Bankruptcy & Restructuring Law Monitor : Bankruptcy Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Restructuring & Chapter 11

In an opinion that has wide-ranging implications for the structured finance industry, the Delaware bankruptcy court recently dismissed a mezzanine borrower’s chapter 11 case as a bad faith filing pursuant to section 1112(b) of the Bankruptcy Code.  In re JER/Jameson Mezz Borrower II, LLC, No. 11-13338, 2011 WL 6749058 (Bankr. D. Del. Dec. 22, 2011).  At the core of the motion to dismiss were allegations that the debtor had filed for bankruptcy in bad faith, solely to benefit the lender to a parent entity, and to the detriment of the debtor’s lender.  The opinion stands in contrast to In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009) (“GGP”), and may leave structurally senior lenders breathing a sigh of relief.

Facts and Procedural History

In 2006, JER/Jameson Mezz Borrower II, LLC (“Mezz II”) and certain of its affiliates borrowed approximately $400M to acquire the hotel chain Jameson Inns and Signature Inns (the “Jameson Hotels”).  The loan was structured as a multi-tiered facility made up of five different tranches of debt.  Operating companies, which owned or leased and operated the Jameson Hotels (the “Operating Companies”), borrowed $175M, secured by the hotel properties.  Four mezzanine borrowers, which were formed for the sole purpose of the financing (referred to herein as “Mezz I,” “Mezz II,” “Mezz III,” and “Mezz IV”), each borrowed $40M.  Mezz IV’s loan was secured by its 100% equity interest in Mezz III, Mezz III’s loan was secured by its 100% equity interest in Mezz II, Mezz II’s loan was secured by its 100% equity interest in Mezz I, and Mezz I’s loan was secured by its 100% equity interest in the Operating Companies.  The Operating Companies provided the sole source of revenue for the Jameson Hotel enterprise.

On August 9, 2011, all of the loans matured and the Operating Companies and mezzanine borrowers defaulted.  Lenders at each level commenced enforcement actions.  The lender at the Mezz II level (“Colony”) provided notice of its intent to conduct an auction under Article 9 of the Uniform Commercial Code (the “UCC Auction”) of Mezz II’s equity interests in Mezz I, and also exercised its right to buy the secured debt at the Mezz I level.  The Mezz III and Mezz IV loans were held by a collateralized debt obligation managed by an affiliate of Gramercy Loan Services LLC (“Gramercy Loan”) and JER Investors Trust, Inc. (“JER”) or its affiliate.  Gramercy Loan exercised its right to replace non-independent directors for Mezz II, Mezz III, and Mezz IV and ultimately installed its own director at each of the mezzanine borrowers and at the Operating Companies.  On the eve of the UCC Auction, Mezz II filed for bankruptcy. 

Colony moved to dismiss Mezz II’s chapter 11 petition for bad faith (the “Motion to Dismiss”), arguing that the bankruptcy case served no legitimate purpose, and was filed solely to thwart Colony from foreclosing on Mezz II’s indirect equity interest in the Operating Companies.   Colony’s argument was based, in part, on the fact that Mezz II had no unsecured creditors, Mezz II’s only secured creditor was Colony, and it was the only entity in the capital structure that had filed for bankruptcy.  A few days later, Mezz I and the Operating Companies (together with Mezz II, the “Debtors”) filed chapter 11 petitions.  The Debtors opposed the Motion to Dismiss, contending that the bankruptcy filing should be read in the context of the filings of Mezz I and the Operating Companies.  The Debtors asserted that the valid reorganization purpose was to preserve the value of the enterprise and restructure the entire capital stack, or conduct a sale of the Jameson Hotels. 

