In a recent decision that has captured the attention of the U.S. secondary loan market, the United States District Court for the Western District of Washington starkly concluded that hedge funds “that acquire distressed debt and engage in predatory lending” were not eligible buyers of a loan under a loan agreement because they were not “ﬁnancial institutions” within the Court’s understanding of the phrase.
The decision merits attention because it is a rare decision that interprets the term “ﬁnancial institution” in the context of the transfer provisions that govern a loan trade. While the Court’s holding may be of limited precedential value because of the facts of the case and the application of the law of the State of Washington (which differs substantially from New York law on a key technical matter governing contract interpretation), it may nonetheless provide negotiating leverage to borrowers or competing creditors seeking to challenge assignments of commercial loans to investment funds. Still, the case is a rare exception to the dominant and continuing trend of increased liquidity in the leveraged loan market.
KEY FACTS OF THE CASE
In April 2008, Meridian Sunrise Village LLC (“Meridian”) entered into a loan agreement with U.S. Bank to ﬁnance the construction of a shopping mall. The loan agreement, which was governed by Washington law, designated U.S. Bank as administrative agent and lender.
The loan agreement only permitted sales to entities that were “Eligible Assignees” as deﬁned in the loan agreement, namely:
“any commercial bank, insurance company, ﬁnancial institution or institutional lender approved by Agent in writing and, so long as there exists no Event of Default, approved by Borrower in writing, which approval shall not be unreasonably withheld.”
According to the Court, Meridian speciﬁcally negotiated the deﬁnition of Eligible Assignees to avoid future assignments to entities that Meridian described as “predatory investors.”2
Shortly after the loan was funded, U.S. Bank assigned portions of its position to three other commercial bank lenders, including Bank of America (collectively, the “Lenders”). Meridian consented to each of those assignments.
Four years later, in 2012, U.S. Bank declared an event of default based upon Meridian’s breach of certain ﬁnancial covenants. The Lenders did not immediately foreclose on the loan, however, and during subsequent negotiations, U.S. Bank asked Meridian, among other things, to amend the loan agreement to eliminate the Eligible Assignee restrictions and allow for free transferability to any entity (other than to Meridian or its afﬁliates).
Meridian, however, refused to agree to this amendment. U.S. Bank then advised Meridian that the Lenders would begin immediately to charge default interest. Meridian ﬁled for bankruptcy protection shortly thereafter.
After Meridian ﬁled, Bank of America assigned its interest in the loan to a hedge fund, which further assigned a portion of its interest to two other hedge funds (collectively, the “Funds”). U.S. Bank (in its capacity as administrative agent) consented to the assignments. Because Meridian was in default under the loan agreement, its consent was not required.
When it learned of the assignments, Meridian objected on grounds that the Funds were not “Eligible Assignees.” Meridian sought to enjoin the Funds from exercising their rights as Lenders, and most importantly, from voting on its Chapter 11 plan. The bankruptcy court granted the injunction and the Chapter 11 plan was conﬁrmed without considering the votes of the Funds. The Funds appealed both the injunction and conﬁrmation of the Chapter 11 plan.
On appeal, the Funds argued that the term “ﬁnancial institution” in the deﬁnition of “Eligible Assignee” should be construed broadly to include any and all institutions that manage money (consistent with the deﬁnitions found in Webster’s Dictionary and Black’s Law Dictionary).
Meridian responded that the term “ﬁnancial institution” had a speciﬁc meaning and the types of entities listed in the Eligible Assignee deﬁnition (i.e., commercial banks, insurance companies and institutional lenders) were true ﬁnancial institutions that gave context to the term. Meridian also argued that the parties’ course of conduct in connection with the proposed removal of the Eligible Assignee deﬁnition made clear that it had been the understanding of the parties that hedge funds were not “Eligible Assignees.”
THE COURT’S ANALYSIS
First, the Court reasoned that the term “ﬁnancial institution” could not have meant any entity that “manages money,” as that interpretation would have the effect of eviscerating the transfer restriction by permitting assignments to “virtually any entity that has some remote connection to the management of money – up to and including a pawnbroker.”3
Second, following the rule of contract interpretation that a word “is known from its associates,”4 the Court concluded that “ﬁnancial institution” could be harmonized with “commercial bank,” “insurance company” and “institutional lender” only when the words were read to mean “entities that make loans.” According to the Court, the Funds were not in the business of loaning or advancing money, and this fact was not disputed in the case.5
Finally, the Court reviewed extrinsic (or “parol”) evidence about Meridian’s negotiation of the loan agreement and, in particular the Eligible Assignee deﬁnition, to determine the meaning of “ﬁnancial institution.” Because U.S. Bank had previously tried to eliminate the “Eligible Assignee” requirement, the Court concluded the parties’ actions showed that U.S. Bank and the other Lenders understood that the deﬁnition limited transfers and was, in the Court’s view, intended to exclude assignments to “distressed asset hedge funds who candidly admit they seek to ‘obtain outright control’ of assets.”6
Under the Court’s analysis, because the Funds were not Eligible Assignees, they did not have a right to vote on Meridian’s Chapter 11 plan, and the Court concluded the Funds were properly barred from voting on the Plan.
SIGNIFICANCE OF MERIDIAN TO THE LOAN MARKET
The outcome of the Meridian case appears to have been driven, in large part, by application of the law of the State of Washington, which permitted the Court to review (even in the absence of textual ambiguity), the history of negotiations of between Meridian and U.S. Bank concerning the loan agreement and the proposed amendment. The history of those negotiations (which would not generally be admissible in New York or most other states without a showing that the Eligible Assignee clause was ambiguous) showed that Meridian actively sought to preclude hedge funds and other entities in the market for distressed assets from buying the loan. Had the case been decided in a different jurisdiction and the agreement been governed by the law of a different state, it is likely that a court would reach a different result. A New York court applying New York law would likely not have looked outside of the four corners of the agreement to review the history of negotiations between the parties to gauge the meaning of a term. In addition, there is in New York a strong policy favoring freedom to “alienate” or sell property. Based in part on that longstanding policy, the Second Circuit has held that under New York law, only express limitations on assignability are enforceable.8
More critically, perhaps clouded by a desire to protect Meridian from the perceived predatory nature of distressed investing strategies, the Meridian Court failed to consider the well-established and expanding role that investment funds play in modern ﬁnancial markets, a role that prominently includes lending funds and providing capital to every conceivable type of business venture.9 In fact, investment funds are far more active as original lenders than are insurance companies, which the Court accepted as ﬁnancial institutions without question. This misperception of the role of investment funds in modern ﬁnance will no doubt be corrected over time and fall in line with the prevailing view that hedge funds are ﬁnancial institutions, and should be regulated as such, including under the Dodd-Frank legislation.
Fortunately, over the last decade there has been a trend to eliminate references to “ﬁnancial institutions” in the transfer provisions governing loan sales. Many current loan agreements do not contain “Eligible Assignee” deﬁnitions at all and instead allow borrowers to consent to new lenders on a case-by-case basis, with consent not to be unreasonably withheld – so long as the borrower is not in default under the loan agreement. Although the LSTA Model Credit Agreement includes an “Eligible Assignee” requirement, it provides only, in pertinent part, that no assignments shall be made to the borrower or its afﬁliates, to any individual or to any defaulting lender.10
Meridian is not a compelling precedent outside of the Western District of Washington, but the case is a reminder of the importance of precisely drafted assignment provisions within loan agreements. Buyers of loans should continue to review transfer provisions carefully – Meridian shows that they can be used in unexpected ways to hinder even the best laid distressed investment plans.