The onset of the COVID-19 pandemic in the Spring 2020 brought immense market uncertainty, which in turn placed serious strain on contractual relationships.  Amid that strain, a question on the minds of many commercial parties was the extent to which the underlying contract contained a termination option or other safety valve that could be exercised to relieve a party of the weight of its obligations.  While much has already been written on the subject, a recent decision by Commercial Division Justice Joel M. Cohen adds an interesting angle to the discussion: whether a counterparty may unilaterally extinguish a termination option for market disruption by actions deemed to be “off-market.”  In Cascade Funding LP – Series 6 v. Bancorp Bank,[1] Justice Cohen answered that question in the negative.

Background

Plaintiff Cascade Funding, LP (“Cascade”) is an investment fund formed for the purpose of purchasing and securitizing mortgage loans.  Defendant The Bancorp Bank (“Bancorp”) is a commercial bank that, among other things, originates commercial mortgage loans and sponsors commercial real estate collateralized loan obligations (“CLOs”). 

On the eve of the COVID-19 pandemic, on February 24, 2020, Cascade agreed to purchase from Bancorp a pool of more than $825 million in commercial mortgage loan assets, with the intention of packaging and securitizing those assets into commercial real estate CLOs that would be marketed and sold to investors no later than April 15, 2020.  As part of the deal, Cascade paid Bancorp an initial $12.5 million deposit in advance of the target April 15 closing date.

At the center of the dispute is a “Market Disruption” clause in the parties’ agreement that, as the Court explained, effectively gave Cascade a “securitization out” based on an objective change in market conditions between contract execution and the securitization closing date.[2]  The provision stated, in relevant part:

if (i) the Purchaser elects to pursue a Securitization to fund the purchase of the Closing Date Mortgage Assets and has been working in good faith to close such Securitization on the Target Closing Date and (ii) no earlier than fifteen (15) days prior to the scheduled closing date of the Securitization, the Purchaser provides written evidence to the Seller (satisfactory to the Seller in its reasonable good faith) that, based on levels provided by a retained rating agency for the Securitization, the ‘AAA’ grade bonds in the Securitization would . . . price at a rate higher than LIBOR+200bp . . . , then the Purchaser shall have the right to terminate the Transaction and will have no obligation to purchase the Mortgage Assets.[3]

In addition to termination of the transaction, the “Market Disruption” clause also provided for return of Cascade’s initial $12.5 million deposit.

As the Court explained, this “Market Disruption” clause was an integral part of the agreement: “The magnitude of the LIBOR spread in the proposed securitization was critical to Cascade because its return on the transaction depended on there being excess cash flowing from the mortgage loans after payment to bondholders.  The higher the interest rate paid to bondholders, the less likely that there would be a return on Cascade’s investment.”[4] At the time the parties executed the contract on February 24, 2020, similar securitizations were being priced around LIBOR+100bp, thereby leaving “a substantial cushion” from the LIBOR+200bp threshold that would permit Cascade to invoke the “Market Disruption” safety valve.[5] 

But, as the Court put it, “then came COVID-19.”[6]  Due to pandemic-related uncertainties, the market for commercial real estate CLOs effectively dried up.  The record evidence showed that there was not a single new primary issuance between March 2, 2020 and May 19, 2020; that spreads in the secondary market widened to levels ranging from LIBOR+300bp to LIBOR+500bp; and that Cascade’s own underwriter provided written notice that the proposed issuance would be priced at LIBOR+300bp.

On March 31, 2020, fifteen days before the closing date, Cascade exercised the “Market Disruption” clause, provided Bancorp with notice of termination, and demanded return of the $12.5 million deposit.  Cascade included with its notice a written determination of market conditions prepared by the underwriter.  For reasons discussed below, however, Bancorp rejected the notice.  Cascade ultimately filed suit, seeking among other things recovery of the initial deposit.  Cascade filed a motion for summary judgment, which the Court granted.

Analysis

In opposing summary judgment, Bancorp argued that (1) before concluding that the bonds could not be priced at or below LIBOR+200bp and invoking the “Market Disruption” clause, Cascade should have gone through the process of soliciting actual bids; and (2) had it done so, it would have learned that Bancorp itself was willing to buy the bonds (if offered) at LIBOR+199bp. 

With respect to Bancorp’s willingness to buy the offering, the Court explained that the summary judgment record show that, faced with the prospect of losing the transaction, Bancorp decided internally to buy the bonds in order to “satisfy” the “Market Disruption” clause.[7]  However, the record was undisputed that Bancorp did not disclose this intention to Cascade, and in fact had stated explicitly when executing the contract that it did not intend to buy any bonds in the securitization.[8]

The Court rejected Bancorp’s arguments and granted Cascade summary judgment.  With respect to Bancorp’s argument that Cascade was required to solicit actual bids, the Court reasoned that the clause—as written—provided an objective metric by which to determine disruption and did not say that “actual bids” were the “only acceptable evidence of market disruption.”[9]  The Court concluded that the clause therefore did not require Cascade to “proceed with objectively futile marketing efforts to prove the market potential of the bonds in an admittedly frozen market.”[10]

With respect to Bancorp’s “more intriguing” argument about its own willingness to bid on the offering, the Court noted “some logic” to the theory but concluded that the “problem” was that it “clashe[d] with the language and clear purpose of the contract, which focuses on whether there has been a market disruption measured against an objective standard.”[11] As the Court explained, Bancorp’s interpretation—if accepted—would give counterparties with an “off-market” financial incentive the “unilateral option to extinguish [a] termination right regardless of market conditions.”[12]  The Court noted that the consequence of such an interpretation—i.e., “locking Cascade into a 99-bp adverse change in LIBOR spreads,” with untold spillover effects to lower tranches of the bond—was not what the parties intended or agreed to.[13]

Conclusion

The Cascade Funding decision offers an interesting gloss on the operation of contractual clauses intended to permit termination in instances of market disruption.  Under Justice Cohen’s ruling, to the extent such a clause contains an objective benchmark by which to determine disruption, the counterparty cannot defeat the clause’s operation through actions deemed to be “off-market.”