Fri 02/05/2021 15:33 PM
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Reorg’s Court Opinion Review provides an update on recent noteworthy bankruptcy and creditors’ rights opinions, decisions and issues across courts. Today we consider the default litigation in the CBL & Associates case, the clash between state law and the Bankruptcy Code in the NRA chapter 11 and the upcoming two-day Belk bankruptcy.

A Hot Topic for REITs

A few weeks ago we discussed the conflict between term loan agent Wells Fargo and the CBL & Associates debtors in the context of the mall REIT’s cram-up plan. Now that mediation has failed to resolve the dispute and a multi-day trial has begun, let’s talk about the litigation between the debtors and Wells Fargo. Depending on the outcome, the scrum could provide a rough lesson for bondholders who play hardball with secured lenders in cram-up cases - or dramatically increase their leverage in negotiations.

Recall that the debtors filed for bankruptcy on Nov. 1, 2020, after Wells Fargo took what the debtors call “shocking” and “unprecedented” collection action to seize control of 22 properties pledged as security for the $1.1 billion facility. According to the debtors, the 40-year relationship between the debtors and the bank began to unravel in mid-March, when the debtors sought to draw down the remaining $280 million on their revolver to get through the Covid-19 pandemic shutdown and resulting stress on retail tenant rent payments.

Just one problem, though: The credit agreement includes a liquidity covenant - really, an anti-hoarding provision - designed to prevent CBL from taking a defensive draw on the revolver to bulk up its cash accounts. Under the agreement, CBL cannot hold more than $100 million in proceeds from revolver draws at the end of each reporting period - the money has to be spent down to $100 million, Brewster’s Millions-style. The relevant reporting period ended March 31, so after receiving the defensive draws on March 20, the debtors would have to hustle to spend $180 million in 11 days.

At the first day of trial on Feb. 3, CBL CFO Farzana Khaleel testified that in order to resolve this issue she called the Wells Fargo relationship manager, Scott Solis, with whom CBL had been dealing for about 10 years. Khaleel had an idea: CBL would take the $280 million in two draws, hold $100 million and invest $180 million in U.S. Treasurys with a duration of more than one year. This, CBL maintained, would allow CBL to get around the liquidity covenant because, arguably, the Treasurys would not be considered cash or cash equivalents for the purpose of the $100 million cap. During Khaleel’s direct examination, the debtors introduced an email from Khaleel to Solis on March 17, 2020, suggesting that CBL might eventually use the $185 million to pay bondholders:

Solis graciously agreed to the draws, Khaleel said, though the agent did not provide any written waiver of the liquidity covenant - the idea, Wells Fargo maintains, was that no waiver was needed or implied because CBL would buy sufficient Treasurys to get around the liquidity covenant rather than breach it.

During her direct testimony, Khaleel described in detail CBL’s halting effort to purchase the Treasurys in the volatile early pandemic market, when a run to safety made government securities scarce. According to Khaleel, she told Solis the company was having trouble getting the required amount of Treasurys, and Solis told her to “do your best.” The parties agree that CBL was able to spend only $154 million of the draw proceeds on qualified Treasurys, leaving the company holding $126 million in cash proceeds on March 31 - $26 million too much. Khaleel blamed market conditions but admitted on cross-examination on day two of trial that she decided not to try and use the extra $26 million to buy qualified Treasurys on March 25 - six days before the March 31 reporting record date. At that point, Khaleel said, CBL decided to hold the excess as cash for operating expenses and debt service (including $9 million for Wells Fargo), which she considered permitted uses under the loan documents.

Wells Fargo points out that CBL didn’t tell their lenders about the failure to spend down below the liquidity covenant limit until mid-May, after CBL’s auditors told the company it would have to disclose a liquidity covenant default in its Covid-delayed 10-Q. CBL tried to talk its auditors out of their “black-and-white” position, Khaleel said, but they wouldn’t budge, and insisted that CBL request a written waiver.

