4 Real

Financial Restructuring “Hot Takes” and Legal Practice Origin Stories

• Dechert LLP • Episode 23

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Looking for a primer on the top-of-mind terms and topics in bankruptcy matters today? Dechert 4 Real has you covered as hosts Jon Gaynor and Kate Mylod sit down with David Herman, partner in Dechert’s financial restructuring group, to highlight his “hot takes”/hot tips on the space, including thoughts on substantive consolidation, automatic stay, prepackaged bankruptcy and more! Plus, Dechert partner Lindsay Trapp gives the 411 on recent developments in blind pool ratings and the hosts reveal their superheroic legal origin stories! 

Show Notes 

For more information on blind pool ratings, email ratedfundsteam@dechert.com.

THE CRED Convos video series 

Jon Gaynor:

Hello and welcome back to the Dechert 4 Real podcast, where we discuss current issues and trends in commercial real estate finance. We aim to bring market commentary about developments, updates you can use and, hopefully, a little bit of banter along the way. I'm Jon Gaynor, a partner based in Dechert's Philadelphia office.

Kate Mylod:

and I'm Kate Mylod, a partner based in Dechert's New York office.

Jon Gaynor:

A quick podcast update before we get into it, we're trying out a new to host format. Each episode, I'll be joined by some of the voices you've come to know and love in addition to Kate, including Sam Gilbert, Stewart McQueen or Matt Armstrong depending on the topic. Drop us a line and let us know how you think it works out. This episodem in our 411 segment, Dechert partner Lindsay Trapp briefs us on recent developments about blind pool ratings that could help debt funds trying to raise and deploy insurance capital. After that, our main event is a talk with Dechert partner David Herman, our go-to on all things related to commercial real estate and restructuring to share some practical insights and anecdotes.

Kate Mylod:

Ooh, restructuring. Now that's a word that can scare a lot of folks in our commercial real estate space, but it's also a word that can bring music and hope to certain ears. Looking forward to our chat with David to help us unpack what is good to know given today's market. But before we do anything further, it's time to ...

Jon Gaynor:

Get 4 Real with the hosts. So Kate, what is your legal practice origin story?

Kate Mylod:

Like I'm a Marvel superhero or something?

Jon Gaynor:

Or supervillain! You tell me, I'm not gonna, like, define it for you, but yeah.

Kate Mylod:

Fair enough. All right, so how did I come to do what I'm doing now, financing commercial real estate loans? Actually, it was a little bit of serendipity. I come from a finance family with my dad and my brothers both having cut their teeth on Wall Street, and I wanted nothing to do with that. I was a liberal arts kid, and when I graduated law school, I figured I'd go into education law. The firm where I worked had a rotation program. They encouraged me to rotate, to get to know the other transactional attorneys, because they figured,"She's not going to do that. She's going to come back to education law." And I was paired with sort of like the meanest, scariest, you know, powerful partner who was doing a commercial real estate financing. I had the very important task of running all the estoppels on the deal. And it's like something clicked. This partner and I got along really well. Having something that was structured around bricks and mortar that I could go touch just made a lot of sense to me, and I never rotated back, and that partner became one of my foundational mentors and sponsors as I started my career.

Jon Gaynor:

That's awesome. I like that serendipity brought you to us here today. I guess my origin story for getting into structured finance and securitization was that while I was working at Dechert as a summer associate and trying out lots of different stuff. It was in the context of the Great Financial Crisis having happened and all of this, like, global focus on securitization and skin in the game. And I was just really interested in that, how you can structure deals, to line up incentives to get people to do the right thing. And I'm at lunch with Jason Rozes, who was, like, the partner at the head of the summer program, and he was telling a story about a deal he worked on where they were trying to figure out if they could securitize the income from swimming with the dolphins at hotels, and whether that could be in a REMIC or not. And that just resonated so, like, amusingly and deeply with me, where it was, like, FRE became a top choice for me, and so that's how I ended up here.

Kate Mylod:

So this is interesting. So, we really got into doing what we're doing, Jon, for me, it was being inspired by a big, scary partner, and you being inspired, ultimately, by dolphins.

Jon Gaynor:

Yeah, you amuse me a little, and you can win me over pretty easily. So yeah, and I guess that counts as getting 4 Real. All right, now let's turn our attention to Lindsay Trapp, a partner in Dechert's Charlotte office and Dechert 4 Real podcast episode 13 guest who specializes in, among other things, complex credit fund formation. Lindsay, welcome back. to the podcast.

Lindsay Trapp:

Ah, it's good to be back. Nice to see you again.

Jon Gaynor:

You, too. So, I understand that there has been a positive development in the world of rated funds, and I was hoping you could walk our listeners through it.

