The Senior Living Properties Opinion, Should Lenders be Worried?
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."
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
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
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.
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
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.
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
© 2004 Greenberg Traurig
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