Ceci N’est Pas Une Institution Financière: Existential Crisis For Distressed Debt-Focused Hedge Funds

Wednesday, May 7, 2014 - 15:00

Meridian Sunrise Village, LLC v. NB Distressed Debt Investment Fund Limited, No. 13‑5503, 2014 WL 909219 (W.D. Wash. March 7, 2014).

What You Need To Know

Buyer beware: Distressed debt investors who purchase the debt of a borrower in bankruptcy, where the borrower’s underlying loan agreement contains an “Eligible Assignee” restriction, may be at risk of not being able to hold such debt and exercise the rights of a lender. Meridian Sunrise turned on a choice between two competing interpretations of “financial institution” under a $55 million loan agreement governed by Washington State law. In this case, distressed debt funds were held not to be “financial institutions” by the United States District Court for the Western District of Washington and were therefore not “Eligible Assignees.” It may seem obvious, but purchasers of distressed debt from debtors/borrowers in the secondary market should review loan agreements governing the debt they purchase, confirm they are permitted assignees of the paper, and ensure they have recourse against the seller of the debt in the event of ambiguity or challenge.

The Facts

Meridian, a builder and manager of shopping centers, entered into a loan agreement in 2008 with U.S. Bank to finance the construction of a shopping center in Washington. Shortly after originating the loan, and as contemplated by the parties, U.S. Bank assigned portions of the loan to each of Bank of America, Citizens Business Bank and Guaranty Bank & Trust Company, while maintaining its role as administrative agent for the loan.

In light of the expected assignment of portions of the loan, Meridian negotiated for, and received, additional protection in the loan agreement, restricting the parties to which U.S. bank could assign portions of the loan. The loan agreement included the following provision: “[n]o Lender shall at any time sell, transfer or assign any portion of the Loan . . . to any Person other than an Eligible Assignee.” “Eligible Assignee” was defined as follows:

“Eligible Assignee” means any Lender or any Affiliate of a Lender or any commercial bank, insurance company, financial institution or institutional lender approved by Agent in writing and, so long as there exists no Event of Default, approved by Borrower in writing, which approval shall not be unreasonably withheld.

In early 2012, U.S. Bank called a non-monetary default under the loan agreement based on the breach of a financial covenant by Meridian. Later that year, U.S. Bank requested that Meridian agree to waive the Eligible Assignee restriction in its loan documents to facilitate a sale of the loan. Meridian declined to do so. As is common, prior to an Event of Default, Meridian had the right to withhold consent to any assignee (as long as it was acting reasonably); after an Event of Default, Meridian’s consent was not necessary, but an assignment remained subject to the rest of the restrictions in the Eligible Assignee definition. In January 2013, U.S. Bank notified Meridian that it had elected to commence charging default interest on the loan as a result of the non-monetary default, leading Meridian to file for bankruptcy protection.

During the course of Meridian’s chapter 11 case, and despite Meridian’s repeated objections, Bank of America transferred its portion of the loan to NB Distressed Debt Fund Limited, which subsequently assigned one half of its interest to Strategic Value Special Situations Master Fund II, L.P., and another part to NB Distressed Debt Master Fund L.P. The three funds were, as their names would suggest, investment funds with a focus on acquiring the debt of troubled borrowers.

Meridian objected to Bank of America’s transfer and sought an injunction in Bankruptcy Court to enjoin the distressed debt funds from exercising Eligible Assignee rights, including voting on its plan of reorganization. The Bankruptcy Court granted the injunction, which the distressed debt funds then appealed. The District Court denied the distressed debt funds’ motion for a stay. Voting on Meridian’s plan of reorganization progressed, with the distressed debt funds being denied the opportunity to vote, and Meridian’s broader lender group voted in favor of Meridian’s plan of reorganization, which was confirmed by the Bankruptcy Court in September 2013.

The distressed debt funds appealed the Bankruptcy Court’s preliminary injunction and confirmation of Meridian’s plan of reorganization.

The District Court’s Decision

In a decision that seems to take a dim view of distressed debt funds generally, the District Court declined to adopt a broad interpretation of the term “financial institution,” as such a result would permit an assignment of Meridian’s loan to any entity that manages money, and thereby drain any force from the Eligible Assignee restriction. The District Court agreed with the Bankruptcy Court that applicable rules of contract interpretation in Washington State required courts to interpret words in a way that harmonizes with their context. Thus, the term “financial institution,” when taken in context, was understood by the District Court to mean an entity that makes loans, rather than any entity that manages money.

The District Court rejected the distressed debt funds’ arguments that only an abstract dictionary definition could be used when interpreting the term “financial institutions,” and considered the course of dealings between the parties relevant when considering the term. Prior to Meridian’s chapter 11 filing, U.S. Bank had sought to consensually eliminate the definition of "Eligible Assignee” from the loan agreement, demonstrating that the Eligible Assignee restriction was not interpreted by the parties in a broader sense.  The filing for chapter 11 itself by Meridian, instead of caving in to U.S. Bank’s demands, also demonstrated the importance of the Eligible Assignee restriction to the borrower.

