In re Residential Capital, LLC

• Decision Date: 28 August 2012
• Docket Number: No. 12–12020 (MG).,12–12020 (MG).
• Citation: 478 B.R. 154
• Parties: In re RESIDENTIAL CAPITAL, LLC, et al., Debtors.
• Court: U.S. Bankruptcy Court — Southern District of New York

478 B.R. 154

In re RESIDENTIAL CAPITAL, LLC, et al., Debtors.

No. 12–12020 (MG).

United States Bankruptcy Court,

S.D. New York.

Aug. 28, 2012.

Morrison & Foerster LLP, By: Gary S. Lee, Esq., Jamie A. Levitt, Esq., Larren M. Nashelsky, Esq., Jordan A. Wishnew, Esq., New York, NY, for the Debtors.

Tracy Hope Davis, By: Brian S. Masumoto, Esq., Eric Small, Esq., Michael Driscoll, Esq., New York, NY, United States Trustee for Region 2.

Kirkland & Ellis LLP, By: Richard M. Cieri, Esq., Ray C. Schrock, Esq., Stephen E. Hessler, Esq., New York, NY, for Ally Financial Inc. and Ally Bank.

Kramer Levin Naftalis & Frankel LLP, By: Kenneth H. Eckstein, Esq., New York, NY, for the Official Committee of Unsecured Creditors.

MEMORANDUM OPINION AND ORDER DENYING DEBTORS' MOTION FOR APPROVAL OF A KEY EMPLOYEE INCENTIVE PLAN

MARTIN GLENN, Bankruptcy Judge.

Pending before the Court is the motion (the “Motion”) of Residential Capital, LLC and its affiliated debtors (the “Debtors” or “ResCap”) for authorization to implement a key employee incentive plan (the “KEIP” or the “Plan”) for certain key insiders of the Debtors (the “KEIP Participants”). ¹ (ECF Doc. # 812.) The Debtors' chapter 11 cases were filed on May 14, 2012 (the “Petition Date”). The instant Motion was filed on July 17, 2012, and a hearing on the Motion occurred on August 14, 2012. The Debtors' Plan provides for the award of between $4.1 million and $7 million in the aggregate (the “KEIP Awards”) to seventeen insiders of the Debtors provided that the Debtors businesses meet or exceed certain enumerated bankruptcy-related targets. The KEIP Awards vest upon the occurrence of various milestones. Most significantly, the Debtors' Plan provides that 63% of the KEIP Awards may vest upon the closing of the two sales of the Debtors' principal assets.² Greenspan Decl. ¶ 34.

The United States Trustee (the “UST”) opposes the Motion. (“UST Objection,” ECF Doc. # 987.) The UST argues that section 503(c)(1) of the Bankruptcy Code applies to the KEIP because it is primarily retentive, and should not be approved because it does not meet the requirements of that section. The Debtors argue in their reply that section 503(c)(1) does not apply because the primary purpose of the KEIP is incentivizing; therefore, section 503(c)(3) applies and the KEIP is permissible under the facts and circumstances of this case.³ (ECF Doc. # 1005.)

The question raised by the Motion is whether the KEIP is primarily incentivizing—and therefore subject to review under section 503(c)(3)—when it allows for nearly two thirds of the KEIP Awards to vest upon the closing of two section 363 asset sales that were negotiated before the commencement of these cases, and where that KEIP does not impose any additional financial metrics or hurdles in order for those KEIP Awards to vest. For the reasons discussed below, the Court concludes that, as designed, the KEIP is primarily retentive in nature and accordingly subject to the more rigid requirements of section 503(c)(1). While other aspects of the KEIP may be permissible, the Plan as a whole does not pass muster under section 503(c)(1). Consequently, the Motion is DENIED WITHOUT PREJUDICE. If the Debtors decide to modify the Plan, they should confer with the UST and other constituencies in an effort to avoid further objections.

I. BACKGROUND

The Debtors assert that their plan is designed to “incentiviz[e] the KEIP Participants to close the value-maximizing” sales of the Debtors assets. Mot. ¶ 35. Accordingly, a review of the events leading up to the filing of these cases, including the decision to sell substantial portions of the Debtors' businesses, and the Debtors' compensation practices before and after these cases were filed, is useful in evaluating whether the KEIP, as designed, is in fact primarily incentivizing.

A. Events Leading Up to the Bankruptcy Filing

The Debtors are the country's fifth largest servicer of residential mortgages, servicing over 2.4 million mortgage loans with an aggregate unpaid principal balance of approximately $374 billion as of March 2012.⁴ The Debtors and their non-debtor affiliates are also the tenth largest originator of residential mortgage loans in the United States. Whitlinger Decl. ¶ 10. The collapse of the housing market in the United States has taken a heavy toll on the Debtors' business and finances. The Debtors suffered net losses of $5.6 billion and $4.5 billion in the years ended December 31, 2008 and 2009, respectively. Id. ¶ 82. In 2010, the Debtors had net income of $575.1 million. Id. at ¶ 84. But in 2011, the Debtors had a consolidated net loss of $845.1 million. Id. ¶ 86.