Delaware Bankruptcy Court Ruling

The court first recognized that good faith is a “predicate to the right to file a petition in bankruptcy . . . .”  The burden is on the debtor to show good faith based on a totality of the circumstances.  The court distinguished case law from the Second Circuit, which considers both objective futility and subjective intent.  The court observed that the test in the Third Circuit is “based more on an objective analysis of whether the debtor has sought to step outside the ‘equitable limitations’ of Chapter 11 than the subjective intent of the debtor.”  In making the bad faith determination, the JER/Jameson court cited the factors set forth in In re Primestone Inv. Partners, L.P., 272 B.R. 554, 557 (D. Del. 2002), and found that nearly all the so-called Primestone factors were present: Mezz II had only one asset (the membership interest in Mezz I), there were few if any unsecured creditors, Mezz II has no ongoing business operations or employees, the petition was filed on the eve of foreclosure solely to obtain the benefit of the automatic stay, and Mezz II had no cash or income and no possibility of reorganization because Colony would oppose any reorganization plan.  In addition, the case involved a two-party dispute between Colony and the lender at the Mezz III and IV levels.  Finally, litigation in state court was already pending.

The court further reasoned that even absent analysis of the Primestone factors, evidence that Mezz II’s bankruptcy petition had been filed as a mere litigation tactic was compelling, given the timing of the filing, the role of the non-independent director installed by Gramercy Loan in the filing, and Gramercy Loan’s payment of the independent directors’ fees.  In addition, the court concluded that the filing could not serve a valid reorganizational purpose as Colony, Mezz II’s only creditor, would not vote to accept a plan of reorganization.  Accordingly, the court dismissed Mezz II’s bankruptcy case.

The court also granted Colony relief from the automatic stay pursuant to sections 362(d)(1) and (d)(2) of the Bankruptcy Code to foreclose on Mezz II’s ownership interest in Mezz I.  The decision effectively removed the enterprise’s revenue stream from the parent entities, and the reach of the lender at the Mezz III and Mezz IV’s levels.

Conclusion

In the wake of GGP, this opinion may provide structurally senior lenders comfort that, at least in Delaware, bankruptcy proofing a single asset borrower within a larger capital structure may succeed.  However, it also leaves the type of mezzanine financing used in this case suspect, as the structurally subordinated lender was left high and dry, with the enterprise’s revenue stream snatched out from underneath it.  Had the Mezz III and Mezz IV lender made a junior loan at the Mezz II level (or lower down the chain), rather than a structurally subordinate loan at the Mezz III and Mezz IV levels, it would have had some skin in the game in Mezz II’s bankruptcy case, making a potential consenting impaired class and, thus, plan confirmation theoretically possible.  It is unclear, however, whether the result would have been different if the structure of the Jameson Hotel enterprise had the complexity of GGP.  In addition, a simultaneous bankruptcy filing of all the entities in the capital stack would have looked less like a mere litigation tactic, and more like a good faith attempt to restructure the enterprise as a whole.  Thus, while the opinion provides some assurance to finance professionals, its scope and application remain to be seen.

[1] The implication was that Gramercy Loan had acted in bad faith by appointing its own director and directing him to file Mezz II for bankruptcy the day before the UCC Auction.

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The Delaware Supreme Court recently held that creditors lack standing to bring a derivative suit on behalf of an insolvent Delaware limited liability company (an “LLC”) under the Delaware Limited Liability Company Act (the “LLC Act”).  CML V, LLC v. Bax, No. 735, 2011 WL 3863132 (Del. Sept. 2, 2011, corrected Sept. 6, 2011).  In an opinion written by Chief Justice Steele, the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of claims brought by a junior secured creditor against the LLC’s present and former officers directly and derivatively for breaching their fiduciary duties.  The Delaware Supreme Court’s holding was based on a plain reading of 6 Del. C. § 18-1002 which requires that a plaintiff be a “member” or an “assignee” of a limited liability company interest to bring a derivative action on behalf of an LLC. 

Facts and Procedural History

Defendant JetDirect Aviation Holdings, LLC (“JetDirect”), a Delaware limited liability company, was a private jet management and charter company.  In 2005, JetDirect began a series of transactions to acquire small and midsized competitor and charter service companies which left the company heavily leveraged.  Between 2006 and 2007, JetDirect’s officers and board of managers learned of “serious deficiencies” in the company’s accounting system and internal controls.  Nevertheless, the board continued its aggressive acquisition strategy.  In April 2007, on the basis of outdated information, CML V, LLC (“CML”) made a loan to JetDirect of approximately $26 million, which later increased to approximately $34 million.  Shortly thereafter, in June 2007, JetDirect defaulted on its loan obligations to CML, and by January 2008, JetDirect was insolvent and began to liquidate its assets.

