GT Alert

The Senior Living Properties Opinion, Should Lenders be Worried?

June 2004
By William L. Medford, Greenberg Traurig, Dallas Office

  View or download the PDF version of this Alert.

On April 22, 2004, the Honorable Stephen A. Felsenthal, Chief Bankruptcy Judge in the Northern District of Texas, issued his Memorandum Opinion and Order in an adversary proceeding styled Dan B. Lain, Trustee of Senior Living Properties, L.L.C., Trust, Plaintiff and Counter-Defendant v. ZC Specialty Insurance Company, Defendant and Counter-Plaintiff, Adv.P.No. 03-3262 (the “Senior Living Opinion”). The Senior Living Opinion quickly became the topic of conversation in the bankruptcy and lending community, yet its precedential value is widely misunderstood. Indeed, while some read the Senior Living Opinion as a threat to the entire lending community, Judge Felsenthal’s conclusion was that a partnership existed between a debtor and its surety, which resulted in the surety being jointly and severally liable for all of the debtor’s debts, based upon the unique structure of the financial arrangement.

"...Judge Felsenthal’s conclusion was that a partnership existed between a debtor and its surety, which resulted in the surety being jointly and severally liable for all of the debtor’s debts, based upon the unique structure of the financial arrangement."

Background Facts

Beginning in 1997, the Texas nursing home industry experienced dire financial straits as a result of several factors. Specifically, the Texas legislature made dramatic changes in the procedures for Medi-care and Medi-caid reimbursements. Simultaneously, med-mal tort reform made the then well-insured nursing home industry the target of choice for Texas’ zealous plaintiff’s bar. As a result, in less than three years the nursing home industry could no longer afford liability insurance and over seventy percent (70%) of Texas’ nursing homes were in bankruptcy.

In 1998, Senior Living Properties (“Senior Living”) sought to purchase and operate a chain of nursing homes in Texas and Illinois. GMAC Commercial Mortgage Corporation (“GMAC”) agreed to provide mortgage lending, but would only make an investment grade loan that it could sell on the secondary market. Despite the $226 million purchase price, the nursing homes’ income stream supported an investment grade loan of only $80 million. GMAC, however, was willing to lend additional sums if the loan were of a higher investment grade. Senior Living, therefore, sought to enhance the investment grade through surety bonds.

ZC Specialty Insurance Company (“Zurich”) proposed a surety bond credit enhancement that gave the loan proposal a greatly improved investment grade and resulted in the purchase and operations of Senior Living’s eighty-seven (87) nursing homes. The basis of the dramatic credit enhancement, in addition to surety for the mortgage, was a waterfall provision that insured payment of operational expenses (food, medical supplies, liability insurance, etc.). Because operation expenses were to be paid first, lenders such as GMAC could rely on Senior Living’s ability to continue operations, thereby increasing the investment grade of mortgage lending to Senior Living.1 Indeed, the surety accommodations assured the marketplace that vendors, service providers and patients would be protected by receiving the first distributions from gross revenues. The Reimbursement Agreement provided that Senior Living would reimburse Zurich for certain obligations, with interest.

In exchange for the surety bonds, Senior Living paid several premiums, including a premium whereby Zurich received seventy percent (70%) of Senior Living’s free cash-flow over $4 million. Indeed, Zurich received the largest share of Senior Living’s profits.2

Legal Analysis

Illinois law governed the Reimbursement Agreement, and Zurich and Senior Living’s relationship. As such, the Court examined the allegations that Zurich and Senior Living were partners under Illinois partnership law.

The Illinois Uniform Partnership Act defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit and includes for all purposes of the laws of this State, a registered limited liability partnership.” The Court further noted that, under Illinois law, the receipt by a person of a share of the profits of a business is prima facie evidence that he or she is a partner in the business, but no such inference should be drawn if such profits were received in payment: (a) as a debt by installments or otherwise; (b) as wages; (c) as an annuity; (d) as interest on a loan, though the amount of payment vary with the profits of the business; (e) as the consideration for the sale of the good-will of a business or other property by installments or otherwise.

