June 8, 2020
By: Steve Jakubowski
In the ten years before COVID-19, the national and global economy, along with business optimism, steadily improved. Some businesses, of course, failed as competitive pressures or mistaken assumptions led to missed projections, blown covenants, loan defaults, and financial restructuring, if not outright liquidation.
But a prudent ABL lender typically suffered little in a properly underwritten loan, even in a wind down. Receivables remained generally collectible, inventory readily converted into receivables, and machinery and equipment was salvageable at auction.
Often, an ABL borrower (“OpCo”) would lease its operating facility from a single-purpose real estate entity (“PropCo”), with OpCo and PropCo sharing common ownership. Bifurcating operating and real property assets enabled the common owner to finance a significant portion of its acquisition or development plans at commercial mortgage rates rather than ABL rates.
For its part, the ABL lender benefited because more favorable operating lease terms meant improved OpCo’s cash flows and margins. The ABL lender took additional comfort in the fact that the landlord’s owner had a vested interest in the ABL borrower’s success.
To secure the most favorable commercial mortgage rates, the owner often raised high-yield mezzanine debt at PropCo’s parent (the “mezz borrower”), secured by a pledge of the mezz borrower’s equity interests in PropCo. The mezz borrower would then contribute these proceeds to PropCo to support a favorable commercial mortgage at PropCo.
If OpCo’s liquidity dried up, the mezz lender was often was the first casualty of OpCo’s expenditure cutbacks. With the consent of the ABL lender and the mortgage lender, OpCo and PropCo would amend the real property lease to reduce OpCo’s outlay to an amount necessary to keep the mortgage lender current, but not the mezz lender.
The intercreditor agreement between the mortgage lender and the mezz lender would sanction this move. That agreement would also prevent the mezz lender from taking any significant action to recover on its claim other than foreclosing on the equity pledge. While such a move would terminate the intercreditor agreement between the mezz lender and the mortgage lender, foreclosure alone did little to improve the mezz lender’s leverage since property valuations pre-COVID supported full recovery for the mortgage lender, even in a contested bankruptcy.
The mezz lender’s options pre-COVID, therefore, were limited. If it foreclosed on the pledged equity interests in PropCo, it could—as PropCo’s new owner—declare the lease in default. But that would only trigger a default under the senior mortgage, thereby risking foreclosure of PropCo’s underlying real estate through a credit bid by the mortgage lender. Unless the mezz lender was willing to assume the entirety of the senior mortgage at face value, the mezz lender’s investment would be wiped out. With properties generally selling in foreclosure at prices sufficient to take out the mortgage lender, but not much more, there was little incentive for the mortgage lender to accept a discounted payoff. Pre-COVID, therefore, the mezz lender stood the greatest chance of suffering a near total loss from a failing OpCo.
Yet from the ABL lender’s perspective, even if OpCo failed, full recovery seemed assured, especially given the “landlord waiver” and related intercreditor agreements by and among the ABL Lender, PropCo, and the mortgage lender. Together, these agreements allowed an ABL lender use of the premises for up to 90 to 120 days in order to liquidate its collateral through an orderly wind down.
The economic shocks from the COVID crisis, however, have upended commercial property valuations across a wide array of business sectors. REITs in the retail, entertainment, office, hospitality, and lodging industries are down 30-40% percent to date. An orderly liquidation of any single asset in these depressed sectors would likely bring significantly less. “Uncertainty is the overwhelming problem,” the Nobel Prize-winning economist Paul Romer stated in looking at the COVID crisis from an economic perspective.
In this uncertain valuation environment, beware the revenge of the foreclosing mezz lender. Its most likely move after a foreclosure of the equity pledge would be to cause PropCo to file a chapter 11 bankruptcy petition with the goal of confirming a reorganization plan that “crams down” the suddenly undersecured mortgage lender to the current value of the property. Such a cram down might also credibly propose stretching the maturity of the mortgage loan for another five to ten years at prime plus 1% and extinguishing the lender’s unsecured deficiency claim through a new capital infusion.
The mortgage lender can try to preserve the right to future appreciation in the property’s value by electing to have its entire claim be treated as secured under Bankruptcy Code section 1111(b)(2), but that benefit often comes at the expense of a significantly longer maturity. Certainly, the potential loss of upside appreciation from such an election might deter the mezz lender from pursuing this revenge strategy. But it won’t always.
Should the mezz lender seek such a bankruptcy cram down of the mortgage lender, the bankruptcy judge will have to sort through the credibility of reports and testimony from dueling valuation experts. One judge privately commented that selecting the appropriate valuation from among competing testimonies “often means kicking a field goal somewhere between two competing valuations.” But as anyone living through recent Chicago Bears football knows all too well, some kickers do hit the goalpost consistently.
Pursuing an aggressive bankruptcy strategy provides the mezz lender with certain intangible benefits. By establishing its resolve in one distress situation, it bolsters its reputation for toughness across its entire portfolio. Further, even if the mezz lender surrenders and is wiped out in the mortgage lender’s subsequent foreclosure, the mezz lender is not much worse off than it would have been had it done nothing. At least it was in control of its own destiny, with the only real costs being for lawyers and experts.
ABL lenders, therefore, should take note of PropCo’s disruptive potential. Once in bankruptcy, PropCo can reject not only the OpCo lease, but the “Landlord Waiver” too. Without such a waiver, the ABL lender will surely face a much steeper challenge in realizing projected collateral values.
In sum, today’s uncertain valuation environment has shifted leverage in favor of well-capitalized mezz lenders that are comfortable with a “loan-to-own” strategy. ABL lenders need to beware the revenge of the mezz lender and should reexamine their intercreditor agreements in light of this shifting leverage, especially since bankruptcy courts are reluctant to enjoin or rewrite contractual rights of non-debtor parties to an intercreditor agreement.
Should an ABL lender have no intercreditor agreement with PropCo’s mezz lender, then it should consider demanding one as a condition to making further advances or accommodations. If that agreement does exist, then the ABL lender should make sure the agreement continues in force even after the mezz lender forecloses on the pledge of equity interests in PropCo.
In bankruptcy, rights can be abridged on shortened notice. Silence is often considered assent. Being prepared for potential bankruptcy litigation is important to managing risk. To that end, the advice first documented by Sir Henry De Bracton in his 1240 legal treatise still rings true today: “An ounce of prevention is worth a pound of cure.”