A federal district court’s opinion in Meridian Sunrise Village v. NB Distressed Debt Investment Fund Ltd. is one of the most important recent decisions for distressed debt investors and loan investors generally. It is also one you haven’t probably heard of. Indeed, but for a brief mention in one of Bill Rochelle’s invaluable columns on Bloomberg Law a few weeks back, I would have missed it myself.
The case involves a relatively small loan, of about $75 million, with U.S. Bank as lead agent and lots of others taking subsidiary roles in lending the money to the debtor. The loan agreement looks to be pretty standard for anyone who has seen a few syndicated loan agreements. But it nonetheless seems to have thrown the federal courts in Washington State for a bit of a loop.
The problems began when Bank of America sold its piece of the loan to a distressed debt fund. The debtor normally had a right to approve transfers of the loan - subject to the usual rule that consent could not be unreasonably withheld, whatever that means - but the right to consent went away when the debtor was in default. Thus, the debtor being in Chapter 11 would seem to remove any barriers to Bank of America’s move.
But the bankruptcy court, and then the district court, disagreed. The problem, as they saw it, was that the loan agreement limited loan transfers to “financial institutions.†And the courts in Washington tell us that hedge funds are not “financial institutions†â€" something that may come as a bit of a surprise to the drafters of the Dodd-Frank Act.
The court’s argument that financial institutions should be interpreted as entities that make loans almost proves the point, as hedge funds are increasingly making direct loans themselves. And did the court really mean to say that a mutual fund or an exchange traded fund could not buy a stake in this loan?
The clause in question might have more reasonably been interpreted to prohibit assignment of the loan to individual investors. But the Washington courts did not seem to be too worried about the broader context in which this loan exists.
The opinion further faults the distressed debt fund for selling part of the stake it got from Bank of America to another fund. Apparently, the courts viewed this as an attempt to manipulate the Bankruptcy Code’s voting rules, which turn on getting approval by creditors in a class “that hold at least two-thirds in amount and more than one-half in number of the allowed claims of such class.â€
Of course, if the debtor is going to issue debt that generally can be transferred, this sort of thing is bound to happen. One doubts that the courts would have objected if a bondholder sold half of its holdings to another creditor, but somehow the result seemed to change once we were talking about a loan agreement.
If the debtor could show the loan traded in smaller increments deliberately to manufacture a block, that’s one thing, but instead the court blithely adopts a blanket prohibition on breaking up original positions in loans. Something lenders might want to keep in mind next time they make a loan to a Washington-based company - the ability to trade the loan has been greatly diminished.
The opinion of the United States District Court in Tacoma is problematic for many other reasons as well. For example, we are told that the lender group “forced Meridian into a nonmonetary default†based on the debt coverage covenants. Others would call that the terms of the deal, without any “force†whatsoever, but I digress.
Why is the opinion important? Because you can expect to see it in a Chapter 11 case soon. After all, this is an appellate decision that gives the debtor a great big club against its lenders. Why not try to use it?
Stephen J. Lubben is the Harvey Washington Wiley Chair in corporate governance and business ethics at Seton Hall Law School and an expert on bankruptcy.
