Structured & Real Estate Finance Case Update

Willard Moore, Jason DeJonker, and Joshua Kurtz*

This update reports on recent legal opinions of relevance to commercial real estate lenders, developers and owners, with particular focus on state and federal court decisions involving litigation with respect to distressed or nonperforming assets.

In re Tousa1 vent, unless the transfer is for “reasonably The South Florida Bankruptcy Court in the equivalent value.” Fraudulent conveyances Tousa case ordered various creditors that may deprive a borrower's pre-existing credi- had benetted from a fraudulent conveyance tors of recourse to assets that they relied on to disgorge $421,000,000 to the jointly- in making loans to the borrower. Fraudulent administered Tousa bankruptcy estates. The conveyances are legally reversible because court also ordered the avoidance of liens on they remove assets from the borrower's bal- the assets of various Tousa subsidiary enti- ance sheet without replacing them with other ties who were also debtors in the bankruptcy assets of “reasonably equivalent value.” proceedings. This case may raise increased The parent debtor company in Tousa, focus upon the legal theory of fraudulent called Tousa Inc., had previously incurred conveyance, which was the rationale used by $500,000,000 in debt in an unsuccessful the bankruptcy court to order the money business venture. To renance that debt, it returned. arranged for itself and its subsidiaries to receive loans and to give liens in order to The two major elements of a fraudulent raise the money to repay its business debts. conveyance are that (1) a debtor makes a The subsidiaries, however, were not liable for transfer for less than reasonably equivalent the business debts being repaid. Conse- value and (2) the transfer either makes the quently, the Tousa subsidiaries did not bene- debtor insolvent or occurs at a time when t from the liabilities they incurred and the the debtor was already insolvent. In a nut- liens they gave in the debt renancing and shell, the doctrine of fraudulent conveyance loan transaction. (or fraudulent transfer) gives a legal remedy to pre-existing creditors when a borrower As Tousa has conrmed, the liabilities and makes transfers to third parties while insol- obligations incurred by subsidiaries in sup-

*Willard Moore and Jason DeJonker are partners at Seyfarth Shaw LLP. Mr. Moore represents lenders, developers, owners, and investors in a variety of real estate nancing transactions. Mr. DeJonker concentrates his practice on bankruptcy cases, pre-bankruptcy workout negotiations and compositions, troubled borrower restructur- ing and forbearance, and general commercial litigation. Joshua Kurtz is an associate in the Real Estate Practice Group. The authors may be contacted at [email protected], [email protected], and jkurtz@seyfarth. com, respectively.

The Real Estate Finance Journal E Fall 2010 © 2010 Thomson Reuters 59 The Real Estate Finance Journal port of their parent companies, often called fact, the junior lender had previously as- “upstream” obligations, are especially vulner- signed its note to another bank, Sovereign, able to fraudulent conveyance attack by and therefore no longer had an interest at disgruntled junior or unsecured creditors of a stake in the legal proceedings. The junior bankruptcy estate. As in Tousa, subsidiaries lender apparently did not notify either MERS may not fully benet from loans and liabilities or Sovereign when it received notice of the incurred for the sole benet of parent lawsuit. corporations. Thus, subsidiaries do not The use of MERS as a nominee is intended receive “reasonably equivalent value” for to facilitate the purchase and sale of mort- incurring liabilities or giving lien-backed gage loans. Lenders who put mortgages in guaranties of such loans. Moreover, such MERS's name retain equitable and economic new liabilities and obligations can render sub- ownership of their loans as well as servicing sidiaries insolvent if they are not so already. rights and obligations. MERS allows lenders to buy and sell interests in mortgage loans The court ruled that the business creditors with other MERS participants without having who had been repaid from the proceeds of to publicly record those transactions with the fraudulent loan transaction had to return county real estate oces. $421,000,000 of principal and interest received. Section 550 of the Bankruptcy Senior lender did not serve process upon Code allows for the disgorgement of pay- MERS or Sovereign. The foreclosure action ments made to a secondary transferee of a eventually culminated in a motion to conrm fraudulent transfer, or to the “entity for whose the results of a sheri's sale. Sovereign and benet such transfer was made.” Here, Sec- MERS at that point became aware of the tion 550 allowed for recourse to the parties foreclosure proceedings and led motions to whose business debts had been repaid with intervene and to vacate the default judgment. the loan proceeds even though the fraudu- Because Sovereign has no recorded interest lent transfer itself was received by the lend- in the mortgaged property, its motion was ing banks. The liens placed on the subsidiar- denied. ies' assets were also avoided. At issue before the Kansas Supreme Court Landmark National Bank v. Kesler2 was whether the trial court had abused its discretion in ruling that MERS, as a non- A Kansas Supreme Court ruling concerned lender and holder of the junior mortgage in a dispute between real estate lenders with name only, was not a necessary party to the claims on the same collateral. In Kesler,a foreclosure proceedings and therefore not senior bank initiated a foreclosure action that entitled to join the proceedings or to seek to eventually terminated a junior mortgage on vacate previous court orders. By holding that the same property. The junior mortgage MERS was not so entitled, the trial court al- named Mortgage Electronic Registration lowed the foreclosure sale to stand and the Systems, Inc. (“MERS”) as mortgagee, but junior mortgage to be extinguished. only as “nominee” for the actual junior lender. Senior lender properly served process upon The Kansas Supreme Court in Kesler af- the junior lender, who failed to answer and rmed the lower ruling, holding that parties had a default judgment entered against it. In who do not hold a full range of substantive