Lindsay Trapp:

Yeah, absolutely. So back when we recorded our prior podcast, at that point in time, there wasn't really an ability to get commercial real estate debt rated on a blind-pool basis. And that just kind of related to the nature of the assets and the rating agencies' sort of views and capabilities at that point in time. However, very excitingly, we've now been informed that, you know, there are blind pool debt funds that have been rated, which is great. And the thing that will be very helpful for folks when they're looking at doing, you know, commercial real estate debt in this type of structure is that it operates very similarly to the way that we do this in the commercial credit space, you know, middle market where, essentially, managers are going to need to bring with them, you know, a track record and loan tapes from prior vintages of their CRE debt funds, or perhaps separately managed accounts, deals that had been done maybe at, you know, prior shops, that kind of thing, which can be really helpful, you know, for folks. If you've got a track record in this space and you're running a fund, particularly a successor fund, or a fund that's going to operate a strategy that's quite similar to something you've been operating already, you can come with this. You don't have to have any assets in the ground. This doesn't require a warehouse, as it kind of maybe previously did. So this should hopefully unlock and open up the rated fund universe for CRE debt. There is, you know, sort of the nuance, ultimately, that some investors in the CRE space may still prefer to have a separately managed account to the extent that that's possible. So there are also structures, you know, that we do that allow that to maybe invest side by side with a regular way CRE debt fund. But ultimately, if you've got somebody who has a more medium-sized ticket or a smaller ticket than would be able to get an SMA rated fund, can be a really great option for them to get exposure to your CRE debt and then also still get their good regulatory capital charges for that insurance investor

Jon Gaynor:

Hey, I think everybody will welcome more flexibility and options in terms of fundraising and structure. And this sounds at least marginally simpler where it's applicable, so that's kind of welcome as well.

Lindsay Trapp:

Yeah, absolutely. I think it's something that we get so many questions on and people have wanted for so long. So, I think it's fantastic. You know, everybody in the rating space is sort of ever increasingly reviewing their methodologies, looking at all the different asset types that, you know, we can get rated on a blind-pool basis. And so having CRE debt in there, you know, really helps to advance the cause for insurance investors getting a very broad exposure to lots of different types of assets, which is really exciting.

Jon Gaynor:

Well, I'm certain our listeners are going to welcome that news, and we really appreciate you coming to the podcast again to share it with us.

Lindsay Trapp:

Yeah, absolutely. And if anybody you know needs some further information or would like to discuss we're always around ratedfunds@dechert.com you can send us an email we will, we will help you out.

Jon Gaynor:

Oh, I didn't even realize we had an email inbox. That's awesome. We can put that in the show notes.

Lindsay Trapp:

Yes, absolutely, we have that. And also, you can catch our vlog series on Dechert's THE CRED.

Jon Gaynor:

Oh, yeah.

Lindsay Trapp:

We'll be doing, hopefully, a vlog series to discuss some things about these advancements and other asset types that we're seeing increasing in rated fund land here soon.

Jon Gaynor:

Yeah, you guys are braver. You go on video. We like to hide behind the audio-only format here.

Lindsay Trapp:

Yes. I know. I know. It's braver. And in fact, I thank our listeners for not being shocked sometimes at the tired faces on the videos, but we're grateful for the audience.

Jon Gaynor:

It's all those rate of funds you're closing. Lindsay, thank you so much for joining us again.

Lindsay Trapp:

No problem. Thank you.

Jon Gaynor:

All right, today we're delighted to welcome David Herman to the podcast.

Kate Mylod:

David is a partner in Dechert's financial restructuring group sitting in our New York office. Hey neighbor! David represents clients in complex chapter 11 and municipal bankruptcy cases out of court, restructuring matters and high-stakes bankruptcy litigation. David has experience representing debtors and creditor parties in many of the most complex and contentious U.S. bankruptcy proceedings in recent years, leveraging his expertise in all aspects of financial restructuring, with first-chair trial experience. When our finance and real estate folks here at Dechert have questions about bankruptcy and creditors' rights matters, David is always our first call, and he always picks up. So David, welcome to the Dechert 4 Real podcast.

David Herman:

Thank you for having me.

Jon Gaynor:

Before we get into the substance, let's get 4 Real with you. David, can you tell us about your legal practice origin story?

David Herman:

Sure, and it's more serendipity. You know, it all started when I was in high school and I decided to spend a summer living in Spain. I lived with a family in Madrid for part of the time, and the adults were working during the day, so I spent a lot of the day just walking around the city, wandering aimlessly with my 15-year-old host brother, Sergio, talking about random things. And that's how I came to learn to speak and understand Spanish. So fast forward, I started my career as a commercial litigator. I never took a bankruptcy course in law school. Never thought I would be a restructuring lawyer, it frankly sounded kind of boring to me, which turned out to be wrong but I didn't know that the time. But in 2016, we were hired at a prior firm to represent the Republic of Argentina in its sovereign debt restructuring and related litigation. I didn't know much about that, but it was thought that having a senior associate who could speak Spanish would be helpful. That turned out to be wrong, because the people we worked with in Argentina's finance ministry were all lawyers or former investment bankers, and they spoke perfect English. But through that matter, which turned out to be one of the most interesting of my career so far, I met my firm's restructuring lawyers. And after that, as cases and issues came in to that practice that had a litigation angle, I'd start to get calls. And it turned out we fell into some pretty big cases. We represented the Weinstein Company, you know, following the Harvey Weinstein scandal, PG&E, Sears, abunch of other big cases. And over time, I just came to do and and oversee not just the litigation work associated with those matters, but also what we think of as the core restructuring work. When it came over to Dechert in 2020 I joined the restructuring group.

