The Fatal Flaw in the Recoup of a Failed Investment: Learning from DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC
Gavriel Haviv
I. Introduction
“Like a good neighbor, State Farm is there.”[1] One likely read that sentence in the little jingle that we hear over and over. Written in 1971, by famed musician Barry Manilow, it was designed to permanently reside in one’s head, in case they ever needed help.[2] The same rang true in a 2012 advertisement for the company. You have likely seen it yourself. Two women are shopping for handbags at a store, when one sees one she loves, but it looks a little pricey.[3]Immediately, she belts out the aforementioned anthem and her insurance agent appears out of nowhere, and assures her that she has saved enough to splurge on the handbag.[4] Her dumbfounded friend, who would also love a bag, desperately sings, in the same tune “I don’t have State Farm, but insurance find me money!”[5] Suddenly, a fisherman appears with a dollar bill hanging from a fishing rod. “I caught you a dollar,” he said in his rugged southern accent.[6]Begrudgingly, the luckless lady swipes at the bill from the rod, as the fisherman pulls back. “Ooh, you almost had it, better be quicker than that,” he said.[7]
“Ooh you almost had it, better be quicker than that” was the conclusion in DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC, a December 2023 Supreme Court case.[8]
II. Background
Any hotel connoisseur is familiar with the W Hotel chain. Founded in 1998, Barry Sternlicht decided that it was time for hotels to get with the times.[9] He was talking cordless telephones and internet service through the TV![10] His biggest change would be to the lobby. Sternlicht wanted to eschew the term “lobby” in favor of a more comfortable “living room.”[11] His big change was merging the bar and the lobby into one big room.[12] Sternlicht set out on this journey, and situated his prototype at 541 Lexington Avenue, New York.[13] Eighteen years later, Marriot International, Inc.(“Marriot”) loved the idea of these cordless telephones and internet filled televisions and wanted in, taking over a chain of 51 W’s, with 14,145 rooms.[14] However, two years later, Marriot decided that the W New York was on its last legs.[15] The bang was too little for the buck, as “cozy rooms,” which gave a guest between 130 and 150 square feet, were being rented out for as much as $500 during busy season.[16] On May 9, 2018, the W New York, the first of the W Hotels, was no more.
Enter Capstone Equities (“Capstone”) and Highgate Hotels, L.P. (“Highgate”).[17] The two companies joined forces to create eight different LLCs and LPs.[18] The Plaintiffs in this case are six of these companies.[19] Ultimately, those six companies will be referred to as the Property Company (“Propco”), who owned the hotel, and the Operating Company (“Opco”) who operated the hotel. As with any massive real estate deal, they needed loans. So, they went to Loan Capital Credit REIT LLC (“Loancore”) to strike some deals.[20]
Loancore extended three loans to Propco and Opco, each serving different purposes.[21] The first was a $9.44 million Building Loan for lease and retail upgrades, allowing the companies to renovate, renegotiate tenant leases, and choose new retail operators to attract customers.[22] The second was a $20.56 million Project Loan, used for three key needs: debt service to manage existing or future debts, severance payments for terminating employees due to new management, and lease termination payments, covering costs like fees, security deposits, or tenant improvement reimbursements when ending leases.[23] The third and largest loan was an Acquisition Loan worth $140 million, which provided funds to pay off existing debt, and cleared financial obligations to improve flexibility.[24] It also covered accrued costs and funded subaccounts for future business needs.[25] The loan supplied working capital for daily operations and covered transaction costs related to the loan agreements and other business activities.[26] Together, these loans aimed to stabilize finances, support operational changes, and boost the property's appeal.[27]
The Borrowers obtained guarantees from Dune Real Estate Fund IV LP and Aynsley Capital, L.P,[28] both sides signed the contracts, and everything was off and running. The Borrowers decided to rechristen the hotel with a new name, steering clear of its history as a Marriot or a W. They decided to rename the hotel the Maxwell.[29]
III. Issue
For the Borrowers, this purchase of the Maxwell was unquestionably a nightmare. For one, they knew that they were in for a fight—because fighting for the consumer’s dollar would not be easy to attract visitors to a hotel that is not connected to a massive chain conglomerate. This concern was nothing compared to the big fish, however, we all know what happened in 2020. Arguably, no business was hit harder than the hotel business.[30] When the world shut down for months on end, people were not staying at hotels, and the same was certainly said for the Maxwell.[31] Just to show how bad the operation was at the Maxwell, for their two years of ownership it only took one month for the Maxwell to close its doors permanently.[32]
An analogy of the downfall of the Maxwell would be a city that is under siege. If disciplined with enough provisions, a siege can last years, but if there was a drought, and the provisions were not well kept, the siege will not last long before the city collapses. This type of unpreparedness was what led to the downfall of the Maxwell. Everything that Capstone and Highgate tried to do to spruce the place up did not work, and they were not generating enough money in the first place, so when the pandemic hit, the Maxwell was doomed.
