The legal and social implications of insolvent cross-border real estate developers: reviewing the U.S. and Canadian commercial real estate markets.

• Author: Canuel, Edward T.

ABSTRACT

This article analyzes the phenomena associated with cyclical real estate markets, discussing the theoretical and market influences which motivate developers during this cycle. Fluctuating commercial real estate markets necessitate a focus on market upswings and downswings, and consideration of the roles and motivations of a wide array of actors, ranging from industry analysts and developers to lenders. Legal considerations, particularly during real estate downturns, or busts, include a variety of issues, particularly if the commercial real estate developers in question conducted business internationally. This Article details the theoretical and economic conditions found during real estate market cycles, with special emphasis on cross-border real estate developers. Relevant legal considerations faced by such developers confronting insolvency are also considered. Finally, the Article notes possible measures which may mitigate the many pitfalls confronting the insolvent developer.

TABLE OF CONTENTS I. INTRODUCTION II. ANALYZING REAL ESTATE MARKETS, THE DOWNFALL OF DEVELOPERS, AND THE "TYPICAL" REAL ESTATE ENTREPRENEUR A. Real Estate Markets: Noting Upswings and Downturns B. Cross-Border Real Estate Developers C. Real Estate Entrepreneurs: Idiosyncratic Factors III. CROSS-BORDER REAL ESTATE DEVELOPMENT AND INSOLVENCIES: LEGAL CONCEPTS AND STRATEGIES A. Statutes and Protocols in Canada and the United States B. Legal Strategies 1. Substantive Consolidation: Real Estate 2. Debtor-in-Possession Financing 3. Extending the Stay of Proceedings 4. "Executory" Real Estate Contracts--Termination of Interests 5. Cram Down Provisions IV. REVIEWING OPTIONS: CLIMBING OUT OF THE WELL I. INTRODUCTION

Real estate development forms a crucial aspect of the closely-linked economies of Canada and the United States. (1) During the late twentieth century, real estate markets suffered a variety of market rises and crashes. For example, in the U.S. real estate market bust of 1990, a resulting financial drain gripped the United States: The bankruptcy of thousands of savings and loan institutions carried a debt of $600 billion, and the government-owned Resolution Trust Corporation held 40,000 foreclosed properties. (2) The Canadian markets during the most recent real estate bust were also in turmoil; the drop in market value of the shares of the five largest Canadian developers in the first quarter of 1991 amounted to $1,935 million (CDN). (3)

Business cycles in the real estate development market are characterized by certain identifiable phases: stagnation, recovery, credit-based expansion, speculative fever, and crash. (4) Each phase elicits different behavioral responses from the business community, as "booms" lead to crises and depressions. (5) During the market downslide, credit becomes scarce as banks and entrepreneurs seek liquidity, although very few borrowers exist to replace the lost loans. (6) The developers' responses have direct effects on the real estate markets, particularly evident in periods of dramatic over-building. (7) Real estate development has been characterized as a series of stages, building upon initial real estate market recovery and ending with a crash, leading to economic stagnation. (8)

Recently, the tide of real estate market investment has again surged. Large-scale developers in major North American metropolitan centers such as Miami (9) have developed substantial real estate projects. Lenders, once hesitant to finance mid-size or small-market real estate ventures, have become aggressive; (10) financiers are again looking at the leverage ratios of certain clients with guarded optimism. (11) As the development market cautiously grows, concerns are raised as to what will occur when (or if) the market drops. The current expansionist market has once again triggered theorists to analyze real estate market trends. Theorists contend that the boom of a business cycle predicts an increased volume of real estate inventory hitting the market in a relatively short timeframe. (12) Alternatively, the market bust signals that there are no longer any purchasers, and business cycles end with over-supply, business failures, and financial crises. (13)

Part II of this Article explores the cyclical commercial real estate industry, addressing the causes of real estate development market swings. Issues analyzed include: (i) the interrelationship between developers and lenders and the general concept of real estate cycles; (ii) the insolvency of well-known Canadian developers, most notably Olympia & York and its vast cross-border holdings; and (iii) the idiosyncrasies of real estate developers, with a focus on the personal attributes that precipitated their businesses' demise. Part III reviews legal issues faced during the cross-border insolvencies of developers, including: (i) substantive consolidation; (ii) debtor-in-possession (DIP) financing; (iii) the extension of the stay of proceedings, particularly when a landlord "goes dark"; (iv) executory contracts; and (v) cramdown provisions. The Article concludes by noting what safeguards can be instituted to either slow the economic slide of a developer or cushion its fall into insolvency.

