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When Elephants Fight: Participant Lender Disputes

Law 360
March 19, 2010

Law360, New York (March 19, 2010) -- In distressed debt situations, normally one thinks of the debtor as being in distress. Yet, now it frequently is the lending group that is in "distress." This is a relatively new phenomenon. While disputes within a lender group were not unheard of, those disputes usually did not become public and impact case outcomes. No more.

In the current economy, loan participations[1] are now resulting in contentious disagreements among the participants, frequently spilling over into dealings with the debtor and creating dilemmas for both debtors' and lenders' counsel.

The issues relate to the actions that the agent bank can take on its own authority or with participants' consent. Issues revolve around the necessary level of consent. Some actions require unanimity, others a majority vote, still others a supermajority vote. More complex schemes utilize a bankruptcy voting concept combining total votes and percentage of the participation.

These consent provisions need to be read in concert with general delegations of authority -- specific and implied -- to the agent contained elsewhere in the agreement. General principles of agency under common law may apply as well.

Further, practically complicating the legal issues, lenders now frequently sell their participations to a new lender with no experience with the credit and, sometimes, a different agenda.

Moreover, within a particular lender, the loan may move from the commercial lending group to a special assets group, again changing the dynamic. Even if the provisions are clear, these disputes may raise practical issues, such as a number of participants refusing to fund additional advances.

Because these disagreements historically did not become contentious or public, there is relatively little case law on point. What there is, is of recent origin; Beal Savings Bank v. Sommer, 8 N.Y.3d 318, 865 N.E.2d 1210 ( N.Y. 2007) and In re GWLS Holdings Inc., 51 Bankr. Ct. Dec. 72 (Bankr. D. Del. 2009) are the most frequently cited.

Whatever else can be said of the Chrysler bankruptcy, the Second Circuit decision was the only federal appellate circuit case to deal with the issue. In re Chrysler LLC, 576 F.3d 108 (2d Cir 2009).

While the lender dispute was only a tertiary part of the decision, it was still a decision by a well-respected court known for commercial decisions.

"Was" is the appropriate term because in mid-December 2009, when the U.S. Supreme Court denied the Indiana Pension Fund appeal as "moot," it not only remanded the appeal, it vacated the Second Circuit's decision. Indiana State Police Pension Trust, et. al v. Chrysler LLC, 175 L.Ed. 2d 614 (2009).

While the reasoning will still be helpful, the baby was thrown out with the bathwater so to speak, although the bankruptcy court decision remains. In re Chrysler, 405 B.R. 84 (Bankr. S.D. N.Y. 2009).

Now deprived of that level of persuasive (mandatory in the Second Circuit) authority, what are lawyers facing these disputes to do?

While a headache for the agent's counsel, it is a real problem for the debtor's counsel. When debtor's counsel asks what the bank wants to do, the answer may be "We can't tell you" or "We don't know" or "We can't agree."

The debtor now is put in the unenviable position of having to make its own interpretation based on the documents to determine what level of lender approval is needed, whether it is likely to occur, and what to do if it is not obtained.

Agent bank lawyers usually take one of two approaches: 1) the contract says we can and we have the required votes, or 2) try to act as a neutral party because they are either unable or unwilling to push issues because the collective client (that being the entire lender group, an issue here too) does not agree.

More cases, however, are on the way. Two of the most recent are companion cases in the Middle District of Florida: PNC Bank NA v. Branch Banking and Trust Co.

There are two decisions in these cases. The first denied summary judgment to the plaintiff on Jan. 14, 2010. Case No. 8:08-cv-611-T-24TGW. The second is a Feb. 2, 2010 decision, holding in favor of plaintiff after a bench trial. Case No. 8:08-cv-610-T-27TGW.

These cases highlight many of the issues. First, neither litigant was a party to the original loan agreement. Colonial Bank NA ("Colonial") was the predecessor in interest to Branch Banking and Trust Co. ("BBT") and Mercantile Mortgage Corporation ("Mercantile") was the predecessor in interest to PNC. The loans at issue were for a residential development and a 264-unit condominium development that turned into distressed properties.

In one case, the participation was set up on a "last-in, first-out" ("LIFO") method whereby Colonial would fund the first $26 million and Mercantile would fund the next $10 million, but all principal payments would go to Mercantile until it was paid and the overall loan was reduced to the $26 million that Colonial loaned.

Mercantile's money, while lent after Colonial's, was to be paid back first. Hence, "last-in, first-out." As is common, there was also a separate revolving credit loan that the banks funded on a pro rata or pari passu basis. Colonial was the agent bank. Colonial admitted making an error by treating both loans as if they were on a pari passu basis, but later remedied that error.

PNC sued BBT for violating the participation under a number of legal theories and moved for summary judgment on its claims. The court read the participation agreement and, relying on that, denied summary judgment, saying that it could not determine precise restrictions on the uses of funds from the documents submitted.

