CMBS Certificate Holders Denied Standing in Innkeepers

After the bankruptcy court denied approval of the Debtors' first restructuring proposal, the Debtors filed a motion (the “Motion”) for approval to enter into an equity commitment agreement with Five Mile Capital II Pooling REIT LLC (“Five Mile”) and Lehman (the “Five Mile/Lehman Bid”). The Five Mile/Lehman Bid contemplated an enterprise-level transaction involving the Debtors' entire portfolio of hotels and a reduction of the Debtors' overall debt by approximately $750 million. Specifically, the principal amount of the Fixed Rate Loan would be reduced from $825 million to $622.5 million. Midland, as servicer, agreed to the reduction on behalf of the CMBS Trusts. Also as part of the Five Mile/Lehman Bid, Midland agreed to provide staple financing to fund the Five Mile/Lehman Bid or any other qualified bid at the auction that contained a debt-to-capitalization ratio for the reorganized enterprise of not greater than 70% and provided for a payment to Lehman of not less than $200.3 million in cash.

Several parties filed objections to the Motion, including: 1) the Ad Hoc Committee of Preferred Shareholders; 2) LNR Securities Holdings, LLC and ML-CFC 2006-4 and CSFB 2007-C1 Trusts; 3) TriMont Real Estate Advisors, Inc.; 4) Appaloosa; 5) CWCapital Asset Management LLC and CIII Asset Management LLC; and, 6) the Official Committee of Unsecured Creditors. By the time of the hearing on the Motion, the Five Mile/Lehman Bid had been revised, and all objections other than those of Appaloosa had been withdrawn.

Appaloosa contended, inter alia, that the bidding procedures impeded competitive bidding and that they improperly mandated terms of a plan of reorganization. The Debtors and Midland argued that Appaloosa lacked standing as a certificateholder to object to the Motion. Appaloosa argued that a “party in interest” under ' 1109(b) of the Bankruptcy Code should be interpreted broadly, and that ' 1109(b) conferred rights on it sufficient to permit it as a “party in interest” to participate in the case and protect its financial stake.

The Bankruptcy Court's Ruling

The bankruptcy court began with an analysis of ' 1109(b) of the Bankruptcy Code, which provides that “[a] party in interest ' may raise and may appear and be heard on any issue in a case under this chapter.” 11 U.S.C. ' 1109(b). The bankruptcy court determined that in the Southern District, courts have been reluctant to find that a “party an interest” may extend beyond direct parties. In previous cases, courts held that while a creditor of one of the debtor's creditors may be “deeply concerned about the bankruptcy proceeding ' the party's legal rights and interests can only be asserted against the debtor's creditor, not against the debtor ' .” Southern Blvd., Inc. v. Martin Paint Stores, 207 B.R. 57, 61 (S.D.N.Y. 1997).

The court then proceeded to examine two cases that, despite not being directly on point with the CMBS/REMIC standing issue, provided persuasive guidance. The court first looked to In re Shilo Inn, 285 B.R. 726 (Bankr. D. Or. 2002). In Shilo Inn, the court denied standing to certificate holders of pooled real estate loan trusts. The court rejected the debtors' attempt to allow certificate holders of certain trusts to vote on a proposed plan, finding that any claims against the debtors belonged to the trusts as creditors, and not the certificate holders. Looking at the actual language of the pooling and servicing agreement, the court determined that the trust was the party that had the right to vote. The court made a key distinction between a corporate bond and a securitization, noting that in the case of a corporate bond, the bondholder has a right to payment from the corporation, whereas in a securitization, the certificate holder's right to payment is generated from the underlying assets, not the originator of the assets themselves.

The second case the court looked to was Krys v. Official Comm. of Unsecured Creditors of Refco, Inc. (In re Refco, Inc.), 505 F.3d 109 (2d Cir. 2007), in which the Second Circuit held that an investor of a creditor is not a “party in interest” within the meaning of ' 1109(b). In its decision, the Second Circuit determined that investors in a nondebtor segregated portfolio company (“SPC”) did not have standing to object to a settlement between the SPC and the official committee of unsecured creditors. The investors had placed control over their investment in the hands of the SPC, and, thus, their rights were purely derivative of the SPC's.

