JER/Jameson Mezz Borrower II LLC (“Mezz II”) was formed in 2006 as part of the mezzanine financing used to acquire a chain of economy hotels. To facilitate the acquisition, JER/Jameson Properties LLC and JER/Jameson NC Properties LP, the operating companies, borrowed $175 million under a CMBS loan with Wells Fargo. Four mezzanine borrowers, including Mezz II, were formed for the sole purpose of borrowing an additional $40 million. The capital structure, typical of mezzanine financings, is as follows: Mezz I is the sole member or partner of the operating companies; Mezz II is the sole owner of Mezz I; Mezz III is the sole owner of Mezz II; and Mezz IV is the sole owner of Mezz III.
The acquisition debt matured on August 9, 2011, at which time the Debtors were unable to service the debt and the lenders at each level commenced various enforcement actions. CDCF JIH Funding, LLC and ColFin JIH Funding, LLC (collectively, “Colony”), the holder of the debt at the Mezz I and II levels, issued a notice of intention to auction Mezz II’s interest in Mezz I under Article 9 of the Uniform Commercial Code. The night before the auction was scheduled to take place, Mezz II filed a voluntary chapter 11 petition in the United States Bankruptcy Court for the District of Delaware (Mezz I and the operating companies filed for bankruptcy protection a week later). Shortly thereafter, Colony moved to dismiss the case and sought relief from the automatic stay, arguing that Mezz II had filed its chapter 11 petition in bad faith to stave off Colony’s foreclosure proceedings.
Motion to Dismiss
After conducting an objective examination of the circumstances surrounding Mezz II’s bankruptcy filing, the Bankruptcy Court granted Colony’s motion to dismiss Mezz II’s chapter 11 case with prejudice pursuant to sections 349(a) and 1112(b) of the Bankruptcy Code. Referring to the factors enumerated by the District Court for the District of Delaware in In re Primestone Inv. Partners, L.P., 272 B.R. 554, 557 (D. Del. 2002), the Bankruptcy Court concluded that the circumstances of Mezz II’s filing indicated that the filing was in bad faith. The Bankruptcy Court based its decision on a broad panoply of factors, including, among other things, that: Mezz II had only one asset, no unsecured creditors, no cash or income, no employees or ongoing business operations, no prospect of reorganization, and its petition was filed on the eve of Colony’s UCC auction. The fact that the bankruptcy case was essentially a two-party dispute between Colony and Mezz II did not go unnoticed by the Bankruptcy Court. The Bankruptcy Court found that Colony’s foreclosure would merely change the ownership of Mezz I. The only entities that would be affected, the Mezz III and Mezz IV lenders, had the right to buy out Colony’s position pursuant to an intercreditor agreement or could attend the auction and bid for an ownership interest in Mezz I. Additionally, the Bankruptcy Court found that there was compelling evidence that the filing was a litigation tactic – Mezz II had filed a bare petition on the eve of the UCC sale, it had not sought any additional relief since filing for chapter 11, and the only beneficiaries of the filing were the Mezz III and IV lenders.
The Bankruptcy Court agreed with the debtors that based on Judge Gropper’s decision in In re Gen. Growth, Props., Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009), the court must consider the debtors on a holistic basis to determine whether there is a realistic possibility that Mezz II could be reorganized. However, because the debtors were not substantively consolidated and Colony was Mezz II’s only creditor, the Bankruptcy Court found that confirmation of a plan without Colony’s consent was impossible because Mezz II would not have an impaired accepting class under section 1129(a)(10) of the Bankruptcy Code. Relying on the fact that Mezz II would be unable to confirm a plan without Colony’s consent, the Bankruptcy Court also rejected the debtors’ argument that dismissal was premature because they had not been given sufficient time to propose a plan.
While the Bankruptcy Court agreed with the debtors that a bankruptcy sale of Mezz II’s interest can be a legitimate purpose for a chapter 11 filing, the Bankruptcy Court found that there was no evidence that a sale would be more cost effective in bankruptcy rather than through a UCC sale. Because the only parties affected by the sale, the Mezz III and IV lenders, could protect their interests outside of bankruptcy, the Bankruptcy Court found there was no benefit for Mezz II to remain in bankruptcy. Moreover, the Bankruptcy Court emphasized that not only did the debtors fail to present any evidence that additional value could be realized in bankruptcy, but the debtors had failed to refinance or sell in the past, and had failed to take any action to initiate a sale process in bankruptcy.
Motion for Relief from Automatic Stay
The Bankruptcy Court also found that Colony should be granted relief from the automatic stay under sections 362(d)(1) and (d)(2) of the Bankruptcy Code. First, the Bankruptcy Court found that cause existed to lift the automatic stay under section 362(d)(1) because a de minimis equity cushion of 9%, which was eroding daily, did not constitute adequate protection of Colony’s interest. The Bankruptcy Court also rejected the debtors’ argument that excess cash at the operating level adequately protected Colony’s interest and could be used to pay administrative expenses. To the contrary, the Bankruptcy Court found that the “excess” cash had never been offered to Colony, and the debtors’ budget revealed that the cases were administratively insolvent, and there were no unencumbered assets at the Mezz II level. Next, the Bankruptcy Court determined that Colony was entitled to relief from the automatic stay under section 362(d)(2) because as Mezz II’s only creditor, Colony’s consent was required for a reorganization of Mezz II, and therefore Colony’s collateral was not necessary to an effective reorganization of the debtors.
Appeal of the Bankruptcy Court’s Order
On December 28, 2011, Mezz I, Mezz II, and the operating companies appealed the Bankruptcy Court’s decision and concurrently moved for an emergency stay pending the appeal. Judge Walrath denied the motion for an emergency stay on December 29, 2011, holding that the movants did not establish cause to justify a stay pending appeal. On January 11, 2012, Mezz I and II, the operating companies, and Colony stipulated and agreed to voluntarily withdraw the appeal, thereby permitting the Mezz II bankruptcy case to be closed.
Judge Walrath’s decision in In re JER/ Jameson Mezz Borrower II LLC will likely impact bankruptcy planning for distressed mezzanine financings. Where potential debtors are not substantively consolidated, each individual mezzanine entity will need to meet the requirements for a good faith filing, including, whether the entity can realistically confirm a plan. Mezzanine borrowers without ongoing business operations, property, or employees, and with only one creditor—which is often the case—will need to strongly consider these hurdles before deciding to file for chapter 11 relief.