Developments in Distressed Lending

The Cases

TOUSA and Capmark both involved borrowers whose operations suffered during the recent recession. In each case, a borrower with well over $1 billion of outstanding obligations possessed non-performing illiquid real estate assets. Unable to meet their debt obligations, both companies filed for bankruptcy.

TOUSA

TOUSA Inc., a home-building company, entered bankruptcy together with certain affiliates obligated under a first-lien loan in the approximate principal amount of $832.5 million, secured by substantially all of TOUSA's assets. The company conceded that the collateral's value exceeded the amount of first-lien debt. Stipulated Final Order (I) Authorizing Limited Use of Cash Collateral Pursuant to Sections 105, 361 and 363 of the Bankruptcy Code and (II) Granting Replacement Liens, Adequate Protection and Super Priority Administrative Expense Priority to Secured Lenders at 7, No. 08-10928 (Bankr. S.D. Fla. June 20, 2008) (“TOUSA CCO”). In exchange for the debtors' use of cash collateral, the TOUSA lenders received adequate protection in the form of replacement liens, superpriority claims, payment of interest, fees and expenses, and a principal paydown of $175 million, with an optional additional paydown at the debtors' discretion. TOUSA CCO at 20-25.

TOUSA's unsecured creditors' committee and certain minority noteholders, who ultimately successfully pursued an avoidance action against secured creditors, filed objections to the proposed cash collateral order arguing that paydown of principal was more than adequate protection. The committee's objection was resolved and the cash collateral order was approved. That decision was appealed by parties, including the minority noteholders, who sought to remove paydowns from the adequate protection package. In affirming entry of the cash collateral order, the Southern District of Florida found that: 1) the noteholders lacked standing to appeal because they had no direct economic interest in the lenders' cash collateral; 2) the appeal was equitably moot because the order had been substantially consummated and excising a provision of the order could cause the product of intense negotiations to unravel; and 3) it lacked jurisdiction because potential disgorgement of principal payments prevented the order from being final and appealable. Aurelius Capital Master, Ltd. v. Tousa Inc., 2009 WL 6453077, at *7, *10, *16 (S.D. Fla. 2009).

Capmark

Capmark Financial Group Inc., a commercial real estate finance company, entered bankruptcy together with certain affiliates while obligated under a $1.5 billion term loan secured by mortgage loan assets. In exchange for their consent to the debtors' use of the cash generated by collateral, Capmark lenders received as adequate protection replacement liens, superpriority claims, fee and expense reimbursement, interest payments and quarterly principal payments from funds generated by the collateral on specified dates, less a cash cushion. Final Order (I) Authorizing Use of Certain Cash Collateral Postpetition and (II) Providing Adequate Protection to Prepetition Secured Parties in Connection Therewith at 11-14, No. 09-13684 (D. Del. Dec. 22, 2009) (“Capmark CCO”).

Due to the nature of Capmark's collateral, which were real estate loans made by Capmark to third parties that were being serviced and/or sold, it was anticipated that a significant amount of principal could be repaid during the four quarterly payments. To provide the unsecured creditors' committee some ability to limit the amount of principal payments made, the Capmark cash collateral order provided that the committee could move to terminate the payments after $400 million in principal was paid (though approval of such an order would terminate the debtors' ability to use cash collateral). Id. at 11-12, 28. There were no objections to the entry of the Capmark CCO.

Certification of Ability to Repay Principal Payments

Although the trend of paying principal as adequate protection is relatively new, the payment of interest is widely accepted as a form of adequate protection. In cases where cash interest is paid, unsecured creditors typically preserve their rights in the event that the secured creditor is later found to be undersecured (and, therefore, not entitled to post-petition interest under ' 506(b) of the bankruptcy code) or even unsecured (for example, as a result of an avoidance action), by negotiating for a provision in a cash collateral that provides for recharacterization of interest to principal in such an event. It rarely is a concern, given the relative size of interest payments, that the amount of interest paid under a cash collateral order would either exceed the amount of the secured creditor's interest in the collateral, or, even if the secured creditor were ultimately found to be unsecured, the size of ultimate distribution to unsecured creditors. As a result, although such orders typically have provisions regarding disgorgement, they tend to be very general in nature as the likelihood that recharacterization alone would not be a sufficient remedy is remote.