The Real Estate Finance Journal E Fall 2010 © 2010 Thomson Reuters 60 Structured & Real Estate Finance Case Update economic rights in mortgage loans—such as borrowers put the loans in default at its “nominees” like MERS—are not “lenders” outset, triggering the repurchase obligations and therefore do not have economic interests of UBS under the UBS loan purchase that are prejudiced by default judgments. As agreement. such, there was no “abuse of discretion” in denying MERS's motions to vacate the UBS was not the originator of these loans, default judgment or to intervene in the case. but acquired some of them from Love Fund- ing Corporation pursuant to a separate loan The procedural posture of this case makes purchase agreement. Like the UBS loan it appear more unfriendly to nominees and purchase agreement, the Love Funding loan organizations like MERS than it actually is. purchase agreement contained an analogous The precise legal issue in Kesler was whether representation that none of the loans were in a trial court had “abused its discretion.” This default at the time of the transfer to UBS. question the court answered in the negative. The agreement also provided that Love The Kansas Supreme Court acknowledged Funding would indemnify UBS for any loss that MERS may have been technically entitled related to said breach. to receive service of process, but reasoned As part of the settlement arrangement be- that this precise question was not before it. tween the Trust and UBS, UBS assigned to The case calls renewed attention to the the Trust its rights under the Love Funding administrative and enforcement issues raised loan purchase agreement. The Trust subse- by the use of MERS as a nominee, issues quently sued Love Funding under the as- which some lenders may not have focused signed agreement from UBS. The U.S. District on during the origination process and Court for the Southern District of New York thereafter. ruled that the assignment was void for champerty because the Trust's primary Trust for the Certicate Holders of purpose in taking the assignment was to the Merrill Lynch Mortgage Investors, bring a lawsuit against Love Funding. The Inc. Mortgage Pass-Through decision was appealed to the U.S. Court of Certicates, Series 1999-C1 v. Love Appeals for the Second Circuit, which certi- Funding Corporation3 ed to the New York State Court of Appeals New York State's highest court claried certain questions relating to New York State's New York State's “champerty” statute and champerty statute. conrmed that the statute will not generally The New York State Court of Appeals prevent buyers of distressed debt from stated that New York's champerty statute is enforcing their remedies through litigation generally limited in scope and largely directed when pursuing a legitimate claim. toward preventing attorneys from ling suit In Love Funding, a REMIC Trust sued UBS merely as a vehicle to obtain costs. The court Real Estate Securities, Inc. to enforce its conrmed that the concept of champerty remedies under a loan purchase agreement, does not, therefore, apply when the purpose alleging that UBS's predecessor sold the of the assignment is the pursuit of a legiti- Trust several defaulted loans, and demand- mate claim. In the instant case, the court ing that they be repurchased. The Trust as- found the champerty doctrine inapplicable, serted that certain frauds committed by the because the Trust, as holder of a defaulted