Khaleel said that at this point she sent Solis, her Wells Fargo relationship manager, an email requesting a written waiver of the apparent liquidity covenant default, even though CBL did not believe a default had occurred. Khaleel testified that she expected this to be provided “without hesitation,” considering her relationship with Solis, CBL’s relationship with Wells Fargo, Solis’ consent to the draws and subsequent reassurances. CBL’s first clue that it was in for a bit of rough wooing was total radio silence from Solis. Wells Fargo’s distressed workout group had, unbeknownst to CBL, taken over the situation in mid-April. Wells Fargo would not grant the written waiver, the meanies in collections told Khaleel, and sent a default notice. CBL then disclosed the purported default without reservation or dispute, and on May 26 Wells Fargo sent a default notice. Later SEC filings did dispute the defaults, but Khaleel claimed that the first 10-Q did not include reservations because CBL didn’t know it could do that.

The situation deteriorated from there, as CBL engaged in restructuring negotiations with an ad hoc group of noteholders on one hand and the banks on the other. As Khaleel put it, after the denial of the waiver and the takeover by the workout group, the CBL-Wells Fargo relationship went “down the tubes.” Two more default notices from the bank group arrived on June 2 and June 16, when the debtors announced that they had skipped interest payments on the notes. On June 30, the debtors, Wells Fargo and the noteholders entered into a forbearance agreement, which was extended on July 27. On July 29, the forbearance agreement with Wells Fargo expired, though the debtors secured further extensions from the noteholders through Aug. 5 and made the skipped interest payments before that date.

The interest payments probably clued Wells Fargo in to the fact that CBL had found a new dance partner in its effort to survive the extended IRL retail coma. This was confirmed on Aug. 19, when CBL announced a restructuring support agreement with the noteholder group. The RSA left treatment for the bank lenders unspecified, though the banks must have expected the worst: On the same day, Wells Fargo served another notice of default and accelerated the $1.1 billion due under the facility. The RSA contemplated an Oct. 1 filing, but on Sept. 28 the debtors announced that the filing target date had been pushed to Oct. 15 to allow for further discussions with the banks.

CBL CFO Khaleel insisted on direct that the company still desired a tripartite agreement including the banks and had not committed to filing chapter 11 with only the bondholders’ support prior to Wells Fargo’s “extreme” remedies later in October. However, on cross-examination she admitted that the debtors were bound to the milestones in the RSA, including the filing deadline, and had done considerable work toward a filing before the RSA was agreed - including a chapter 11 analysis of proposed key employee retention programs. Wells Fargo also introduced an illuminating email from a CBL director to management from June 2020 reacting to a restructuring proposal from Wells Fargo (highlighting courtesy of Wells Fargo counsel):

Obviously that “and they know it” was a dangerous assumption. By September, CBL asserts, Wells Fargo’s lawyers were “secretly” drafting the documents necessary to seize control of the pledged properties and their SPE owners (though CBL could hardly have expected the agent to disclose that). On Oct. 14, the debtors announced an extension of the RSA chapter 11 filing deadline to Monday, Nov. 2. When the debtors filed on Sunday, Nov. 1, we expected a typical set of RSA-based first day pleadings and, potentially, the setup for a future fight over treatment of the banks under a plan.

But the debtors’ filings and Khaleel’s testimony paint an entirely different picture. According to Khaleel, the filing would not have happened, notwithstanding the Nov. 2 RSA deadline, had Wells Fargo not reacted to an Oct. 27 restructuring term sheet from the noteholders with a “shocking” midnight robbery of the pledged properties. Again, if CBL’s claims of surprise are true - and counsel for Wells Fargo poked some holes in this idea in his cross-examination of the CFO - this suggests that CBL and the noteholders had severely misjudged Wells Fargo’s intentions, though they should have had a pretty good idea the banks were unhappy. In a term sheet sent to the company on Sept. 3, Wells Fargo proposed a restructuring of the loans using $500 million in five-year notes secured by the existing pledged properties and a number of additional properties, with tight covenants and tight REIT dividend limitations; the noteholders’ Oct. 27 proposal that triggered the takeover of the pledged properties contemplated $950 million in notes due 2027 secured only by existing pledged properties, no fees, covenants “TBD” and no dividend restrictions. The debtors’ Dec. 30 plan provides similar cram-up treatment for the banks, except it is now clear that there will be no covenants attached to the new notes. The parties didn’t seem that close to a deal.

