"Perfect Storm"n. 1. a critical or disastrous situation created by a powerful concurrence of factor (Merriam-Webster Dictionary) 2. the simultaneous occurrence of weather events which, taken individually, would be far less powerful than the storm resulting of their chance combination (Wikipedia).

In late 2007 and early 2008, the country was suffering from a credit crisis and a severe downturn in the real estate market. As a result, Phoenix lender Mortgages Ltd. ("ML") might not have made the front page amidst the myriad of foreclosures, bank closings, and bankruptcies. ML had been in the "hard money" lending business for over 45 years and had typically provided its investors with high rates of return, even in economic down times. The company had weathered many Phoenix real estate declines. But, this time there was a remarkable confluence of events. On June 2, 2008, Scott Coles, ML's principal committed suicide. Because of Coles' years-long authoritarian management style, the company was left completely rudderless. It soon became apparent that ML had lent millions of dollars on some of the most speculative real estate projects in metro-Phoenix, which in good times might have survived, but in bad times were doomed. The real estate crash was going to be worse than anyone anticipated. Home foreclosures were at an all time high, Fannie Mae and Freddie Mac were in financial chaos, and investor capital was non-existent. As matters unraveled, it became clear that frightened investors had stopped investing in ML and ML had stopped funding loans to which it had committed. Borrowers seized on the situation and stopped paying, sued ML on all sorts of lender liability theories, and for the most part, the payments to 2800 investors who had funded all of the ML loans literally evaporated. A real estate crash, hard money, a company without leadership-indeed the perfect storm.

The Bankruptcy Case
On June 23, 2008 one of the largest ML borrowers ($120 million) who was in default filed an involuntary petition against ML. Another defaulted large borrower ($109 million) had already filed suit against ML claiming its loan had been underfunded. Even though ML believed these were litigation tactics to deflect collection actions, the entire ML financial condition seemed to justify consent to relief. What followed was a tsunami. In the one year from commencement of the case to the effective date of the confirmed plan of reorganization, 6 related Chapter 11 and 17 state court cases were filed. Historically speaking, it was one of the largest Chapter 11 bankruptcies filed in the State of Arizona, involving a $1 billion loan portfolio, 2,800 investors, 61 borrowers, 3 Court-appointed committees, one unofficial committee of large investors, and approximately 91 mechanic lien holders on multiple different properties. The related Chapter 11 cases and state court cases involved over $500 million in assets. And, to add to the complexity, administrative proceedings involving three regulatory governmental agencies were initiated or maintained, and the probate of the Coles estate was commenced.

ML's Business
The business structure for ML worked essentially as follows. ML made short term loans secured by real estate, including multifamily residential projects, office building and undeveloped mixed-use projects in Arizona. The loans were evidenced by a promissory note and deed of trust on the real estate. Money for the loans was raised mainly from investors who received a fractional interest in the note and deed of trust. The deeds of trust had as many as 90 beneficiaries. Through various agency agreements, investors granted ML the authority to act on their behalf with respect to the loans. ML was paid a servicing fee in addition to receiving what was known as the "spread," the difference between the interest paid by the borrower and the interest paid to the investor. The structure became a driving issue in the case. As borrowers stopped paying and consequently, there was no money to pay investors, investors began to challenge the agency agreements, ML's authority to deal with the troubled loans and its ability to retain any servicing or spread monies. In addition, it became troubling as to how the investor's interests should be treated. Since they owned the notes and deeds of trust, which would mean the notes and deeds of trust were not property of the estate, did the investors really have a claim against the estate?

The Cast of Characters
ML was anything but the usual Chapter 11 with standard "first day" motions, cash collateral and dip financing issues. By the second week of the case, motions to appoint a trustee had been filed and scheduled for trial, post-Coles management had been fired, and ML's counsel Greenberg Traurig as well as financial advisors MCA Financial had been ousted. For the next month, the company was literally "weaving and bobbing" until new counsel could be hired, dip financing could be obtained, a CEO could be put in place and the trustee motions could be quieted. In the meantime, borrowers continued to capitalize on the events and only 6 of the 66 loans were paying.

