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The theatre was delapidated. In 2020 FH financed a $3 million renovation of the theatre. This increased GPLLC's debt to $7.5 million. GPLLC entered into an interest rate swap in early 2020 to hedge interest rate risk associated with the adjustable rate mortgage loan. GPLLC fixed its rate at 3.77% and the FH counterparty agreed to pay the adjustable rate on the mortgage loan.
Typically, a swap transaction tied to a debt instrument will provide that the swap notional balance adjusts upon a prepayment of the related debt to reflect such prepayment and the swap balance is equalized with the debt principal balance. If the swap balance does not so adjust, the fixed-rate borrower has the option in a high interest rate environment to prepay the related debt and reduce its interest payments while continuing to collect swap payments based on the higher swap balance. In such a transaction, sufficiently large prepayments on the loan will eventually cause the swap payments to the borrower to exceed the interest the borrower pays on the loan.
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There is no corresponding option on the part of the financial institution. This one-way option has value, and I would have been prepared to pay for this option. But FH was offering it for free.
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Prior to executing the swap agreements, GPLLC received two separate Swap Presentations from FH, purporting to disclose the material terms of the agreements. The first was received in September 2019, and the second in December 2019. The presentations are substantially identical. Neither made mention of adjusting the swap balance upon a prepayment of the related debt, a very material term.
There were at least three drafts of the Schedule to the ISDA Master circulated (inclusive of the final, execution version), each prepared by FH. None contained a partial prepayment provision.
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When I approached FH in November 2023 about a large prepayment on the mortgage loan, one-month SOFR (the base index for our adjustable rate loan) was at 5.32%, a record high. That meant that FH was paying an adjustable rate on the swap of 7.39%, nearly twice our fixed 3.77% rate. FH was paying nearly 50% of our interest payments on the mortgage loan.
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I emailed FH representatives on November 15, 2023 to inform them of our intention to make a substantial prepayment on the mortgage loan and to confirm that there would be no adjustment to the swap balance.
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FH replied on November 17 with an absurdist reading of the contract that unambiguously signaled their bad faith. I replied on November 18. I realized the futility of trying to engage with the swap desk given their bad faith reply, and suggested that their lawyers would readily allay their concerns about a release of collateral upon prepayment. (Our mortgage loan, like every other commercial loan to a borrower like GPLLC, provides for release of collateral only upon repayment in full of the debt.)
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FH replied on November 20 by simply reasserting that the swap balance would adjust upon a prepayment of the debt. They suggested that this was a matter of bank policy. I replied by insisting that the contracts, not bank policy, were controlling.
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I emailed FH on November 20 rather bluntly characterizing their arguments as baseless and syntactically unsound. This was the first of various emails I would send FH in ensuing months essentially accusing them of bad faith.
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I informed John that FH was repudiating the swap contracts. We agreed to set the matter aside until we had marshaled approximately $3 million to effect a prepayment on the mortgage loan (approximately $1 million of which would come from the subsequently proposed land sale). At that point, GPLLC would file for declaratory judgment on the swap contracts.
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​​​After my email of 11/15/2023 FH immediately realized they had neglected to include a partial prepayment provision in the swap schedule. They attempted to pass off a very conventional "Additional Termination Event" provision as a partial prepayment provision. Of course, the only consequence of an Additional Termination Event is that it permits the "non-defaulting" party to terminate the swap in full. It in no way provides for an adjustment to the notional swap balance upon a partial principal prepayment of the loan. In fact, there is no provision anywhere in the swap agreements for an adjustment to the notional swap balance under any circumstance.
FH's bad faith reading of the definition of Additional Termination Event* in the swap schedule can be succinctly summarized:
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1. FH interpreted the phrase "is repaid, in whole or in part, whether upon acceleration of principal, at maturity or otherwise..." to apply to a principal prepayment by the borrower because such prepayment would "accelerate" the loan principal. Of course, "acceleration" is a term of art in a financing agreement, and only the lender can "accelerate" principal; borrowers "prepay" principal.
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2. FH completely omits the phrase "or for any other reason is not an obligation of Party B." This phrase modifies the phrase "is repaid, in whole or in part...". Accordingly, only a repayment of the loan that terminates Party B's obligation on the mortgage note would constitute an Additional Termination Event.
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3. FH completely fabricates a provision in the mortgage agreement that releases collateral upon a partial prepayment of the loan. There is no such provision in the mortgage agreement. Section 3.2 of the Construction Loan Agreement executed in connection with the 2019 refinancing contains the only provision in the mortgage contracts regarding release of collateral. It provides: ​​"Provided that no Event of Default exists, Lender agrees to release the Lien of the Mortgage from the Collateral upon indefeasible repayment in full of all obligations under the Loan." **
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4. FH interprets Additional Termination Event to provide that the swap balance adjusts to reflect prepayments on the mortgage loan. Their reading is not only syntactically and logically absurd, it is vastly over broad. An Additional Termination Event as defined in the swap schedule, like the other Termination Events specified in the ISDA Master Agreement, gives the "non-defaulting" counterparty the right to terminate the swap in full.
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5. Partial prepay provisions in swap agreements are not uncommon, and in fact are the rule in debt-basis swaps (i.e., swaps in which the swap is tied to a separate debt instrument, like GPLLC's swap transaction with FH). These provisions are explicit, detailed and occupy the better part of a page. This is an example of such a provision in a swap transaction involving Societe Generale.
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* Part 1(g) of the swap schedule: “Additional Termination Event” will apply. It shall be an "Additional Termination Event" with Party B being the Affected Party if (i) the loan or other indebtedness in connection with which a Transaction is entered into by Party B for the purpose or with the effect of altering the net combined payment of Party B from a floating to fixed or a fixed to floating rate basis is repaid, in whole or in part, whether upon acceleration of principal. at maturity, or otherwise, or for any other reason is not an obligation of Party B, (ii) any Credit Support Document expires, terminates, or ceases to be in full force and effect for the purpose of this Agreement unless this Agreement is expressly amended in writing to reflect that it is no longer a Credit Support Document hereunder, or (iii) the obligations of Party B cease to be secured equally and ratably on a pari passu basis with the obligations owing to the lenders in respect of any loan or other indebtedness in connection with which a Transaction is entered.
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Section 3 of the Construction Loan Agreement:
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