Economic Downturn Still Evident in Court of Chancery Cases
The economic downturn has affected many sectors and litigation is no exception. The Delaware Court of Chancery's docket reflects, and will continue to reflect for some time to come, the consequences of the economic downturn. The most recent example of this trend is Trilogy Portfolio Co. v. Brookfield Real Estate Financial Partners.
This case arose from the proposed restructuring of a $2.8 billion mortgage loan secured by resorts in the Bahamas. In 2006, the resort owner decided to expand the resort through a $3.8 billion LBO and the $2.8 billion mortgage loan was originated as part of that transaction. The loan was securitized and sold as part of an investment vehicle holding mortgages and other securities backed by residential and commercial mortgages. As part of the securitization, the loan was broken up into promissory A-Notes and promissory B-Notes. The A-Notes were senior in priority to the B-Notes. The B-Notes were broken into seven junior participants of descending priority. Defendants Brookfield Real Estate Financial Partners and BREF One held the most junior B-Notes. As the holder of the most junior notes, the defendants were entitled to act as the controlling holder under certain circumstances, which included the power to appoint a special servicer in the event of a loan default, under the participating and servicing agreement. The special servicer could take certain actions necessary to deal with any default.
As a result of the economic downturn in 2007 and 2008, the resort owner could not repay the loan by the final maturity date. To avoid a default, the resort owner agreed to transfer 100 percent of its equity interest in the resort to BREF One in exchange for the elimination of the principal amount held by BREF One (approximately $175 million). BREF One would also replace the owner as guarantor of various obligations owed by the borrower to the creditors. The plaintiffs, the third-most-junior creditors, objected to the proposed transaction as unfair to the other creditors and sought a temporary restraining order.
In his opinion temporarily restraining the proposed transaction, Vice Chancellor Donald F. Parsons Jr. focused on whether the plaintiffs had established the imminent, irreparable harm required for issuance of a temporary restraining order because the defendants did not dispute the existence of a colorable claim for breach of contract. The plaintiffs claimed the proposed transaction would irreparably harm their interests because it would modify critical contractual provisions and guarantees. These modifications would afford the creditors less security and increase their risk of not receiving payment in full. The transaction would also cause the plaintiffs to lose the benefits of the creditor priority scheme that the parties had negotiated. As a holder of less junior interests, the plaintiffs would have certain negotiating leverage in dealing with the borrower and more junior creditors like the defendants. The defendants, on the other hand, argued that the plaintiffs were essentially speculating that the transaction exposed them to greater investment risk and if this harm ever materialized, monetary damages were a sufficient remedy.
The court recognized that increased risk resulting from a legitimate business transaction does not, by itself, constitute irreparable harm. Here, however, the underlying threat was more than increased investment risk. The court believed that the proposed transaction would cause the plaintiffs to lose the benefit of their contractual priority relative to other creditors like the defendants. This priority increased the likelihood of complete repayment, but also meant the plaintiffs had leverage in negotiating any modifications to the loan with other creditors and the borrower. The potential loss of negotiating leverage to other creditors constituted an imminent, irreparable harm. Moreover, the proposed transaction would make it easier for BREF One to force the borrower into voluntary bankruptcy as the 100 percent equity owner of the borrower and tamp down the interests of other creditors. According to the court, the defendants had not identified a contractual provision giving them the sole opportunity to control the borrower as part of a loan restructuring.
This decision shows that the Court of Chancery will consider the nonmonetary aspects of priority interests negotiated by borrowers and creditors — specifically negotiating leverage. In an appropriate case, the Court of Chancery may conclude, as it did here, that monetary damages cannot remedy a loss of negotiating leverage and grant equitable relief to prevent the loss of such leverage. In negotiating solutions to loans on the verge of default as a result of the economic downturn, practitioners should pay close attention to the terms of the governing instruments and the priorities originally negotiated by the parties. While materially changing the priorities originally negotiated by the parties might lead to a deal among some creditors and the borrower, there is a possibility that such a deal will not withstand judicial scrutiny if other creditors can show a loss of negotiating leverage not contemplated by the governing instruments.