On Oct. 28, Wells Fargo put its takeover of the pledged properties in motion by delivering a notice to CBL that it had exercised pledged proxy rights to name a Wells Fargo workout representative as sole manager of the pledged property owners, with sole authority to put the entities into chapter 11. Obviously Wells Fargo did not believe the company would delay filing until after that Nov. 2 RSA deadline. Wells Fargo also sent notices to hundreds of tenants directing them to send rent to new Wells Fargo accounts rather than to the company. CBL claims that it then initiated an “emergency” chapter 11 filing over the weekend, spurred by Wells Fargo’s “unprecedented” effort to collect $1.1 billion based on “non-monetary” defaults - including the liquidity covenant breach. Counsel for noteholders Oaktree and Canyon called the collection measures “draconian” at the first day hearing; counsel for Wells Fargo responded that not only were the remedies justified, they were also effective to prevent the pledged property debtors from filing for chapter 11. CBL had filed them anyway; “we believed we were still in control,” Khaleel testified.

The debtors say that the stakes could not be higher: According to counsel’s opening statement on Feb. 3, if Wells Fargo prevails, then their appointed manager would dismiss the pledged property debtors’ chapter 11 cases and seize all rent. The pledged properties, Khaleel testified, constitute one-third of CBL’s portfolio, and their removal would be akin to taking out a “vital organ.” CBL denies that its failure to purchase enough Treasurys by March 31 to meet the liquidity covenant qualifies as a default, and it maintains that even if a default occurred, allowing Wells Fargo to seize the properties and remove them from chapter 11 would be inequitable, futile and a violation of the pledged property debtors’ “constitutional right” to file bankruptcy. Also, Khaleel said, Wells Fargo would not be able to run the malls profitably without CBL’s management, leaving local communities blighted by dead malls.

Wells Fargo asserts that this is all a smokescreen - the company agreed to the liquidity covenants and other non-monetary covenants, it breached those covenants without a written waiver, and thus the agent was entitled to exercise remedies after negotiations took a hopeless turn. Wells Fargo counsel also pointed out during opening arguments that “everyone agrees” the banks are undersecured, as evidenced by the debtors’ Dec. 30 plan, so they are entitled to the full value of the pledged properties either way.

Trial will continue for at least two more days, so stay tuned.

The Takeaway: Counsel for Wells Fargo made an interesting policy point in his opening statement at trial: Assuming Wells Fargo can prove a default, if the debtors nevertheless prevail on their equitable defenses to enforcement and their “foot fault,” “no harm no foul” arguments, then future restructuring negotiations may be chilled. Lenders would be wise to exercise their remedies immediately upon default rather than risk losing them by continuing to negotiate and possibly granting an implicit “equitable” waiver. Of course, we thought it was standard operating procedure for lender counsel to reserve all rights and defaults from the creation of the world until the end times in every correspondence with a borrower approaching a credit event … but that’s what separates workout groups from the nice folks in client relations.

The Fine Print: If Wells Fargo prevails, then the noteholders may regret pushing the banks to the limit with a cram-up on the assumption that the banks would not treat the company like a common commercial real estate borrower that misses a few payments rather than a multi-billion-dollar, publicly traded REIT. If the debtors win, it could serve as precedent for disregarding non-monetary defaults going forward.

New York v. NRA

Another fun one from our Americas Middle Market product. At a first day hearing on Jan. 21, Judge Harlan Hale in Dallas urged the parties in the National Rifle Association of America case to dial down the “strong feelings” and treat the NRA chapter 11 as a “regular bankruptcy case.” Recognizing, perhaps unconsciously, the need for divine intervention, Judge Hale added that bankruptcy court can be a “miraculous” place. We hope that bench comes equipped with seat belts and airbags just in case, because (nice words on all sides be damned) the NRA filing is shaping up as a serious collision between the Bankruptcy Code and the enforcement power of a hostile state government.

