Secured Lenders Beware – Overreaching and Predatory Lending Tactics Can Cause Your Claim To Be Equitably Subordinated In Bankruptcy
A recent bankruptcy court decision highlights the risks of equitable subordination faced by lenders in bankruptcy. In Credit Suisse v. Official Comm. of Unsecured Creditors, et. al.,1 the Bankruptcy Court subordinated a $232 million secured claim, finding that Credit Suisse ("Lender") had engaged in a predatory lending practice by: (i) inducing a borrower to accept a loan that it did not need by allowing the borrower to disburse the majority of the loan proceeds for purposes unrelated to the borrower, and (ii) selling participations for loans where it had already earned its fees notwithstanding its failure to properly perform due diligence.
The loan at issue here was marketed by Lender to the Yellowstone Mountain Club, LLC ("Borrower"), a second-home development that contained a private ski and golf course. The $375 million loan was a non-recourse secured loan that earned the Lender a $7.5 million fee upfront and permitted Borrower to disburse $351 million of the loan for purposes unrelated to Borrower. Most of the loan was sold by the Lender to participants.
Issues with the Loan
In subordinating Lender's claim, the Court found that Lender had engaged in "naked greed" by reaping the rewards of an unnecessary loan to Borrower while Borrower's creditors "were left holding the bag." The Court focused on incentives built into the loan structure (the fee structure, lack of risk and distributions) for Lender, the lack of financial due diligence performed by Lender, the lack of benefit of the loan to Borrower, and the personal benefit of the loan to Borrower's majority shareholder.
The bankruptcy court held that Lender encouraged Borrower to accept a loan that Borrower did not need so that Lender could earn origination fees. In return, the majority shareholder of Borrower was given incentives to accept the loan - the ability to use the loan proceeds for purposes unrelated to Borrower.
The bankruptcy court also focused on the lack of risk that the loan posed to Lender. Since Lender sold most of the loan to participants after it had earned its fee - the risk of loss if the loan failed was placed primarily upon the participants.
The Court held that the incentive and ability to earn fees without incurring substantial risk precipitated Lender's failure to properly conduct due diligence. The Court found that, in originating the loan, Lender failed to request audited financials; and ignored other financial statements and an existing, recent appraisal of the property. Instead, Lender merely relied on: (i) financial projections that bore no relationship to Borrower's financial history; and (ii) an "appraisal" of the property which was based upon a new appraisal methodology developed by Lender. The Court noted that Lender's new valuation "methodology does not comply with the Financial Institutions Recovery Act of 1989, but that was not important to [Lender] because [Lender] was seeking to sell its syndicated loans 'to non bank institutions.'"2
In conclusion, the Court found that the loan allowed Lender to earn its fees up front, sell off the majority of the loan, permit Borrower to distribute the proceeds for purposes unrelated to its business, while leaving creditors of Borrower to bear all the risk of loss. The Court held that Lender's actions "shocked the conscience" and merited equitable subordination of its claim against Borrower.
Click here for a copy of the Credit Suisse decision. Please contact the attorneys listed in the left-hand column if you have any questions concerning the decision or its implications.
1 09-00014-RBK, Doc #: 289,(MT. Bankr. May 12, 2009).
2 Id. at page 7.
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