The Real Estate Finance Journal E Fall 2010 © 2010 Thomson Reuters 61 The Real Estate Finance Journal loan, would directly suer the damages of a receiving J-51 benets, not to properties that default. If, as a matter of fact, the Trust's were already rent stabilized prior to receiving purpose in taking assignment of UBS's rights J-51 benets. under the Love Funding loan purchase agree- In the instant action, MetLife applied for ment was to enforce its rights, then it did not J-51 benets in 1992, which was more than violate New York's champerty statute. 20 years after the property became subject to the RSL. Thereafter, the luxury decontrol Roberts v. Tishman Speyer provisions of the RSL were enacted and, with Properties, L.P.4 DHCR's approval, MetLife began charging New York State's highest court ruled that market rents for those rental units that the owner of the massive apartment com- purportedly satised the requirements for plexes known as Peter Cooper Village and luxury decontrol. In late 2006, after MetLife Stuyvesant Town in Manhattan improperly sold the properties to the Tishman Speyer overcharged rent to thousands of tenants. partnership, nine residents on behalf of a The court held that the current owner, a putative class of current and former tenants partnership of Tishman Speyer Properties sued MetLife and the Tishman Speyer part- and BlackRock Realty, and the former owner, nership for overcharging rent during the pe- Metropolitan Life, were not entitled to take riod when the landlord received J-51 tax advantage of the luxury decontrol provisions benets. Consistent with DHCR's interpreta- of the Rent Stabilization Law (“RSL”) while tion, MetLife and the Tishman Speyer part- nership argued, among other things, that the simultaneously receiving tax incentive ben- properties were not precluded from luxury ets under New York City's J-51 program. decontrol because the properties were rent The luxury decontrol provisions of the RSL stabilized prior to receiving J-51 benets. generally provide that rent-stabilized apart- Therefore, the properties did not “become ments cease to be subject to rent stabiliza- subject to the RSL by virtue of receiving J-51 tion if either: (1) in the case of a vacant apart- benets.” ment, the legal regulated rent equals $2,000 The court rejected DHCR's long standing per month or more; or (2) in the case of an interpretation of the J-51 exclusion to the occupied apartment, the legal regulated rent luxury decontrol provisions of the RSL and equals $2,000 per month or more, and the found that building owners that receive J-51 combined annual income of all occupants benets forfeit their rights under the luxury exceeds $175,000 per year for the two pre- decontrol provision even if the properties ceding calendar years. The luxury decontrol were already subject to the RSL. Accord- provisions of the RSL, however, exclude ingly, the court armed the decision of the housing accommodations which “became or Appellate Division to reinstating the tenants' become subject to [the RSL] by virtue of complaint. receiving [J-51] tax benets . . ..” For the last 13 years, the New York State Division of The court's decision leaves many open is- Housing and Community Renewal (“DHCR”), sues for the lower court to decide including, which administers the RSL, interpreted the the retroactive eect of its decision, the stat- J-51 exclusion to apply to properties that ute of limitations and class certication, became rent stabilized as a condition of among other defenses that may be applicable