Following the reasoning by the courts in Shilo Inn and Refco, the court examined the terms of the CMBS Trusts and concluded that Appaloosa was merely an investor in a creditor and did not possess “party in interest” standing in its capacity as a certificate holder. In reaching this conclusion, the court noted that this was not the first time Appaloosa had attempted to circumvent a pooling and service agreement in order to override the actions of a CMBS special servicer. In Bank of America, N.A. v. PCV ST Owner L.P., Case No. 10-1178 (S.D.N.Y.) (“Stuytown“), Appaloosa, a certificateholder of the CMBS trust in those cases, sought the right to intervene in a foreclosure action against the borrower of a securitized mortgage loan. The district court summarily denied Appaloosa's motion to intervene, which lent further support to the court's decision to deny Appaloosa standing in the instant case.

The basic conclusion of the court was that Appaloosa lacked privity with the Debtors sufficient to confer standing to be heard. In a securitization, as pointed out by the court in Shilo Inn, the investor's relationship 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 themselves. Taking special note of the distinction made in Shilo Inn between bondholders and certificateholders, the court found that unlike bondholders who have a direct interest in the obligations of the Debtors, certificateholders' interests are limited to the assets of the trusts. Therefore, Appaloosa, as a certificateholder, did not have any direct interest in the obligations of the Debtors. Only the trusts themselves were creditors of the Debtors.

The court proceeded beyond the privity argument for denying standing and examined Appaloosa's failure to follow the “no action” clause of the servicing agreement. The “no action” clause prohibited a certificateholder from instituting any suit, action, or proceeding unless specific conditions were met. The court found that none of the conditions precedent to “action” had been met, and therefore Appaloosa was unable to surpass the CMBS special servicer and assert independent standing.

Despite Appaloosa's assertions that Midland was engaging in conflicted and self-enriching behavior, the court avoided making any specific determinations of misconduct. Citing the Second Circuit in Refco, the court emphasized that the place for disputes between a creditor and its investors was not in bankruptcy court. If Midland was acting improperly, then Appaloosa possessed the option of pursuing its contractual remedies in another forum. The court found that the “servicing standard” to which a servicing agent is contractually bound provided a sufficient “check” on the agent's conduct, and therefore did not require the involvement of the bankruptcy court.

Finally, the court emphasized certain policy concerns, stating that granting standing to certificateholders such as Appaloosa would “dramatically alter the CMBS landscape and render the delegation to a special servicer meaningless.” InnKeepers, 2011 WL 1206173 at *19. In particular, the court feared that such challenges to the special servicer's authority would permit investors like Appaloosa with “its varied holdings” to “pursu[e] its own pecuniary interests which may be at odds with the interests of other certificateholders.” Id. Despite its focus on the policy issues concerning the standing of certificateholders of CMBS, the court reiterated that it's ruling was “based entirely on controlling law as well as the applicable language of the servicing agreement.” Id. at *20.

Despite denying Appaloosa standing to be heard and object to the Motion, the court evaluated their substantive objections. Applying the standards applicable to a 363-sale motion in the Second Circuit, the court granted the Debtors' motion.

Implications of the Court's Decision

At first glance, it would appear that the court's decision in Innkeepers has set a strong precedent barring certificate holders in CMBS transactions from asserting standing in a related bankruptcy case. While it has surely stacked the deck against certificate holders, there may still be opportunities for future certificate holders to assert standing.

One of the more interesting aspects of the court's decision was the determination that Appaloosa was bound by the “no action” clause of its servicing agreement. After examining the court's decision, it appears unclear whether the door has been left open to certificate holders who were capable of establishing the conditions required under a “no action” clause.

The court does not give a strong indication of whether Appaloosa could have overcome its absence of privity with the Debtors by establishing the necessary conditions precedent for “action.” It only states that none of the conditions had been met “such that Appaloosa [was] entitled to circumvent the special servicer and be afforded independent standing to be heard on its motion.” Id. The court determined that Appaloosa failed to make any notice of default to Midland or acquired the necessary 25% of voting rights. With a bit of cleverness and the appropriate foresight, these are things that certificateholders can easily avoid.

