Residents of Insolvent Senior-Living Facility Lose Out to Bondholders’ Mortgage!

September 19, 2023

Wisconsin Supreme Court Decision Underscores the Importance for Lenders and Prospective Senior-Living Facility Residents of Careful Review of Financing Documents and Entrance-Fee Arrangements

In a recent Wisconsin Supreme Court decision, the court addressed the respective priority of the mortgage lien of bondholders and claims by residents of a senior-living facility owed repayment of their entrance fees. After a detailed analysis of the agreements and financial transactions at issue, the court sided with the bondholders, and the residents received nothing. The court’s decision, which reached the opposite result of a court of appeals case with similar facts, highlights the importance of careful review of the transaction documents and a thorough understanding of the underlying economic structure when evaluating claim priority.

Casanova v. Polsky involved a multi-unit senior-living facility that was placed into a Chapter 128 receivership proceeding after the facility defaulted on debt-service payments. The bondholders held a mortgage lien on the property of around $6 million, while the residents had entered into residency agreements with the facility that entitled them to repayment of approximately $7 million in entrance fees they paid when moving into the facility (ranging from $40,000 to $238,000). The sale of the facility resulted in net proceeds of around $4 million. Accordingly (as is frequently the case), whichever side in the dispute had priority to the distribution proceeds would get all of the net funds, while the other side would get nothing.

The bondholders argued that they were secured creditors with a properly perfected mortgage lien, which under Wisconsin law would give them priority over the unsecured claims of the residents. To counter this, the residents advanced two arguments: (1) that the bondholders had agreed to subordinate their claims in the Official Statement the bond underwriter was required to file under the securities laws and in the financing documents that established the bondholders’ secured claims; and (2) that a prior court of appeals case with parallel facts (M&I v. Episcopal Homes) had held that residents were entitled to full repayment of their entrance fees before distribution of proceeds to bondholders.

Concerning subordination, the residents argued that the Official Statement provided that the bondholders’ mortgage lien was “subject…to Permitted Liens” allowed by the project contract and the mortgage, and these documents collectively provided that entrance fees qualified as Permitted Liens. Accordingly, the residents argued that the bondholders had agreed that their loans were “subject to” any Permitted Liens, which (in the residents’ view) meant that the bondholders had agreed to subordinate their secured loans to any Permitted Liens, including the entrance fees at issue. The residents also pointed to language in the Official Statement warning the bondholders that: (a) Permitted Liens “may be” superior to the mortgage lien of the bondholders; and (b) entrance fees “may not” be available to repay their bonds in the event of a foreclosure.

Regarding the prior court of appeals case, the residents argued that Episcopal Homes also involved a dispute between bondholders and residents of a senior-living facility, in which the court addressed whether entrance fees paid by the residents were subordinate to the bondholders’ lien. In Episcopal Homes, the court of appeals held that the entrance fees were effectively security deposits subject to special protections under Wisconsin law, and denied the bondholders’ claims that the residents had validly agreed to subordinate their claims for entrance-fee repayment to the bondholders’ lien. As a result, the residents in Episcopal Homes were repaid their entrance fees and the bondholders were not able to access these funds to help pay their lien.

The court in Casanova rejected all of the residents’ arguments. As to the assertion that the Official Statement constituted an agreement by the bondholders to subordinate their claims to the residents’ entrance-fee repayment claims, the court first held that the Official Statement was not a contract and therefore it cannot constitute a legally binding subordination agreement. The court also noted that “subject to” is a broad phrase with many potential meanings and does not necessarily mean “subordinate to.” Rather, “subject to” can mean “to be affected or possibly affected by,” which in this context would mean that the bondholders were on notice that their mortgage may be impacted in some way by the residents’ entrance-fee agreements, but not necessarily that the bondholders’ claims were subordinate to the residents’ claims for repayment of their entrance fees. Similarly, the language the residents pointed to indicating that claims for repayment of entrance fees “may be” superior to the bondholders’ claims or that the entrance fees “may not” be available as funds for the repayment of the bonds simply indicated that these were possibilities that could occur, not that the bondholders via this language were agreeing to subordinate their lien.

As to Episcopal Homes, the court noted that in that court of appeals case (which was not binding on the Wisconsin Supreme Court), entrance fees were kept in a segregated account that only held entrance fees and were not used for operating expenses. Here, entrance fees were paid into the facility’s general operating account and comingled with all other income and expenses received and paid by the facility. In addition, the entrance fees in Episcopal Homes remained in their original segregated account at the time of the dispute, whereas in Casanova the parties were fighting about who was entitled to the net proceeds of sale of the facility, which is another step removed from a segregated account devoted exclusively to holding entrance fees. Accordingly, the court concluded that it had no basis to override Wisconsin statutory law, which gives priority to the properly perfected lien of the bondholders. As a result, the bondholders received all of the net proceeds of the sale of the facility, and the residents received nothing.

Casanova provides valuable guidance to both lenders and prospective senior-living facility residents regarding the status and priority of entrance fees. The decision underscores the importance for senior-living facility residents to understand whether their entrance fee will be held in a segregated account. If so, the residents or their representatives may need to verify from time to time that the segregated account continues to be fully separate from other funds. Casanova and Episcopal Homes reached opposite results for the facility residents due to the different status of the entrance fees. Because of these differences, the residents in Episcopal Homes had their entrance fees fully repaid, while in Casanova the residents did not.

Parties should consult with competent counsel to ensure they fully understand the implications of their agreements and the priority of their claims. If you are involved in a dispute over the priority of your claim, lien or mortgage, or are seeking guidance to maximize your recovery, please contact KMK Attorneys Samuel C. Wisotzkey (swisotzkey@kmksc.com) or Samuel M. Draver (sdraver@kmksc.com). Both can be reached at (414) 962-5110.