Commercial Finance

In a recent decision, New York state judge Charles E. Ramos granted summary judgment in favor of aggrieved syndicate members on both their breach of contract and conversion claims against exit lenders following the acceptance by the exit lenders of collateral sale proceeds contrary to the plaintiffs’ right to receive pro rata distributions. But for an exculpation clause in the credit agreement that created a triable issue of fact, summary judgment against the agent would also have been granted. The case, Prudential Insurance Co. of America et al. v. WestLB AG, New York Branch, et al. (37 Misc. 3d 1208(A) (N.Y. Sup Ct. 2012)), is the latest in a recent series of collective action doctrine cases, in which the objecting minority co-lenders dispute some aspect of the agent/majority lender-approved enforcement process.

The plaintiffs and 16 other lenders extended credit in 2006 to ASA Ethanol Holdings LLC and its affiliates, the operators of three ethanol plants. In 2008, ASA and its affiliates filed a Chapter 11 bankruptcy petition, which constituted an event of default under the borrowers’ Credit Agreement. Debtor-in-possession financing was provided by the lenders to the borrowers during the pendency of the bankruptcy case and post-confirmation exit financing was provided by some, but not all of the lenders following confirmation of the plan of reorganization. None of the plaintiffs elected to contribute to the exit financing at that time. WestLB, as the lenders’ administrative and collateral agent, successfully credit bid on two of the ethanol plants pursuant to a Section 363 sale. These plants were then acquired by two limited liability companies formed by WestLB for that purpose.

The operating agreements of the two acquisition vehicles were drafted by WestLB and stipulated the ownership terms of the two remaining plants. Those agreements rewarded the exit lenders through “participation enhancements” by separating membership interests in the limited liability companies into Class A, Class B, and non-member unit holders, whereby non-member unit holders were not granted voting rights, were excluded from participating in management, and were barred from receiving financial statements and other information about the plants. Moreover, Class A members were given an option to convert their interests into Class B interests, resulting in a dilution of distributions otherwise payable to Class B members and non-member unit holders. Because they declined to contribute funds under the exit facility and sign the operating agreements at the outset, the plaintiffs were classified as non-member unit holders.

In 2009, the plaintiffs brought suit based on the terms of the operating agreements, asserting causes of action for (i) breach of contract, (ii) conversion, and (iii) declaratory judgment (the request for declaratory judgment was ultimately dismissed by the court). With regard to the breach of contract claim, the plaintiffs argued that (i) the sale of the ethanol plants constituted “a sale of all or substantially all of the Collateral,” an event which, pursuant to the terms of the Credit Agreement, required the consent of all lenders, and (ii) after the occurrence and during the continuance of an event of default, the terms of the loan documents mandated a pro rata distribution of collateral proceeds to the lenders, contrary to the terms of the operating agreements. In contrast, WestLB argued both that its actions were approved by the required lenders and that it did not even need such approval because it was authorized to act within its discretion as agent. The court agreed with the plaintiffs, ruling that (i) because the sale was indeed a sale of all or substantially all of the collateral, the consent of all lenders was required and (ii) there was no legal justification for WestLB’s disparate treatment of lenders regarding their rights in the collateral without their consent because the Credit Agreement “in no uncertain terms” provided for distributions to all lenders on a pro rata basis. Regarding WestLB’s discretion as agent, the court found that the Credit Agreement did not grant WestLB unfettered discretion. Rather, its discretion was limited to the extent specifically delegated or required of it—language common to many credit agreements. However, because the Credit Agreement contained an agent exculpation clause, the court found that a triable issue remained with respect to WestLB’s liability under this cause of action.

With regard to the conversion claim, the court dismissed the claim as against WestLB because it was duplicative of the breach of contract claim. However, as to the remaining majority lender defendants, the court held that summary judgment in favor of the plaintiffs was appropriate because the majority lenders accepted preferential equity rights in violation of the pro rata distribution provisions of the waterfall contained in the Credit Agreement.

The case ultimately settled, and now that the dust has settled, we can identify several key takeaways: The sharing of collateral proceeds on a pro rata basis among all lenders required under a credit agreement obviously extends to the proceeds of the collateral, but equally important, it also extends to the equity interests issued by the entity formed by the lenders to hold title to collateral acquired by the lenders after foreclosure (whether pursuant to an Article 9 credit bid, or, as in the this case, pursuant to a section 363 sale). In addition, Collateral agents often find themselves in the difficult position of needing to simultaneously (i) act swiftly to preserve and maximize collateral values and (ii) obtain the unanimous consent of all lenders for certain actions designed to accomplish the former. The Prudential decision will not make the agent’s decision-making process any easier. This case highlights the importance of both the careful evaluation of intercreditor issues at the outset of a loan transaction, and thorough consultation of the loan documents before exercising rights and remedies after a default.