Assuming that fulfillment of the “no action” clause is sufficient to overcome the certificate holders' lack of privity with the debtor, there still may be an issue regarding the court's policy concerns. As stated previously, the court expressed concern about individual certificate holders with other varied holdings pursuing interests at odds with the interests of other certificate holders. These same concerns were recently considered in the enactment of the amendments to Rule 2019. The fear of an “empty creditor” within a specific class or committee is almost identical to what could be referred to as an “empty certificate holder” within its group of other certificate holders. Just as the recent changes to Rule 2019 were passed to alleviate the risks posed by the “empty creditor,” it is plausible that these changes could also alleviate the court's concerns over certificate holders with varied other holdings.

Conclusion

In summary, while Innkeepers decidedly limited the standing of investors in certificates representing beneficial interests in trusts holding mortgage-backed securities, it does not appear to be a complete limitation. Such investors should now be on notice that if they hope to effectively argue standing, they must complete the necessary trust agreement requirements, such as a “no action” provision.

Grant L. Cartwright is an attorney in the Delaware office of Cole, Schotz, Meisel, Forman & Leonard, P.A. Ryan J. Dattilo is a law clerk to the Hon. Mary F. Walrath in the United States Bankruptcy Court in the District of Delaware. Dattillo has accepted a post-clerkship position with the New York office of Kirkland & Ellis LLP.

In one of the first decisions of its kind, the United States Bankruptcy Court for the Southern District of New York, in In re Innkeepers USA Trust, et al., 2011 WL 1206173 (Bankr. S.D.N.Y. Apr. 1, 2011) ruled that a holder of commercial mortgage-backed securities (“CMBS”) did not have standing to raise objections as a party-in-interest in a bankruptcy case. The case has significant implications for investors of commercial mortgage-backed securities involved in bankruptcy proceedings.

Factual Background

Innkeepers USA Trust (“Innkeepers” or the “Debtors”) is a real-estate investment trust that owns and operates a portfolio of 72 hotels across the United States. Its capital structure includes $1.29 billion of secured debt consisting of: 1) a securitized mortgage loan in the amount of $825 million (the “Fixed Rate Loan”) with Lehman ALI Inc. as the lender (“Lehman”), collateralized by 45 of the Debtor's hotel properties; 2) a floating rate senior mortgage loan in the amount of $250 million, collateralized by 20 of the Debtor's hotel properties; 3) a mezzanine loan in the amount of $118 million; and 4) seven loans, each separately securing individual hotel properties ranging in amount from $24 million to $48 million. The Fixed Rate Loan was held in two CMBS trusts (the “CMBS Trusts”), which were serviced by Midland Loan Associates (“Midland”). Appaloosa Investment Fund L.P. I, and other related entities (collectively, “Appaloosa”) held more than $200 million in principal amount of CMBS certificates in the CMBS Trusts. Following defaults on several of its loan obligations, the Debtors filed for bankruptcy protection in July 2010.

After the bankruptcy court denied approval of the Debtors' first restructuring proposal, the Debtors filed a motion (the “Motion”) for approval to enter into an equity commitment agreement with Five Mile Capital II Pooling REIT LLC (“Five Mile”) and Lehman (the “Five Mile/Lehman Bid”). The Five Mile/Lehman Bid contemplated an enterprise-level transaction involving the Debtors' entire portfolio of hotels and a reduction of the Debtors' overall debt by approximately $750 million. Specifically, the principal amount of the Fixed Rate Loan would be reduced from $825 million to $622.5 million. Midland, as servicer, agreed to the reduction on behalf of the CMBS Trusts. Also as part of the Five Mile/Lehman Bid, Midland agreed to provide staple financing to fund the Five Mile/Lehman Bid or any other qualified bid at the auction that contained a debt-to-capitalization ratio for the reorganized enterprise of not greater than 70% and provided for a payment to Lehman of not less than $200.3 million in cash.

Several parties filed objections to the Motion, including: 1) the Ad Hoc Committee of Preferred Shareholders; 2) LNR Securities Holdings, LLC and ML-CFC 2006-4 and CSFB 2007-C1 Trusts; 3) TriMont Real Estate Advisors, Inc.; 4) Appaloosa; 5) CWCapital Asset Management LLC and CIII Asset Management LLC; and, 6) the Official Committee of Unsecured Creditors. By the time of the hearing on the Motion, the Five Mile/Lehman Bid had been revised, and all objections other than those of Appaloosa had been withdrawn.