In April 2019, the NRA sued advertising agency Ackerman McQueen, accusing Ackerman of “systematically overcharging” the advocacy group, “falsifying invoices” and “misrepresenting the benefits of a significant amount of the services it provided.” That last one is a pretty ironic claim to make against an advertising firm. According to the debtors’ first day filings, Ackerman didn’t take this lying down but retaliated with false public accusations of “financial improprieties” by NRA management, including misappropriation of donated funds for personal use. This, the debtors say, precipitated the filing of a class-action lawsuit by an NRA donor in Tennessee federal court. The class-action complaint alleges that executives, including former CEO and current VP Wayne LaPierre, used donated funds to pay for clothing, private jet travel and “other personal benefits.”

In August 2020, New York Attorney General Letitia James joined the fray by filing a state court complaint in New York City alleging that the NRA’s top brass breached their fiduciary duties to the nonprofit by, among other things, diverting “millions of dollars away from the charitable mission of the organization for personal use,” awarding contracts for “the financial gain of close associates and family” and doling out “lucrative no-show contracts to former employees in order to buy their silence and continued loyalty.” The AG maintains that between 2015 and 2018 the debtors “reported a reduction in unrestricted net assets by $63 million” as a result of this misconduct. The AG seeks restitution from management (including LaPierre) for their alleged ill-gotten gains, removal of said management and dissolution of the NRA as a New York nonprofit corporation under several provisions of the New York Not-for-Profit Corporation Law - including section 1101(a).

Section 1101(a) provides that a New York nonprofit may be dissolved at the AG’s request for conducting its business “in a persistently fraudulent or illegal manner” or abusing its privileges as a nonprofit for purposes “contrary to public policy of the state.” According to the AG, the NRA “is fraught with fraud and abuse,” and she has sought dissolution because “no organization is above the law.”

On Jan. 20 the debtors filed chapter 11 in Dallas and issued an extraordinarily spicy press release touting the case as a way to “restructure the Association as a Texas nonprofit to exit” a “corrupt political and regulatory environment in New York.” The filing, the debtors say, “will enable long-term, sustainable growth and ensure the NRA’s continued success” once liberated from “the toxic political environment of New York.” The NRA’s plan seems to consist of paying all creditors in full and “dumping New York.”

At the first day hearing on Jan. 21, NRA counsel was a bit more politic, telling Judge Hale that the debtors did not file because they are “afraid” of the AG or to avoid regulatory scrutiny. Thing is, why else would the debtors file if they are, as they insist, in their “strongest financial condition in years”? A nonprofit corporation need not file chapter 11 to reincorporate in a new jurisdiction. The debtors say they seek a “breathing spell” from various lawsuits against them, which they would also like to centralize in the bankruptcy court - but three or four discreet lawsuits isn’t exactly a crisis like thousands of claims based on opioid distribution or wildfires. Ackerman had insisted (correctly - see below) that the litigation is unlikely to be consolidated via a multidistrict litigation proceeding, and called the chapter 11 a “temporary speed bump.” Another adversary, former lobbyist Christopher Cox, has also questioned the debtors’ narrative, arguing in a motion for relief from stay to proceed with arbitration that “there are apparently only a handful of litigation matters involving the NRA, and the NRA does not need to centralize or streamline litigation” in the bankruptcy court.

If the debtors really hoped to get a “breathing spell” from the AG’s lawsuit, they were quickly disabused of that notion. On Jan. 21, the day after the filing, the New York state court denied the debtors’ motion to dismiss the AG action notwithstanding the automatic stay. Although only a bankruptcy judge can grant relief from the stay, any judge can decide whether the stay applies to a particular proceeding, and the state court seems to have agreed with the AG that the dissolution action falls within section 362(b)(4) of the Bankruptcy Code, the “police powers” exception to the stay. The NRA did not press the issue.

In another setback for the NRA, on Feb. 4 the MDL panel declined to consolidate the Ackerman litigation with the Tennessee donor class action, as Ackerman predicted. The panel found that although there is some “factual overlap,” it is “overshadowed by the many individual questions presented by the alleged facts, claims, and parties in each action.” Further, the panel noted that the NRA’s chapter 11 filing “is likely to further impact the disparities in progression among these cases.”