And, under Illinois law, all partners are liable . . . jointly for all other debts and obligations of the partnership; but any partner may enter into a separate obligation to perform a partnership contract. Indeed, the Court based its decision largely upon whether the payments to Zurich were premiums or profits.

The Court found that Zurich charged five premiums, the fifth of which was seventy percent (70%) of Senior Living’s free cash flow. And, free cash flows existed only after the payment of all operating expenses, funding the capital expenditure account and funding the liquidity account. Under such circumstances, the Court found that the remaining free cash flow constituted profits. Because Zurich paid expenses while receiving profits, the Court held that the Reimbursement Agreement was prima facie evidence of Zurich’s partnership with Senior Living.

Though the Court held that parol evidence was irrelevant, the Court included its findings regarding such parol evidence, including the negotiations leading to the execution of the Reimbursement Agreement. These findings serve to further support the Court’s partnership conclusions as they reveal Zurich’s intent to invest in a business they would help manage, rather than loan funds to a business that operated independently of its lender.

Indeed, Zurich negotiated the waterfall provisions to assure vendors and service providers would be paid, just as an owner would conduct such negotiations. More importantly, Zurich had ultimate control of the nursing home’s management, as an owner would.

For example, Zurich required Senior Living to retain Complete Care Services, LLP (“CCS”), based upon a management agreement negotiated between Zurich and CCS, as manager of the nursing homes, which retention governed all aspects of the nursing homes’ operations. In fact, Senior Living could only alter or terminate the CCS management agreement with Zurich’s approval, in its sole discretion. Nor, could Senior Living enter into any other management agreement without Zurich’s approval.

In addition, Zurich subsequently took control over cash management and directed the priority of payments to creditors in a manner inconsistent with the Reimbursement Agreement’s waterfall provision. Zurich also arranged and negotiated for extensions of credit and insurance coverage. Though Judge Felsenthal recognized that certain of these aspects are typical in debtor/creditor relationship, Zurich exercised control over so many aspects of the debtor’s management that, when combined with its receipts of profits, Zurich fulfilled Illinois’ definition of a partner. And, as a partner, Judge Felsenthal found that Zurich agreed to share the risks of Senior Living’s business ventures, and concluded that Zurich was liable for all of the debtor’s financial obligations.

Conclusion

The Senior Living Opinion has the attention of many a practitioner, trustee and lender as it creates devastating precedence for similarly structured transactions. The Senior Living Opinion does not, however, create a threat to typical commercial lending.

Specifically, the Senior Living Opinion’s reasoning derives from Illinois Partnership law and the unique structure of the Senior Living/Zurich arrangement. This was not mainstream asset based lending, nor a typical mezzanine financing. Mezzanine financing, after all, typically results in the financier receiving equity under a corporate structure that limits shareholder’s liability. Had Zurich taken stock/LLC units of Senior Living, it may have limited its liability.

Instead, as the Court found, Zurich obtained an equity position, which it disguised as a lending position, by virtue of its sharing in profits and exercise of control. Indeed, the most damning facts were the sharing of profits with the exercise of control over operations, particularly in directing payment priorities in contradiction to a negotiated waterfall provision. Therefore, while the Senior Living Opinion poses grave danger to those structures that disguise equity positions, it poses little danger to the typical lending vehicles used by most commercial lenders.

Footnotes

1 Judge Felsenthal notes early in the Senior Living Opinion that, had “the parties adhered to the Reimbursement Agreement, [the Trustee’s] constituency would not include Senior Living’s general unsecured trade creditors and personal injury claimants.”

2 Zurich repeatedly asserted that this was not a distribution of profits but a “premium” in the ordinary course of the surety business.

© 2004 Greenberg Traurig

Additional Information:

For more information, please review our Business Reorganization and Bankruptcy Practice description, or feel free to contact one of our attorneys.

• Business Reorganization and Bankruptcy Practice Area
• Business Reorganization and Bankruptcy Attorneys