The Official Committee of Investors (the "OIC")
Immediately after the case was filed, a group of investors formed an unofficial committee to protect their interests. They hired counsel who began participating in the case and subsequently convinced the United States Trustee to make the committee official. This was an unusual committee in that it had inherent conflicts. Unlike unsecured creditors whose interests are generally aligned, the investors had interests in different notes. Treatment of one borrower and set of investors under one note was not always advantageous to other investors. Nevertheless, the authority was never challenged and the OIC eventually confirmed a plan calling for investors to be invited to transfer their interests to individual limited liability companies governing each note.

Radical Bunny, LLC
During ML's heyday, a company run by ML's accountant, Radical Bunny, LLC, raised investor money at resort seminars and then made a series of loans to ML. Each of the loans was evidenced by a separate promissory note and purportedly secured by all of ML's assets, consisting of its note and deed of trust interests and certain real estate obtained through previous foreclosures. At the time of the bankruptcy filing, Radical Bunny was owed about $200 million. Numerous issues arose as to this claim. First, there was a question as to Radical Bunny's security interest in that, despite the enormity of the debt, there was no security agreement, it appeared ML's name was improperly identified on the UCC-1, and it failed to obtain deeds of trust on the real property. Radical Bunny argued that its security interest was based on a letter to Coles stating its notes were secured by ML's assets even though no collateral was specifically identified. It also argued that its secured interest in the REO was through a UCC filing on proceeds, i.e. the real estate foreclosed on was proceeds of the notes and deeds of trust on which it had a lien. The issue was never resolved and ultimately, Radical Bunny was granted a secured interest as part of the OIC Plan.

Whether secured or unsecured, Radical Bunny was the largest creditor and a driving force in the proceedings. To complicate matters, however, Radical Bunny was thrust into its own bankruptcy by an involuntary petition filed by its investors and eventually consented to relief under Chapter 11. Shortly thereafter, a trustee was appointed. The members of Radical Bunny have been sued by the Securities and Exchange Commission for various securities law violations relating to their fund-raising activities.

The Coles Contingency and the Multiple Conflicts
ML's sole shareholder was the S.M Coles Revocable Trust which also owned S.M. Coles, LLC, an entity apparently used by Coles for his private investment activities. The beneficiaries of the Trust were Coles' first and second wives. The creditors in the case claimed the wives had received benefit from Coles alleged wrong-doing. After Coles' death, a new trustee was appointed for the Coles Trust and he also served as the personal representative for Coles' probate estate. Then, a few months after ML's bankruptcy, Coles LLC filed a Chapter 11 bankruptcy to stop foreclosure on its real estate interests.

Undeniably, everything was intertwined. ML's funds could be traced as having been used by Coles LLC and in fact, ML filed a proof of claim in the Coles LLC bankruptcy for over $30 million. Coles LLC was ML's landlord and despite the fact that the Trust owned both entities, Coles LLC filed for and was awarded an administrative rent claim and an order for eviction.

Board governance became an issue. After management was ousted in the early days of the case, the Trust appointed two ML employees to serve as board members. Neither had board-related experience and because of Coles authoritarian management style, they had no experience in supervising the entire business. Significantly, both were also investors and one was the trustee for the company's 401(k) plan--also a significant investor.

The Other Committees
An Unsecured Creditor Committee was appointed, but that raised the problem of defining its constituency. The unsecured trade debt was relatively small, about $5 million. But, there was a question as to whether all of the investors should be treated as unsecured creditors. First, although investors had received a fractionalized interest in the borrower notes and deeds of trust, there was a dispute as to the validity of the assignments. The consequence with this determination would be that the notes and deeds of trust were property of the estate and hence, the investors were mere unsecured creditors. The second question was whether investors had an unsecured claim based on allegations that they were defrauded. Ultimately, they were granted an unsecured claim based on the amount of their deficiency in recovering on their notes.

Another committee was appointed representing certain a group known as the Value to Loan investors ("VTL's"). One of the ML investment vehicles was known as the MP Funds which were limited liability companies set up to purchase fractionalized interests in various borrower notes. ML investors could purchase an interest in an MP Fund and would have a more diversified investment. In order to fund the MP Funds, ML borrowed money from the VTL's, about $7 million. Thus, the VTL's were not creditors of ML but rather of the MP Funds which never filed bankruptcy. Nevertheless, yet another committee was established to protect their interest.