In short, because the District Court found that the distressed debt funds were not in the business of loaning money, but instead were businesses that invested and held investment assets, they did not qualify as “financial institutions” under the loan agreement. The distressed debt funds have appealed the District Court’s judgment to the United States Court of Appeals for the Ninth Circuit.

Fathomless Thoughts

The District Court’s decision in Meridian relies on a somewhat tenuous distinction to define the term “financial institution”: in the District Court’s view, entities that make loans are financial institutions, and entities that manage money are not. Such a distinction may create problems when larger credit funds that are active as both lenders and investors are considered. As distressed credit markets have evolved, and credit funds have grown in assets under management and experience, we have seen competition to traditional lenders from other non-traditional financing sources. Language lives and breathes the realities of its time, and even a quick survey of the various uses of the term “financial institution” in both a statutory and colloquial context betrays a trend towards a more expansive use of the term.

Does such a blurring of the lines mean that distressed debt funds should be included under the umbrella of the term “financial institution”? Meridian, as many borrowers in the same situation might, argued that it had affirmatively chosen to face a plain vanilla lender when entering into its banking relationship, and not a “predator,” as it (and the District Court) described the distressed debt funds. The District Court’s decision in favor of Meridian and its narrower interpretation of the term “financial institution” reflects this commercial reality.

As for Meridian’s business justification for distinguishing between traditional lenders and non-traditional financing sources, are banks any friendlier than distressed debt funds when dealing with a borrower in distress? Although a “financial institution” like U.S. Bank might, just like a distressed debt fund, seek to liquidate collateral on a default, some argue that because traditional lenders have relationships with borrowers and care about their reputation in the market, they might be less aggressive when facing a borrower in default. A lender may indeed find it harder to attract borrower clients in the future if it develops a reputation in the market as being overly aggressive. Distressed debt funds, on the other hand, do not necessarily face such a quandary. Clearly they are institutions engaged in the business of finance, but not of the type, as Meridian convinced the Bankruptcy Court and District Court, that Meridian would have chosen to face given the choice.

The Bankruptcy Court and District Court decisions are definitely pro-borrower and pro-debtor, but they make sense within the court’s broader interpretation of what was intended when the borrower entered into a relationship with its lender in that case – even if the District Court’s wider proposition of what is and is not a financial institution is debatable. And that’s what this case really comes down to: Meridian was able to convince the Bankruptcy Court and the District Court that it intended to restrict the universe of potential lenders capable of holding its loan when it entered into its loan agreement with U.S. Bank, and it specifically contemplated excluding any “financial institution” that was not a plain vanilla lender. I’m not so sure, as commentators have argued, that courts in other districts wouldn’t also rule the same way given the facts of that particular case. The District Court’s ruling paints distressed debt funds negatively, but the legal arguments are clear and logical: when interpreting the term “financial institution” under Washington State law (or any term for that matter), courts are able to look at extrinsic evidence and consider the disputed terms in context. And the context in this case led to a particular result. Nothing particularly groundbreaking about that (although other states’ laws might vary on when extrinsic evidence can be consulted).

Where does this leave us? Standard form loan agreements, to the extent they use an Eligible Assignee construct rather than a schedule of “black-balled” entities (or a “Disqualified Institutions List”), will need to evolve to encompass the new normal of non-traditional financing sources being active in traditional lending markets. After all, it may have been possible for the District Court in this case to find that the individual distressed debt funds involved were not financial institutions given its view of that term, but what if the institutions involved were hedge funds with tens of billions of dollars under management that make regular loans from one arm, while playing actively in the distressed debt markets with another?  I can think of quite a few hedge funds that fit the bill.

Borrowers

Borrowers are lucky that, for now, courts are on their side. They should not rely on luck alone to ensure that lenders they consider predatory are kept away from their collateral when they get into trouble. Indeed, the general trend in the syndicated loan markets is to move away from Eligible Assignee clauses altogether. In most deals now in the syndicated loan market, assignments are permitted to any person (other than a natural person) except for a person listed on the Disqualified Institutions List that is part of the loan agreement. To the extent that an Eligible Assignee clause is used, more precise language to clarify the types of lenders that are, and are not, eligible to participate in their loans is recommended. Borrowers should also ensure that they maintain a record of their intent when it comes to Eligible Assignee restrictions in case the restrictions are ever challenged.

Lenders

On the other hand, lenders who value liquidity and the ability to trade their debt freely are advised to negotiate for Eligible Assignee definitions that are expansive and clearly permit them to trade to hedge funds, especially following an Event of Default.

Distressed Investors

As for distressed debt investors, although paying legal fees may eat into returns, paying close attention to underlying credit documents prior to acquiring positions will help avoid this type of situation in the future.  There’s a reason the term caveat emptor comes from Latin: unwary buyers have been around since the dawn of time.

This article was originally published as a post on the Weil Bankruptcy Blog.

David Griffiths is a Senior Associate in Weil’s Business Finance & Restructuring Department and is based in the firm’s New York office.

Please email the author at david.griffiths@weil.com with questions about this article.