When Centerline Capital Group, a New York-based commercial mortgage servicer, ran into financial trouble and launched a series of transactions to recapitalize its equity and restructure its debt, local lawyers from Kutak Rock and Paul Hastings Janofsky & Walker were in on the action.
Specifically, the lawyers worked on modifying Centerline’s obligations to Merrill Lynch Capital Services related to more than $400 million in credit default swaps associated with guaranteed low income housing tax credit funds.
Credit default swaps are essentially agreements that allow a lender or investor to transfer credit risk to another party, who guarantees a rate of return in exchange for a fee. In this instance, credit default swaps were used to encourage investors to pour equity into low income, multi-family housing developments so they could receive tax credits associated with those projects in return.
“Centerline was one of those entities that would go out and acquire interests and be entitled to get tax credits, then they’d syndicate those,” said Kutak partner David Nix, who, along with associate Andrew Egan, represented Merrill. “They’d put 15 properties together and sell them to other investors or provide credit to guarantee those tax credits, and investors would buy, essentially, a guaranteed return. “
Investors who buy these tax credits take a risk, Nix said, because a project may not be built correctly, or the developer may lose the credit because it fails to set aside enough units for low and moderate income people. Investors don’t want to have to monitor this process, so Merrill steps in to do so, guaranteeing investors’ rate of return in exchange for a fee.
What investors get, according to Michael Haun, an Atlanta Paul Hastings partner who worked on the deal for Centerline along with about a dozen attorneys from his firm’s New York office, is some fairly minimal cash distribution along with the more lucrative depreciation deductions and tax credits that they can monetize by claiming them on their own corporate tax returns.
The groundwork for this deal was laid in July, Nix said, when Centerline ran into financial trouble and needed to revamp its debt and equity structure to sell off some assets. Island Capital, a company owned by New York real estate investor Andrew Farkas—who made a fortune in the mid-1990s by purchasing troubled real-estate limited partnerships for his company, Insignia Financial Group—wanted to buy Centerline’s unit that specialized in restructuring ailing mortgages that had been packaged into bonds. But to get the $110 million deal done, Nix said, Farkas wanted Centerline to restructure its debt, and modifying its obligation to Merrill was part of that package.
Nix said he and Egan—along with Atlanta partners Cory B. Thompson and Calvin P. Jellema, who handled security and corporate due diligence matters, and lawyers in Kutak’s Omaha and Denver offices—helped the company revamp, in just eight days, an earlier agreement with Centerline that had taken years to build.
“We worked with Merrill probably about two years to structure this under the ISDA [International Swaps and Derivatives Association] documentation,” Nix said, explaining that much of that time was spent working to understand the market for these types of agreements. “They’re a version of a credit default swap. We called them Investor Floor Return Agreements, or IRFAs, because the investor is assured a minimum rate of return.”
Nix said it was possible to renovate the agreement quickly because documentation was based on ISDA terms that all the parties were familiar with. “You’re not negotiating a 200-page document, you’re negotiating an 8- to 10-page modification of the standard terms of ISDA,” he said.
Haun, of Paul Hastings, examined the tax aspects of the deal to make sure that the two swaps put in place wouldn’t cause adverse tax consequences, lowered yields or cancellation of indebtedness issues that would affect either Merrill or guarantor Natixis Financial Products Inc.
In the end, according to an 8-K filed with the Securities and Exchange Commission, Centerline altered its debt service coverage ratio by transferring its obligations to a subsidiary, relieving Centerline of a potential contingent liability in a notional amount of about $400 million.
“One of the risks to the purchaser of tax credits is if the project goes into default on other debt,” Nix said. “So Merrill agreed to release some collateral if they pay down debt on some projects that are overleveraged, once construction is completed.”
As part of this, according to the 8-K, Centerline assigned its rights to future fees or loan repayments and to the transfer of $67.2 million in cash collateral posted to secure its obligations to Merrill. Merrill, for its part, agreed to release up to $35 million of that collateral to help properties in which various tax credit funds hold interests if, Nix said, Centerline pays down debt on overleveraged projects.
Nix, whose practice focuses on derivatives and structured finance work, said the economy took less of a toll on his billables than it could have because Merrill, a significant client, used collateralized swaps.
“Swaps have obviously gotten a bad name—credit default swaps especially, but a swap is a financial transaction, and either you can get good collateral for your transaction or not. A lot of swaps are essentially done on the general credit of a party, and that’s basically an unsecured loan. An example of that is Enron,” he said. “The vast majority of what we’ve done in the Atlanta office with Merrill is collateralized … essentially secured. We’ve done pretty well because they underwrote them the correct way, which some people in the business did not.”