Equitable Subordination: Lenders Beware – It Is Not Enough That Actions Are Permitted Under the Loan Documents

In re Aida’s Paradise, LLC, 45 B.R. 806 (Bankr. M.D. Fla. 2013) –

A chapter 11 debtor sought to equitably subordinate a lender’s unsecured deficiency claim based on actions that it claimed interfered with operation of its property.  The lender responded that it was merely exercising its rights under the loan documents to protect its investment.  The court denied the lender’s motion to dismiss, finding that the debtor’s allegations were sufficient to state a plausible claim for relief.

As background, the debtor leased a large portion of its real estate to a restaurant operation (Salt Island), which was ~70% of the debtor’s rental income.  The property was subject to a bank’s mortgage and assignment of rents securing a loan of $9 million.  Apparently the debtor fell behind on its loan payments in February 2009, although reportedly cured the monetary default in March.

The bank revoked the debtor’s rights to collect rents and directed that all tenants, including Salt Island, pay the bank directly.  The bank contended both that the debtor did not cure all defaults and that the bank was entitled to continue to exercise its right to collect rents once a default occurred even though it was subsequently cured.  The bank initially refused to allow the debtor to resume collecting rents until it executed a forbearance agreement with additional representations and warranties, and then added a requirement that the debtor also escrow $1.2 million.  The debtor refused, and the bank initiated foreclosure proceedings in July 2010.

Beginning in April 2009, Salt Island made only partial rent payments to the bank.  Among other things, the debtor contended that the bank’s acceptance of partial rent payments prevented it from evicting Salt Island.  Shortly after the foreclosure proceedings commenced in July 2010, Salt Island closed.  When the debtor regained possession of the premises, it found that the property was significantly damaged and claimed that Salt Island “tore the furniture, fixtures, and equipment (FF & E)” from the space after the bank requested removal.

The debtor lined up a new replacement tenant with a 15-year lease that was contingent upon execution of a nondisturbance agreement by the bank (so that the new tenant would not be evicted in connection with a mortgage foreclosure).  The bank declined, and instead added the potential new tenant as a defendant to the foreclosure action.

When the debtor filed a chapter 11 bankruptcy proceeding, it scheduled the bank’s claim as a $9 million secured claim.  However, everyone agreed that the property was “worth vastly less than $9 million” so that the bank had a very large unsecured deficiency claim.  (As discussed in prior posts, generally a secured claim will be considered secured to the extent of the value of the collateral and unsecured to the extent of the deficiency.  See, for example, Chapter 11 Secured Loans: “Lien Stripping” Lives.)

The debtor filed a motion to equitably subordinate the bank’s deficiency claim.  The court consolidated the motion and an adversary proceeding asserting nearly identical claims that had been removed from state court.  The bank then brought motions to strike or dismiss the debtor’s claims.  As a procedural matter, the motion for equitable subordination was not subject to a motion to strike or dismiss (since a motion is not a “pleading”).  However, the bankruptcy court addressed the motion to dismiss with respect to the adversary proceeding claims.

The court noted that for equitable subordination the 11th Circuit requires a showing that (1) there is some sort of inequitable conduct by the creditor, (2) the conduct injures others or gives the creditor an unfair advantage, and (3) subordination is not otherwise inconsistent with the Bankruptcy Code.

If the creditor is an insider or a fiduciary, the debtor is only required to present “material evidence of unfair conduct.”  At that point the burden shifts to the creditor to prove that it acted fairly.  If it is not an insider or creditor, the debtor must “prove with particularity more egregious conduct such as fraud, spoliation or overreaching.”  Although a creditor is not generally a fiduciary, there is an exception if it “exerts so much control over the decision-making processes of a debtor such that it dominates the free will of the debtor.”

The debtor’s allegations included arguing that:

[T]he bank unduly dominated and controlled the Debtor’s business decisions by constructively preventing the Debtor from evicting Salt Island, by unreasonably collecting partial rent, by requiring an unjustified $1.2 million escrow, by unreasonably rejecting a proposed replacement tenant for the restaurant, and by instructing Salt Island to remove FF&E which caused significant damage to the restaurant.

In response to the bank’s argument that it was simply a prudent lender taking actions that it was authorized to take under the loan documents, the court conceded that each of the decisions may have been justified under the loan documents and that the bank is entitled to protect its interests.

However, even where all acts are technically or legally permissible, a lender must be careful not to become overly involved in a debtor’s affairs.  “Whenever a creditor interferes in the business affairs of a financially troubled corporate debtor, it risks the possibility that such interference may provide a basis for the equitable adjustments of its claims against the debtor, the imposition of statutory liability, or the imposition of liabilities at common law.” [footnotes omitted]

The court characterized the question as whether the bank went too far and whether it violated the “rules of fair play and good conscience,” and concluded that the debtor made a sufficient showing so that the motion to dismiss should be denied.

As the court notes, the decision on equitable subordination will likely determine whether the debtor can propose a confirmable plan of reorganization.  If the bank’s claim is equitably subordinated, then the debtor will be justified in separately classifying that claim.  If not, and if the bank’s deficiency claim is included in the class of general unsecured creditors, it will be able to prevent acceptance by that class – which likely means that the debtor will not be able to propose a “cramdown” plan over the objection of the bank since it likely will not be able to obtain an accepting impaired class of creditors.  (See Classification of Mortgage Deficiency: The Difference Between a Veto Right and Disenfranchisement.)

In deciding on a strategy to exercise rights and remedies, the lesson of this case is that a lender should recognize that finding a basis for taking action in the loan documents is usually necessary, but may not be sufficient to protect itself from exposure to claims.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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