Jon Gaynor:

And what a five years it's been since, right? You guys have been just absolutely gangbusters over the last little bit.

David Herman:

It's been wild. It's been great.

Kate Mylod:

I always like it when we have serendipity, you know, kind of leading us to where we are, whether it's, you know, lunches with key people during formative times of our careers, or, you know, falling into a restructuring line of business like yours, David.

Unknown:

Yeah, you just got to be open to the opportunities that come up.

Jon Gaynor:

I feel like we're getting very, like, new age hippie, let the universe, like, guide you to where you're gonna go.

Kate Mylod:

That's so what we are as, you know, the Type A attorneys we are at our core. Well, that's great to hear David and to set the stage for our conversation today around restructuring matters. I think it's important and will be helpful both for Jon and me, as well as for our audience, to lay the groundwork on a number of basic creditors' rights and restructuring-related terms that percolate in conversations around bankruptcy. Some folks know what these terms mean. Some folks think they know what these terms mean, and some folks have no idea what they mean. I probably fall more in the latter category. So we're going to play a little game with you, David, where we are going to throw out some bankruptcy-related terms to you and have you tell us in as few words as possible what they mean, and then give us some hot takes. You ready to start?

Unknown:

Yeah, I'm ready to start. Although I noticed you didn't ask me to define "hot take." I asked my kids last night what a hot take is, because I thought they would know, and they told me that a hot take is a comment or piece of commentary that's offered quickly and without much deep thought or analysis, and that may be deliberately provocative or controversial. I don't know if I'm provocative enough to give hot takes

Jon Gaynor:

And they usually don't hire us to be doing anything other than think deeply. So, let's say it is something that is quick and people might find provocative, but it, you know, is correct. Quick and correct.

Kate Mylod:

Like a tool that people can put in their pocket when they walk away from this podcast around restructuring matters. So.

Jon Gaynor:

Almost like a hot tip.

Kate Mylod:

Hot tip, hot take.

David Herman:

That I can do. That I can do.

Kate Mylod:

All right, well, let's get started. So, the first one we're going to throw out at you, David, is substantive consolidation.

Unknown:

So, substantive consolidation, or subcon to those of us in the business, is when a bankruptcy court uses its equitable power to combine the assets and liabilities of distinct corporate entities, so that creditors of each entity share in the common pool of assets rather than each recovering from their respective debtor that owes them money. So, say you have a big company with a parent and 150 direct and indirect subsidiaries that do all different things, and they all file for bankruptcy, and there's claims of all different types against those entities, as well as intercompany claims between and among those entities. Some of the creditors may not even know which entity technically owes it the money, say somebody who slipped and fell in a department store. A bankruptcy court has the power in appropriate circumstances to treat all of those entities as a single entity, or to consolidate them into a small set of entities and let the creditors share recoveries proportionally from the common pool. In a complex case, this can make things a lot simpler.

Jon Gaynor:

So, why do lenders and other creditors, like, for example, folks who are lending against real estate, care about substantive consolidation? What's the risk to them?

Unknown:

Yeah, so, subcon is often going to help some creditors and hurt others, and that's because different corporate entities have different ratios of assets to liabilities. So, just to take a simple example, say you have two creditors that are each owed$100. One has a claim against the parent, which has only $25, and the other has a claim against the subsidiary, which has $75. In an unconsolidated case, the second creditor, the one that has the claim against the wealthier subsidiary, is going to get 75 cents to the dollar. But if the entities are consolidated, they both get 50 cents to the dollar, even though the second creditor perhaps lent money to a healthier entity. So if you're a creditor of the entity with greater assets relative to its liabilities, when that entity is substantively consolidated with one that has fewer assets relative to its liabilities, your proportional recoveries are going to decline. So, here's the

hot take:

most of your financing deals in the commercial real estate world are non-recourse, right?

Jon Gaynor:

That's right.

David Herman:

Yeah. So the lender is relying on the underlying real estate as its source of funds to pay debt service and ultimately repay the loan. The lender doesn't want its collateral being combined with other assets and benefiting other creditors that did not lend to that particular entity.

Kate Mylod:

You know, that's absolutely a risk and a concern in our commercial real estate financing world. You know, such a risk that, given the deal size, non-consolidation opinions are required to give the lender further comfort that the risk of substantive consolidation is fairly remote. How else, you know, other than getting legal opinions around it, David, how can lenders mitigate this risk of substantive consolidation when they're making their financing available?