Just because the Maxwell closed their doors did not mean that the loan that the Borrowers assumed simply goes up in smoke. They still owed a lot of money, and they were not paying back, as agreed upon.[33]
No source is necessary to explain that litigation is time consuming and expensive. Here is one anyway.[34]Loancore wanted to do anything possible to circumvent any unnecessary litigation.[35] Thus, they tried to contractually appoint themselves power of attorney to reconfigure the loans that they are owed to take control of the available equity of the Borrowers.[36] The Borrowers were having none of it.[37] The Borrowers brought suit to preliminarily injunct the Defendant from being able to secure a mezzanine loan, which would thereby give the Defendant control of the company.[38]
IV. Analysis
There are three terms that necessitate a deep dive to determine why the court decided in the Plaintiffs’ favor: “power of attorney,” “mezzanine loans,” and “preliminary injunction.”
A. Power of Attorney
According to the General Obligations Law (GOL), any business is allowed to sign away power of attorney rights.[39] This is what happened in the loan agreements between the Borrowers and the lender, as Propco and Opco signed over the rights to the Defendant, so in case of a default on the payments, that the Defendant would be able to sign on Propco and Opco’s behalf, for anything they want.[40] According to contract, during an Event of Default, the Lender may “sever the Note, the Other Notes, the other Loan Documents and the Other Loan Documents into one or more separate notes, mortgages and other security documents” with payment priorities and liens “as Lender shall determine” to enforce its rights.[41] Additionally, each Borrower Party “absolutely and irrevocably appoints Lender as its true and lawful attorney, coupled with an interest,” authorizing the Lender “to make and execute all documents necessary or desirable to effect such severance,” and they ratify all actions taken by the Lender under this authority.[42]
This law allowed the Defendant to separate their notes, making it easier for the Lender to enforce specific rights against Propco and Opco, upon default. Consequently, the Lender sought to utilize contract provisions to adjust the types of loans they could pursue. While they could collect on a mortgage loan, securing the ability to collect on a mezzanine loan would significantly help their strategy, as it would allow them to bypass court proceedings to seize Propco and Opco’s equity.[43]
B. Mezzanine Loans
As established in the loan documents, the Lender secured a mortgage loan debt.[44] On its face, that sounds good for the Lender, as a mortgage loan debt is completely secured by the property itself which serves as collateral, and lessens any involved risk. On top of that, because there is a tangible property attached to the loan, the Lender gets priority regarding repayment, with respect to any default. There is only one downside: foreclosure. As noted, foreclosure is a drawn out, expensive process that many companies would love to not have to deal with.