Moreover, the court stated that it could not determine if PNC had any actual damages at this point. The other case went on to a bench trial that had a markedly different outcome.

The trial decision focused heavily on the document language. That underlying document, like many of these agreements, had an exculpatory clause releasing the lead bank for most actions and mixing concepts of tort and breach of contract. This particular agreement was governed under Florida law.

Plaintiff alleged that Colonial released specific lots for less than the minimum price set forth in the agreement and used funds other than for what they were authorized, thus allowing the debtor to over-extend without written consent from Mercantile. Plaintiff also contended there was a breach of Colonial's fiduciary duties to Mercantile.

In response, Colonial denied that it breached the agreement, asserted that the plaintiff failed to mitigate and that Mercantile consented to Colonial's actions and therefore waived its rights to object. Colonial's defense rested in part on the concept of "no harm, no foul."

For instance, the release price on the individual condominiums was approximately $74,060.00 per unit. This was equal to 125 percent of the amount loaned on each unit. Because Colonial was unable to calculate the exact proceeds and believing that the minimum $74,060.00 release price would be met, it approved the sales.

Colonial argued that the closings in aggregate averaged $79,038.00 and the proceeds were applied toward the loans, satisfying the agreement. The court described these arguments as "rationalizations."

Colonial informed Mercantile of these issues. The court observed that, while Mercantile acknowledged that it understood Colonial's rationale, this was not the same as written consent for releasing the units at less than the minimum price, required by the participation agreement.

Whatever the relationship and functional or practical reasons for the actions, the court found that Colonial breached the material terms of the participation agreement by modifying or altering the terms of the loan agreement without obtaining the written consent.

The court also found that Mercantile, by consenting to extensions of the loan maturity, even with knowledge of the other breaches, did not consent in writing on other issues. Mercantile was functionally doing to some extent what Colonial did, which was accommodating a borrower who was facing a declining market.

Moreover, the court held the general "no warranties" clause in the participation agreement related to the decision to enter into the participation, not the lead lender's obligations afterwards.

The court went further to hold that, while there was a breach of contract, there was no fiduciary duty involved in the participation agreement because banking institutions normally engage with each other at "arm's length," the word "trustee" and other words describing that relationship notwithstanding.

BBT defended in part by saying that Colonial suffered no damages because the appraised value of the remaining unsold units was sufficient to make Colonial whole at the end of the day.

The court viewed these arguments of setoff or credits, to which the defendant may be entitled, to be in the future and not relevant at the moment to the judgment to be awarded to the plaintiff. It was acknowledged that PNC could never be paid more than the amount it lent plus interest, and the court reserved jurisdiction to consider setoffs and credits against the judgments.

These cases reflect the way many of these cases actually resolve. Many times the lending group waits until after most interactions with the debtor are completed and then litigate any dispute. These cases also emphasize that the language of the particular participation agreement is going to be where the court focuses its efforts.

Accordingly, all counsel are well advised to read the language carefully in context and look at the law of the state which governs the agreement. While these cases are instructive, they will come back to the specific language which varies.

While the management of the credit is ongoing, counsel needs to decide how to handle a divided lending group. If a collective bank decision cannot be reached, then the options include filing some kind of declaratory action regarding the interpretation of rights.

Another option is to simply press forward and see if the dissenting parties take any action. Threats and bluster are one thing, but when attorneys fees need to be paid, many times bravado is not supported by dollars.

There is also the bankruptcy option in which section 363(k) may help resolve the dilemma depending on the contractual language. The agent bank may be able to use this provision with a simple majority vote to credit bid for the assets. Also, the plan provisions of section 1126(c) require only more than one-half the number of claims and two-thirds of the claim amount to vote to accept a plan.

Going forward, future drafters will need to pay more careful attention to these documents based on recent experience. While courts seem to be favoring an agent's action for the collective group, these cases still rely on the documents' language and construction. If minority lender protection is desired, it needs to be made more explicit to avoid litigation later.

Consider additional term definitions so that defaults, duties, remedies and authorities are unambiguously defined. Consider more precisely defining the agent's role both in and out of a default scenario, the terms for releases of collateral and the extent of the agent's authority for both commencing and operating within a forbearance.

The agreement should carefully describe the process for voting under bankruptcy plans, credit bidding and section 363 sales. Further, both agents and participating lenders need to pay closer attention to both their respective rights and obligations during the term of the subject credit facilities.

Someday this will be a more settled area of law. Right now, it is not.

--By Timothy F. Nixon, Godfrey & Kahn SC

Timothy Nixon is a shareholder and team leader of Godfrey & Kahn's business finance and restructuring practice group in the firm's Green Bay, Wis., office. He can be reached at

The opinions expressed are those of the author and do not necessarily reflect the views of Portfolio Media, publisher of Law360.

[1] References throughout this article to loan participations are not limited to true participations, but are intended to encompass all multilender situations.

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