Calling the 21st century: Competition, consolidation, and convergence

Continued from last page

The definition of a "fraudulent transfer" leaves plenty of discretion to the judge. In applying the "fair consideration" or "reasonably equivalent value" tests, courts can be skeptical of indirect or secondary benefits that allegedly accrued to an insolvent borrower. If the other "fraudulent transfer" tests were met, the court might invalidate and set aside a Property-Specific Mortgage. In that case, Lender would become, at best, an unsecured creditor and, at worst, might find that some or all of the Portfolio Loan could not be enforced against the particular Property Owner.

Lenders can add language and structural elements to their loan documents to reduce the "fraudulent transfer" risk in several ways. How far to go depends on the particular Lender's concern about the particular borrower group and the marketplace at the time - i.e., whether the next lender down the street would be willing to overlook this risk and save the borrower some attorneys' fees and potentially some risk. The following discussion summarizes some steps a Lender might take to mitigate the "fraudulent transfer" risk in transactions of this type. 1). Liability Limitation - The loan documents can limit each Property Owner's liability for the Portfolio Loan to the maximum amount of liability that Property Owner can bear without becoming insolvent. Provisions of this type are common in corporate loans guaranteed by all the subsidiaries in a group of companies. They should reduce, but do not necessarily eliminate, the "fraudulent transfer" risk. A court bent on invalidating a Property-Specific Mortgage might decide the liability limitations are self-serving and formalistic and do not alter the underlying substance of the Portfolio Loan. Lender and its counsel would, of course, disagree. The court might also decide that the liability limitations, as written, did not limit liability enough to fully prevent insolvency.

2). Effect of Nonrecourse Clause - Because the Portfolio Loan is nonrecourse for each Property Owner, such Property Owner will, by definition, normally have no meaningful liability or exposure for the Portfolio Loan beyond the value of its interest in its Property. Each Property Owner's liability is automatically limited, in most cases, to (the value of) its Property. Regardless of how much nominal "liability" any Property Owner appears to have assumed for the Portfolio Loan, that liability is meaningless to the extent it exceeds the value of the Property. A Lender can therefore reasonably argue that, by definition, the Portfolio Loan could not possibly have rendered any Property Owner "insolvent."

That argument may, however, suffer the same judicial response as the liability limitations discussed above. Moreover, bankruptcy would introduce another layer of uncertainty and complexity, because for purposes of Chapter 11 reorganizations, a "nonrecourse" claim will often automatically become a "recourse" claim. But even so, if Property Owner is a single-purpose entity that has only one asset, the Property, totally encumbered by the Property-Specific Mortgage, how can one say Property Owner has any meaningful liability beyond the value of the Property? The answer may depend, in part, on the nature and magnitude of the entity's other creditors (if any).

3). Format Contribution Agreement - All Property Owners can enter into a formal contribution and indemnity agreement. This agreement could be built into the loan documentation or stand alone. Either way, it would amount to a mutual aid pact among Property Owners. If any one Property Owner ever paid more than its share of the Portfolio Loan, it could look to the other Property Owners for help on an equitable basis. This agreement would try to give each Property Owner an identifiable and formal "contingent asset" to balance out the "contingent liability" created by potentially disproportionate liability for the Portfolio Loan.

A contribution and indemnity agreement could help prevent insolvency of any individual Property Owner. It would do this by having all Property Owners acknowledge, formalize, and strengthen whatever informal contribution rights they would otherwise have among themselves. The value of this approach depends, in part, on the value of the reimbursement claims among Property Owners.

A mutual-aid agreement probably further diminishes the "fraudulent transfer" risk, but may not eliminate it. In addition, any reimbursement rights among Property Owners would need to be subordinate to Lender's Loan and could raise other issues. And, if the entire group of Property Owners becomes insolvent in the aggregate, the mutual aid pact will not help.

4). Structuring and Disbursement - When Lender documents and disburses the Portfolio Loan, Lender can try to demonstrate on paper why a court should allocate the Portfolio Loan among the various Property Owners and not treat it as a huge liability that overwhelms the assets of any individual Property Owner. For example, Lender can:

Disburse the Portfolio Loan in pieces to the various Property Owners, in recognition that courts have invalidated loans where the lender could not show that the loan proceeds were disbursed to the actual borrower.

Require the various Property Owners to execute separate notes evidencing their shares of the Portfolio Loan. Each note would be secured by a first mortgage executed by the corresponding Property Owner. Then each Property Owner would grant a second mortgage to secure only the entire Portfolio Loan except the part represented by the specific Property Owner's individual promissory note.

Establish a record to show that the parties agree and believe in good faith that when the Portfolio Loan is considered and reasonably allocated as a whole, each individual Property Owner remains solvent.

Although these documentation and disbursement measures may help, they may be less likely to help prevent or diminish "fraudulent transfer" problems than the measures previously described.

5). Indemnity to Lender - All Property Owners and their partners (and other affiliates?) can indemnify Lender against any fraudulent transfer risks that might affect any one Property Owner. These indemnities could be secured by all the mortgages on all the Properties, as well as by pledges of all the equity in the deal. Although this arrangement does not provide any meaningful credit enhancement to protect against the fraudulent transfer risk, it does at least make it hard for any borrower affiliate to use the "fraudulent transfer" argument against Lender selectively, for any particular Property.

In deciding whether to require equity pledges, though, a Lender needs to remember that this security device raises its own issues and concerns, primarily relating to the reliability of the security package and what a lender can realistically do if the Portfolio Loan ever goes into default. Also, the equity pledges might themselves be subject to fraudulent transfer attack, depending on the overall ownership structure of the equity owners.

6). Global Bankruptcy - If any one Property Owner were subjected to bankruptcy proceedings or a "fraudulent transfer" action, the circumstances would probably have already allowed Lender to declare a default on the entire Portfolio Loan, against all the Property Owners. Lender might go a step further and say in the loan documents that commencement of any fraudulent transfer proceedings against any Property Owner would automatically allow Lender to accelerate the Portfolio Loan. Any such acceleration would, in all likelihood, force all other Property Owners into bankruptcy proceedings, if they were not already.

Lender might prefer a single global bankruptcy for all Property Owners as opposed to separate "fraudulent transfer" actions affecting each Property Owner. In a global bankruptcy, the court might treat the assets and liabilities of all Property Owners as if they were assets and liabilities of one entity a "substantive consolidation." This would support a single-entity fraudulent transfer analysis that would probably benefit Lender by tending to validate the entire structure. Moreover, based on how particular Property Owners conducted their affairs, the particular facts might provide further basis for substantive consolidation.

Substantive consolidation is, however, a rather flexible and unpredictable legal doctrine. How and when to apply it depends very much on the discretion of the particular bankruptcy judge. It would depend on the particular facts and the positions taken by the unsecured creditors in the case.

source: find articles.com

next>>