Structured Finance and Securitization Update
In a recent decision, the United States Bankruptcy Court for the Southern District of New York ruled that a certificateholder of two CMBS securitization trusts ("CMBS Trusts") had no standing to be heard in a chapter 11 case involving the borrowers under a securitized mortgage loan held by the CMBS Trusts. The case, In re Innkeepers USA Trust, et. al. (Case No. 10-13800) (SCC), involves hotel company Innkeepers USA Trust and certain of its debtor affiliates ("Innkeepers" or the "Debtors"). Appaloosa Investment Fund L.P. I and related investment vehicles (collectively, "Appaloosa"), held more than $200 million in principal amount of CMBS certificates in the CMBS Trusts that owned in equal parts a mortgage loan made to Innkeepers. Appaloosa sought to oppose the Debtors’ motion seeking authority to enter into an equity commitment agreement with asset management firm Five Mile Capital Partners LLC ("Five Mile") and creditor Lehman ALI Inc. ("Lehman"), and the Court"s authorization of bid procedures for a competitive auction of the Debtors" assets (the "Stalking Horse Motion").
On March 11, 2011, the Court approved the Stalking Horse Motion and held that Appaloosa's status as a CMBS certificateholder did not give it standing as a "party in interest" under section 1109(b) of the United States Bankruptcy Code to be heard on the motion, and that the "no-action" clause of the pooling and servicing agreements (together, the "PSA") that govern the CMBS Trusts also barred Appaloosa from appearing in the proceeding.
The Innkeepers decision on standing has meaningful implications for participants in commercial mortgage securitization transactions.
Section 1109 of the Bankruptcy Code
Section 1109(b) of the Bankruptcy Code provides that a "party in interest" may raise and be heard on any issue in a bankruptcy proceeding. Although the Bankruptcy Code does not define that term, section 1109(b) provides a nonexhaustive list of who may be considered a "party in interest." That list includes the debtor, the trustee, a creditor or a creditors' committee, an equity security holder or an equity holders' committee, and an indenture trustee.
Innkeepers owns and operates dozens of hotels through a number of special purpose vehicles. Its capital structure includes $1.29 billion of property-level secured debt, consisting of (i) an approximately $825 million fixed rate loan (the "Securitized Loan"), secured by mortgages on 45 of the Debtors' hotel properties and held in the two CMBS Trusts in which Appaloosa is an investor; (ii) an approximately $250 million floating rate mortgage loan (the "Floating Rate Loan"), secured by mortgages on 20 of the Debtors' hotel properties and held by Lehman, and an approximately $118 million junior mezzanine loan; and (iii) seven additional mortgage loans, each secured by an individual hotel property. The PSA pursuant to which the Securitized Loan is held designates Midland as the special servicer, responsible for administering defaulted loans. Like most CMBS pooling and servicing agreements, the PSA requires Midland to adhere to a servicing standard that requires it to consider the interests of all certificateholders as a collective whole.
Following defaults on several of its loan obligations, Innkeepers filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code in July of 2010. After an initial restructuring proposal was denied by the Court, the Debtors filed the Stalking Horse Motion in January 2011. The motion contemplated an enterprise level transaction sponsored by Five Mile and Lehman (the "Five Mile/Lehman Bid"), involving the entire Innkeepers portfolio of hotels, and a reduction of the Debtors' overall debt by approximately $350 million. Of that debt reduction, the majority would come from the reduction of the principal amount of the Securitized Loan, from $825 million to $622.5 million, which reduction was agreed to by Midland as special servicer on behalf of the CMBS Trusts. In addition, Midland agreed to provide "stapled financing" to fund the stalking horse bid or any other qualified bid that satisfied certain conditions, including a cash payment to Lehman, holder of the Floating Rate Loan, of no less than $200.3 million. Under the terms of the Five Mile/Lehman Bid, other qualified bidders could offer competing bid proposals, but bids for less than the entire enterprise would not be automatically qualified.
Several parties, including Appaloosa, filed objections to the Stalking Horse Motion, contending, among other things, that the Five Mile/Lehman Bid was not in the Debtors' best interests and that the proposed bid procedure would impede competitive bidding by discouraging bidding on individual hotel assets. By the time of the hearing on the motion, the terms of the initial Five Mile/Lehman Bid had been revised, among other things, to exclude the seven individually mortgaged hotels and to eliminate a proposed break-up fee, and all objections other than those of Appaloosa had been withdrawn.
