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Gaia House Mezz, LLC, et al. Company v. State Street Bank and Trust

April 30, 2012

GAIA HOUSE MEZZ, LLC, ET AL. COMPANY, PLAINTIFFS,
v.
STATE STREET BANK AND TRUST
DEFENDANTS.
STATE STREET BANK AND TRUST COMPANY,
COUNTERCLAIM PLAINTIFF,
v.
GAIA HOUSE MEZZ LLC, ET AL.
COUNTERCLAIM DEFENDANTS.



OPINION

This is a dispute regarding a loan to build a luxury condominium in the West Chelsea neighborhood of Manhattan. In early 2011 when the building was nearly finished and almost all of State Street's loan had been paid off, the parties had a dispute regarding approximately $4.5 million dollars of interest, which State Street had agreed to waive at one point, but subsequently refused to waive. Gaia House ultimately paid State Street this sum under protest, and now seeks its return. Gaia House also seeks up to $370,000 of attorneys' fees that it paid State Street under protest and a declaration that it is entitled to a fund of approximately $700,000, which it is currently holding subject to the court's decision. Three of Gaia House's affiliates seek approximately $328,000 of increased financing costs they incurred as a result of the dispute with State Street. The court held a bench trial on December 19-21, 2011, January 4-6, 2012, and January 12, 2012. The court reserved decision at the conclusion of the trial.

The following opinion sets forth the court's findings of fact and conclusions of law.

INTRODUCTION

The detailed facts are intricate and need to be set out at length. However, the court believes that it would be helpful to present, by way of this Introduction, a summary of the evidence about how the transactions between the parties concluded. The court realizes that it is unusual to start with the ending, but the reasons for doing so will appear.

The main issue in this case is whether State Street is entitled to retain $4.5 million in interest, which Gaia House paid under protest when it paid off a construction loan.

During the course of the two-year relationship between Gaia House and State Street, it was agreed that Gaia House, which had become obligated to pay a very substantial amount of interest on the loan, would not be required to pay further interest, so long as certain conditions were met. This was what has been referred to as the "Accrued Interest Waiver." One of these conditions was that no "Event of Default" would occur prior to the maturity date of the loan.

As the detailed factual description will show, the Accrued Interest Waiver was considered by all parties to be a strong inducement for the principals of Gaia House to continue with the construction of the building and the sale of apartments under very difficult economic conditions. The Accrued Interest Waiver was of substantial value, amounting to about $4.5 million at the time the State Street loan was paid off.

However, the time came when State Street notified Gaia House that it would not honor the Accrued Interest Waiver and that, in paying off the final balance of the State Street loan, which had been paid down from about $30 million to $4.1 million, it would need to double that payment by paying the additional Accrued Interest of $4.5 million. This notification came in a letter from State Street to Gaia House dated March 24, 2011. The letter stated quite explicitly why the Accrued Interest Waiver was being voided. The letter specified, "As Lender has previously advised you, two Events of Default have occurred and are continuing . . . ." Although the letter did not expressly describe what these two Events of Default were, the reference was to the failure to obtain the Temporary Certificate of Occupancy for Penthouse 2 by July 15, 2010, and the failure to attain "Substantial Completion" by July 15, 2010. Despite what the letter says, these alleged Events of Default were not continuing as of March 24, 2011. But it is true that under a certain modification to the loan arrangements, Gaia House was supposed to obtain the Certificate of Occupancy for Penthouse 2 by July 15, 2010, and was to attain Substantial Completion by July 15, 2010. This July 15, 2010 date had not been met as to the Penthouse 2 Certificate of Occupancy, and had arguably not been met as to Substantial Completion. Thus, State Street could reasonably take the position that two Events of Default had occurred as of July 15, 2010.

