Once again, those of us in the commercial finance world are reminded of the age-old adage caveat emptor. This time the warning is directed at hedge funds and other investors with a penchant for purchasing distressed debt from bank syndicates.

On March 7, 2014, the United States District Court for the Western District of Washington handed down a decision that should be of concern to distressed debt investors, and their counsels. The case, Meridian Sunrise Village v. NB Distressed Debt Investment Fund Ltd., involved a syndicated $75 million credit facility secured by a shopping center in Puyallup, Washington, a town best known for its fairgrounds (and I can say this with certainty because my family lives there), and a group of banks that were desperate to unload the underperforming loan. What transpired is a parable about the importance of understanding the exact meaning of what may seem to be every day words and phrases in loan agreements.

In April 2008, Meridian Sunrise Village (“Meridian”) borrowed approximately $75 million from U.S. Bank, as the administrative agent and sole initial lender, for the construction of the shopping center. Shortly after closing, U.S. Bank syndicated portions of the loan to other institutional lenders, including Bank of America.

What Constitutes an “Eligible Assignee?”

The loan agreement, which by all accounts was a standard syndicated agreement, contained a provision that permitted lenders to assign the loan, but only to certain types of entities. Specifically, the loan agreement provided that a lender could only assign its interest to an “Eligible Assignee,” which was defined as any lender or affiliate thereof under the credit facility, “or any commercial bank, insurance company, [or any] financial institution or institutional lender.” According to the District Court’s opinion, Meridian had been careful in its drafting of this definition based on prior bad experiences it had had with predatory investors employing “loan to own” strategies.

Following a series of defaults under the loan agreement, Meridian filed for chapter 11 in early 2013. During the course of the bankruptcy case, and over Meridian’s objection, Bank of America sold its piece of the loan to NB Distressed Debt Fund Limited (“NB”), which subsequently assigned one half of its interest to two other distressed debt investors (together with NB, the “Funds”).

Meridian, now faced with the very problem it had hoped to avoid by limiting the definition of Eligible Assignee, sought an injunction in bankruptcy court to prohibit the Funds from exercising their rights under the loan agreement, including their right to vote on Meridian’s plan of reorganization. Meridian argued that the Funds were neither institutional lenders nor financial institutions, and therefore were not Eligible Assignees under the loan agreement.

Court Decided “Financial Institution” is Limited to Lenders; Excludes Hedge Funds and Private Equity Players

The bankruptcy court agreed with Meridian and granted the injunction, enjoining the Funds from exercising their rights and remedies under the loan agreement. Notwithstanding the Funds’ attempt at an interlocutory appeal, voting on Meridian’s plan commenced to the exclusion of NB and the other Funds. The plan, which was supported by Meridian’s other lenders, was confirmed by the bankruptcy court in September 2013. The Funds then appealed both the confirmation order and the bankruptcy court’s preliminary injunction.

In referring to the Funds early on in the opinion as “…hedge funds that acquire distressed debt and engage in predatory lending…”, the appellate court telegraphed how the appeal would likely turn out. Not surprisingly, the district court affirmed the bankruptcy court’s decision, declining to adopt the Funds’ broader definition of “financial institution” that would include any entity that manages money. Instead, the court limited the meaning to “an entity that makes loans.” In other words, because the Funds were investors that had purchased the loans they did not qualify as financial institutions.

In making its decision, the appellate court seemed to rely heavily on the fact that, in this case, one of the precipitating factors for the bankruptcy filing was the administrative agent’s insistence that Meridian consent to broadening the definition of “financial institutions” to include entities such as the Funds.

Future Implications

The court’s decision relies on a somewhat tenuous distinction of the phrase “financial institution” and it bears asking whether the court really meant to say that hedge funds and certain other private equity players can never qualify as financial institutions. This is a real concern given the recent trend of hedge funds lending directly to target companies.

Moreover, the drafters of the Dodd-Frank Act certainly believe that hedge funds are financial institutions; indeed, that’s how Congress has justified its regulation thereof.

Is it really appropriate to limit the definition to lenders when the word “financial” has so many different meanings and connotations in both the vernacular and professional circles?

More importantly, where does this leave us? Standard form loan agreements, to the extent they contain prohibitions on loan assignments, may need to be revised to expressly include the new normal — non-traditional financing sources active in the previously bank-dominated commercial finance market.

Moreover, every transaction, be it an acquisition, assignment, transfer or restructuring requires careful diligence. A closer read of the Meridian loan agreement by NB’s advisors might have avoided the entire issue or at least raised concerns that would warrant follow-up with Bank of America and the administrative agent before NB purchased the debt. As they say…Buyer Beware!.

The case is Meridian Sunrise Village, LLC v. NB Distressed Debt Investment Fund Ltd., 2014 WL 909219 (W.D. Wash. Mar. 7, 2014). The Funds have appealed the decision to the United States Court of Appeals for the Ninth Circuit.