Unknown:

There's a bunch of things you can do. Require that your borrowers be structured as bankruptcy remote entities, and bear in mind the factors that courts consider in assessing subcon - that's not a hot take, but a hot plug to call your friendly local restructuring lawyer who knows those factors cold. Make sure the entity you're lending to is required to keep its assets and liabilities and its books and records and operations separate from those of its affiliates. We want separate financial statements. Courts look at that for subcon purposes. If you can, put in place an independent manager whose consent is required for filing bankruptcy. And build in recourse to a guarantor, a so-called "springing recourse provision," or a "bad boy guarantee," in the event of the borrower voluntarily filing bankruptcy. Incidentally, another hot take? The phrase"bad boy guarantee" is outdated and should be replaced.

Jon Gaynor:

Oh man, I totally agree. I actually go to the level of, like, renaming documents when they come in to, like, bad act guarantee or something like that. It always struck me as a little bit, like, everyone can be bad. Come on.

David Herman:

Yeah. I don't know why we're still using that phrase.

Jon Gaynor:

I think it's, like, tradition and, like, momentum and like, it's just what everybody calls it, but I'm totally bought in on this one. I want to explore, though the kind of recourse elements a bit and the, like, voluntary bankruptcy filing. Do these sort of bankruptcy springing recourse carve-out guarantees actually hold up in court as a means of, you know, disincentivizing a borrower from doing this kind of behavior?

Unknown:

Yeah, generally speaking, they do. There was a time around the 2008 Financial Crisis where there were parties that challenged these clauses as being against public policy, and there are various other types of provisions that you might find in deal documents that courts have ruled, you know, are against public policy if they basically disincentivize parties from exercising the rights that Congress established to file for bankruptcy. But in New York, at least, you know, these provisions were upheld against challenges, and they've been enforced by bankruptcy courts. Following those decisions, there have been some states that have passed statutes that make such clauses unenforceable, so the choice of law of your loan documents matters.

Jon Gaynor:

Good news, I think that the vast majority of guarantees that I see are all governed by New York law. So here's the next one for you, David: automatic stay.

Unknown:

Automatic stay. So, when a party files for bankruptcy, that bankruptcy petition operates as an automatic stay of all actions against the debtor or its property. That means no lawsuits, no foreclosures, demands for payment, debt-collection efforts or any other actions to go after the debtor or grab its property. So,

hot take:

It's actually automatic.

Kate Mylod:

What does that mean, David?

David Herman:

So, the reason I give that hot take is I think there's sometimes a misconception that you need to go to court to get an order or some sort of notice or something like that, for the stay to attach. That's not the case. It is literally automatic. The stay happens by operation of law upon the filing of a bankruptcy petition, and it applies to all entities, no matter where they're located.

Jon Gaynor:

So that's, like, very broad and very powerful. Why is it so expansive? And what's the point of this stay?

Unknown:

So, imagine you have an insolvent company that doesn't have enough money to go around, what's going to happen? Well, creditors have an incentive to start grabbing assets. And the automatic stay, I kind of like to describe it as a referee jumping into the middle of the brawl and saying, "OK, everybody stop." It gives the debtor some breathing room, it gives the bankruptcy court some breathing room to run an orderly reorganization process or liquidation if necessary that hopefully maximizes the value that's available for distribution and provides distribution equitably to creditors, not simply to the first ones that happen to pile them on.

Jon Gaynor:

So somebody files for bankruptcy, the automatic stay goes into effect. What do creditors have to do at that point? Like, are they just stuck?

Unknown:

They're not stuck. What it does is it centralizes all of the disputes about a debtor's assets into one form, which is the bankruptcy court. So, if you're a creditor, you can file a claim. It's actually very easy to do. It's a standard form. You can fill it out. For our clients, we will typically include some prose behind it, and some supporting documentation. And if there are reasons, and those reasons, you know, often come up in the commercial real estate context, you can ask the court for relief from the automatic stay to pursue your non-bankruptcy remedies in your form of choice.

Kate Mylod:

So, David, are there any exceptions to the automatic

Unknown:

There are exceptions to the automatic stay, and they're stay? all enumerated in Section 362 of the Bankruptcy Code. One that just comes to the top of my head is criminal proceedings. If you've got a criminal proceeding against you and you file bankruptcy, that does not stop the prosecutors.

Jon Gaynor:

That's interesting. I think repurchase agreements and securities contracts are something I do a lot of also have an exception to the automatic stay, and we're grateful for it.

Kate Mylod:

Hopefully there's not too much of a parallel between repurchase agreements and criminal activity. David, one more question on this. Master of the obvious question: When does the automatic stay end?