The payment of large amounts of principal dramatically increases the prospect that recharacterization alone would be insufficient if a secured creditor were later found to be undersecured or unsecured. In those circumstances, effective clawback procedures, which not only require disgorgement, but also account for the credit risk of lenders who receive cash payments, take on heightened importance. As a result, the cash collateral orders in both TOUSA and Capmark contained complex certification procedures that debt holders were required to comply with in order to receive principal payments.

As the representatives of the parties that would most directly be impacted in the event that disgorgement were required, the unsecured creditors' committee, not the debtors, was responsible for determining whether to accept lenders' certifications. Capmark CCO at 17; TOUSA CCO at 30-31. If the committee objected to a certification and that objection was not resolved consensually, the Capmark cash collateral order provided that the affected lender could appeal to the court. Capmark CCO at 17-18.

To address the general risk of disgorgement, certifications in TOUSA and Capmark contained an acknowledgement of the certifying lender's obligation to return paydowns it received if so ordered, as well as consent to personal jurisdiction over the lender by the bankruptcy court with respect to principal paydown disputes and consent to accept service of process. Capmark CCO at 14-16; TOUSA CCO at 26-29. To address the ability of a lender to repay should disgorgement be required, the certification also contained a representation that the lender maintained certain asset and liquidity levels keyed to its payment share.

As evidence of their ability to repay, lenders also were required to provide financial information to the creditors' committee to confirm their representations. To help lenders meet the financial requirements of the certifications, the TOUSA and Capmark orders permitted lenders to certify together with an “affiliate guarantor” if the affiliate was willing to be liable for potential disgorgement. This proved useful for special purpose lenders that did not maintain high liquid asset levels and families of funds that did not have the required financial information readily available on a fund-by-fund basis. Capmark CCO at 14-15; TOUSA CCO at 26. A simple provision in the Capmark cash collateral order also allowed the creditors' committee to agree, on a case-by-case basis, to alternate certification requirements, which served lenders that could not gather required information or signatures by applicable deadlines by allowing them to agree with the creditors' committee to extensions of time or alternate indicators of financial health. Capmark CCO at 18; TOUSA CCO at 30.

To facilitate the certification and paydown process, trading in the facility was frozen several weeks prior to each principal paydown so that the universe of potentially certifying lenders remained constant. Once submitted, the creditors' committee had several days to review and object to certifications, after which it provided the administrative agent with a final list of certified lenders. On the payment date, the debtors transferred the principal payment to the administrative agent, which distributed the money to certified lenders.

The aggregate amount of principal attributable to non-certifying lenders was placed into an escrow account maintained by the administrative agent and, from the estate's perspective, treated as repaid for all purposes including interest accrual. Capmark CCO at 20; TOUSA CCO at 31. The escrowed funds were held in ordinary deposit accounts, and, therefore, earned interest at rates well below the contract rate. However, because the principal had been repaid from the debtors' perspective, non-certifying lenders would be unable to recover the differential while their paydown share was held by the administrative agent.

Capmark lenders were required to reaffirm their certifications prior to each paydown for the sum of all prior principal payments received. This was true even if a certifying lender had sold its position, because the cash collateral order provided that lenders actually receiving a paydown would be liable for future disgorgement. Capmark CCO at 19. To track potential disgorgements, the administrative agent kept a register of payments received by certifying lenders and amounts in the paydown account. To facilitate that task, lenders choosing to certify were required to certify their entire position in the loan on each certification date.

Trading in Loans Subject to Principal Paydowns

Having both certifying and non-certifying lenders holding debt in the same facility raises issues for lenders and counterparties trading in the loan. In both TOUSA and Capmark, the majority of those issues were resolved through amendments to the applicable form of assignment and acceptance agreement. Foremost among the amendments was an acknowledgement by certified assignors, regardless of whether they continued to be lenders, that they remained bound by the cash collateral order and its attendant risk of disgorgement of amounts received prior to assignment.

The Capmark assignment documents also were amended to allow trading parties to record whether the interest being assigned had been the subject of a principal paydown or whether any related amount was held in the paydown escrow account. Non-certifying lenders assigning an interest in the loan were required by the Capmark cash collateral order to assign their ratable interest in the paydown escrow account, and the form of assignment and acceptance was modified to reflect this requirement.

