Hotel Owners, Lenders and Stakeholders Square Off:
Equitable Subordination

By Irvin W. Sandman and Russell C. Savrann
May 27, 2009

The hotel industry’s year-over-year declines continued in the second quarter of 2009. Demand is leveling out at a lower baseline, and the hotel industry is adjusting to a new reality.

Hotel owners, lenders and stakeholders are now beginning to square off to determine who will take a haircut and who will be squeezed out altogether. This process will not be quick or easy. As this process lurches through its early stages, an issue has temporarily taken center stage: equitable subordination.

Earlier this month, In In re Yellowstone Mountain Club, the bankruptcy court subordinated Credit Suisse’s $375 million secured loan. How did this happen? Will it happen again in other cases? What are the lessons?

The Yellowstone Mountain Club LLC

The Yellowstone Club development began in late 1999, touted as the world’s only private ski and golf community. In 2005, Credit Suisse made a secured loan of $375 million to the then-owner of the development, Yellowstone Mountain Club, LLC (the “Debtor”). Credit Suisse made the loan under a “new loan product” referred to as a “syndicated term loan.” A Credit Suisse loan officer described it as akin to a “home-equity loan” for commercial real estate owners.

Last November the Debtor filed a Chapter 11 bankruptcy. The unsecured creditors committee and others faced off against Credit Suisse, attacking its secured claim on a number of grounds. Then, after motions and hearings, the bankruptcy court on May 13 entered an interim order subordinating Credit Suisse’s $375 million loan to the claims of unsecured creditors. In other words, the unsecured creditors and post-petition lenders will be paid ahead of Credit Suisse, even though Credit Suisse has a first lien mortgage on the development.

A New Loan Product Built on Shaky Ground

Credit Suisse’s “new loan product” did work much like a home equity loan—it allowed development owners to take equity out of their developments and use the proceeds freely for other purposes. As the Yellowstone bankruptcy court described it:

“[The product allowed] owners of luxury second-home developments the opportunity to take their profits up front by mortgaging their development projects to the hilt. Credit Suisse would loan the money on a non-recourse basis, earn a substantial fee, and sell most of the credit to loan participants. The development owners would take most of the money out as a profit dividend, leaving their developments saddled with enormous debt. Credit Suisse and the development owners would benefit, while their developments—and especially the creditors of their developments—bore all the risk of loss.”

The court believed that, like some securitized home equity loans in recent years, the Credit Suisse product was based on inflated and manipulated property valuations. The court noted that Credit Suisse, to support the product, had developed “a new form of appraisal methodology,” termed “Total Net Value” methodology. This new methodology “relied almost exclusively on the Debtors’ future financial projections, even though such projections bore no relation to the Debtors’ historical or present reality.” The court stated that the methodology did not comply with FIRREA, and then pointedly remarked that this fact “was not important to Credit Suisse because Credit Suisse was seeking to sell its syndicated loans ‘to non bank institutions’.” The court concluded that the product “enriched Credit Suisse, its employees and more than one luxury development owner, but it left the developments too thinly capitalized to survive…. [T]hey were doomed to failure once they received their loans from Credit Suisse.”

“Let the Chips Fall Where They May”

The Yellowstone court found that the Credit Suisse product had this same “dooming” effect on the Yellowstone Club development. Of the $375 million loan proceeds, “approximately $209 million was transferred out of the Yellowstone Club” to the Debtor’s primary equity owner. The court obviously believed that Credit Suisse callously disregarded that the loan and the expected disbursements would leave the project without sufficient capital to survive. Credit Suisse “had not a single care how [the developer] used a majority of the loan proceeds.” It turned “a blind eye to Debtors’ financial statements,” and its due diligence was “all but non-existent.” The only plausible explanation for Credit Suisse’s actions, the court said, was that it “was simply driven by the fees it was extracting from the loans it was selling, and letting the chips fall where they may.”

Building to a crescendo, the court concluded:

“Unfortunately for Credit Suisse, those chips fell in this Court with respect to the Yellowstone Club loan. The naked greed in this case combined with Credit Suisse’s complete disregard for the Debtors or any other person or entity who was subordinated to Credit Suisse’s first lien position, shocks the conscience of this Court. While Credit Suisse’s new loan product resulted in enormous fees to Credit Suisse in 2005, it resulted in financial ruin for several residential resort communities. Credit Suisse lined its pockets on the backs of the unsecured creditors. The only equitable remedy to compensate for Credit Suisse’s overreaching and predatory lending practices in this instance is to subordinate Credit Suisse’s first lien position to that of CrossHarbor’s superpriority debtor-in-possession financing and to subordinate such lien to that of the allowed claims of unsecured creditors.”

Why “Equitable Subordination?”