The Borrowers
Since ML was a hard money lender, it stood to reason that its borrowers could not qualify for conventional financing. Perhaps, that factor was irrelevant in the days of the company in which loans where by and large made on a 50 percent loan to value ratio. But, Coles had abandoned that model and began lending aggressively, including 100 percent construction loans on high-rise condominiums. The list of borrowers included several long-time Phoenix developers, rumored to have reputations for un-collectability and for hiding assets. The bankruptcy made it easy to flaunt non- payment and that much easier for other borrowers to follow suit. And, to make matters more difficult, the OIC decided to insert itself in dealing with borrowers even though that task was clearly within the purview of the company. To say the least, the borrowers seized on the confusion and what might have been ordinary lender "work-outs" became litigation fiascoes. Four borrowers filed bankruptcies, one representing about $120 million of the portfolio. Several borrowers filed lawsuits against the investors on theories of lender liability since the investors were the actual owners of the notes and deeds of trust.

One of the daunting issues in the case was the question of foreclosure. Since the notes and deeds of trust for each borrower property were held by multiple investors, foreclosure would mean taking title in the names of multiple beneficiaries. Then, how would title be conveyed without the consent of each of those beneficiaries. This problem will undoubtedly persist post-confirmation.

The Small Investor Group
The MP Funds had a number of smaller investors apparently so their investments would be diversified. One particular group known as the Mahakian Group hired counsel and was quite vocal in the case particularly in challenging ML's authority to modify the borrower loans. Eventually, however, the Mahakian Group became a co-proponent of ML's plan.

The Big Investor Group
Another significant investor group was known as the RevOps. These investors had invested in the individual borrower notes but then had received from the company a guarantee of payment. The RevOps represented a significant dollar amount of the investors, about $125 million. Some individual investments were as much as $40 million.

The Dynamics
Greed versus greed. In the first meeting with the company and the OIC, one committee member stated that he expected investors would receive 100 cents on the dollar. This position was voiced in July 2008 when people in every other kind of investment had lost at least two thirds of their investments and in light of the fact ML investors had 1) received double-digit interest rates when most people were receiving half as much and 2) signed multiple documents acknowledging the enormity of the risk of their investments. On the other hand, Coles had abandoned any notion of conservatism and was plunging the company into high-risk ventures with high-risk borrowers. And, he was apparently maneuvering investors in and out of loans, some on demand of the investors themselves, but all in a juggle to survive the company motto of "no investor has ever lost a dime with ML." Add in the Radical Bunny situation where the principal had solicited $200 million mainly from "moms and pops" on the strength of the return from ML. These dynamics created an extremely vitriolic atmosphere and made a consensual plan difficult.

The Plan of Reorganization

The Plan Alternatives
Prior to the bankruptcy, the company made the decision to suspend any solicitation of new funds from investors. So, the initial question was whether there was some sort of business to salvage or whether the fate of the company would be a liquidation of the portfolio. Certainly, the servicing of a $1 billion portfolio had value, but the "sale" of that value was daunting in a more-than-troubled market. More importantly, the largest investors wanted nothing to do with any kind of continued or reorganized ML.

The liquidation options were two-fold:

  • A pooling plan in which all of the notes and deeds of trust were placed essentially in a pool, liquidated, and the proceeds divided on a per investment basis; or
  • The somewhat "business as usual" liquidation of the portfolio.

The largest investors were firmly against a pool plan, even though the financial analysis showed that creditors would likely receive a larger distribution. The sentiment of many of the investors was that "I selected my investment and I'm going to stick with it."

Two plans were eventually filed, one by the OIC and the other by ML. They differed in three major respects: structure, financing, and the collection and use of the spread and fees. The OIC proposed a plan in which the investors would transfer their note and deed of trust interests to individual limited liability companies, about 47 in number, which would be managed by a single entity and serviced by another. Investors were given the option on the ballot to transfer their interests. It proposed exit financing which would be secured by the interests and it waived all spread and fees. Investors were given an unsecured claim called "Investor Damages," representing the difference between the amount of their notes and the amount eventually received. These amounts would be paid from a liquidating trust which would hold the remaining assets of the estate and the estate causes of action. The RevOps, Radical Bunny and general unsecured creditors would share in the trust as well.

