What Happened to Real Estate Bankruptcies?
| Publication year | 2010 |
| Pages | 0026 |
A Look at the Law
by Alfred G. Adams Jr. and Jason C. Kirkham
In prior recessions, real estate borrowers routinely sought refuge in Chapter 11 of the Bankruptcy Code[1] to avoid foreclosure and to modify defaulted mortgage loans. Chapter 11 provides many benefits to borrowers not available outside of bankruptcy. For example, the mere filing of a Chapter 11 petition constitutes an automatic stay enjoining virtually all acts against the debtor or the debtor's property, including foreclosure.[2] Further, unlike a Chapter 7 liquidation, where a trustee is appointed immediately upon filing, the borrower in a Chapter 11 reorganization generally remains in control of its assets as a "debtor-in-possession."[3]
Virtually all business entities may seek Chapter 11 relief, and insolvency is not a requirement.[4] Chapter 11 also provides the owner of a real estate project the opportunity to restructure its mortgage and other debts and to retain ownership of the project by confirming a plan of reorganization. The plan does not have to be consensual, as even without uniform creditor consent, a debtor may "cramdown" a plan over the objections of some creditors so long as at least one class of impaired creditors votes for it and the plan complies with certain fundamental requirements.[5]
Despite these attractions, the current "Great Recession," unlike prior downturns, has not generated widespread Chapter 11 filings by single-asset real estate borrowers. In fact, there have been very few. Why is this the case? What has reduced the flood of Chapter 11 real estate filings that accompanied prior recessions to a mere trickle in the current downturn?
Three fundamental changes in the world of commercial real estate finance since the last real estate recession have severely curtailed the ability of borrowers to utilize Chapter 11 as an effective mechanism to restructure mortgage debt: (1) the increasingly widespread use of so-called "springing," "exploding" and "non-recourse carve-out" guaranties in commercial real estate loans; (2) the impact of the Bankruptcy Abuse and Consumer Protection Act of 2005[6] (BAPCPA) on bankruptcies by single-asset real estate entities; and (3) caselaw which has virtually eliminated the ability of borrowers to confirm cramdown plans reducing the mortgage lender's debt to the current fair market value of the project while leaving the borrower in place as owner of the project in consideration for the borrower's contribution of (typically modest) "new value" to the project. Together, these changes make it very difficult for borrowers to use bankruptcy to restructure their secured debt.
Springing, Exploding and Non-recourse Carve-out Guaranties
Following the recession of the early 1990s, lenders increasingly insisted that loans be structured with the borrower as a single-purpose, "bankruptcy remote" entity (SPE), which would own no assets other than the mortgaged property and which would therefore be insulated from economic problems unrelated to that property. The market in commercial mortgage-backed securities also encouraged the use of SPEs, as the rating agencies which "rated" those securities required their use.
Because, by definition, the SPE has no assets other than the real property (and personal property used in connection with its operation), the lender almost always insists that a creditworthy person or entity, typically a principal of the borrowers, enter into a "non-recourse carve-out guaranty." That guaranty, which is sometimes referred to as an "exploding" or "springing" guaranty, makes the guarantor liable for certain "bad acts" ? typically intentional acts that would diminish the value of the collateral (e.g., fraud, waste or misappropriation of insurance proceeds and rents).[7]In addition, and most important for a borrower contemplating a bankruptcy filing, the guaranty typically makes the guarantor liable for the full amount of the loan if the borrower files a voluntary bankruptcy petition or does not resist an involuntary petition.[8]
The automatic stay does not enjoin creditor actions against third parties, such as individual guarantors of the debtor's obligations. Guarantors who control bankrupt debtors sometimes seek discretionary stays on the grounds that warding off collection suits diverts management from the reorganization effort. Courts, however, rarely grant those requests.[9]
This threat of personal liability against the warm bodies who control the typical real estate borrower is a serious deterrent against those borrowers filing for bankruptcy protection. Guarantors may challenge enforceability of these guaranties on a number of grounds, both directly (when lenders attempt to enforce the guaranties) and indirectly (by asking bankruptcy courts to enjoin enforcement of the guaranties). Guarantors can argue that by encouraging the guarantor to put its personal interest ahead of the rest of its partners, these guaranties foster breaches of fiduciary duty and are, therefore, void as a matter of state law public policy. Further, guarantors may also claim that such guarantees violate federal bankruptcy policy by effectively precluding access to the bankruptcy courts, and are therefore unenforceable. Guarantors are also likely to ask bankruptcy courts to use their equitable powers to enjoin collection efforts against guarantors. The few reported cases dealing with the enforcement of non-recourse carve-out obligations have upheld the lender's position.[10] Of course, as in the recent case of General Growth Properties, where the guarantor itself is insolvent, a springing guaranty is no deterrent.
Insider springing guarantees are probably the most important impediment to borrower bankruptcies. At bottom, the central debate will be balancing state and federal public policy concerns against the realities that (1) the actual debtor is not a party to the guaranty, and (2) assuming a court is willing to refuse enforcement on some ground, drawing principled distinctions between which agreements should be upheld and which should not will be very difficult. Given the ubiquity of these guaranties in the last real estate cycle, more cases are certain to arise.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
The BAPCPA, while best known for its provisions making it more difficult for consumer debtors to discharge their debts under Chapter 7 of the Bankruptcy Code, also removed the $4 million cap that formerly applied to the Bankruptcy Code's special provisions for single-asset real estate entities. As modified, the requirements applicable to single-asset real estate debtors make it quite difficult for many real estate borrowers to utilize Chapter 11.
The threat of a bankruptcy petition was a significant leverage point for borrowers in prior recessions (especially that of the early 1990s), and the loss of that leverage is one of the most important reasons that this downcycle differs from its predecessors.
In recognition of the abuse of bankruptcy by real estate borrowers during the recession of the early 1990s, Congress enacted Section 362(d)(3) of the Bankruptcy Code in 1994, which requires the court to grant relief from the automatic stay to a secured creditor of a singleasset real estate entity unless, within 90 days after the order for relief (such as filing of a voluntary petition) or 30 days after the court determines that the debtor is a singleasset real estate entity, whichever is later: "(A) the debtor has filed a plan that has a reasonable possibility of being confirmed within a reasonable time; or (B) the debtor has commenced payments that. . . are in an amount...
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