So, the AG action appears poised to continue while the chapter 11 plays out - which raises some interesting questions. First, what happens if the New York court agrees with the AG and decides to remove existing management in favor of a statutory receiver or other manager more palatable to the state while the bankruptcy is still pending? That would effectively achieve the same result as appointment of a chapter 11 trustee, except the bankruptcy court would not be the one kicking management to the curb. The AG might have to file a separate motion to appoint the receiver as a chapter 11 trustee in the chapter 11 - but would the state court decision have preclusive effect, or would the debtors have another opportunity to show they can be trusted to run the case? The AG might also ask Judge Hale to appoint the receiver or replacement as “responsible person” for the debtors - an old tactic used to avoid the trustee question, but one of questionable legality. And what if Judge Hale decides to keep existing management in place after the state court decides to remove them?

Second, what happens if the New York court finds that the nonprofit should be dissolved during the case? Dissolution generally does not mean termination under state law but triggers a controlled wind-down process. Would the debtors be able to undertake this process via chapter 11? Perhaps the AG would have the new manager file a motion to dismiss? Could the dissolution be the practical equivalent of involuntary conversion to chapter 7, which the court lacks authority to do under section 1112(c) of the Bankruptcy Code?

Third, what happens if the NRA proposes and secures confirmation of a plan before the AG action is resolved? Presumably, the debtors hope to exit bankruptcy without the AG action hanging over their heads. Under section 1141 of the Bankruptcy Code, confirmation of a chapter 11 plan “discharges the debtor from any debt that arose before the date of such confirmation” and vests the debtor’s assets in the reorganized debtor “free and clear of all claims and interests of creditors, equity security holders, and of general partners in the debtor.” The debtors’ problem is that the AG doesn’t seek payment of monetary damages from them - the AG only seeks cash from LaPierre and the other insiders. Instead, the AG seeks a judgment removing management and dissolving the debtors - both forms of injunctive or declaratory relief - based on prepetition conduct. Does this request qualify as a “debt that arose before the date of such confirmation” or render the AG a “creditor” whose claims are effectively wiped out by confirmation?

This leads us to the extremely broad definition of debts and claims under the Bankruptcy Code. Section 101(12) of the Bankruptcy Code defines “debt” as “liability on a claim.” So, let your fingers do the walking back to section 101(5), which defines a “claim” as a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured” or a “right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.” The first provision doesn’t seem to apply to the AG’s dissolution action, which does not seek any payment from the debtors. So, the second provision: What is an “equitable remedy” that “gives rise to a right to payment”? Does that include a claim by a state attorney general to remove management or dissolve an organization for violation of state law relating to nonprofits?

We can’t find a decision directly on point in our database - bored associates, you are welcome to take a swing - but the question often arises in another context: state and local governments seeking to force debtors to clean up environmental messes. In a 1985 decision, Ohio v. Kovacs, the U.S. Supreme Court found that a governmental claim for environmental cleanup cost reimbursement qualifies as a “claim” subject to discharge under section 101(5) because it seeks monetary relief. In In re Chateaugay, a 1991 decision, the Second Circuit took that rule a bit further: If the state chooses to seek an injunction mandating cleanup over seeking cost recovery for its own cleanup (presumably to avoid fronting the money for the task or, more cynically, to escape discharge), the court of appeals held, then the demand is a dischargeable “claim,” since the government could have chosen to clean up itself and sought reimbursement, leaving it with a dischargeable reimbursement claim under Kovacs. Conversely, if an injunction is the only available remedy for the state, then the demand would not be discharged.

So if you apply those environmental decisions by analogy, the question in the NRA case is whether under New York law removal of management and dissolution of the nonprofit are the only remedies available to the state for the illegal conduct alleged. If the AG could seek some other remedy, such as a fine, then the AG’s choice to pursue removal and dissolution instead could qualify as a dischargeable claim and get cleared out by confirmation, even though the AG is not actually seeking payment of any monetary penalties or fines from the debtors. Notably, section 1101(a), which governs dissolution, does not appear to allow for alternative monetary remedies, though I’m sure the NRA could scrounge up an argument.

