Executive Letter: Wisconsin Supreme Court Upholds Priority of Secured Creditor Under Receivership Rules

By Rose Oswald Poels

I am happy to report that the Wisconsin Supreme Court (Court) recently released a unanimous decision which protects secured creditors’ interests under receivership rules. The Court’s decision addressed the issue of whether properly perfected secured creditor interests were subject to unsecured creditor interests under receivership rules. The Wisconsin Bankers Association (WBA) filed an amicus brief on behalf of the membership given the significance of the issue. I have outlined below some of the facts of the case, the court’s rationale, and decision.

Background

The case involves a dispute between a secured lender and unsecured creditor residents of an insolvent independent senior-living facility formerly known as The Atrium of Racine (The Atrium). Bank of New York Mellon Trust Company (BONY) is the trustee under the terms of a November 1, 2002 Trust Indenture between the Elderly Housing Authority of the City of Racine and BONY’s predecessor trustee. The indenture describes series 2002A Fixed Rate Revenue Bonds and series 2002B Extendable Rate Adjustable Securities, each issued in the aggregate principal amount of $4,025,000. Payments of principal, premium, and interest were secured by promissory notes in the aggregate principal amount of $8,050,000 and were further secured by a mortgage and security interest also dated November 1, 2002.

The Atrium defaulted on its May 1, 2017 interest payment and stipulated with BONY to an assignment for the benefit of creditors and the appointment of a receiver pursuant to s. 128.08(1)(b), Stats. The receiver assumed management of The Atrium and, with BONY’s consent, proceeded to market The Atrium for sale. Residents of The Atrium, however, claimed entitlement to the sale proceeds, asserting claims for entrance fees paid to The Atrium in connection with residency agreements. On the receiver’s motion for declaratory relief, the circuit court properly held that the residents’ claim for entrance fees were not secured claims entitled to priority payment from the proceeds of the asset sale.

On July 31, 2019, the circuit court affirmed the receiver’s sale of The Atrium assets, but the residents objected to the disbursement of the sale proceeds to BONY. The parties agreed to hold the proceeds of the sale in trust pending appeal.

In July 2021, the Wisconsin Court of Appeals issued an unpublished opinion holding that the residents’ claims had priority over the properly perfected security interest of the bondholders. The result of the decision elevated the obligation to refund the entrance fees above the first mortgage securing bonds, the proceeds of which were used to finance the senior facility.

The Wisconsin Supreme Court agreed to review the issues presented by the dispute. The principal issue on appeal was whether a secured lender’s properly perfected mortgage and security interest have priority over resident claims for entrance fees from the proceeds of the sale of the building and assets. A secondary issue on appeal was whether the residents’ appeal was timely and sufficient to confer appellate jurisdiction. In filing its amicus brief on behalf of the membership, WBA was focused on the principal issue on appeal.

Wisconsin Supreme Court Decision

As outlined in the Court decision, the residents of The Atrium relied upon provisions within documents executed between The Atrium and BONY and a statement required under securities regulations regarding the risks of investing to assert that the bondholders contracted away the superiority of their mortgage lien. The Court disagreed with the residents.

The Court looked to the receivership statutes for resolution of the issue. Section 128.17, Stats. establishes an order of payment for how a receiver is to distribute proceeds of a sale among the estate’s creditors. The order is to follow: (i) the actual and necessary costs of preserving the estate subsequent to the commencement of the proceedings; (ii) costs of administration including a reasonable attorney’s fee for the representation of the debtor; (iii) wages, including pension, welfare, and vacation benefits, due to workmen, clerks, traveling or city salespersons or servants, which have been earned within three months before the date of the commencement of the proceedings, not to exceed $600 to each claimant; (iv) taxes, assessments and debts due the United States, Wisconsin, or any county, district, or municipality; (v) other debts entitled to priority; (vi) debts due to creditors generally, in proportion to the amount of their claims, as allowed; and (vii) after payment of the foregoing, the surplus, if any, shall be returned to the debtor.