Principal paydowns and associated disgorgement risk presumably affect pricing. For purchases from certified lenders, pricing issues should be relatively obvious, as any paydowns received would have reduced the outstanding principal balance of any loan purchased. For purchases from non-certified lenders, pricing issues are more subtle. In pricing non-certified debt, purchasers should consider that, as described above, prior principal payments would have been made into an escrow account that may earn minimal interest for a significant amount of time before the purchaser is able to certify and receive them.

Conclusion

Adequate protection principal payments are a flexible tool that debtors, secured lenders, and unsecured creditors can use to their advantage, and as a result, distressed lenders should look for this adequate protection trend to continue to develop in the future. Although principal paydowns present significant opportunity to lenders trading in the distressed debt market, the risks and burdens that accompany any paydown certification process should be considered. A well-drafted set of principal paydown procedures can benefit all parties-in-interest and be easy for sophisticated lenders to trade and experienced agents to administer.

Fredric Sosnick, the Practice Group Leader of the Bankruptcy & Reorganization Practice Group of Shearman & Sterling LLP, regularly represents debtors and secured creditors in Chapter 11 bankruptcies and out-of-court restructurings. Jill Frizzley is counsel and Robert Britton is an associate in the firm's Bankruptcy & Reorganization Practice Group.

Most participants in the distressed debt market for secured loans are familiar with the concept of adequate protection in bankruptcy. Typically, as part of a cash collateral order or an order approving a priming DIP loan, adequate protection is provided to secured lenders to protect against diminution in value of their security during a bankruptcy case. Although adequate protection often takes the form of replacement liens, superpriority claims, and payment of interest, fees, and expenses, the bankruptcy code allows it to take any form that results in the realization by secured lenders of the “indubitable equivalent” of their interest in collateral. 11 U.S.C. ' 361(3). Recently, in In re TOUSA Inc. (“TOUSA“) and In re Capmark Fin. Group Inc. (“Capmark“), secured lenders have received, as part of their adequate protection package, the right to obtain principal paydowns during a bankruptcy case.

Principal paydowns during a Chapter 11 case not only provide lenders with obvious benefit, but also could benefit debtors' estates by reducing interest expense in cases where secured creditors are oversecured. In such cases, pursuant to ' 506(b) of the bankruptcy code, the oversecured creditor would be entitled to receive post-petition interest at the applicable rate provided in the loan document through the effective date of the plan of reorganization, while debtors typically are required to hold their cash in bank accounts at approved financial institutions that have minimal risk and corresponding loan interest rates. 11 U.S.C. ' 345. The resulting negative interest spread, therefore, could be significant.

As illustrated by TOUSA and Capmark, when principal payments are made during a Chapter 11 case, the payments can be tailored to account for single or multiple payments of fixed or floating amounts under circumstances involving single or multiple liens. They can even be used when there is a threat of an avoidance action which could ultimately result in disgorgement of the payments.

The Cases

TOUSA and Capmark both involved borrowers whose operations suffered during the recent recession. In each case, a borrower with well over $1 billion of outstanding obligations possessed non-performing illiquid real estate assets. Unable to meet their debt obligations, both companies filed for bankruptcy.

TOUSA

TOUSA Inc., a home-building company, entered bankruptcy together with certain affiliates obligated under a first-lien loan in the approximate principal amount of $832.5 million, secured by substantially all of TOUSA's assets. The company conceded that the collateral's value exceeded the amount of first-lien debt. Stipulated Final Order (I) Authorizing Limited Use of Cash Collateral Pursuant to Sections 105, 361 and 363 of the Bankruptcy Code and (II) Granting Replacement Liens, Adequate Protection and Super Priority Administrative Expense Priority to Secured Lenders at 7, No. 08-10928 (Bankr. S.D. Fla. June 20, 2008) (“TOUSA CCO”). In exchange for the debtors' use of cash collateral, the TOUSA lenders received adequate protection in the form of replacement liens, superpriority claims, payment of interest, fees and expenses, and a principal paydown of $175 million, with an optional additional paydown at the debtors' discretion. TOUSA CCO at 20-25.