Unknown:

So, the automatic stay ends when the debtor has emerged from bankruptcy, and what emerged means is that the restructuring plan that has been developed in the bankruptcy, and hopefully approved by creditors and confirmed by the court, ultimately goes effective, and the plan goes effective upon its terms. And at that point, the debtor is or the reorganized debtor, if it's a reorganization, is free to go and the stay is lifted. However, I will caution that if you have a claim that arose before the effective date, it has been discharged at that point, unless the plan provides otherwise.

Kate Mylod:

Got it. So it's like that ref blows the whistle and the game resumes, maybe with players in a different formulation.'

David Herman:

Correct.

Kate Mylod:

All right. So let's move on to our next term, pre-pack or pre-packaged bankruptcy. Tell me about that, David.

Unknown:

So, a pre-pack, or pre packaged bankruptcy, is when a company files for bankruptcy with a restructuring plan that has already been accepted by its creditors. Let me unpack that pre-pack definition a little bit. Normally, a bankruptcy case starts with a petition and it ends, as I mentioned a moment ago, with confirmation of a plan, either a reorganization plan or a plan of liquidation. For a plan to be confirmed, that's the magic word for approval by a court, it has to take all the claims against the debtor and group them into classes, and then it has to get a so-called accepting vote of each class of claims that are impaired - impaired meaning that those claims are not getting everything they owed. So basically, everybody who's taking a haircut gets to vote, and you need the requisite accepting vote in each class, which is half the creditors in that class by number and two-thirds in amount, or at least one accepting class if you can satisfy the cram-down requirements, which is a lesson for another day. There's another term that people throw around: cram down. So, to get those votes, you actually mail out ballots to creditors, and there's a bunch of court-approved disclosures that have to go with them, and that's called solicitation. So, there's all these bankruptcy terms of art, and that's how we stay employed, by the way. Anyway, with the pre-pack, you actually do the solicitation and get the acceptances before you even file the bankruptcy petition. So, on the first day of the case, you file the petition and your plan, and you ask the court to schedule your plan confirmation hearing. So that's what it means that the bankruptcy is pre-packaged. This is distinct from a plan that's merely pre-negotiated. That means that it's been negotiated with some portion of the creditor body, maybe the principal lenders, and they've agreed to a plan with certain terms. And often you'll reflect that agreement in something called a restructuring support agreement, or an RSA. With a pre-pack, you've actually gone a step further. You don't just have an agreement with some of your creditors, you've actually done the formal solicitation process, and you have the accepting votes necessary for the plan to be confirmed.

Kate Mylod:

Got it. So, it sounds like by doing a lot of up-front work to put this pre-pack together, it can save a lot of heartburn, maybe, during the bankruptcy process itself. Is that really why creditors like pre-packs when they can use

Unknown:

it can save heartburn, it can save uncertainty and it them? can save money. There's a lot of advantages. Bankruptcy cases can be very expensive and there are risks associated with them. So, a pre-pack is faster than a traditional chapter 11 case, you've done your negotiations with the plan already. You don't have to just start doing that once you file the case. There's lower cost, there's less business disruption. You can present to the market in terms of your publicity that, you know, you have a plan already, that you have a controlled process that's already been agreed to, and the company has a path forward, but you're also still getting the benefits of the bankruptcy code that you wouldn't get from an out-of-court restructuring. So, you get the automatic stay, you get the discharge of all the claims that arose before the bankruptcy, you have the ability to bind all creditors, even those that don't vote for the plan, and you have the ability to sell assets free and clear of claims or liens and various other advantages.

Kate Mylod:

Well, it sounds like, I mean, it can't quite be bulletproof, or is it a sure thing once it's put into the hands of the court?

Unknown:

it is not bulletproof. And that brings me to my hot take, which is that there are risks associated with a pre-pack. One is that once you file for bankruptcy, you do lose some measure of control. You may have a plan that you've put forward, but any creditor is a party in interest with the right to be heard, and could challenge the plan, could object to the plan, and the court would, of course, rule on that. So, although you've done a lot of the work up front and you've de-risked the process to a certain extent, it's not necessarily smooth sailing. It just increases the odds that things go smoothly.

Jon Gaynor:

That also somewhat limits the ability of a creditor-on-creditor violence scenario, because the folks who are maybe the junior creditors who aren't a part of the pre-pack plan get an opportunity to challenge it if the plan is really unfair to them or substantially detrimental to their interests in a way that would be an equitable court would find objectionable. Is that right?

Unknown:

There is an opportunity to challenge and if there is creditor-on-creditor violence, as you say, built into the plan, particularly the sort of violence where creditors are grouped together in a class and are given different treatment or different opportunities, you can have significant litigation over that. We handle a lot of those matters. We recently argued and prevailed in the Serta case, which challenged a transaction similar to that. These are hot topics in the bankruptcy world right now.

Jon Gaynor:

OK. So another term of art that we hear a lot: fraudulent transfer.