A bizarre circumstance arose at the trial of this action. Robert Emslie, who supervised the Gaia House transaction for State Street and who was State Street's main witness at the trial, testified about why State Street decided not to honor the Accrued Interest Waiver. He presented an entirely different version from what had been stated in the March 24, 2011 letter. He testified that State Street objected to certain actions by Gaia House, as to which the March 24 letter had expressly stated that State Street "has no objection." He stated that the reason for not honoring the Accrued Interest Waiver was that affiliates of Gaia House had purchased the remaining three apartments, and that this deprived State Street of its opportunity to turn a profit on the basis of a provision in the lending arrangements allowing for a possible 50/50 sharing of part of the proceeds of apartment sales. Later in this opinion there will be a description of the provisions in the loan arrangements dealing with this 50/50 sharing, as well as a description of the provision dealing with the possible purchase of apartments by Gaia affiliates. The point to be made in this Introduction is simply to show the difference between the position State Street took in its notice of March 24, as to the reason for voiding the Accrued Interest Waiver, and the position State Street took in trial testimony. This difference has an important bearing on the factual and legal issues to be decided by the court.

The crucial trial testimony came from Emslie in answer to a question of the court:

THE COURT: Now, is it your testimony, as far as your intention and your purpose, that if Gaia had stayed with the idea of selling to third parties and having the waterfall procedure go forward, you would not have decided to charge the accrued interest, is that what you're saying?

THE WITNESS: Yes, sir.

The "waterfall procedure" refers to the 50/50 sharing. This testimony has only one possible meaning. It means that State Street was prepared to disregard or waive the eight-month old Events of Default that had accrued on July 15, 2010 and had been cured. According to the Emslie testimony, State Street's decision to void the Accrued Interest Waiver had nothing to do with those Events of Default, but had to do with something entirely different: being deprived of a possible profit under the 50/50 sharing arrangement.

The court will of course make its ruling later in this opinion about whether State Street is or is not legally entitled to the $4.5 million in Accrued Interest. However, the court has the following comments in this Introduction, based on the circumstances just described.

The decision to void the Accrued Interest Waiver was a weighty one. It was anything but a routine bookkeeping matter. Nor was it something automatically arising from the two Events of Default which accrued on July 15, 2010. The notice of March 24, 2011 occurred eight months after this July 15, 2010 date and the actual charge of the Accrued Interest would occur about a year after. During the months and the year following July 15, 2010, Gaia House carried out in an exemplary fashion its responsibilities for completing the building and marketing of apartments. This was sufficient to completely pay off the senior loan of $45 million and, as has been described, to pay down the State Street debt to $4.1 million. As Emslie in effect admitted at trial, this was grounds for disregarding the two long-ago Events of Default of July 15, 2010, in connection with the Accrued Interest Waiver. State Street's decision, in the face of these circumstances, to void the waiver was a decision of substantial consequence, to say the least.

The court believes that State Street has not been candid with the court in explaining this decision. The purported reason given in the March 24, 2011 notice was essentially repudiated in the trial testimony. As to the trial testimony, the court believes that it cannot be credited in material respects. The court wishes to say that Emslie's testimony was not merely his personal version. Undoubtedly what was presented was the position of State Street (meaning Emslie and colleagues). State Street's house counsel attended the trial throughout.

The court testimony was that State Street took the $4.5 million Accrued Interest because it was deprived of a valuable opportunity under the 50/50 sharing provision. The court does not credit this. The people at State Street surely took their pencils and made calculations, and for reasons which will be explained later in this opinion, it was clear beyond any question that the most which could be expected from the 50/50 sharing was about $1 million, and that whether and when even this amount could be realized was a matter of speculation.

The one thing that is clear is that State Street decided to earn an additional $4.5 million. The justification for doing so is something about which State Street has made contradictory and unconvincing assertions. No credible and satisfactory justification has been shown. The fact is that, beginning in September 2009, when the Accrued Interest Waiver provision was inserted into the Loan Agreement, and continuously thereafter, to the end of the project (including, most importantly, before and after July 15, 2010), Gaia House did exactly what State Street intended to induce it to do -- finish the project and sell apartments so that the senior loan and the State Street loan would be paid off. In the last phase, Gaia House exercised the Affiliate Purchase Rights for the remaining three apartments to carry out the exact purpose for which the Affiliate Purchase Rights were provided -- to raise money to complete the payment of the State Street loan.