CML filed a complaint in the Delaware Court of Chancery asserting derivative claims against JetDirect’s present and former managers for: (1) breach of the duty of care for their approval of transactions without informing themselves of JetDirect’s financial condition; (2) bad faith for consciously failing to implement adequate internal controls; and (3) breach of the duty of loyalty for benefitting from self-interested asset sales.  CML also brought a direct claim for money damages against JetDirect for breach of the loan agreement, but the parties agreed that the Court of Chancery would only have jurisdiction over the direct claim if any of the derivative claims survived a motion to dismiss.  The Court of Chancery granted JetDirect and the individual defendants’ motion to dismiss the claims on the basis that “CML, as a creditor, lacks standing to pursue derivative claims on behalf of JetDirect.”  CML appealed to the Delaware Supreme Court.

Delaware Supreme Court Ruling

CML advanced the following arguments on appeal: (1) the LLC Act does not deny creditors standing to bring derivative actions on behalf of insolvent LLCs and (2) if the LLC Act denies the Court of Chancery jurisdiction over such derivative actions, it places an unconstitutional limit on the Court of Chancery’s equitable powers.  The Delaware Supreme Court rejected both arguments.

The Delaware Supreme Court first addressed the plain language of § 18-1002 of the LLC Act, which provides:

In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and:

(1)  At the time of the transaction of which the plaintiff complains; or

(2)  The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transactions.

6 Del. C. § 18-1002.

The court reasoned that this provision is clear and unambiguous—only a member or an assignee of an LLC interest can bring a derivative action.  The court found it significant that § 18-1002 uses the term “must” be a member or assignee rather than “may”, and applies to “a derivative action” rather than “the derivative action.”  Although a different section of the LLC Act, § 18-1001, provides that a member or assignee “may” bring “the derivative action”, the court reasoned that § 18-1001 created the right to file a derivative action by members and assignees while § 18-1002 explicitly limited that right to members and assignees.  The court rejected CML’s argument that the General Assembly intended to take the corporate rule of derivative standing (which allows creditors of an insolvent corporation to sue derivatively) and apply it to the LLC context.  The court reasoned that the General Assembly is well suited to make a policy choice to deny derivative standing to creditors of an LLC, but allow such standing for creditors of a corporation, to promote business entity diversity.  The court further acknowledged the freedom of contract provided under the LLC Act.

The Delaware Supreme Court next rejected CML’s argument that limiting the Court of Chancery’s jurisdiction over derivative standing to members or assignees violates Article IV, Section 10 of the Delaware Constitution.  Under Delaware law, the General Assembly cannot limit the equity jurisdiction of the Court of Chancery to less than the general equity jurisdiction of the High Court of Chancery of Great Britain when Delaware first ratified its constitution.  The court observed that, unlike a corporation, an LLC as an entity did not exist at the time of enactment of the Delaware Constitution.  Accordingly, the Delaware Constitution does not prevent the General Assembly from limiting the Court of Chancery’s jurisdiction over derivative claims to members and assignees of LLC interests.  Moreover, the LLC is a creature of statute and the LLC Act was passed “in derogation of the common law.”  Accordingly, common law may supplement, but cannot override, the LLC Act’s express provisions, including § 18-1002.  Finally, the court reasoned that CML had an ample remedy at law, as it could have negotiated remedies by contract.

Conclusion

In structuring a finance transaction, lenders should be mindful of the differences in lending to a corporation, LLC or other Delaware business entity.  The Delaware Supreme Court emphasized the flexibility of an LLC as a business entity, and the freedom of contract available to its creditors.  The court suggested adding provisions that would, in the event of insolvency, convert the creditor’s interests to that of an “assignee” or give the creditor control of the LLC’s governing body.  Such provisions, however, place a creditor at risk of being viewed as an “insider”, or having its debt recharacterized as equity if the borrower becomes insolvent and files for bankruptcy.  An alternative solution not mentioned by the court would be to include a contractual fiduciary duty to creditors in the LLC agreement (to the extent permitted by law), and provide that creditors are third-party beneficiaries of such provision with a right of enforcement.  The lender could also enter into an agreement directly with the managers of the LLC, outlining the managers’ duties and providing a mechanism for enforcement.  Time will tell whether creditors are able, by these or other measures, to create enforceable protections against LLC managers’ misdeeds.