Appaloosa contended, inter alia, that the bidding procedures impeded competitive bidding and that they improperly mandated terms of a plan of reorganization. The Debtors and Midland argued that Appaloosa lacked standing as a certificateholder to object to the Motion. Appaloosa argued that a “party in interest” under ' 1109(b) of the Bankruptcy Code should be interpreted broadly, and that ' 1109(b) conferred rights on it sufficient to permit it as a “party in interest” to participate in the case and protect its financial stake.

The Bankruptcy Court's Ruling

The bankruptcy court began with an analysis of ' 1109(b) of the Bankruptcy Code, which provides that “[a] party in interest ' may raise and may appear and be heard on any issue in a case under this chapter.” 11 U.S.C. ' 1109(b). The bankruptcy court determined that in the Southern District, courts have been reluctant to find that a “party an interest” may extend beyond direct parties. In previous cases, courts held that while a creditor of one of the debtor's creditors may be “deeply concerned about the bankruptcy proceeding ' the party's legal rights and interests can only be asserted against the debtor's creditor, not against the debtor ' .” Southern Blvd., Inc. v. Martin Paint Stores , 207 B.R. 57, 61 (S.D.N.Y. 1997).

The court then proceeded to examine two cases that, despite not being directly on point with the CMBS/REMIC standing issue, provided persuasive guidance. The court first looked to In re Shilo Inn, 285 B.R. 726 (Bankr. D. Or. 2002). In Shilo Inn, the court denied standing to certificate holders of pooled real estate loan trusts. The court rejected the debtors' attempt to allow certificate holders of certain trusts to vote on a proposed plan, finding that any claims against the debtors belonged to the trusts as creditors, and not the certificate holders. Looking at the actual language of the pooling and servicing agreement, the court determined that the trust was the party that had the right to vote. The court made a key distinction between a corporate bond and a securitization, noting that in the case of a corporate bond, the bondholder has a right to payment from the corporation, whereas in a securitization, the certificate holder's right to payment is generated from the underlying assets, not the originator of the assets themselves.

The second case the court looked to was Krys v. Official Comm. of Unsecured Creditors of Refco, Inc. (In re Refco, Inc.), 505 F.3d 109 (2d Cir. 2007), in which the Second Circuit held that an investor of a creditor is not a “party in interest” within the meaning of ' 1109(b). In its decision, the Second Circuit determined that investors in a nondebtor segregated portfolio company (“SPC”) did not have standing to object to a settlement between the SPC and the official committee of unsecured creditors. The investors had placed control over their investment in the hands of the SPC, and, thus, their rights were purely derivative of the SPC's.

Following the reasoning by the courts in Shilo Inn and Refco, the court examined the terms of the CMBS Trusts and concluded that Appaloosa was merely an investor in a creditor and did not possess “party in interest” standing in its capacity as a certificate holder. In reaching this conclusion, the court noted that this was not the first time Appaloosa had attempted to circumvent a pooling and service agreement in order to override the actions of a CMBS special servicer. In Bank of America, N.A. v. PCV ST Owner L.P., Case No. 10-1178 (S.D.N.Y.) (“Stuytown“), Appaloosa, a certificateholder of the CMBS trust in those cases, sought the right to intervene in a foreclosure action against the borrower of a securitized mortgage loan. The district court summarily denied Appaloosa's motion to intervene, which lent further support to the court's decision to deny Appaloosa standing in the instant case.

The basic conclusion of the court was that Appaloosa lacked privity with the Debtors sufficient to confer standing to be heard. In a securitization, as pointed out by the court in Shilo Inn, the investor's relationship 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 themselves. Taking special note of the distinction made in Shilo Inn between bondholders and certificateholders, the court found that unlike bondholders who have a direct interest in the obligations of the Debtors, certificateholders' interests are limited to the assets of the trusts. Therefore, Appaloosa, as a certificateholder, did not have any direct interest in the obligations of the Debtors. Only the trusts themselves were creditors of the Debtors.