The Takeaway: The AG seems unlikely to settle her claims against the NRA for less than full relief - this is clearly an important political issue rather than an economic one. Nor does it seem probable that the NRA will voluntarily dissolve to kill the action - otherwise, why bother with a chapter 11 filing, when you could simply dissolve the existing New York nonprofit and form a new one in Texas or some other state with a less anti-NRA attorney general? This means we could see some very interesting state law and Bankruptcy Code issues aired and decided in this case. Our money is on serious and lengthy appeals regardless.

The Fine Print: Note that in Purdue and Mallinckrodt, the state opioid claims don’t seem to raise the same issues because the states are seeking monetary relief for the cost of remedying the opioid epidemic rather than exercising their “police powers” - though Judge Drain’s decision on that point is currently up on appeal.

24-48-Hour Party People

On Jan. 26, Belk announced a restructuring agreement that contemplates a first day confirmation hearing and emergence within 24-48 hours of filing chapter 11 on or about Feb. 24. Putting aside the merits of the super-expedited bankruptcy process generally (great discussion with the Kirkland & Ellis folks on the subject here), this one, if successful, seems poised to extend the practice to more, shall we say, problematic cases.

Belk claims to have the support of 75% of first lien lenders and 100% of second lien lenders for its plan, which makes sense when you consider how much the second lien lenders will be getting despite being out of the money. Under the proposal, first lien lenders would receive new first lien second-out loans worth 55% of their claims, which total about $999 million. First lien lenders could also elect to fund their pro rata share of $225 million in new-money first lien first-out loans and receive an additional 25% of their claims in new FLSO loans and up to 10% of reorganized equity. The debtors estimate recoveries for the first lien class at between 55.1% and 86.4% (taking into account the book value of new equity).

Second lien lenders would receive $82.5 million, or 15%, of their $550 million claim in new FLSO loans, 34.9% of reorganized equity and $110 million in new second lien term loans. The second lien lenders could also elect to receive up to an additional 5% of reorganized equity for participating in one-third of the $225 million in new FLFO loans, for a total of 39.9% of reorganized equity. The debtors estimate recoveries for the second lien class at between 68.9 and 73.7% (again, taking into account the book value of new equity).

General unsecured creditors would be paid in full. Existing equity would be reinstated but diluted: Current sponsor Sycamore would end up holding 50.1% but retain control of the reorganized debtors. Here’s the reorganized equity breakdown from our analysis:

I’m sure the debtors will be able to come up with an expert valuation of reorganized equity that makes this look like a great deal for the first lien lenders, but it seems a bit dicey for a case seeking the two-day express treatment. It is not typical even in ordinary chapter 11 cases for first lien lenders to get as little as 55% on their claims while second lien creditors get at least 68.9%, general unsecured creditors get paid in full and existing equity gets anything. The absolute priority rule is, well, a rule, and first lien lenders are legally entitled to get paid in full before anyone else gets anything. Of course, a class of creditors can agree to take less, and Belk will have an extended prepetition solicitation period to secure more consensus than they already have, which is probably enough - barring some challenge to the votes of first lien/second lien cross-holders.

The Takeaway: If the dissenters stay mum and the debtors are out in a day or two, expect the case to be used as precedent for quickie treatment of other borderline cases - the threshold for 24-48 hour confirmation will have been effectively lowered.

The Fine Print: If dissenting first lien holders do try to hold up the deal, it will be interesting to see how the Houston judges react. Will they default to an “ordinary” expedited time frame of 30 to 60 days, or will we see a new class of 10-day cases? There’s some precedent for the 10-day option from GATE in the SDNY; in that case the debtors held a contested confirmation hearing on their prepack four days after the filing of their prepackaged cases and plan.

Other Matters

Congratulations to new SDNY bankruptcy judges Lisa G. Beckerman, formerly of Akin, and David S. Jones, formerly of the United States Attorney’s Office.

Wait, the SDNY now has its own David Jones? This is a copy edit desk nightmare.

--Kevin Eckhardt
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