Both the Debtors and Midland argued that Appaloosa lacked standing as a certificateholder to object to the Stalking Horse Motion. Appaloosa asserted, among other things, that the term "party in interest" should be interpreted broadly, and that section 1109(b) afforded it an "unqualified right" to be heard to protect its significant financial stake in the outcome of the case, particularly where Midland, as special servicer, did not, in Appaloosa's view, adequately represent its interests.
The Court’s Decision
On March 11, 2011, the Court approved the Stalking Horse Motion. The Court also held that Appaloosa, as a certificateholder, was not a section 1109(b) party in interest with standing to object to the motion,1 and that the express “no action” language of the PSA also barred Appaloosa’s appearance.
Noting that the Bankruptcy Code does not define "party in interest," the Court looked to Second Circuit case law, which generally has defined "party in interest" as one who has a sufficient interest in the outcome of the case that would require representation, or a pecuniary interest that will be directly affected by the case. The Court observed that while section 1109(b) generally has been interpreted broadly in the Second Circuit, party in interest standing has not been afforded where a party lacks a direct pecuniary relationship with the debtors.
Specifically, the Court determined that it was bound by the Second Circuit’s ruling in Krys v. Official Comm. of Unsecured Creditors (In re Refco Inc.), 505 F.3d 109 (2d. Cir. 2007), which held that a creditor of a creditor is not a party in interest within the meaning of section 1109(b). In Refco, the Second Circuit determined that investors in a nondebtor segregated portfolio company, or SPC, lacked standing to object to a settlement between the SPC and the unsecured creditors of the debtors because the SPC, and not its investors, had the direct relationship with the debtors. The Innkeepers Court also relied on In re Shilo Inn, Diamond Bar LLC (In re Shilo Inn), 285 B.R. 726 (Bankr. D. Or. 2002), which held that the trustees of CMBS trusts, and not the certificateholders of those trusts, were entitled to vote on a plan of reorganization of the borrowers under mortgage loans owned by the trusts. In that court's view, the claims against the Shilo debtors belonged to the securitization trusts, as the direct creditors of the debtors, and not to the individual certificateholders, and a certificateholder vote was further barred by language in the pooling and servicing agreements giving the right to vote to the servicer.
Applying the reasoning of Refco and Shilo Inn, the Court determined that because a certificateholder is a beneficiary and a creditor of the CMBS Trusts, with no right to payment directly from the Debtors, Appaloosa is akin to a "creditor of a creditor," lacking privity with the Debtors that would confer party in interest standing.
The Court also held that the "no-action" clause of the PSA barred Appaloosa from seeking standing independent of Midland, the special servicer. The no-action clause in the Innkeepers' PSA, as is typical in CMBS transactions, generally prohibits a certificateholder from instituting any action under the PSA or relating to a loan held by the CMBS Trust unless specified conditions are met,2 and states that no certificateholder has "any right in any manner whatsoever … to enforce any right under this Agreement, except in the manner herein provided." According to the Court, granting standing to Appaloosa in contravention of that clause would not only override the terms of the PSA, but would change the bargained-for terms and risks CMBS investors assume when they buy a CMBS security. Specifically, certificateholders would be encouraged to hire their own counsel to advance their individual and often conflicting pecuniary interests in bankruptcy cases, rendering the delegation to special servicers meaningless, and potentially causing chaos in what the Court described as an "already tumultuous CMBS market."
Finally, the Court rejected Appaloosa's argument that an expansive interpretation of section 1109(b) was warranted because Midland was not (in Appaloosa's view) adequately representing Appaloosa’s interests as a certificateholder. In the Court's view, if Appaloosa believed that Midland was in breach of its PSA obligation to act in the interests of certificateholders "as a collective whole," Appaloosa could pursue a remedy for that breach in another forum.
1 Appaloosa is also a lender under the Innkeepers senior secured debtor-in-possession financing agreement, and an owner of preferred shares in debtor Innkeepers Trust USA. The Court noted that even though Appaloosa had standing to be heard in its capacities as a preferred shareholder and as a DIP lender, the Stalking Horse Motion did not directly affect Appaloosa’s interests in those capacities.
2 To satisfy these conditions, a certificateholder must give the CMBS Trust trustee a written notice of a default under the PSA, certificateholders possessing at least 25% of the certificateholder voting rights must request the trustee to institute the action, and the trustee must have failed to institute the action for at least 60 days.
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This Sidley Update has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers.
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