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The Bankruptcy Court for the District of New Jersey (Kaplan, J.) recently held that hotel revenues (including revenues generated from room occupancy, food and beverage sales, catering, gift shop purchases, spa, and related hotel services) do not constitute “rent” within the meaning of the Third Circuit decision of In re Jason Realty, L.P., 59 F.3d 423 (3d Cir. 1995).  Therefore, even if they are absolutely assigned to the secured lender, hotel revenues can be used by the debtor as cash collateral to pay its ordinary and necessary operating expenses and to reorganize.  In re Ocean Place Dev., LLC, No. 11-14295 (Bankr. D.N.J. Mar. 31, 2011).

Ocean Place Development, LLC (“Debtor”) owned a 254-room beachfront resort in Long Branch, New Jersey, which included a large conference center, three restaurants, a bar/lounge, a full-service spa, and numerous other amenities.  Ocean Place owed approximately $58 million pursuant to the terms of its loan agreement with AFP 104 Corp., as successor to Barclays Capital Real Estate Inc. (“AFP”).  Repayment of the loan was secured by, among other things, a Mortgage and an Assignment of Rents and Leases (the “Assignment of Rents”).  Both the Mortgage and Assignment of Rents defined the term “rents” broadly, to include all “… revenues and credit card receipts collected from guest rooms, restaurants, bars, meeting rooms, banquet rooms and recreation facilities, all receivables, customer obligations, installment payment obligations and other obligations now existing or hereafter arising or created out of the sale, lease, sublease, license, concession or other grant of the right of the use and occupancy of the property or rendering of services by Borrower [Debtor] or any operator or manager of the hotel . . . .”

Following the Debtor’s default under the loan, AFP obtained a foreclosure judgment.  The Debtor filed a Chapter 11 petition before the scheduled foreclosure sale, and sought authority to use cash collateral consisting of hotel revenues.  AFP objected, and cross-moved for an order dismissing the Debtor’s case as a bad faith filing or, alternatively, for relief from the automatic stay to proceed with the foreclosure sale.  The Bankruptcy Court granted the Debtor’s request to use cash collateral, and denied AFP’s motion.

In a case of first impression, the Bankruptcy Court commenced its opinion with an analysis of whether hotel room revenues constitute property of the estate within the meaning of Section 541 of the Bankruptcy Code.  The Court framed its task as two-fold: (i) first, it had to decide whether a security interest in hotel room revenues constitutes an interest in realty or an interest in personalty that must be perfected and enforced under Article 9 of New Jersey’s version of the Uniform Commercial Code (“UCC”); and (ii) second, even if such interest was deemed personalty, whether the Debtor’s use of hotel revenues was consistent with Jason Realty. 

Article 9 governs transactions which create security interests in personal property or fixtures.  The Court found that the loan transaction in this case clearly was a “secured” transaction, as the loan documents granted the lender a security interest in the rents and leases and further stated that “Borrower [Debtor] intends for the security instrument to be a ‘security agreement’ within the meaning of the UCC.”  Additionally, the loan documents provided other indications of a secured transaction as they allowed: (i) the Debtor to collect rents as long as it was not in default of the mortgage; (ii) AFP to use post-default rents only to reduce the Debtor’s obligations to AFP; and (iii) for automatic termination of the Assignment of Rents after repayment of the loan. 

The Court then noted that Article 9 does not extend to interests in or liens on real property, including a lease or rents thereunder.  However, based on a case from the Bankruptcy Court for the Southern District of New York, In re Kearney Hotel Partners v. Richardson, 92 B.R. 95 (Bankr. S.D.N.Y. 1988), the Official Comments to the UCC and an examination of New Jersey statutes, the Bankruptcy Court concluded that hotel room revenues are “accounts” or “payment intangibles,” and not “rents.”  In so ruling, the Court adopted the distinction from those authorities between guests in hotel rooms, who are simply licensees, and tenants under a lease.  Thus, Judge Kaplan held that despite the definition of “rents” in the loan documents, hotel revenues are personal property included in the definition of property of the estate.