Unknown:

This is one of my favorite terms. A fraudulent transfer is a mechanism for debtors in bankruptcy under certain circumstances to claw back assets that were transferred in the two years before the bankruptcy or longer, under some states' law, and it does so under two basic sets of circumstances. The first is what we call actual fraud, an actual fraudulent transfer. And that means that the debtor transferred its property or an interest it had in property with actual intent to hinder, delay, or defraud its creditors. Like,

David Herman:

With business decisions like that, it's not if you know you can't pay your debts, so you transfer everything you have to your cousin, and you do that on purpose to defraud your creditors or make it harder for them to recover on your debts. That would be an actual fraudulent transfer. But, hot take: You can commit a fraudulent transfer without actually committing fraud. It's a term of art. It doesn't necessarily require actual fraud. There's another type of fraudulent transfer that we call constructive fraudulent transfer. And what that means is that the debtor, at the time that it was insolvent, transferred an interest it had in property and received less than a reasonably equivalent value in return. zthat's a term of art - less than a reasonably equivalent value. So, for example, say you're insolvent and you sell your $1 million house to your cousin for $100. surprising that you're insolvent.

Unknown:

Yeah, or maybe it wasn't a business decision at all. But the point is that you don't have to prove that there was actual intent to defraud your creditors. It's enough to show that there was less than a reasonably equivalent value in return. And that's obviously an extreme case. There's also no-closure cases where you have whole disputes over whether the value is reasonably equivalent. So, in either of these circumstances, we have actual fraud or constructive fraud, the debtor in bankruptcy in a Chapter 11, or a trustee in Chapter Seven, or a trustee that's set up under a plan that stands in the shoes of the debtor, can avoid the transaction. That's a term of art, and that means that the transaction is voided, it's undone, and the money gets clawed back so that it can be distributed to creditors in the normal way, according to the priorities of the bankruptcy code.

Kate Mylod:

So, David, how does fraudulent transfer play out in the bankruptcy case, for example, who's the one who determines that it's occurred? Is it something that a creditor raises or brings a motion about? Is it something that the judge can discover during the course of the hearing? How does it get used?

Unknown:

So, a fraudulent transfer is a cause of action. It is a claim that a debtor can bring, and that cause of action belongs to the debtor - belongs to the estate. Now you may think, "OK, well, how can that be? The debtor owns this cause of action, but I thought you said it was the debtor who gave its property away for less than reasonably equivalent value, or with actual intent to defraud." And so that's why, in the bankruptcy context, we have derivative standing. A creditor, or, more commonly, an official committee of creditors has been appointed in case, can seek and obtain derivative standing to stand in the shoes of the debtor and bring this lawsuit for the benefit of the estate. If you're familiar with derivative suits, and under corporate law, it's very similar. You have to show either that you made a demand on the debtor to bringthe action and it was refused, or that demand would be futile for various reasons. You also sometimes see fraudulent transfer actions being brought after a plan has been confirmed. A lot of times, rather than litigate those sorts of claims during the course of a bankruptcy case, which can be very disruptive at the time that people are trying to get together and agree on a plan, sometimes those claims will be conveyed to a trust, and a trustee will be appointed to pursue any and all avenues that the estate has to recover more value that could then be distributed. And so, ultimately the claim will be brought by somebody in bankruptcy court. It could also be brought elsewhere, and it would go before the bankruptcy court, ultimately. You'd have a trial, and the court would rule on whether there was a fraudulent transfer.

Kate Mylod:

So, we've made it through four terms, and there's one more to go, but I'm just sitting here reflecting, and I think I have a hot take of my own, which is, you absolutely need to have restructuring expertise - meaning somebody like a David - help you sort through all of these issues on your deal. Like, there's a lot of stuff going on here.

Unknown:

I'm so happy to hear you say that.

Kate Mylod:

Well, you know, you always pick up the phone when I call.

Unknown:

We have to earn our paycheck somehow.

Kate Mylod:

We do, we do. Well, here's one more for you, David: preference period. What does a preference period in a bankruptcy context mean?

Unknown:

This is another avoidance framework. I just described fraudulent transfer as an avoidance action, where you can avoid a transfer. So the preference period ... preferences are similar, but they're distinct from fraudulent transfers. And when we say the preference period, what we mean is a period of time before a bankruptcy filing during which transfers of a debtor's property can be unwound for certain reasons. The period is 90 days, or in the case of transfers to insiders, the period is one year. And, as I mentioned, this is different from a fraudulent transfer. Fraudulent transfer is based on actual or constructive fraud. Preferences don't require that. Instead, preferences are concerned about some creditors being treated better than others in the months before bankruptcy filing. So say you owe a million dollars to all different kinds of creditors. I hope this never happens to me, but say you do, like maybe there's banks or vendors or your best man who won a Vette. Before you file your bankruptcy petition, you might think, "Hey, let me pay off some of my debts, like the bills from my favorite gardener or the invoices from my favorite bankruptcy lawyer." That might be a nice thing to do, but it's not fair to the other creditors. Under the bankruptcy code, creditors of equal rank are supposed to recover proportionally. You're not supposed to pay 100 cents to the dollar, or even 80 cents to the dollar to your gardener or your bankruptcy lawyer in the weeks before bankruptcy, when other creditors ultimately get less. And so, the bankruptcy code deals with that by letting the trustee or Chapter 11 debtor claw back those payments that were made during the preference period and redistribute the money according to the ordinary priorities of the bankruptcy code. nd if the person that you pay back is an insider, as I mentioned, like your brother or the co-owner of your business, or, say, your commercial real estate lender, that's also a 40% equity holder, that look-back period can extend for an entire year. So here's a hot take: Having your money clawed back in a preference action can feel really unfair to the creditor, like the gardener who did nothing wrong actually did the gardening work and was just trying to get paid for that work.