The Debtors are also parties to numerous lawsuits and investigations throughout the nation, including lawsuits brought either by (i) investors in or insurers of residential mortgage-backed securities (“RMBS”) created or serviced by the Debtors or their non-debtor affiliates,⁵ (ii) borrowers of loans originated or serviced by the Debtors, and (iii) federal and state law enforcement authorities or agencies. The Debtors face the potential for enormous liability in these cases and investigations.⁶ The Debtors have entered into several significant settlement agreements with government authorities.⁷

Operating losses and civil and regulatory liability have substantially curtailed the Debtors ability to fund their operations:

Since January 1, 2008, the Debtors have lost $12.8 billion of committed financing capacity and $8.8 billion of uncommitted capacity has not been replaced. Moreover, because the ability to sell or obtain long-term financing for assets is a function of the perceived market value of those assets, the continuing adverse conditions in the residential mortgage loan market have restricted the Debtors' alternatives, including their ability to finance assets in the secondary markets. Furthermore, since 2008, because of these adverse conditions and lenders' concerns about the Debtors' financial condition, most of the Debtors' debt facilities have maturities of no more than one year, which requires the Debtors to negotiate extensions on more onerous pricing terms and on a nearly continuous basis, adversely affecting Debtors' ability to manage their operations and financial condition.

Id. ¶ 94.

Faced with these daunting prospects described above, AFI—which also owns substantial nonresidential mortgage-related businesses—developed a strategy to file these chapter 11 cases, seek an early sale of its significant mortgage-related businesses, and seek to limit its own present and future liabilities through third-party non-debtor releases.⁸ AFI's goal was obviously to separate and shed its money-losing residential mortgage-related businesses and as much of the present and future liabilities associated with those businesses as possible.

The Debtors announced in their first day filings that they had entered into two separate asset purchase agreements. One, with Nationstar Mortgage LLC (“Nationstar”) as the proposed stalking horse bidder, was for the sale of their “mortgage loan origination and servicing businesses” (the “Platform Sale”). Id. ¶ 7. The other, with AFI as the proposed stalking horse bidder, was for the sale of Debtors' “legacy” portfolio “consisting mainly of mortgage loans and other residual financial assets” (the “Legacy Sale” and together with the Platform Sale, the “Asset Sales”). Id.

B. Marketing and Sale of the Loan Servicing Platform and Legacy Loan Portfolio

AFI and the Debtors made the decision to sell substantial portions of the Debtors' businesses before the bankruptcy filing. The marketing process for the proposed sales was designed and implemented before the bankruptcy filing; and agreements were reached with potential purchasers before the bankruptcy filing. No one at this stage (including the UST) has questioned the appropriateness of the business judgment to sell these two businesses early in these chapter 11 cases; no one (including the UST) has questioned the need to maintain “one of the largest servicing and origination businesses in the country as a going concern, while at the same time undertaking a sales process that could yield billions of dollars in sale proceeds for the Debtors' estates.” Suppl. Janiczek Decl. ¶ 24.

The Whitlinger Declaration recounts the genesis and development of the sales process.

By August 2011, ResCap was focused on (i) concerns regarding its liquidity and inability to satisfy its (or its subsidiaries') tangible net worth and liquidity covenants under credit facilities and agreements with Fannie Mae, Freddie Mac, and Ginnie Mae; (ii) looming expirations of credit facilities, unsecured note maturities and interest payments; (iii) the magnitude of the Debtors' potential liability for representations and warranties the Debtors made related to mortgage loans sold by them, and the significant time and defense costs in respect of litigation claims alleged with respect to such mortgage loans and sales; (iv) the continuing volatility in the interest rate markets, which affects the Debtors' ability to hedge the value of their MSRs and to comply with the financial covenants in their credit facilities and other agreements; and (v) continued uncertainty over the future of ResCap and how such uncertainty could negatively impact business performance. During this period, ResCap continued reviewing its strategic alternatives and began to contemplate a sale of its business operations and a potential filing under Chapter 11.

Whitlinger Decl. ¶ 218.

As early as August 2011, the Debtors began contemplating a potential chapter 11 filing as one of its options. Id. ¶ 219. In October 2011, the Debtors retained Centerview Partners LLC (“Centerview”) as a financial advisor, and began preparing for a potential auction of the Debtors' businesses. Over the next several months, Centerview evaluated strategic alternatives, conducted due diligence, including meetings with the Debtors' senior management team and...