The Court then examined whether classifying hotel room revenue as personal property conflicts with the Third Circuit’s precedent in Jason Realty.  After discussing the background of Jason Realty, Judge Kaplan noted that case involved an absolute assignment of rents due from tenants of a two-story retail and office building, and not the assignment of receipts from a debtor’s operation of a hotel, restaurant or spa.  Additionally, the Court distinguished Jason Realty on the basis that the Third Circuit was tasked with assessing the “treatment of an assignment under New Jersey property law and the ensuing rights of an assignee arising under an absolute assignment of rents.”  Judge Kaplan, to the contrary, had to determine whether hotel room revenues should be treated as real property interests.  Because he determined that interests in hotel revenues should be treated as personalty under Article 9, he was not required to address whether “the assignment of rents absolutely vested title in AFP.”  Indeed, Judge Kaplan did not even necessarily dispute that the loan transaction evidenced both a security agreement and an absolute assignment of rents.  Based on his distinction of Jason Realty from the case before it in Ocean Place, Judge Kaplan declined to extend Jason Realty to personal property security interests, and allowed the Debtor to use its hotel room revenues as cash collateral so long as AFP remained adequately protected.

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The U.S. Bankruptcy Court for the District of Delaware recently extended the common-interest doctrine to pre-petition communications between the debtor and an informal committee of claimants in In re Leslie Controls Inc.  Gerald Gline and David Kohane, Members of Cole Schotz, and Jason Finkelstein, an associate at Cole Schotz, recently wrote an article for the American Bankruptcy Institute Journal about the common-interest doctrine's role in bankruptcy proceedings.  Click here to read the article.

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Over the last several years, there have been a series of decisions rendered by the federal courts of appeals that grappled with the application of §510(b) to a claim that does not readily fall within the statute’s language.  Click here to read about the continuing expansion of §510(b).

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In these days of economic uncertainty and write-offs, sellers should be aware of their right under Section 2-705 of the Uniform Commercial Code (UCC) to stop the delivery of goods in transit to an insolvent buyer who has not taken physical possession of the goods. “Insolvent,” within the meaning of the UCC, means that a buyer has “…generally ceased to pay debts in the ordinary course of business other than as a result of bona fide dispute ….” In some cases, litigation may be necessary to determine the issue of insolvency. Additionally, a buyer may refuse or defeat a demand to stop goods in transit where (a) it has actually received the goods in question, (b) a bailee of the goods (other than a carrier) acknowledges it is holding the goods for the buyer, (c) a carrier, through reshipment or warehousing, makes such acknowledgment to the buyer, or (d) the buyer has negotiated a negotiable document of title to the goods.

A seller’s right to stop in transit exists even where the buyer has filed for bankruptcy protection, as courts have held that a seller is not required to seek relief from the automatic stay provisions of the Bankruptcy Code before exercising its right to stop delivery. Moreover, because an effective stoppage of delivery divests the buyer of title to the goods at issue, goods purchased, but never received, by a buyer who has filed for bankruptcy protection, never become part of the bankruptcy estate.

Cole Schotz recently represented a client who stopped goods in transit to Fortunoff’s, which purchased a substantial amount of furniture and other merchandise on credit from various overseas sellers shortly before filing a Chapter 11 bankruptcy petition. In many cases, the bill of lading issued by the carrier provided that title to the goods passed to Fortunoff’s when they were loaded for delivery to New York. Upon learning of Fortunoff’s bankruptcy filing, many sellers (including our client), whose shipments had not yet arrived at Fortunoff’s New York warehouse facility, issued notices that they were stopping the shipments in transit pursuant to Section 2-705 of the UCC. The bankruptcy court in Fortunoff’s Chapter 11 case rejected Fortunoff’s argument that the passage of title and the application of the automatic stay rendered the sellers’ demands ineffective, and held that any goods that were the subject of a valid stop in transit demand were not property of Fortunoff’s bankruptcy estate.

As the Fortunoff’s example illustrates, a seller of goods to an insolvent buyer, including a buyer who has filed for bankruptcy protection, who seeks to minimize its losses should consider the stop in transit provisions of the UCC and seek relief in the bankruptcy court to ratify its actions.
 

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