Is it time to formally make “Single Asset Real Estate” entities ineligible to file for bankruptcy?
Have you ever come across some really in-depth writing on involved topics on the internet? It’s pretty rare. I try my best at the OCHN to give a greater level of depth than what people find in the mainstream media, but there are others out there who take it to another level entirely. Last weekend, I introduced you to the Strategic Deals Law Blog. In their own words, “Strategic Deals Law Blog offers insights into the complicated world of business transactions, bringing clarity and the tools needed to make your business a success.” The blog is written by clear-thinking practicing attorneys who really know what’s going on.
I have recently come to the conclusion that serious thought needs to be given to amending the United States Bankruptcy Code so that “Single Asset Real Estate” entities are not eligible to file for bankruptcy under Bankruptcy Code Section 109, thereby closing the door to that workout option and leaving such entities to their rights and remedies under applicable state law and state courts. For instance, insurance companies and insured depository institutions are ineligible to file for bankruptcy as must look elsewhere in times of financial distress.Last week, I organized and moderated a panel entitled “Does Chapter 11 Still Provide a Viable Option for Preserving Real Estate Companies as a Going Concern? If Not, What Next?” at the USC School of Law’s annual Real Estate Law and Business Forum.One of the issues that was heavily discussed was single asset real estate bankruptcies. Under the United States Bankruptcy Code, specifically 11 U.S.C. § 101(51B), “Single Asset Real Estate” means “real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental.” If an entity files for bankruptcy and falls within such definition, the Bankruptcy Code imposes specific restrictions specific on such entities that are designed to limit the financial onus placed on creditors with security interests in the underlying real property as well as shorten the length of the bankruptcy case.A very recent Seventh Circuit Court of Appeals decision, In re River East Plaza, LLC, No. 11-3263, 2012 WL 1697690 (7th Cir. Jan. 19, 2012), may have effectively closed the door to the ability for many Single Asset Real Estate entities to reorganize under chapter 11 of the bankruptcy code. In re River East involved a Single Asset Real Estate chapter 11 case. The debtor’s, River East Plaza LLC (“River East”), sole asset was a commercial building known as “River East Plaza” located in downtown Chicago. LNV Corporation (“LNV”) was its sole creditor and held a first mortgage position in the real estate. In February 2009, River East defaulted on its mortgage and LNV soon thereafter commenced foreclosure proceedings in state court leading to the scheduling of a foreclosure sale. As is so often the case, just a few hours before the foreclosure sale was to occur, River East filed for chapter 11 protection under the Bankruptcy Code (chapter 11 being the “reorganization” provisions of the Bankruptcy Code, in contrast to the chapter 7 liquidation provisions and route). Immediately upon the commencement of the chapter 11 case, the “automatic stay” under 11 U.S.C. § 362(a)(4) of the Bankruptcy Code kicked-in, thereby precluding the consummation of the foreclosure sale.Another angle on the legal issues here were taken by Kevin Garland and Michael Goldstein of GreenbergTraurig in an Alert entitled Seventh Circuit Holds that Treasure Bonds are Riskier than Real Estate and Cannot Provide the Indubitable Equivalence of a Claim.At the time of the chapter 11 filing, River East owed LNV $38.3 million. However, the value placed on the real estate was only $13.5 million. River East proposed a plan of reorganization (its second proposed plan after the first one failed) that relied on Bankruptcy Code section 1129(b)(2)(A)(iii), which provides that a plan of reorganization can be confirmed over a secured creditors objection whereby the creditor’s security interest (such as LVN’s mortgage lien) can be removed from the real property securing the creditors’ claim if exchanged for what is termed the “indubitable equivalent.” River East argued that its proposed plan of reorganization provided the “indubitable equivalent” to LNV because it exchanged LNV’s $38.3 million mortgage lien against the real estate for a lien on a $13.5 million portfolio of U.S. Treasury bonds which were to bear interest at 3% per annun and were to mature in 30 years. River East argued that this treatment provided the mortgagee with the “indubitable equivalent” of the mortgagee’s claim under section 1129(b)(2)(A)(iii) of the Bankruptcy Code because the $18.5 million bond portfolio would be worth $38.3 million at maturity. River East further alleged that at current interest rates the bond portfolio would grow to $38.8 million, thus guaranteeing that what LNV was to receive under the proposed plan of reorganization (i.e. its “treatment”) was the equivalent of being paid in full (albeit in 30 years). The Bankruptcy Court denied confirmation of the proposed plan of reorganization on the grounds that it did not provide the “indubitable equivalent” to LNV.In a direct appeal to the Seventh Circuit Court of Appeals, the Seventh Circuit held that the Bankruptcy Court had not erred in denying confirmation of River East’s proposed plan. In a well reasoned opinion, the Seventh Circuit emphasized the likely volatility in the value of the proposed substitute collateral versus the likely volatility in the value of the originally bargained for collateral that was subject to LNV’s existing mortgage lien (the Seventh Circuit also discussed the interplay of the Bankruptcy Code Section 1111(b) election made by LNV, which allows an undersecured claim who would normally have a secured claim in the amount of the value of its security and a separate unsecured claim in the amount of the deficiency to have just one secured claim with a lien in the full amount of the underlying claim, but the strategic significance of that issue is for a later blog).
In the case of River East, the Seventh Circuit found that the “indubitable equivalent” was not exchanged because if LNV retained its mortgage lien on the real estate and River East later defaulted a second time, LNV would most likely be able to foreclose and be paid immediately with the potential for payment in full. LNV expected the value of the real estate to increase in value, potentially to the value of its original claim ($38.3 million) long before the 30-year Treasury Bonds matured. In contrast, under the treatment proposed by the plan of reorganization, LNV would have to wait the full 30 years to recover the full amount of its secured claimed against River East. Because it concluded, among other things, inflation was almost certain to occur over that 30-year period, the Seventh Circuit found that the substitute collateral would be worth less than if LNV retained its mortgage lien on the real estate. Thus, the Seventh Circuit further concluded that the proposed exchange of LNV’s mortgage lien against the real estate for a lien on the Treasury bond portfolio was not “indubitable equivalent.” LNV was then granted relief from the automatic stay and was thus free to proceed with the foreclosure it commenced nearly three years before.
River East thus appears to have greatly increased the ability of an undersecured creditor, who makes an election under Bankruptcy Code Section 1111(b)(2), to obtain relief from the automatic stay in a single asset real estate case because it is very unlikely that such debtor will be able to confirm a “cramdown” plan of reorganization under Bankruptcy Code section 1129(b)(2)(A)(iii) that proposes to provide the electing undersecured creditor the “indubitable equivalent” of its secured claim. Finally, the question that also arises is why the Bankruptcy Court didn’t try to strictly enforce Bankruptcy Code section 362(d) and instead let the case go on for years without a confirmed plan, especially after the first proposed plan was rejected by the Bankruptcy Court.
So I arrive at the conclusion: why not just make single asset real estate entities ineligible to file for bankruptcy protection? Such entities can be left to the state law system and the disposition of the underlying real estate can be left to its contractual rights and remedies and addressed through the state court system as needed. That sounds like a better system to me that what currently exists whereby single asset real estate entities continue to game the system in their favor leaving courts, like the Seventh Circuit in In re River East Plaza, to rein in such foolish endeavors.
I like these detailed looks at complex issues. It’s good weekend reading when people have more time to really digest the content. I hope you have enjoyed this installment.