Gaia House earned the Accrued Interest. State Street's conduct during the transaction and its testimony at the trial confirmed this.

FACTS

The Parties

Plaintiff Gaia House is a company formed to build a luxury condominium in the West Chelsea neighborhood of Manhattan, at 200 Eleventh Avenue. Its principals are Glauco Lolli-Ghetti, Young Woo, and Margarette Lee, who are also counterclaim defendants in this action. Lolli-Ghetti, Woo, and Lee are experienced real estate developers.

Plaintiffs West Sky, LLC; 200 11th 11S LLC; and 24th Street Capital Group LLC are affiliates of Gaia House who were created by Gaia House in order to exercise Gaia House's "Affiliate Purchase Right," which will be discussed in detail later in this opinion. Lolli-Ghetti appeared as a witness for Gaia House at the trial.

State Street Bank and Trust Company is the bank that, until recently, held a "mezzanine" loan in connection with the Gaia House project.*fn1 Robert Emslie, a Vice President of State Street, testified on State Street's behalf at the trial.

Background of the Dispute

The condominium apartments in Gaia House range in price between $5 million and around $12 million. The building contains 16 units and is approximately 50,000 square feet. One distinctive feature is that Gaia House has a "sky garage." This sky garage allows the residents to take their cars up to a garage on their floor.*fn2

In order to build their luxury condominium building, Gaia House incurred over $65 million in debt. $45 million of this financing was borrowed from iStar, the senior lender who held a mortgage on the land where Gaia House was building. As will be described below, iStar has now been fully repaid and is not involved in this litigation.

The second piece of financing for this project is what is at issue in this litigation. Lehman Brothers loaned Gaia House $11.8 million pursuant to a Mezzanine Loan Agreement. This is the Loan Agreement which will be referred to frequently in this opinion. In a modification, Lehman Brothers increased that amount to $20.7 million. The initial interest rate on the loan was over 20%, compounded monthly. As noted above, the loan was secured by a security interest in the membership interests of Gaia House. Lee, Lolli-Ghetti, and Woo also executed a Completion Guaranty, in which they guaranteed the full and prompt payment and performance of Gaia House's obligations under the loan agreement. Gaia House initially invested $6.5 million of its own money in this project. Over time that figure has increased to $13.4 million.

State Street came to be the lender under the Loan Agreement after Lehman Brothers went bankrupt. State Street had loaned Lehman Brothers $1 billion secured by rights in a number of commercial loans, including the loan to Gaia House. State Street acquired these loans after Lehman Brothers' collapsed. Robert Emslie, a Vice President of State Street, was assigned to manage the repayment of the Gaia House loan. The Second Modification

During the economic downtown in 2008 and 2009, Gaia House had serious difficulty making progress on the condominium project. Certain contractors and subcontractors were in trouble. Some went out of business altogether and a number of them defaulted on their agreements with Gaia House. As a result, Gaia House suffered delays and cost overruns, and was unable to meet the initial July 1, 2009 maturity date for the loan held by State Street.

Meanwhile, the interest due on Gaia House's loan with State Street ballooned to $10.1 million dollars, owed on a $20.7 million loan, due to the high compound interest rate.

As of mid-2009, the Gaia House condominium project looked as if it might not be completed. Lolli-Ghetti informed Emslie that Gaia House was considering giving up on the project. These conditions were the impetus for a Second Modification to the Loan Agreement, which Gaia House and State Street entered on September 23, 2009.*fn3

A number of provisions of the Second Modification are at issue in this litigation. The central such provision is the "Accrued Interest Waiver" term, which first appeared in the Second Modification. This provides:

On the Maturity Date, the entire Debt, if not sooner paid, shall become due and payable in full. Notwithstanding the foregoing, if the entire Debt, other than . . . [Accrued Interest], is paid in full on the Scheduled Maturity Date and no Event of Default occurs prior to such Scheduled Maturity Date, lender shall waive the payment of Accrued Interest from Borrower.