The Court determined that “other debts entitled to priority” encompasses mortgages under s. 706.11, Stats. which grants priority to mortgages that are executed by a state or national bank. The Court also determined that “debts due to creditors generally, in proportion to the amount of their claims, as allowed” applied to unsecured claims. The parties of the case agreed the bondholders were secured creditors and the residents were unsecured creditors and under the order set forth under receivership rules, the claims of the secured creditors would have priority over those of unsecured creditors. However, the residents further argued the bondholders subordinated their secured interest to the residents’ interest in their entrance fees.

The Court looked to case law and the Restatement of Property in its review of how a party is to subordinate a security interest. The residents pointed to definitions of “permitted liens” and “permitted encumbrances” in documents executed between The Atrium and BONY.

The executed mortgage included language which stated, “permitted encumbrances” include “[l]iens permitted under Section 5.12(b) of the [Project Contract].” According to the Project Contract, “Permitted Liens shall consist of … [e]ntrance fees or similar funds deposited by or on behalf of such residents[.]” The residents argued that if the financing documents grant either permitted liens or permitted encumbrances priority over the bondholders’ mortgage lien, the entrance fees must be refunded before the mortgage is paid.

The Court looked to the language of the contract and mortgage which the relevant terms included the following:

“Pursuant to the Mortgage, the Corporation has granted to the Trustee a first mortgage lien on the campus currently owned by the corporation…subject in each case to Permitted Liens as defined in the Project Contract.”

“This Mortgage constitutes a direct and valid lien on and security interest in the Mortgaged Property subject only to Permitted Encumbrances.”

While the language of the mortgage states the mortgage is subject to permitted encumbrances, the Court concluded nothing within the documents subordinated the bondholders’ mortgage. The documents contemplate the possibility entrance fees could take priority over the bondholders’ mortgage, but the provisions within do not create a lien, nor accord it priority over a properly perfected mortgage. The residents never attempted to create liens. Having never become liens, the residents’ claims are unsecured claims and recovery of the fees would not trump the bondholders’ perfected security interest of the mortgage; the order set forth in s. 128.17 must be applied to the payments from the sale proceeds.

The Court also reviewed the use of the finding in M&I First National Bank v. Episcopal Homes Management Inc., 195 Wis. 2d 485, 536 N.W.2d 175 (Ct. App. 1995), by the Court of Appeals in its decision to deem the residents’ claim superior to the bondholders’ lien.

The Episcopal Homes case involved a senior-living facility that defaulted on bond repayments. In that case, a group of roughly 1,700 bondholders bought more than $11 million in bonds to fund the construction of a facility. Under a series of financing documents, the bondholders held a security interest in an account containing approximately $1,000,000 in entrance fees. The residency agreements subordinated entrance fee repayments to the bondholders’ lien. After default on bond repayment, the bondholders claimed a secured interest in a segregated entrance fee account funds. Based upon language of the rental agreements, the Court of Appeals concluded the entrance fees were effectively security deposits under Wis. Admin. Code sec. ATCP 134.02(11). Based upon language within agreements, administrative code, and public policy, the Court of Appeals held the residents’ entrance fees were protected from the bondholders’ interests.

The residents in The Atrium case claimed their entrance fees were like those interests of the residents in the Episcopal Homes case. However, the Court determined the facts between Episcopal Homes and The Atrium were different and that the equitable powers used by the Court of Appeals in the Episcopal Homes against a segregated account containing funds traceable to residents’ entrance fees could not be used in The Atrium case as sections 706.11 and 128.17, Stats. so clearly grant the bondholders’ mortgage lien unequivocal superiority. The Court concluded it has no legal authority to extend the Court of Appeals decision in Episcopal Homes beyond a segregated account of entrance fees not in receivership to reach the distinct proceeds from the sale of real property subject to a perfected mortgage lien. The Court could not disregard the plain language under Chapter 128.

I am certainly sympathetic to the residents impacted by the Court’s decision. However, the unanimous decision does uphold Wisconsin’s clear priority order under receivership rules and under s. 128.17, Stats., that the bondholders, given their security interest of the perfected mortgage, were entitled to payment from the proceeds of the sale of The Atrium assets before payment to unsecured creditors, the residents.

I wish to thank the BoardmanClark law firm and Attorney James Bartzen in particular for their assistance with drafting and filing WBA’s amicus brief for this case.

At time of release of this letter, the opinion had not yet been posted to the Court’s website, however, it may be viewed on the WBA Compliance Page.