A mezzanine loan, on the other hand, is a type of financing that serves as a secondary layer of funding beyond a traditional mortgage.[45] Instead of being secured by real estate directly, it is backed by an equity interest in the company behind the project, such as the owner of the equity on the burrower.[46] The benefit of mezzanine loans lies in the quicker ability to seize collateral if a borrower defaults.[47] Since the lender's claim is against the borrower's equity interest in the company rather than the real estate itself, it can avoid lengthy foreclosure processes typically required to repossess physical property.[48]
The goal for the Defendant was to use their power of attorney rights to sign off (on the Borrowers’ behalf) on a transition from their mortgage level debt to a mezzanine level debt.[49] Based on borrowers who default, this would have allowed them to take over the Borrowers’ equity.[50] However, there was one issue that held everything back.
C. Preliminary Injunction
Plaintiffs asked for a preliminary injunction to restrict the Defendant from swapping the debt owed from a mortgage loan debt to a mezzanine loan debt.[51] The first question to be asked is what factors will motivate a court to grant a preliminary injunction request? Luckily, this case provides the answer.[52] According to General Obligations Law § 5-1502E, “[t]he party seeking a preliminary injunction must (i) demonstrate a probability of success on the merits, (ii) danger of irreparable injury in the absence of an injunction, and (iii) a balance of equities in its favor.”[53] Let us break the three prongs down.
1. Demonstration of the probability of Success
This is where the fisherman/insurance agent pulls up the dollar bill in the State Farm commercial as the lady reaches out to snatch it. The scope of power of attorney rights are not extended to the non-borrower.[54] The section of the contract that transfers this right to the Defendant only mentions that they can take the power of attorney privilege from the Borrowers.[55] As noted, Propco and Opco are not Plaintiffs in this case. The Plaintiffs here are the other companies who did not sign the loan agreements to be deprived of their rights from the Lender.[56]
The biggest decision that the Court needed to make here was whether the section of the contract which allowed for the Borrowers to sign over their power of attorney rights included the other companies involved in the ownership of the Maxwell, who were not Propco and Opco.[57]
By way of analogy, there are eight students in a class. Two of the students started talking and were warned by the teacher that if they do not stop, the whole class will get detention. The students ignore this threat, and the teacher gives everyone detention. Now this might fly in the classroom, but in the court of law, the transgressions of one company cannot be taken out on another when it comes to power of attorney rights.[58]
It is important to note that the Plaintiffs sued in both New York and Delaware, and the court in Delaware granted the preliminary injunction, before staying the case “in favor of the New York action [because the loan documents stipulated that the lawsuit should be brough in New York] and provided for a 90 day lift of the injunction to give the movants time to obtain an injunction from this Court.”[59] When it came to the first prong of the preliminary injunction question, the Court agrees with their Delawarean counterparts who had previously ruled in the Plaintiff’s favor.[60] While the Court did not follow any specific case law, they used their discretion and equity to read Section 8.2.3(b) of the contract narrowly, as to not allow the use of powers of attorney over any other companies other than Propco and Opco.[61] Thus, it would be incorrect to strip the Plaintiffs of their rights to their own volitions.
Therefore, the Court decided that the Plaintiffs would likely win the case on the merits if it went the distance.[62]
2. Danger of Irreparable Injury in the Absence of an Injunction
The second part of the GOL requires a determination of the danger of irreparable injury if the Court does not grant the preliminary injunction. Returning to the “students” analogy, let us say that all the students would be expelled, not merely receive detention. At this point, for the innocent six students, there is a clear argument that their records would be permanently damaged and that they would have trouble finding another school to attend and eventually finding work. Here, if the Lender was able to seize the equity of two of the defaulted companies, then the other six single-purpose entities (“SPE’s”) would surely be left without any recourse.[63] As one SPE goes, so do the others, and if you cut off two transgressing SPE’s, the others will not have air to breathe.