TOUSA's unsecured creditors' committee and certain minority noteholders, who ultimately successfully pursued an avoidance action against secured creditors, filed objections to the proposed cash collateral order arguing that paydown of principal was more than adequate protection. The committee's objection was resolved and the cash collateral order was approved. That decision was appealed by parties, including the minority noteholders, who sought to remove paydowns from the adequate protection package. In affirming entry of the cash collateral order, the Southern District of Florida found that: 1) the noteholders lacked standing to appeal because they had no direct economic interest in the lenders' cash collateral; 2) the appeal was equitably moot because the order had been substantially consummated and excising a provision of the order could cause the product of intense negotiations to unravel; and 3) it lacked jurisdiction because potential disgorgement of principal payments prevented the order from being final and appealable. Aurelius Capital Master, Ltd. v. Tousa Inc., 2009 WL 6453077, at *7, *10, *16 (S.D. Fla. 2009).

Capmark

Capmark Financial Group Inc., a commercial real estate finance company, entered bankruptcy together with certain affiliates while obligated under a $1.5 billion term loan secured by mortgage loan assets. In exchange for their consent to the debtors' use of the cash generated by collateral, Capmark lenders received as adequate protection replacement liens, superpriority claims, fee and expense reimbursement, interest payments and quarterly principal payments from funds generated by the collateral on specified dates, less a cash cushion. Final Order (I) Authorizing Use of Certain Cash Collateral Postpetition and (II) Providing Adequate Protection to Prepetition Secured Parties in Connection Therewith at 11-14, No. 09-13684 (D. Del. Dec. 22, 2009) (“Capmark CCO”).

Due to the nature of Capmark's collateral, which were real estate loans made by Capmark to third parties that were being serviced and/or sold, it was anticipated that a significant amount of principal could be repaid during the four quarterly payments. To provide the unsecured creditors' committee some ability to limit the amount of principal payments made, the Capmark cash collateral order provided that the committee could move to terminate the payments after $400 million in principal was paid (though approval of such an order would terminate the debtors' ability to use cash collateral). Id. at 11-12, 28. There were no objections to the entry of the Capmark CCO.

Certification of Ability to Repay Principal Payments

Although the trend of paying principal as adequate protection is relatively new, the payment of interest is widely accepted as a form of adequate protection. In cases where cash interest is paid, unsecured creditors typically preserve their rights in the event that the secured creditor is later found to be undersecured (and, therefore, not entitled to post-petition interest under ' 506(b) of the bankruptcy code) or even unsecured (for example, as a result of an avoidance action), by negotiating for a provision in a cash collateral that provides for recharacterization of interest to principal in such an event. It rarely is a concern, given the relative size of interest payments, that the amount of interest paid under a cash collateral order would either exceed the amount of the secured creditor's interest in the collateral, or, even if the secured creditor were ultimately found to be unsecured, the size of ultimate distribution to unsecured creditors. As a result, although such orders typically have provisions regarding disgorgement, they tend to be very general in nature as the likelihood that recharacterization alone would not be a sufficient remedy is remote.

The payment of large amounts of principal dramatically increases the prospect that recharacterization alone would be insufficient if a secured creditor were later found to be undersecured or unsecured. In those circumstances, effective clawback procedures, which not only require disgorgement, but also account for the credit risk of lenders who receive cash payments, take on heightened importance. As a result, the cash collateral orders in both TOUSA and Capmark contained complex certification procedures that debt holders were required to comply with in order to receive principal payments.

As the representatives of the parties that would most directly be impacted in the event that disgorgement were required, the unsecured creditors' committee, not the debtors, was responsible for determining whether to accept lenders' certifications. Capmark CCO at 17; TOUSA CCO at 30-31. If the committee objected to a certification and that objection was not resolved consensually, the Capmark cash collateral order provided that the affected lender could appeal to the court. Capmark CCO at 17-18.

To address the general risk of disgorgement, certifications in TOUSA and Capmark contained an acknowledgement of the certifying lender's obligation to return paydowns it received if so ordered, as well as consent to personal jurisdiction over the lender by the bankruptcy court with respect to principal paydown disputes and consent to accept service of process. Capmark CCO at 14-16; TOUSA CCO at 26-29. To address the ability of a lender to repay should disgorgement be required, the certification also contained a representation that the lender maintained certain asset and liquidity levels keyed to its payment share.

