Restructuring

Contributed by Blaire Cahn and Abigail L. Lerner
In the wake of the financial crisis, investments in residential and commercial mortgage backed securities have raised questions for bankruptcy courts.  In commercial mortgage backed securities structures, investors take beneficial interests, evidenced by certificates, in investment vehicles that hold mortgage loans and residential and commercial mortgaged-backed securities in trust.  While it appears uncontroverted that the investment vehicle, and not the certificate holder, is typically treated as the creditor in a chapter 11 case, the question as to the role – and even the “standing” to appear and be heard – of the certificate holders as “parties in interest” for purposes of section 1109 of the Bankruptcy Code had yet to be answered with any certainty.
On April 1, 2011, Judge Chapman of the United States Bankruptcy Court for the Southern District of New York addressed this issue in In re Innkeepers USA Trust, et al., Case No. 10-13800 (Bankr. S.D.N.Y. Apr. 1, 2011) in the context of a bid procedures motion filed by the debtors.  The objecting party – Appaloosa Investment L.P. I – asserted that the special servicer of its loan placed its own financial interests above those of the certificate holders by supporting the bid in question.  The debtors, on the other hand, asserted that Appaloosa, in its capacity as a certificate holder, lacked standing to object to the motion.
While Judge Chapman found that Appaloosa had standing to be heard in its capacity as a preferred shareholder and DIP lender, she concluded that because Appaloosa was merely an investor in a creditor, it could not be given “party in interest” standing to be heard on the debtors’ bid procedures motion in its capacity as a certificate holder.  The court explained that Appaloosa had no privity or other relationship with the debtors that would confer standing to be heard.  Further, while Appaloosa asserted that it was not a “creditor of a creditor” but rather that it held a beneficial interest in the assets of the CMBS trusts, the court found that this did not change the result.  The court explained that in a securitization, the investors’ relationship is with the special purpose vehicle holding the assets, and the right to payment comes from the cash generated by the assets, not from the debtor as the originator of the assets itself.  Accordingly, the certificate holders did not have any direct interests in the obligations of the debtors.
Moreover, the court found that Appaloosa was contractually bound by the “no action” clause of the servicing agreement.  The “no action” clause prohibited certificate holders from instituting any suit, action, or proceeding under the servicing agreement or relating to the relevant loan unless certain conditions were met.  These conditions included a certificate holder providing written notice to the trustee under the servicing agreement of a default under such agreement and a written request submitted by certificate holders entitled to at least 25% of the voting rights to institute a suit, action, or proceeding where the trustee neglected to take such action for at least 60 days.  Because neither of these conditions precedent to “action” were met, the court ruled that Appaloosa was not entitled to circumvent the special servicer and be afforded independent standing to be heard on the debtors’ motion.
The court went on to hold that granting standing to a certificate holder would not only override the terms of the servicing agreement and alter the bargained-for terms and risks investors undertook when they bought certificated interests in the fixed rate loan, but it would also encourage and embolden other certificate holders to hire their own counsel to challenge the special servicer’s authority and to advance their individual and conflicting pecuniary interests.  This would dramatically alter the CMBS landscape and render the delegation to a special servicer meaningless.  In addition, it would inevitably serve to delay and complicate bankruptcy cases as debtors would be forced to litigate issues with additional parties who previously were contractually obligated to speak with one voice, that of the special servicer.
Judge Chapman is not the first bankruptcy judge to have addressed issues surrounding certificate holder standing.  For example, the court cites the decision in In re Shilo Inn, 285 B.R. 726 (Bankr. D. Or. 2002) to support its ruling.  There, the debtors filed a motion seeking to allow the certificate holders of certain trusts to vote on a proposed plan. The court denied the debtors’ motion, holding that, because the claims belonged to the trusts, and not to the individual certificate holders who had purchased the beneficial interests in the loans as part of an asset securitization, the servicing agent for the trusts was the appropriate party to vote the trusts’ claims.  Another case to address this issue was AmericanWest Bancorporation, where the bankruptcy court determined that indirect investors in trust preferred securities did not have standing to participate in the chapter 11 case and, therefore, could not object to the sale.  There, the debtor argued, and the court agreed, that the investors were creditors of a creditor of a creditor of the debtor.  Such interest, the bankruptcy court concluded, was too attenuated to justify the investors’ participation in the bankruptcy case.
Notwithstanding its ruling, the court noted that its decision did not conflict with Judge Peck’s decision in In re Extended Stay Inc., 418 B.R. 49 (Bankr. S.D.N.Y. 2009).  The court stated that, in Extended Stay, ” a special servicer had not been appointed prior to the petition date, leaving the Extended Stay debtors no other option but to engage in prepetition negotiations with certificate holders which, by necessity, continued through the ‘first day’ cash collateral hearing.”  The court reasoned that, in light of those facts, Judge Peck allowed “all parties, including certificate holders, to appear and be heard on the debtors’ motion to approve the interim use of cash collateral.”  In Innkeepers, however, the special servicer was appointed two months prior to the commencement of the debtors’ cases and had been an active participant since then.  Accordingly, the Innkeepers court noted, the facts and circumstances of Extended Stay were entirely distinguishable from those present in Innkeepers.
The Innkeepers decision serves as a warning to certificate holders who hope to have a voice in bankruptcy cases.  Certificate holders should be aware that if their servicing agreement precludes them from speaking up, the bankruptcy court is likely to honor the terms of the agreement, and the certificate holders will have to heed to the direction of the special servicer.