3. A Balance of Equities in its Favor
The Court does not say too much about the third “balance of equities” prong, as even though it is unclear what would happen to the Defendant if the preliminary injunction was enacted, the Plaintiffs’ state would be in much dire straits.[64] Therefore, all three prongs favored the Plaintiffs, and the preliminary injunction was granted.[65]
V. Conclusion
There are many takeaways from this case, but two should be highlighted. One, the Court's decision emphasizes that, even though the SPE’s were related and part of the same borrowing structure, each SPE's legal boundaries remained distinct and would not be blurred in legal proceedings. The Court seems to indicate its reluctance to allow Lender to treat interconnected SPEs as a single entity for the purpose of restructuring debt or exercising power of attorney rights. Despite the Borrowers’ financial defaults, the Court preserved the separation between the SPEs, ensuring that the Lender could not automatically impose changes across multiple entities without explicit contractual language authorizing such actions.
The second takeaway is that contracts regarding powers of attorney, especially in commercial settings, are interpreted strictly, often favoring the party whose rights are being reduced. This bias was evident in this case, despite their clear history of defaults and the interconnected nature of their SPE’s. The court's reluctance to expand the Lender's rights underscores the necessity for meticulous drafting of power of attorney provisions. If specific powers are not expressly included in the contract, the courts are unlikely to infer them. This judicial approach protects the principal’s rights, emphasizing that powers of attorney cannot be used to impose obligations not clearly stated, thus reinforcing the principle of limiting overreach in commercial contracts. Because in the case of DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC, Defendant almost got it, they had to be quicker than that.
[1] State Farm, Shopping (Sept. 13, 2012), https://www.ispot.tv/ad/7LaG/state-farm-shopping.
[2] Id; see also Nicholas Gilmore, Barry Manilow: The Surprise Jingle Hitmaker, Saturday Evening Post, (Oct. 4, 2018), https://www.saturdayeveningpost.com/2018/10/barry-manilow-the-surprise-jingle-hitmaker/.
[3] Id.
[4] Id.
[5] Id.
[6] Id.
[7] Id.
[8] DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC, No. 654836/2023, 2023 N.Y. Misc. LEXIS 22981, 2023 NY Slip Op 34296(U), 1, (N.Y. Sup. Ct. Dec. 4, 2023).
[9] Jeff Higley, W Put ‘lifestyle’ on Map 15 Years Ago, CoStar Group, (Apr. 29, 2013), https://www.costar.com/article/727172641/w-put-lifestyle-on-map-15-years-ago.
[10] W Hotels: The McDonald’s of Hipster Exclusivity, The Slate Group, (Aug. 1, 2000), https://slate.com/business/2000/08/w-hotels-the-mcdonald-s-of-hipster-exclusivity.html.
[11] Higley, supra note 9.
[12] Id.
[13] Nancy Trejos, W Hotels to drop original flagship hotel in New York City, USA Today, (Mar. 1, 2018), https://www.usatoday.com/story/travel/hotels/2018/03/01/w-hotels-drop-flagship-hotel-new-york-city/385995002/.
[14] 2016 Annual Report, Marriott International, https://marriott.gcs-web.com/static-files/ff009de0-7abe-4813-9342-f4d8e33b87d2.
[15] Terry Trucco, Covid-19 Closing: So Long to the Maxwell — and the Very First W Hotel, Overnight New York, (June 16, 2020), https://overnightnewyork.com/hotel-openings-and-closings/covid-19-closing-so-long-to-the-maxwell-and-the-very-first-w-hotel/.
[16] Id.
[17] Mark Maurer, Capstone and Highgate score $130M loan to buy W hotel, The Real Deal, (May 11, 2018), https://therealdeal.com/new-york/2018/05/11/capstone-and-highgate-score-130m-loan-to-buy-w-hotel/.
[18] DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC, No. 654836/2023, 2023 N.Y. Misc. LEXIS 22981, 2023 NY Slip Op 34296(U), 1, (N.Y. Sup. Ct. Dec. 4, 2023).
[19] Id.
[20] Maurer, supra note 17.
[21] DCH LEX Propco GP LLC, 2023 N.Y. Misc. LEXIS 22981, at 1-2.