As evidence of their ability to repay, lenders also were required to provide financial information to the creditors' committee to confirm their representations. To help lenders meet the financial requirements of the certifications, the TOUSA and Capmark orders permitted lenders to certify together with an “affiliate guarantor” if the affiliate was willing to be liable for potential disgorgement. This proved useful for special purpose lenders that did not maintain high liquid asset levels and families of funds that did not have the required financial information readily available on a fund-by-fund basis. Capmark CCO at 14-15; TOUSA CCO at 26. A simple provision in the Capmark cash collateral order also allowed the creditors' committee to agree, on a case-by-case basis, to alternate certification requirements, which served lenders that could not gather required information or signatures by applicable deadlines by allowing them to agree with the creditors' committee to extensions of time or alternate indicators of financial health. Capmark CCO at 18; TOUSA CCO at 30.

To facilitate the certification and paydown process, trading in the facility was frozen several weeks prior to each principal paydown so that the universe of potentially certifying lenders remained constant. Once submitted, the creditors' committee had several days to review and object to certifications, after which it provided the administrative agent with a final list of certified lenders. On the payment date, the debtors transferred the principal payment to the administrative agent, which distributed the money to certified lenders.

The aggregate amount of principal attributable to non-certifying lenders was placed into an escrow account maintained by the administrative agent and, from the estate's perspective, treated as repaid for all purposes including interest accrual. Capmark CCO at 20; TOUSA CCO at 31. The escrowed funds were held in ordinary deposit accounts, and, therefore, earned interest at rates well below the contract rate. However, because the principal had been repaid from the debtors' perspective, non-certifying lenders would be unable to recover the differential while their paydown share was held by the administrative agent.

Capmark lenders were required to reaffirm their certifications prior to each paydown for the sum of all prior principal payments received. This was true even if a certifying lender had sold its position, because the cash collateral order provided that lenders actually receiving a paydown would be liable for future disgorgement. Capmark CCO at 19. To track potential disgorgements, the administrative agent kept a register of payments received by certifying lenders and amounts in the paydown account. To facilitate that task, lenders choosing to certify were required to certify their entire position in the loan on each certification date.

Trading in Loans Subject to Principal Paydowns

Having both certifying and non-certifying lenders holding debt in the same facility raises issues for lenders and counterparties trading in the loan. In both TOUSA and Capmark, the majority of those issues were resolved through amendments to the applicable form of assignment and acceptance agreement. Foremost among the amendments was an acknowledgement by certified assignors, regardless of whether they continued to be lenders, that they remained bound by the cash collateral order and its attendant risk of disgorgement of amounts received prior to assignment.

The Capmark assignment documents also were amended to allow trading parties to record whether the interest being assigned had been the subject of a principal paydown or whether any related amount was held in the paydown escrow account. Non-certifying lenders assigning an interest in the loan were required by the Capmark cash collateral order to assign their ratable interest in the paydown escrow account, and the form of assignment and acceptance was modified to reflect this requirement.

Principal paydowns and associated disgorgement risk presumably affect pricing. For purchases from certified lenders, pricing issues should be relatively obvious, as any paydowns received would have reduced the outstanding principal balance of any loan purchased. For purchases from non-certified lenders, pricing issues are more subtle. In pricing non-certified debt, purchasers should consider that, as described above, prior principal payments would have been made into an escrow account that may earn minimal interest for a significant amount of time before the purchaser is able to certify and receive them.

Conclusion

Adequate protection principal payments are a flexible tool that debtors, secured lenders, and unsecured creditors can use to their advantage, and as a result, distressed lenders should look for this adequate protection trend to continue to develop in the future. Although principal paydowns present significant opportunity to lenders trading in the distressed debt market, the risks and burdens that accompany any paydown certification process should be considered. A well-drafted set of principal paydown procedures can benefit all parties-in-interest and be easy for sophisticated lenders to trade and experienced agents to administer.

Fredric Sosnick, the Practice Group Leader of the Bankruptcy & Reorganization Practice Group of Shearman & Sterling LLP, regularly represents debtors and secured creditors in Chapter 11 bankruptcies and out-of-court restructurings. Jill Frizzley is counsel and Robert Britton is an associate in the firm's Bankruptcy & Reorganization Practice Group.