the secured loan, including term, interest rate and amortization, which is often attempted under a “cram-down.” Senior lenders have created devices to minimize such risk, including mezzanine financing coupled with non-substantively consolidate-able separate borrowers (for the senior and mezzanine loans, respectively), “golden shares,” non-recourse carve-outs, and “bad boy” guarantees. In inter-creditor agreements between a senior lender and a mezzanine lender, the senior lender typically negotiates for provisions that are intended to reduce the opportunity for a cram-down.
Recent cases suggest that senior lenders should reexamine the language in their form inter-creditor agreements and the non-recourse carve-out provisions in their form loan agreements to ensure that the provisions address certain issues and are specific enough to have the intended effect.
“Per Plan” vs. “Per Debtor” approach
Section 1129(a)(10) of the Bankruptcy Code (the cram-down provision) provides that to cram down a Chapter 11 plan: “if a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider.” If multiple debtors propose a joint plan on a non-substantively consolidated basis, may section 1129(a)(10) be satisfied if one impaired class of creditors with claims against only one of the debtors rejects the plan but another impaired class of creditors with claims against a different debtor accepts the plan?
The answer depends upon whether the court applies the “per-plan” or “per debtor” approach and courts have differing views. If a per-plan approach is applied, by filing a joint plan and gaining the vote of the mezzanine lender, a senior borrower and mezzanine borrower can effect a cram-down against the senior lender despite there being only one lender at the senior borrower level.
Senior lenders seeking to avoid such a cram-down can consider adding provisions to the inter-creditor agreement that address the mezzanine lender’s right to vote in a joint Chapter 11 plan.
Enforceability of subordination provisions and waterfalls
Another question is whether a subordination agreement (or an inter-creditor agreement that includes subordination provisions) that is otherwise enforceable under Section 510(a) of the Bankruptcy Code (which addresses contractual subordination), can be circumvented by Section 1129(b)(1) (which addresses Chapter 11 plan confirmation).
Section 510(a) of provides that “a subordination agreement is enforceable ... to the same extent that [it] is enforceable under applicable non-bankruptcy law.” Section 1129(b)(1) provides that “notwithstanding section 510(a) of this title, if all of the applicable requirements . . . are met with respect to a plan, the court, on request of the proponent of the plan, shall confirm the plan.”
Most courts have held that, under the plain meaning of Section 1129(b)(1), a cram-down can be effectuated notwithstanding the provisions of a subordination agreement that are otherwise enforceable under Section 510(a). The effect of this is that even if an inter-creditor agreement provides that the junior/mezzanine debt is subordinate, under a cram-down, the junior/mezzanine debt can receive distributions before the senior debt is paid in full.
Relatedly, bankruptcy courts have closely examined the language of inter-creditor agreements to determine whether the distribution waterfalls contained therein were applicable to adequate protection payments and plan distributions in Chapter 11. These cases have demonstrated that drafting clear and unambiguous provisions with specificity is the goal.
Senior lenders may want to reexamine their form inter-creditor agreement to ensure that it (a) does not allow a mezzanine lender to vote in favor of a plan that circumvents the contractual subordination provisions between the lenders, (b) allows for a remedy against the mezzanine lender in the event a mezzanine lender is paid by a borrower in a manner that is inconsistent with the subordination provisions, and (c) the waterfall provisions clearly and unambiguously provide for the senior lenders to receive any and all adequate protection payments, plan distributions, stock, warrants and other equity rights in the reorganized debtors.
“Insider” claims that are sold
Another issue is whether, if an insider sells their claim to a non-insider, the holder of such claim may be considered an insider for purposes of cram-down under Section 1129(a)(10), which requires the affirmative vote of an impaired accepting class without including any acceptance of the plan by any insider.
The Bankruptcy Code provides specific examples of who qualifies as an “insider,” including directors, officers, and controlling persons of a debtor. However, courts have held that such list is not exhaustive, and that other persons can still qualify as “non-statutory insiders.” In 2018, the Supreme Court affirmed a decision holding that under certain circumstances, the holder of a purchased claim would not be considered an insider for cram-down purposes.
Lenders should reexamine the carve-outs to the non-recourse provisions in their form loan documents to ensure that they contain provisions that help mitigate the risk that a borrower may cause insider claims to be sold to third parties in order to cram-down a Chapter 11 plan against the lender.
Conclusion
In conclusion, senior lenders may want to revisit their form loan documents to confirm that they contain provisions that are intended to protect them from the effect of recent case law that may allow a cram-down plan to be effected against the senior lender.
Richard Kanowitz, Lawrence Mittman and Ralph Arpajian are partners and Mordechai Sutton is an associate at Haynes and Boone LLP an international corporate law firm with offices in Texas, New York, California, Charlotte, Chicago, Denver, Washington, D.C., London, Mexico City and Shanghai, providing a full spectrum of legal services in energy, technology, financial services and private equity.