Section 510(c) of the Bankruptcy Code states:

[T]he court may – (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim… ; or (2) order that any lien securing such a subordinated claim be transferred to the estate.

The subordination of a claim based on equitable considerations generally requires three findings: “(1) that the claimant engaged in some type of inequitable conduct, (2) that the misconduct injured creditors or conferred unfair advantage on the claimant, and (3) that subordination would not be inconsistent with the Bankruptcy Code.” Benjamin v. Diamond (In re Mobile Steel Co.) 563 F.2d 692, 699-700 (5th Cir. 1977).

Although the general theory of equitable subordination appears to have a broad reach, its use has been rare and reserved for extraordinary circumstances. Normally, before a non-insider claim is subordinated, “egregious conduct” must be “proven with particularity.” Sharp dealings aren’t enough—one must prove that the claimant “is guilty of gross misconduct tantamount to fraud, overreaching or spoliation to the detriment of others.” In re First Alliance Mortg. Co., 497 F.3d 977, 1006 (9th Cir. 2006).

The Yellowstone court obviously felt that Credit Suisse’s conduct was egregious enough, finding that its actions “were so far overreaching and self-serving that they shocked the conscience of the Court.” What was so egregious? Boiling down the facts, Credit Suisse in essence: 1) made a loan knowing that a large part of the money would be taken out of the project and used elsewhere; 2) planned to syndicate the loan to others; 3) was motivated to ignore red flags because of the large fees it would earn; 4) based its loan on a questionable appraisal methodology; and 5) over-leveraged the project.

Will “Equitable Subordination” Happen in other Cases?

The Yellowstone court freely pointed out that Credit Suisse’s “new loan program” has been marketed to other master-planned residential and recreational communities, “such as Tamarack Resort, Promontory, Ginn, Turtle Bay, and Lake Las Vegas.” Like the loan to the Yellowstone Club, each of those other developments “received a syndicated loan from Credit Suisse’s Cayman Island branch, which allowed the equity holders in said entities to take sizeable distributions from all or part of the Credit Suisse loan proceeds.”

Those other well-known projects are obviously outside of the Yellowstone court’s jurisdiction. The court, however, essentially invited stakeholders in those other developments to make similar attacks on the loans Credit Suisse made to those projects:

“Numerous entities that received Credit Suisse’s syndicated loan product have failed financially, including Tamarack Resort, Promontory, Lake Las Vegas, Turtle Bay and Ginn. If the foregoing developments were anything like this case, they were doomed to failure once they received their loans from Credit Suisse.”

Clearly, whenever Credit Suisse’s “new loan product” was involved in a project, stakeholders will now be able to attack the loan on the basis of equitable subordination.

But the argument likely will reach loans from other lenders. In the real estate bubble of recent years, many loans have the earmarks that “shocked the conscience” of the Yellowstone court. Under the court’s holding, a loan will be susceptible to attack if it has the following attributes:

It allowed the equity owner to take money out of the project;
It was intended to be securitized;
It allowed the lender to earn large fees;
It was based on potentially questionable appraisals or appraisal methods; and
It overleveraged the project.

These circumstances have a familiar ring to many in the hotel industry. The last two bullets might seem somewhat unique to the Yellowstone facts. Most loans in recent years likely were not based on Credit Suisse’s “Total Net Value” methodology. But given the demand and value declines of the last nine months, 20-20 hindsight can make many appraisals look questionable. And at today’s values, many—if not most—development projects look overleveraged.

What are the Lessons?

The industry will learn much as it works through the current extraordinary circumstances. The Yellowstone case can provide many lessons, some broad and philosophical, others practical and technical. A few of the more practical take-aways to consider:

For principal owners: Did you take money out of your project and overleverage it? If so, investors and creditors may have a basis to recover the funds you received. They may also seek to subordinate the secured loan that served as the source of the distributions. Subordination may trigger certain of your guaranty obligations to the lender.
For investors: If the principal owners took money out of your project and overleveraged it, you may have a basis to recover the money and subordinate the loans that funded the distributions.
For lenders: If Credit Suisse’s “new loan program” seems at all similar to loans in your portfolio, take into account the possibility of equitable subordination and other attacks. The banking industry is not popular at this time, and judges may be looking for ways to address what is viewed as “predatory lending practices” and other “abuses” that might be blamed for the financial meltdown. Be sensitive to these issues in the foreclosure process, and, if possible, seek ways to obtain a reasonable recovery outside of the free-fire zone of bankruptcy court.
For buyers: Understand that, if you buy a loan from a lender at a discount, you must look carefully at the circumstances. A first lien mortgage may be susceptible to attack and may present unpleasant surprises.

Hotel Owners, Lenders and Stakeholders Square Off: Equitable Subordination