The Real Estate Finance Journal E Fall 2010 © 2010 Thomson Reuters 62 Structured & Real Estate Finance Case Update to particular tenants. (Since the decision, the two years and was prepared to close on the parties have entered into a stipulation which sale. The Steins, however, refused to close resolves some of the issues with respect to and sued Paradigm for violating the ILSFDA the Peter Cooper Village/Stuyvesant Town by not providing them with a property report. complex, and provides for a consultant to Paradigm argued that it was exempt from the calculate permissible rents at that complex, requirements of the ILSFDA because the but the impact of the decision on many other contract obligated it to complete construction apartments in New York remains very within two years. unclear.) The lower court ruled in favor of the Steins, 5 Stein v. Paradigm Mirasol, LLC holding that Paradigm was not exempt from The United States Court of Appeals for the the ILSFDA because the contract's force ma- Eleventh Circuit issued a ruling clarifying the jeure clause and liquidated damages clause limits of the Interstate Land Sales Full Disclo- rendered Paradigm's obligation “illusory.” sure Act (“ILSFDA”), ruling that a contract of On appeal, the court reversed the lower sale of real property was exempt from the court's decision nding in favor of Paradigm. statute where plainti buyers had an ade- The court reasoned that the Steins had an quate remedy to force the defendant devel- eective remedy under the contract that oper to complete construction within two would threaten or inict enough damage to years. Paradigm to eectively obligate it to complete The ILSFDA, among other things, requires construction within two years. The court also developers selling property to provide pro- found that the force majeure clause did not spective purchasers with a property report transform Paradigm's obligation into an op- prior to the execution of a sales contract, un- tion because it relates to matters beyond its less the contract obligates the seller to erect control. In short, the court rejected the argu- the building within two years. ment that either of these provisions rendered Alan and Karen Stein entered into a con- the contract of sale voidable pursuant to the tract with Paradigm Mirasol, LLC for the sale ILSFDA and remanded in order for judgment of a residential condominium unit in Florida. to be entered in favor of Paradigm. Paradigm never gave the Steins a property CSFB 2001-CP-4 Princeton Park report but the contract obligated Paradigm to Corporate Center, LLC v. SB Rental complete construction within two years, I, LLC6 subject to two provisions analyzed by the court. The rst was the “force majeure” The Superior Court of New Jersey, Appel- clause, which excused construction delays late Division, conrmed that non-recourse provided they were caused by certain cir- carveouts in commercial mortgage loans are cumstances beyond the control of Paradigm. enforceable in New Jersey. The second provision was the “liquidated In CSFB, a commercial mortgage borrower damages” clause, which limited the Stein's granted a $400,000 second mortgage on real remedies to specic performance or return of property collateral without obtaining the their contract deposit. consent of the existing rst mortgage lender. Paradigm completed construction within The borrower satised the subordinate debt

The Real Estate Finance Journal E Fall 2010 © 2010 Thomson Reuters 63 The Real Estate Finance Journal in full after only seven months. The rst is “xed by the terms of the loan” and is mortgage loan was generally “non-recourse;” therefore neither “speculative nor however, following an uncontested foreclo- incalculable.” The court was not swayed by sure of the rst mortgage more than a year the defendant's “cure” of the breach by later, the rst mortgage lender asserted that satisfying in full the subordinate nancing the subordinate nancing triggered a non- long before the foreclosure on the rst recourse carveout provision in the loan docu- mortgage. ments, resulting in the borrower and guaran- The tors' becoming personally liable for the CSFB decision follows in the footsteps approximately $5 million loan balance remain- of pro-lender decisions by federal courts in 7 ing after the foreclosure sale. The court Illinois and Massachusetts. The decisions in agreed. CSFB, Heller, and Blue Hills suggest that courts may not require a lender to show In an attempt to invoke a judicial inquiry substantial, direct harm resulting from the into the “reasonableness” of the result, the triggering of a carveout provision before rely- borrower argued that the carveout provision ing on same to assert full personal liability was a liquidated damages clause and that against a borrower or guarantor. the application of personal liability for the full amount of the debt constituted an unenforce- NOTES: able penalty. The court rejected that argu- ment, nding that such non-recourse carve- 1Bankr. S. D. Florida, Oct. 13, 2009. outs are not liquidated damages provisions 2Kansas Supreme Court, Aug. 28, 2009. 3 because they “operate principally to dene New York Court of Appeals, Oct. 15, 2009. 4 the terms and conditions of personal liability, New York Court of Appeals, Oct. 22, 2009. 511th Cir., Sept. 30, 2009. and not to ax probable damages.” Also, the 6Superior Court of New Jersey, Appellate Division, court found that such carveout provisions Aug. 11, 2009. provide only for actual damages, namely the 7See Heller v. Lee, 2002 WL 1888591 (not reported in F.Supp.2d) (N.D. Ill. 2002); Blue Hills Office Park LLC deciency on the loan following the sale of v. J.P. Morgan Chase Bank, 477 F.Supp.2d 366 the collateral at foreclosure. Such an amount (D.Mass. 2007).

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