Lender Strategies in Chapter 11 Real Estate Cases

Successful banks seek opportunities to minimize default risks in commercial real estate transactions.  In normal times, banks are under pressure to generate profits for their shareholders, manage their deposits, and comply with the labyrinthine regulations and laws governing their industry.  Perhaps most importantly, banks must manage risks associated with lending money to their customers.  This is a daunting task in the consumer banking environment, but the stakes are even higher in commercial lending scenarios.  It is critically important for lender’s counsel to consider bankruptcy issues when negotiating loans if the unthinkable occurs – a customer files bankruptcy.  There are strategies a lender may use to minimize risk.  A decision out of New York, Sutton 58 Assoc. LLC v. Pilevsky demonstrates how careful planning and drafting can be used offensively in chapter 11 bankruptcy proceedings should the unthinkable occur – the commercial customer defaults under the loan and files chapter 11 bankruptcy.

Structure of the Real Estate Transaction

In Sutton 58, there were two entities structured such that if either entity filed bankruptcy, they would be classified as single asset real estate debtors (“SAREs”).  SAREs cases allow lenders to expedite the chapter 11 bankruptcy process and sets short deadlines for the debtor to reorganize and file a plan.  The Sutton 58 lender structured the transaction in the following manner:

The agreements barred the sale or transfer of any direct or indirect interest in either the underlying property or the SAREs without lender’s consent.  The parties structured the transaction this way so that the borrowers would be recognized as SAREs to shorten the chapter 11 bankruptcy process. The lender and the mezzanine borrower also entered into a pledge and security agreement whereby the mezzanine borrower pledged its 100% membership interest in the mortgage borrower as collateral for the mezzanine loan. Absent bankruptcy, the structure allowed the lender to foreclose upon and sell that membership interest, and ultimately the property, if the SAREs defaulted.

The Default and Subsequent Bankruptcy Case

The debtors ultimately defaulted at the time the loan matured and filed bankruptcy before the lender could exercise its remedies under state law. The lender asked the bankruptcy court to dismiss the debtors’ filing as a bad faith filing or allow it to move forward with its foreclosure process in state court. The lender later withdrew its motion.  Later, it cooperated with the proceeding and credit bid its loan interest in the property and ultimately acquired it.

The Lawsuit and Appeals

Prior to its credit bid purchase, the lenders sued debtors’ counsel and affiliated entities in state court for tortious interference with the loan agreements.  The lender alleged that counsel and their affiliated entities engaged in a scheme to purchase ownership in the debtors in violation of the loan documents.  Debtor’s counsel structured the debtors’ prepetition ownership interests and property such that they would not qualify as SAREs.  Specifically, the mezzanine borrower received a $50,000 loan to retain counsel and transferred three rental apartments to the mortgage borrower so that neither entity would qualify as a SARE.  The counsel then sold 49% of the mezzanine borrower to a separately created entity.

The lender claimed that it was damaged because the bankruptcy proceeding was more protracted because the debtors no longer qualified as SAREs in violation of the loan documents.  Counsel and its affiliated entities moved for summary judgment arguing that the lawsuit was preempted by federal bankruptcy law.  At issue was whether this type of pre-bankruptcy restructuring would upset the expectations of lenders for large-scale real estate projects under similar loan agreements. 

The lenders appealed and the Court of Appeals of New York, its highest court, held that the lender’s state law remedies were not preempted by the bankruptcy case.  The court reasoned that Congress did not intend to preempt the lenders from pursuing essentially third-party claims.

Contact a Business Bankruptcy Attorney to Discuss Your Options

Sutton 58 provides an example of how lenders can use the bankruptcy code to protect their interests in SARE cases.  If you are a lender in a similar situation, call Jermaine Watson for a consultation today at 817-877-2861.