Kate Mylod:

Well, thanks for that, David. That was a really great overview, and thanks for being a good sport with all those hot takes and our follow up questions. Shifting to a few more things to unpack in this podcast, there's another area I want to explore with you, David, and it relates to what I've seen in my loan restructuring space around rescue capital and some of what you were just saying about fraudulent conveyance and preference period and insider kind of has my wheels spinning on that. Let's say, for example, we've got a distressed property, and the equity holder of that property wants to make a new investment in order to help stabilize it, but wants to do so with some kind of beneficial treatment, so that equity holder puts in the investment as junior debt. So, of course, the existing senior creditors on that deal, whether it's a mortgage lender or senior mezz lender, you know, they'll make sure that that new debt is subordinate and that it's neutered if it's held by an equity holder. But from a creditors' rights perspective, it sounds like there's some issues brewing here if we have an investor that's holding both debt and equity.

Unknown:

Yeah, there's a whole bunch of issues. I mean, the first thing that got my antenna up, that you need to be thinking about is something called re-characterization. You have a re-characterization risk, and this is another buzz word which, again, helps us earn our paychecks. Bankruptcy courts have the power, in appropriate cases, to re-characterize debt as equity. So, maybe you structured this rescue capital infusion as a loan, but I also heard you call it a new investment, and if the court thinks that what's really going on here is the equity holder is injecting new capital into the business, that injection of new capital can get re-characterized as equity, and therefore receive no recovery in a bankruptcy unless and until debt is paid back in full. This is the Absolute Priority Rule, which provides that equity doesn't recover unless creditors consent or are paid in full. It comes behind the debt. So, you could have a re-characterization risk, and there are specific factors that the courts apply in determining that you could evaluate on a case by case basis. You may also have a preference risk depending on how the investment is structured. If the transaction involves some pre-existing debt getting paid off, and then there's a subsequent bankruptcy filing that payment in the run-up to bankruptcy could be considered a preference, you'd have to evaluate that. And here's where it matters that this is an existing equity holder making the new investment, because recall that the preference period is 90 days, but it's an entire year if you're an insider. And there's various ways to be considered an insider, but one way is if you're an affiliate, which is a defined term in the bankruptcy code, meaning that you own or control at least 20% of the voting securities of the debtor. So if that's the case, you could be dealing with a year preference period and risk. You could also potentially have fraudulent transfer risk that you'd want to evaluate, depending on the circumstances.

Kate Mylod:

It still could be that this investor wants to go ahead and proceed with the investment, but it really needs to be an eyes wide open, aware of all the risk, you know, recommended course of action here.

Unknown:

Absolutely, and there are things that you can do to mitigate, for example, the re-characterization risk, like I said, that there are factors that courts consider. For example, does this look and feel like debt, or does this look and feel like equity? So factors like, you know, is there a fixed maturity? Are there coupon payments, you know? Is it documented in writing things like that that make it look and smell like debt, not just like an equity infusion. So, if you can structure it in that way and document it properly, you can mitigate your risk.

Jon Gaynor:

Got it. So we get questions from clients from time to time, what happens if you're in a multi tranche deal? Say, for example, you have a mortgage loan and a mezzanine loan above it, and one borrower files bankruptcy, but the senior borrowers do not. So like, for specifically, if a mezz borrower files bankruptcy but not the mortgage borrower, how does the automatic stay at the mezz level affect enforcement actions that the mortgage lender might want to take?