The ML plan entailed a structure similar to the way it had operated in the past. Financing, however, was to be secured by the spread and fees and not investor interests, and investors would be given an across-the-board deficiency claim to be paid by the spread and fees. The investors, Radical Bunny, the RevOPs, and general unsecured creditors would also have an interest in the spread and fees and in a liquidating trust similar to that proposed by the OIC.

The initial OIC plan and disclosure statement were filed on January 21, 2009. The OIC disclosure statement was denied on March 24, 2009 and the OIC subsequently amended and eventually obtained approval of its disclosure statement on April 3, 2009. During this time period, Radical Bunny was somewhat of a wild card. It agreed to be a co-proponent of ML's initial plan, but on the eve of filing, reneged. ML filed on March 4, 2009. After additional negotiation, Radical Bunny agreed to be a co-proponent of an amended ML plan which had committed exit financing. However, again on the eve of filing, Radical Bunny again reneged. ML filed its amended plan and disclosure statement on May 12, 2009.

Balloting and The Rush to Confirmation
Despite the support of the main investor classes, the OIC plan was met with about 15 objections, including Radical Bunny and ML. The VTL's, RevOps, Radical Bunny which were all separately classified, voted against the plan. Initial confirmation was scheduled for Wednesday, May 13, 2009. The Court set final confirmation for Monday, May 18, 2009 giving the parties two business days for discovery and preparation.

The Turning Legal Issue
By final confirmation, the OIC had resolved most of the objections except those raised by an individual investor, ML and Radical Bunny. The RevOps announced that they probably had a deal but it was not finalized. The turning point ended up being a ruling from the Court on a motion filed by Radical Bunny a few weeks prior to confirmation.

The OIC's plan proposed classes for "Investor Damages," for unpaid principal and interest on what investors expected to receive; that is, a sort of deficiency claim. In addition, it proposed treatment for the VTL's although they were not creditors of ML. Radical Bunny filed a motion under Bankruptcy Rule 3013 to challenge the inclusion of these classes. Of principal importance was Radical Bunny's argument that the investor claims should be subordinated based on Section 510(b) of the Bankruptcy Code. The basis of the argument was that any damages claimed by investors related to the purchase or sale of a security, i.e. the interests in the borrower notes, and thus were subject to mandatory subordination under 510(b). It also filed a motion challenging the RevOp claims. The motions became known as the 510(b) motions.

Radical Bunny argued the 510(b) motions on the first day of final confirmation and the Court took the matter under advisement. Radical Bunny continued to prosecute its objection to the OIC plan as did ML. However, in the middle of trial, the Court ruled on the motions and denied all relief. That was the turning point. Radical Bunny determined it would no longer resist confirmation of the OIC plan. At that point, ML and the Mahakian Group believed a continued confirmation battle would not be in anyone's best interest and withdrew their objections to the OIC plan. It was confirmed and became effective on June 15, 2009.

Conclusion
Many issues could have been fought; perhaps a better plan could have been achieved by all parties, but the driving force was the need to emerge from bankruptcy. When asked why he had decided at the last to support the OIC plan although his client would receive more under the ML plan, one of the lawyers said the OIC will just continue the fight. Without payments from borrowers, the company was out of cash and was administratively insolvent. Each time there seemed to be a shoreline in sight; it was only the eye of the storm.

Unfortunately, borrowers are still not paying, the real estate market is not yet recovering, mechanic lien holders still claim priorities in a substantial number of the real estate projects, and investors are not receiving any distributions. Extensions have been sought to convince investors who did not agree to transfer their interests to the new limited liability companies to do so. But, a plan has been confirmed and a navigation of sorts set. As lawyers for ML were sitting at the ML offices preparing for final confirmation, the ML sign outside of the office fell down-there was no wind. Was it a signal that it was the end of the storm, or as time will tell, was it the beginning of another.