[22] Id. at 1
[23] Id. at 1-2.
[24] Id. at 2.
[25] Id.
[26] Id.
[27] Id.
[28] Summons & Complaint at 14, Ys 541 Lexington Holdings LLC v. DCH LEX Propco GP LLC, Index No. 653461/2022 (N.Y. Sup. Ct. Sept. 20, 2022).
[29] Manhattan's Original W Hotel is Now Known as Maxwell, Bloomberg News, (May 11, 2018), https://www.crainsnewyork.com/article/20180511/REAL_ESTATE/180519976/manhattan-s-original-w-hotel-is-now-known-as-maxwell.
[30] Alexa Lardieri, Coronavirus Pandemic Sets Hotel Industry Back 10 Years, Report Finds, US News & World Report (Jan. 27, 2021), https://www.usnews.com/news/national-news/articles/2021-01-27/coronavirus-pandemic-sets-hotel-industry-back-10-years-report-finds.
[31] Id.
[32] Rich Bockmann, Capstone and Highgate’s Maxwell Hotel Facing Foreclosure, The Real Deal, (Sept. 21, 2024), https://therealdeal.com/new-york/2022/09/21/capstone-and-highgates-maxwell-hotel-facing-foreclosure/.
[33] Summons & Complaint at 121, Ys 541 Lexington Holdings LLC v. DCH LEX Propco GP LLC, Index No. 653461/2022 (N.Y. Sup. Ct. Sept. 20, 2022).
[34] N.Y. Comp. Codes R. & Regs. tit. 22, § 202.70.
[35] Summons & Complaint at 6, DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC, Index No. 654836/2023 (N.Y. Sup. Ct. Oct. 2, 2023).
[36] Id. at 16.
[37] Id. at 1.
[38] Id. at 3.
[39] N.Y. Gen. Oblig. Law § 5-1501(2)(i).
[40] Exhibit A— Building Loan— Loan Agreement, §8.2.3(b), DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC, Index No. 654836/2023 (N.Y. Sup. Ct. Oct. 2, 2023).
[41] Id.
[42] Id.
[43] DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC, No. 654836/2023, 2023 N.Y. Misc. LEXIS 22981, 2023 NY Slip Op 34296(U), 2-3, (N.Y. Sup. Ct., Dec. 4, 2023).
[44] Id. at 2.
[45]5C West’s N.Y. Prac., Com. Litig. in New York State Courts § 145:35; Samcom 48 DE LLC v. 37-10 114th St. ML Funding, LLC, No. 723742/2021, *2022 N.Y. Misc. LEXIS 26722, at 6 (Queens Sup. Ct. May 4, 2022).
[46] Samcom 48 DE LLC, 2022 N.Y. Misc. LEXIS 26722 at 6.
[47] Id.
[48] Id.
[49] DCH LEX Propco GP LLC, 2023 N.Y. Misc. LEXIS 22981 at 2-3.
[50] Id.
[51] Id. at 3.
[52] Id.
[53] Nobu Next Door, LLC v. Fine Arts Hous., Inc., 4 NY3d 839, 840, 833 N.E.2d 191, 800 N.Y.S.2d 48 (2005).
[54] N.Y. Gen Oblig. Law § 5-1502E.
[55] DCH LEX Propco GP LLC, 2023 N.Y. Misc. LEXIS 22981 at 3.
[56] Id. at 1.
[57] Id. at 3.
[58] Id. at 4.
[59] Id. at 3.
[60] DCH LEX Propco GP LLC v. Ys 541 Lexington Holdings LLC, No. 654836/2023, 2023 N.Y. Misc. LEXIS 22981, 2023 NY Slip Op 34296(U) (N.Y. Sup. Ct., Dec. 4, 2023).
[61] Id. at 3.
[62] Id. at 5.
[63] Id. at 3-4.
[64] Id. at 4-5.
[65] Id. at 5.