The court proceeded beyond the privity argument for denying standing and examined Appaloosa's failure to follow the “no action” clause of the servicing agreement. The “no action” clause prohibited a certificateholder from instituting any suit, action, or proceeding unless specific conditions were met. The court found that none of the conditions precedent to “action” had been met, and therefore Appaloosa was unable to surpass the CMBS special servicer and assert independent standing.

Despite Appaloosa's assertions that Midland was engaging in conflicted and self-enriching behavior, the court avoided making any specific determinations of misconduct. Citing the Second Circuit in Refco, the court emphasized that the place for disputes between a creditor and its investors was not in bankruptcy court. If Midland was acting improperly, then Appaloosa possessed the option of pursuing its contractual remedies in another forum. The court found that the “servicing standard” to which a servicing agent is contractually bound provided a sufficient “check” on the agent's conduct, and therefore did not require the involvement of the bankruptcy court.

Finally, the court emphasized certain policy concerns, stating that granting standing to certificateholders such as Appaloosa would “dramatically alter the CMBS landscape and render the delegation to a special servicer meaningless.” InnKeepers, 2011 WL 1206173 at *19. In particular, the court feared that such challenges to the special servicer's authority would permit investors like Appaloosa with “its varied holdings” to “pursu[e] its own pecuniary interests which may be at odds with the interests of other certificateholders.” Id. Despite its focus on the policy issues concerning the standing of certificateholders of CMBS, the court reiterated that it's ruling was “based entirely on controlling law as well as the applicable language of the servicing agreement.” Id. at *20.

Despite denying Appaloosa standing to be heard and object to the Motion, the court evaluated their substantive objections. Applying the standards applicable to a 363-sale motion in the Second Circuit, the court granted the Debtors' motion.

Implications of the Court's Decision

At first glance, it would appear that the court's decision in Innkeepers has set a strong precedent barring certificate holders in CMBS transactions from asserting standing in a related bankruptcy case. While it has surely stacked the deck against certificate holders, there may still be opportunities for future certificate holders to assert standing.

One of the more interesting aspects of the court's decision was the determination that Appaloosa was bound by the “no action” clause of its servicing agreement. After examining the court's decision, it appears unclear whether the door has been left open to certificate holders who were capable of establishing the conditions required under a “no action” clause.

The court does not give a strong indication of whether Appaloosa could have overcome its absence of privity with the Debtors by establishing the necessary conditions precedent for “action.” It only states that none of the conditions had been met “such that Appaloosa [was] entitled to circumvent the special servicer and be afforded independent standing to be heard on its motion.” Id. The court determined that Appaloosa failed to make any notice of default to Midland or acquired the necessary 25% of voting rights. With a bit of cleverness and the appropriate foresight, these are things that certificateholders can easily avoid.

Assuming that fulfillment of the “no action” clause is sufficient to overcome the certificate holders' lack of privity with the debtor, there still may be an issue regarding the court's policy concerns. As stated previously, the court expressed concern about individual certificate holders with other varied holdings pursuing interests at odds with the interests of other certificate holders. These same concerns were recently considered in the enactment of the amendments to Rule 2019. The fear of an “empty creditor” within a specific class or committee is almost identical to what could be referred to as an “empty certificate holder” within its group of other certificate holders. Just as the recent changes to Rule 2019 were passed to alleviate the risks posed by the “empty creditor,” it is plausible that these changes could also alleviate the court's concerns over certificate holders with varied other holdings.

Conclusion

In summary, while Innkeepers decidedly limited the standing of investors in certificates representing beneficial interests in trusts holding mortgage-backed securities, it does not appear to be a complete limitation. Such investors should now be on notice that if they hope to effectively argue standing, they must complete the necessary trust agreement requirements, such as a “no action” provision.

Grant L. Cartwright is an attorney in the Delaware office of Cole, Schotz, Meisel, Forman & Leonard, P.A. Ryan J. Dattilo is a law clerk to the Hon. Mary F. Walrath in the United States Bankruptcy Court in the District of Delaware. Dattillo has accepted a post-clerkship position with the New York office of Kirkland & Ellis LLP.