Unknown:

So, we get these kinds of questions a lot, and it's a very interesting subject, how the automatic stay applies when you have debtors and also non debtor affiliates though enforcement actions at the mezz level in your hypothetical, would obviously be stayed by the automatic stay. And again, to return to something I said earlier in my hot take, they are stayed. Nothing has to happen for them to be stayed. It's just automatic. Enforcement actions at the mortgage level are more complicated. The general rule is that the stay only protects property of the debtor that's in bankruptcy, not property of a non-debtor affiliate. So there are cases, for example, holding that enforcement actions against an entity structured as an LLC don't violate the stay even if the debtor has a membership interest in that LLC. The theory is that the only asset of the mezz borrower, for example, is its membership interest in the mortgage borrower. So you're not touching those membership interests, as long as if you're taking enforcement actions against the property owner, so long as the mezz borrower doesn't have to be named as a party in the foreclosure process or the like. On the other hand, there are cases that that say that the automatic stay may extend to actions against a non-debtor party if there is an immediate economic effect on the debtor, and you could debate whether that applies in this scenario that you've described, particularly if you're in a distressed situation where the membership interests are worthless. I mean, they were worthless before the enforcement action, and they're worthless after. The problem is that if you're found to have violated the automatic stay, particularly if you're found to have done so willfully, you can be subject to sanctions. So you'd like to avoid that, and you have to sort

David Herman:

So what about claims against the guarantor of weigh the risks and the possibilities, but one option you have is to ask the bankruptcy court for something called a comfort order that the state does not apply and typically courts don't give advisory opinions. But this is an exception where it's very well established that bankruptcy courts will do this, and we recently did this for client in a distressed real estate deal where there was a bankruptcy filing. In that case, it was even further up the structure at the sponsor level, and the ownership of the old underlying real property assets was only partial and indirect, the client wanted to take enforcement actions at the property level. It may be the client could have just gone ahead and enforced, but rather than doing that and finding ourselves in court, potentially defending ourselves against claims that we'd willfully violated the stay and facing the threat of sanctions, our client opted to seek a comfort order to get the bankruptcy court's blessing in advance that the lender would not be subject to the automatic stay with respect to its enforcement action against its real estate collateral. So, this is a situation where we concluded, and the client concluded, that seeking permission was better than asking forgiveness, and there is a policy underlying the automatic stay that the courts have a preference that you ask permission, not forgiveness. So in that matter, we were successful in getting the comfort order, and it turned out to be important because the title insurance company for our client also wanted that comfort order, and with it in hand, was willing to issue the title insurance. I should say that it's not necessarily either or. Lenders also have the option to pair a request for comfort order with an alternative request for relief from the automatic stay in the event it's deemed to apply or, in appropriate cases, to dismiss the bankruptcy case. For example, you're not supposed to file bankruptcy just to stop a foreclosure action when you have only one creditor. That's not really what bankruptcy is for. So there may also, in those circumstances, be other motions and other avenues that you can take. when the guarantor itself is not in bankruptcy,

Unknown:

Not stayed. How's that for a hot take?

Jon Gaynor:

I like it. Easy enough. David, that was really awesome. Thank you for joining us on the podcast this month.

David Herman:

Thanks for having me. This was really great.

Jon Gaynor:

All right, so I think that brings us to our 4 Real High Fives. Does anyone have someone they'd like to thank or recognize?

Kate Mylod:

Oh, I have one. I'd like to give a shout out to Karli Wade, an associate in our financial restructuring group who helped out behind the scenes to make David and especially Jon and me look good while discussing bankruptcy and commercial real estate. So thanks for all the help. Karli, we really appreciate it. Jon, how about you?

Jon Gaynor:

I've got one that's close to the heart. So on behalf of the whole 4 Real podcast team, I want to give a 4 Real High Five to our friend and former colleague, Ella-Marie Smith, who's transitioned over to Mayer Brown. She's graduated from the podcast, and we're really gonna miss her. 4

Kate Mylod:

Yep, we're gonna miss you, Ella. And good luck.

Jon Gaynor:

And thank you to our audience for joining us for another episode of Dechert's 4 Real podcast. If you have any thoughts or your own hot takes or received wisdom on bankruptcy and automatic stays, please share them with us at our email inbox, realpodcast@dechert.com Also, if you like what you heard, give us a five-star rating on whatever platform that you found this on. This episode was hosted by Kate Mylod and me, Jon Gaynor. Stewart McQueen, Matt Armstrong and Sam Gilbert produced it. Production support is by Kara Ray, Mallory Gorham, Alyssa Norton, Peggy Heffner, James Wortman and Jacob Kimmel. Our editor is Andy Robbins of AudioFile Solutions. Thanks for listening, and we'll see you next time on the Dechert 4 Real podcast.

Kate Mylod:

All right, let's not forget our dad joke. David, would you like to do the honors?

Unknown:

I would. My son Noah told me this one. Is it still a dad joke if you got it from your kids?

Jon Gaynor:

I think it's like dads in training, is the argument we've been making. So, go for it.

David Herman:

What do you call a deer with no eyes?

Jon Gaynor:

What do you call a deer with no eyes?

David Herman:

No eyedear.

Jon Gaynor:

My kids are in the phase where all of their jokes are just basically, like, the word "butt" over and over again. So kids, if you're listening in the car to this, go ahead and go crazy.

Kate Mylod:

David, thanks to your son for a joke that made at least Jon and me giggle a little out loud.

Unknown:

He'll be grateful to hear you say that.