Single-asset bankruptcies in a nutshell.

In recent years, individuals, partnerships and corporations whose sole business is the ownership and operation of an office building, apartment complex, shopping center or similar real estate project have turned to bankruptcy to alleviate financial pressures brought on by the recession currently gripping the nation and to forestall actions by lenders, such as foreclosure. This article highlights common issues arising in "single-asset" bankruptcies.

The single-asset bankruptcy case typically involves a single lender with a large non-recourse mortgage against the project, and only a few trade creditors, whose claims are almost negligible in comparison with the mortgage debt. As rental rates fall, the project loses its ability to service the mortgage loan, and the mortgage lender seeks to foreclose. The owners, who have invested substantial capital in the project, hope to save their "equity" through recovery of the project's value, with the "rebound in real estate which is just around the corner." On the eve of the foreclosure sale (or the seeking of a receiver by the lender), the debtor files a Chapter 11 bankruptcy proceeding and the battle is on.

Automatic Stay

Upon the filing of a bankruptcy case, there is an "automatic stay" which in general prevents any further attempts to collect debts, including commencing or continuing any litigation or foreclosure. Even if the mortgage lender has had a receiver appointed, the debtor is able to regain possession. In order to proceed with foreclosure the lender must seek an order from the bankruptcy court to obtain relief from the automatic stay.

The grounds for relief from the stay are (a) cause, including lack of adequate protection, or (b) the debtor has no equity in the property and the property is not necessary for an effective reorganization.

Cause.

Cause for relief from the stay includes improper or "bad faith" filings. The latter sometimes cover the "new debtor syndrome" -- a filing by a newly-created entity that receives the property shortly before bankruptcy, has no other assets, few, if any, employees, no bank accounts and no other business purposes, and usually files for bankruptcy on the eve of foreclosure. "Cause" for relief from the stay also includes lack of "adequate protection" which means that the lender's security should not diminish in value from waste, lack of payment of taxes and similar occurrences. If there is diminution, the debtor can "adequately protect" the lender by making periodic payments or giving the lender a replacement lien on other collateral, equal to the diminution. In the unusual case where the value of the property is more than the secured debt that excess value or "equity cushion" will also act as adequate protection.

No Equity or Possible Reorganization.

For the court to grant relief from stay because the debtor has no equity in the property, it must first find that the aggregate liens against the property exceed the value of the property, and then that the property is not necessary for an effective reorganization. "Effective reorganization" means more than the fact present in every single-asset case that the property is necessary in order for there to be a reorganization; it generally means that there should be a plan of reorganization in process, which is "confirmable on its face," notably as to the "new value" and "separate classification" issues discussed below.

Use of Cash Collateral

Since the lender's mortgage documents typically will have a "rents, issues and profits" clause, the lender will contend that any income generated by the property constitutes cash collateral subject to its lien which cannot be used by the debtor absent the consent of the lender or an order of the court. Some courts have permitted the debtor to use rents free of the lender's lien if, prior to the bankruptcy, the lender did not obtain the right to collect the rents through the appointment of a receiver. In some bankruptcy cases involving debtors who own hotels, courts have held that "room rates" are not "rents" subject to the lender's lien on cash collateral.

Valuation And Plan Treatment

The Bankruptcy Code provides that an undersecured lender has two distinct claims: a secured claim for that portion of the debt equal to the property's value, and an unsecured claim for the balance. It is this two-claim feature that is so important to the plan of reorganization process. In addition, interest stops accruing on an undersecured obligation on the date the bankruptcy is filed.

Once the debtor proposes a plan of reorganization, the lender is faced with a number of issues, including the treatment of its claim or claims. If the lender can establish that it is fully or oversecured, it must receive under the plan property with a value equal to its entire claim, either by payment in full, return of the property, or a lien on the property securing a future stream of payments, the present value of which equals the amount of the lender's claim. However, if the lender is undersecured, the present value of the stream of payments required to be provided by the plan need only equal, the amount of its secured claim, and its deficiency claim is treated as wholly unsecured -- unless the lender exercises a special right it has to have its two claims treated as a single fully secured claim but one with an important distinction: the future stream of payments provided by the plan, even though it must total the entire amount of the lender's claims, need only have a present value (as of the plan's effective date) equal to the value of the property. One way to attempt to understand this difficult concept is to think of the secured note obligation given by the plan to the lender electing single-claim treatment, as having a principal balance equal to the lender's entire claim, but only such interest rate and payment period as will enable the stream of payments to have a present value equal to the value of the property.

If a lender's unsecured claim is relatively small and the lender believes that the court undervalued the property or that the value of the property will go up, it should probably elect to have its entire claim treated as fully secured. In other cases the election should probably not be made, because it may be possible for the lender to block the unsecured class of creditors from voting in favor of the plan, forcing a dismissal of the case and allowing the lender to proceed with foreclosure. Since 66-2/3% of the dollar amount of each class of creditors must generally vote to accept the plan, a lender with a large unsecured deficiency claim can likely block confirmation of the plan by voting against it. To counter this possibility, debtors often attempt to classify the unsecured portion of the lender's claim as a separate class from other unsecured trade creditors in order to create a class of impaired claims that will accept the plan, a necessary requirement for confirmation. However, the courts will normally reject such gerrymandering in single-asset cases where there usually are few other unsecured claimants and it is difficult to establish any rational basis to support separate classification.

Cramdown

It is, however, sometimes possible to have other classes of impaired claims who could vote to confirm the plan (such as a class of secured equipment lenders or lessors), thereby making it possible to confirm a plan under the "cramdown" provisions of the Bankruptcy Code. Cramdown occurs when at least one class of impaired creditors votes to accept the plan and the court confirms it over the objections of a rejecting class. In such a case the court must find, as to an objecting secured lender, that such lender retains its lien on the property and receives the deferred cash payments to which it is entitled, depending on how it has elected to have its claim or claims treated, as discussed above.

As to any nonconsenting class of unsecured creditors, the court can confirm the plan over objections, provided that the class of unsecured creditors gets paid in full or no junior class (i.e. equity) retains any interest in the debtor. Sometimes, under a so-called "new value" exception to the "absolute priority" rule (which dictates that senior classes get paid in full before junior classes receive anything), the existing equity is permitted to remain in place even though unsecured creditors are not paid in full, not because of their existing ownership, but on account of new investments they make in the reorganized debtor.

Policy Considerations

A number of courts have demonstrated hostility to single-asset bankruptcy cases because they view them as private two-party fights between borrowers and lenders, which have unduly consumed the nation's bankruptcy resources. Since the debtor typically manages the "asset" through an on-site management firm, there are few employees whose jobs are needed to be preserved through the reorganization process. Accordingly, such courts might be more inclined to resolve the single-asset bankruptcy issues against the debtor in order to enable the lender to complete its foreclosure and operate the project through the same or some other management firm.

However, the cumulative effect of the staggering number of commercial real estate foreclosures throughout the country may call into question, as a policy matter, whether such hostility is always justified. One counter-argument might be based on the fact that after foreclosure the income-producing nature of the project is usually not increased or improved. Often the entrepreneurial developers are simply replaced by new lender-owners, who may not be equipped to hold and manage the project or who may be compelled to liquidate the asset on the market at reduced prices, creating a downward pressure on commercial real property values throughout the country. Perhaps lenders as well as the community at large might be better served in the long run if bankruptcy decisions encourage skilled real estate owners and developers, whose resources and expertise can increase the value of the asset, to retain some level of ownership and management of their projects.