As described above, over $10 million of interest had already accrued on the $20.7 million loan. While the Accrued Interest Waiver did not excuse Gaia House of the obligation to pay interest that had already accrued, State Street agreed to waive interest that accrued after the Second Modification. This provision, which froze the interest, was crucial to Gaia House's decision to continue with the project.

TriMont Real Estate Advisors, a company which performed certain services for State Street, sent Gaia House monthly statements regarding the loan. Before the Second Modification, TriMont's monthly statements showed that the interest attributable to that month was being added to the principal of the loan each month to show the total balance then due. This addition was occurring under a line called "TRANSACTIONS" on the monthly statement. After the Second Modification, the amount due did not include newly Accrued Interest and the Accrued Interest began to be tracked on a line called "UNCAPITALIZED DEFERRED INTEREST BALANCE."

Another important contractual provision that was introduced in the Second Modification is the "Affiliate Purchase Right." This provides:

Notwithstanding any contrary provisions in this Agreement or the Loan Documents (including, without limitation, the terms of Section 7.27(a)(iv) of the Loan Agreement), Borrower or an Affiliate of Borrower shall be allowed to purchase any of Residential Units 5S, 7S, 8N, 9S, 11S, PH1, and PH2 in order to satisfy the Loan and Senior Loan reduction covenants described above at the applicable "Minimum Unit Sales Price," provided that neither Borrower nor such Affiliate shall be permitted to market, or resell any such Residential Unit or Units until the repayment in full of the Loan unless, in connection with the closing of any such resale the Loan would be paid off.

The applicable Minimum Unit Sales Prices ("MUSP") are set forth in the contract documents. The idea was that these prices might well turn out to be less than fair market value. This provision was repeated in the Third Modification, which will be discussed below, except that some units were no longer included in that iteration of the Affiliate Purchase Right because they had already been sold to third parties.

The purpose of this provision was to allow Gaia House to purchase the units, or cause its affiliates to do so, in order to provide cash and ensure that Gaia House satisfied applicable loan reduction covenants. This would avoid a default and prevent State Street from exercising its security interest in Gaia House's membership interests.

As part of the Second Modification, the parties also amended what is known as the "Lockbox Agreement." The Lockbox Agreement is an agreement that, among other things, provides a mechanism for the distribution of proceeds from the sales of condominiums in the Gaia House project, sometimes referred to as the "waterfall." The Lockbox Agreement provides that proceeds of sales of units were to be put in the Lockbox Account and disbursements were to be made out of that account in the following order of priority:

(1) to Lender, for any unpaid reimbursable costs and expenses or in the enforcement of Lender's rights under the loan documents;

(2) to Lender, for reduction of the outstanding loan balance;

(3) to Lender, for repayment of any other amounts due and owing to Lender pursuant to the terms of the Loan Documents;

(4) to Borrower, for repayment to Borrower of its equity balance in the project;

(5) the balance shall be split and paid 50% to Borrower and 50% to Lender until all of the Units have been sold.

Prior to the Second Loan Modification, the order of priority had always been that State Street would be paid first and then Gaia House would be repaid for its equity investment in the Project, in accordance with steps 1-4 listed above. Gaia House would then keep any profits after recouping its equity. The Second Modification added the fifth step, which gave State Street a right to share profits with Gaia House after Gaia House's equity was repaid. Emslie testified that he would not have been able to commit State Street to the Accrued Interest Waiver, which was previously discussed, if not for the possibility of State Street sharing 50/50 in the proceeds of unit sales under step 5 of the waterfall.

The Second Loan Modification also gave Gaia House four "Extension Options" to extend the maturity date of the loan for another six months so that Gaia House could avoid a default. These extension options allowed for extensions between the following periods: July 2, 2009 until January 15, 2010; January 16, 2010 until July 15, 2010; July 16, 2010 until January 15, 2011; and January 16, 2011 until July 15, 2011. These ...


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