Thursday, December 12, 2013

FYI: 2nd Cir Addresses "Recurring Issue" of Whether Commercial Loan Docs Ambiguous, Finds Ambiguity Precluding Motion to Dismiss

The U.S. Court of Appeals for the Second Circuit addressed what it referred to as the "recurring issue" of whether relevant loan documents are ambiguous, thus precluding their interpretation on a motion dismiss, in the unusual context of an agreement for a loan from a lender to himself and his partner.  The trial court had granted the defendants' motion to dismiss.  The Second Circuit, concluding that the ambiguity in the documents at issue precluded dismissal of the Amended Complaint, vacated the District Court's ruling and remanded for further proceedings. 


A copy of the Court's opinion is available at:  Link to opinion


The case involves three real estate developers, two of whom (the plaintiff and one of the individual defendants) were close friends in a "family relationship of trust" for 35 years and the foreclosure by a company owned by the defendants on the plaintiff's interest in a company he owned that had entered into a business venture with the defendants. 


The individual plaintiff was the sole member of an LLC also named as a plaintiff.  The individual defendants were the controlling partners of the Lender, a named defendant, and the Lender was the sole member of another LLC also named as a defendant.  In 2005, the individual defendants approached the plaintiff about developing a multi-million dollar real estate portfolio.  Plaintiff agreed to act as a developer for the venture, and instead of requiring a development fee agreed to accept a percentage of the profits on each development as compensation for his services.  In 2006 plaintiff's LLC agreed with the defendants' LLC to form a joint-venture LLC (the "Company") (also a named defendant) to purchase and develop a building in New York City (the "Property").  Plaintiff's LLC contributed approximately $5 million and defendants' contributed approximately $20 million to the Company, for which they received 20% and 80% ownership interests, respectively, of the Company.


In September 2006, the Company created the Owner company, which purchased the Property for $113 million.  To fund the purchase and development of the Property, two loans were obtained.  The Company obtained an $85 million loan from a bank.  Plaintiff's LLC and Defendants' LLC then obtained a $20 million "mezzanine loan" from the Lender – the sole member of defendants' LLC.  A mezzanine loan is similar to a second mortgage except that it is secured by the stock of the company that owns the real estate rather than the real estate itself, which is secured by the primary loan.  Plaintiff's LLC and defendants' LLC also signed (1) as Pledgor, a Pledge Agreement with the Lender and (2) a promissory note in favor of the Lender. 


The mezzanine loan was senior to the equity investments of plaintiff's and defendants' LLC's in the Company, but subordinate to the bank loan.  The mezzanine loan gave the Lender, upon an "Event of Default," the remedies provided by the loan documents, which included the Pledge Agreement.  The Pledge Agreement gave the Lender the right to foreclose on the interests of either plaintiff's or defendants' LLCs in the Property upon an "Event of Default."  The mezzanine loan provided several definitions of an "Event of Default." 


A major issue on appeal was which of the definitions of "Event of Default" applied to non-payment of the mezzanine loan, with one of the definitions identifying non-payment of the promissory note as an Event of Default only if there was Available Net Cash Flow.


The Company fell behind on payments for the bank loan and the mezzanine loan.  In response to letters from the Lender that an Event of Default had occurred, plaintiff's LLC filed a complaint in New York State Supreme Court, seeking a declaratory judgment that it was not in default.  The defendants removed the matter to the District Court.  The District Court denied the plaintiffs' motion for injunction and the Lender proceeded to auction plaintiff's LLC's 20% interest in the Company. Soon thereafter, the bank declared the Company in default.  A family member of the individual defendant purchased the bank loan and the defendants' entities sold the Property for $150, realizing profits for more than $10 million, and did not provide any compensation to plaintiff or his LLC for its capital contributions or work as an Operating Member.


The plaintiffs then amended their complaint.  The essence of their claims was that the Lender was not entitled to foreclose on plaintiff's LLC's interest in the Company.  The District Court ruled that the language of the mezzanine loan was unambiguous and that an Event of Default had occurred under the provisions of that loan agreement. 


On appeal, the Second Circuit immediately observed the nature of the parties involved and unusual circumstances of a lender making a loan to itself and its partner.  "We do not doubt that an entity can make a loan to itself and its partner, but the unusual nature of such an arrangement prompts close scrutiny of the documents purporting to provide the lender with a right to foreclose on the partner's interest for an alleged default on the loan."  The Court then stated "the ultimate issue is whether the relevant documents unambiguously accord the Lender a right to foreclose on plaintiff's LLC's 20% interest in the Property for failure to pay the Promissory Note at maturity." 


The court then clarified the issue on appeal: "The ultimate issue is whether the relevant documents unambiguously accord the Lender a right to foreclose on plaintiff's LLC's 20% interest in the Property for failure to pay the Promissory Note at maturity."  "Our concern at this preliminary state of the litigation is only whether there is sufficient ambiguity, either in the phrases of any one document or between conflicting language in any of the documents, to preclude granting a motion to dismiss the Amended Complaint."  In analyzing the language of the relevant loan documents, the Second Circuit focused its attention on the 2 provisions in the mezzanine loan that the District Court relied on to dismiss the Amended Complaint.  One of the provisions defined an Event of Default as when the borrower failed to make required payments and there was Available Net Cash Flow available.  The other provision at issue defined an Event of Default as when the borrower failed to perform any obligation under the loan documents.  The plaintiffs argued that because net cash flow was not available, there was no "Event of Default."  The defendants argued that the second definition applied and the net cash flow analysis was not required.


The Second Circuit conducted a thorough analysis of the 2 provisions, including assessing the grammatical effect of a preceding adjective and whether that adjective modifies only the first word of a series of words or the adjective modifies all of the words in the series.  The issue was critical because the definition that required Available Net Cash Flow available for an Event of Default contained the following language: "the failure of the borrower to pay any installment of principal, interest, or other payments required under the Note."  The issue was whether the term "installment" applied only to the term "principal" or it applied to "principal, interest, or other payments required under the Note."  Relying on a Delaware District Court decision, the Second Circuit ultimately concluded that the term "installment" only applied to the first word of the series, in this case "principal."  Although the District Court felt that the "Available Net Cash Flow" limitation in the definition would present the potential that the loan agreement might never be paid, the Second Circuit concluded that given the relationship between the individual plaintiff and defendant it was plausible that the parties were willing to defer foreclosure until cash flow from their development project was available. 


The final analysis the Second Circuit conducted in concluding that there was sufficient ambiguity in the loan documents was to address the intent of the parties.  "The most persuasive evidence of the agreed intention of the parties in those circumstances (where agreements are not clear) is what the parties did when the circumstances arose."  The Court then noted that after the date the defendants claimed an "Event of Default" occurred, the defendants continued to deal with plaintiff as an operating member of the partnership, insisted that he help obtain extensions on the bank loan, the he make additional capital contributions, and that he extend his $10 million personal guarantee to the bank loan. 


Because all of those events occurred after the supposed Event of Default, the Second Circuit held that there was sufficient ambiguity as to whether the Lender could foreclose on plaintiff's interests if there was no net cash flow available. 


Accordingly, the Second Circuit vacated the district court's finding and remanded the case for further proceedings because it felt there was sufficient ambiguity in the definitions for Event of Default that rendered it inappropriate to grant the defendants' motion to dismiss plaintiffs' Amended Complaint.




Ralph T. Wutscher
McGinnis Wutscher Beiramee LLP
The Loop Center Building
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Chicago, Illinois 60602
Direct: (312) 551-9320
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