Maximizing the Value of Distressed CCRC Bonds

At bond issuance, collateral must be properly perfected. Failure to do so would allow another creditor to obtain a first lien on the collateral and would likely result in the security interest in the collateral being voided in a bankruptcy proceeding.

If the bonds are secured by a mortgage on the property, an assignment of leases and rents will be made. Therefore, if the CCRC residency agreements are legally treated as leases under state law, the filing of the mortgage or a separate assignment of leases and rents will perfect the collateral assignment of the residency agreements.

However, what if the residency agreements are treated as contracts under state law? In this event, the collateral assignment of the residency agreements must be perfected by the filing of a UCC financing statement. Failure to do so would mean that another creditor could obtain a first lien and, in the event of bankruptcy, the bondholders would not be treated as secured by the residency agreements.

If state law is less than crystal clear on the treatment of CCRC residency agreements, we recommend having both a mortgage and a separate assignment of the residency agreements and filing both a mortgage and UCC financing statements to ensure perfection of the security interest granted in these agreements.

Importantly, in addition, if the residency agreements are treated under state law as leases, there could be critical legal implications in a liquidation or bankruptcy proceeding for the treatment and priority of entrance fee refunds. For example, in Wisconsin, an appellate court in 2021 held in Atrium of Racine that upon the liquidation of a CCRC, Wisconsin law requires that entrance fee refunds be paid first to residents prior to any debt service on outstanding bonds. This decision is explicitly non-binding under Wisconsin law but may be cited as persuasive authority. The legal reasoning is based on the residency agreements being characterized as leases and entrance fees being deemed security deposits that, by law, must be returned to tenants. This decision is emblematic of the courts’ desire to protect residents.

Not surprisingly, another Wisconsin appellate court in 1995 similarly went to great lengths to protect senior residents of a CCRC. In M&I First National Bank v. Episcopal Homes, the court held that a bond trustee with a security interest in entrance fees it held in escrow was holding these fees pursuant to a constructive trust on behalf of residents. And, notwithstanding a provision in all the residency agreements subordinating the rights of residents to the rights of bondholders in the entrance fees, the court held that because entrance fees are security deposits under leases pursuant to Wisconsin law, the security deposits were required to be returned to residents. The court voided the subordination provision in the residency agreements.

The Wisconsin cases have implications for bankruptcies as well. Entrance fee refunds owing to prior residents are unsecured claims in a bankruptcy. Bonds are secured. By typical bankruptcy priorities, one would think secured bonds would be paid prior to and treated better than unsecured entrance fee refunds. Yet this has not been the case in recent CCRC bankruptcies.

In states like Wisconsin, where state law requires security deposits to be refunded to tenants, where entrance fees are treated as security deposits, and where resident agreements are treated as leases, the legal basis exists for arguing that entrance fee refunds may be treated better than secured bonds. The counter-argument is that state law priorities cannot trump bankruptcy priorities. We are not aware of this issue being litigated in CCRC bankruptcy cases, but it may be in the future.

Nonetheless, these Wisconsin cases involving liquidations are consistent with how bankruptcy courts have generally treated entrance fee refunds. Whether residency agreements are considered leases or contracts, they are treated as executory contracts which may be assumed or rejected in a bankruptcy proceeding. Not surprisingly, for essential business reasons, these contracts are routinely assumed by debtor CCRCs. In recent cases, such as Amsterdam House Continuing Care Retirement Community (New York) and Buckingham Senior Living Community (Texas), residents owed entrance fee refunds were left virtually unimpaired, while bondholders were impaired by a cut in principal of approximately 15% and a complete loss of accrued interest.[1] This outcome is similar to the way pensioners have been treated in chapter 9 filings. For business, humane and policy reasons, courts will find ways to justify unsecured claims of senior citizens being treated better than claims of secured Bondholders.

For these reasons, bondholders should be proactive in seeking to avoid a liquidation or bankruptcy proceeding. In these scenarios, the bondholders risk bearing the brunt of the impairment that will be deepened by significant costs of the proceedings. Fundamentally, this means that exercising remedies to foreclose on properties is not a viable strategy because any attempt to do so will likely result in a bankruptcy filing. In addition, absent a bankruptcy filing, foreclosing on the property would require the bondholders to own the property with the hopes of improving its operations or selling the property. A sale under these circumstances would likely undercut rather than enhance value. And, in any event, since the vast majority of these CCRC are not for profits to maintain the tax exemption on the bonds, ownership of the property would have to be transferred to another not-for-profit. Finally, complying with state regulations in effectuating the various transfers of the CCRC would contribute to delays and additional costs.

The lack of an effective remedy is similar to P-3 student housing projects. Typically the not-for-profit owner is not the cause of the problem, meaning that exercising remedies to replace the owner is not the solution. In summary, foreclosure is almost never an effective option.

So what is the best overall strategy for holders of distressed CCRC bond debt? Here are our suggestions.

1. We advocate for an early proactive approach to help avoid bankruptcy or liquidation. Upon the tripping of a financial covenant, bondholders should organize a group to work with a user-friendly trustee and enter a bondholder protective forbearance agreement.

2. An assessment of the causes of distress should be conducted promptly.

3. Based on this assessment, a forbearance agreement would address any need to change the manager and/or the operator to the extent and as permitted under the applicable agreements, ways to improve operations and marketing, appropriate budget controls, suitable enhanced financial covenants, improved continuing disclosure and any appropriate changes to documents or the collateral package. Manager and/or operator replacements, in particular, may require compliance with state regulations. The goal of a forbearance agreement is to “right the ship” as much as possible under particular facts and circumstances. This may include agreeing to explore affiliation options.

4. In order to avoid a bankruptcy, it is critical to ensure that liquidity necessary for operations is available to a distressed borrower, subject to meaningful bondholder protections and guardrails. One such protection is a “bad boy” guaranty, and we recommend requesting one as a condition to holders providing liquidity to the borrower. This guaranty would be provided by the parent not-for-profit or for-profit entity that owns the entity that owns the CCRC. The guaranty would make the entire bond loan recourse to the parent in the event the owner of the CCRC were to file for bankruptcy or engage in other bad acts, such as misuse of the liquidity facility funds. Where the parent owns multiple properties, this guaranty would serve as a disincentive to a bankruptcy filing for one or more of its distressed properties. It would not, however, be a disincentive if the parent was willing to file for bankruptcy along with its subsidiaries. Such a guaranty has been quite effective in the CMBS and real estate market in preventing bankruptcy filings by owners of real estate projects, including senior living projects of all types, including CCRCs. We have also successfully used bad boy guarantees in municipal bond workouts in various sectors.

5. Unfortunately, because of increasing interest rates, the strategy of refinancing the bonds to effectuate a debt service schedule that provides some breathing space for a recovery is more difficult to achieve now than it was a few months ago. If a refinancing is not an option, a synthetic “refinancing” of sorts can be implemented in a forbearance agreement to provide the necessary breathing space to enhance a performing project.

Developing a proactive strategic plan is the best way to maximize value for holders of CCRC bonds.

[1] Some bankruptcy courts do provide priority to the secured claims of holders. In Henry Ford Village, the debtor was liquidated through a sale of the property. Holders of approximately $52.3 million principal amount of bonds had a full recovery. About 212 residents owed about $34.2 million in entrance fee refunds were significantly impaired, with the Plan estimating a 24%-40% recovery from a liquidating trust.