2. ANALYZING REAL ESTATE MARKETS, THE DOWNFALL OF DEVELOPERS, AND THE "TYPICAL" REAL ESTATE ENTREPRENEUR

   Jim Whitehead's comprehensive analysis of the cyclical commercial real estate market, The Midas System, remains the most authoritative scholarship contending with the social, legal, and economic implications of international commercial real estate downturns and upswings. Accordingly, the Author acknowledges the sizeable contribution which Whitehead's important study has made to this piece.

   1. Real Estate Markets: Noting Upswings and Downturns

      Theorists have widely analyzed the concept of booms and busts in the commercial real estate market, proposing that the property development industry has suffered three recent and distinctive boom periods: 1973-1974, 1978-1981, and 1987-1989. (14) During these periods, Canadian developers with extensive cross-border holdings, such as Bramlea, Campeau, Carma Developers, Olympia & York, and Trizec, all became insolvent (their liabilities exceeded assets). (15) In the 1991 real estate development collapse, the office markets in many North American cities were overbuilt. (16) While favorable interest rates encouraged real estate investors, one expert argues that developers followed a "natural tendency" to "get carried away" until the real estate cycle ended. (17) In addition, developers, financiers, and government officials blamed each other on a variety of issues, including interest rate increases (arguably decreasing capital flows to projects), (18) overly optimistic developer forecasts, and blaming generous funding. (19) Other theorists, specifically pointing to the U.S. savings and loan crash in the 1980s, take note of financial institutions investing in development projects that promised high return rates (while these institutions took full advantage of then-existing tax subsidies). (20)

      Although historically the initial stimulus of a boom real estate economy varies dramatically (e.g., oil price increases and gluts of petrodollars seeking investments and the deregulation of the financial industry), extremely favorable economic conditions generally precede each property boom. (21) Whitehead aptly noted the hidden dangers that are ignored or unnoticed during a boom:

      First, the shortfall between the supply and the demand is not as large as first perceived. Profit-making opportunities are created for those developers who deliver their products to the market early in the cycle. Second, the magnitude of the property boom is not directly related to the level of economic activity. Rather, the size of the property boom and its intensity seem to be related to the availability of credit, the developer's perceptions of growth potential, and the ability to gauge the actions of competitors. ... The weak correlation between the actual demand for new construction, the builders' perceptions of new housing opportunities, and new construction itself gives rise to decision errors leading either to over-building or under-building. (22) In an economy moving towards the apex of a boom, several themes emerge: (i) developers become reckless and aggressive, given previous successes; (ii) a developer's business associates and bankers often follow the developer blindly and abandon independent thought; (iii) incorrect development forecasts lead developers astray; and (iv) the boldest real property purchases are often made at the market bottom's peak. (23) "The debt accumulated during the boom years reflects both the inflation of real estate values and the leveraging of those values by debt." (24) Under booms, the first developers enter markets characterized by a great unsatisfied demand, and they often make windfall profits; gains encourage increased development, which saturates the market and forces expansion into other markets. (25) Some developers are successful, and the frenzy of buying and selling in hot real estate markets inflates land prices, as developers actually create their own boom. (26) Land Banking, the purchasing and maintaining of real estate inventory, overtakes land development as real property values surpass the costs of keeping inventory. (27) As such, developers commit to massive borrowing, using land as collateral to purchase additional land. (28) "Some of the larger joint-stock companies raising capital use the inflationary increase in land value as a measure of their real equity ... [which] permits the raising of additional capital through corporate debentures and share offerings to purchase even more land." (29) In such a situation, some companies become so financially leveraged that they are vulnerable to interest rate fluctuations and to slight changes in supply and demand of real estate. (30) As a market boom progresses, developers...