As the old saying goes, "History repeats itself." During the savings and loan industry crisis of the late 1980s, bankruptcy courts were inundated with cases filed by developers of failed real estate projects where — in the days before electronic filing — bankruptcy lawyers went to the courthouse and filed the bankruptcy petition on the eve of the foreclosure sale or immediately after the hearing on the mortgagee's petition for appointment of a receiver.
Thousands of these "single-asset real estate cases" were filed involving real estate with values substantially less than the mortgage, few other non-insider creditors, and few or no employees. These "reorganizations" were about investment partnerships that owned only one asset — the project — attempting to force the mortgage lender to stay in the deal for years to come on the hope the market would recover and the debtor could convince the court to allow the mortgage loan debt to be reduced substantially over the lender's objection and investors reap the upside later.
These acrobatic attempts usually failed, but the body of law created in the process was substantial. Even the U.S. Supreme Court issued a significant single-asset real estate case decision. In fact, Congress later amended the Bankruptcy Code to include specific provisions regarding single-asset real estate cases.
Recently, in Philadelphia Rittenhouse Developers Inc., the U.S. Bankruptcy Court for the Eastern District of Pennsylvania adjudicated the highly contested bankruptcy filing by the owner of "10 Rittenhouse," one of the largest and most ambitious residential condominium projects in the city of Philadelphia. Every conceivable argument that could be raised in a singleasset real estate Chapter 11 case was argued and briefed, from bad faith to adequate protection to bankruptcy plan classification, voting, and treatment of creditors and equity. In a 59-page opinion dated May 25 by Chief Bankruptcy Judge Stephen Raslavich, the Bankruptcy Court dismissed the bankruptcy filing as a case not filed in good faith, and in the process, reviewed and analyzed 25 years of jurisprudence on the bankruptcy niche of single-asset real estate cases.
The property, known as "10 Rittenhouse," is located near 18th and Walnut streets in Center City, Philadelphia, and includes a 33- story new-construction luxury condominium building, an underground parking garage and a connected five-story historic structure known as the Rittenhouse Club. As of May 2011, only 33 of approximately 140 residential units had been sold.
According to the opinion, in 2006, Delaware Valley Real Estate Investment Fund L.P. (DVREIF) loaned the debtor "seed money" for construction and marketing. By the time of the opinion, $62 million remained outstanding. DVREIF's loan was not secured by a lien on the realty. Instead, the debtor's original equity pledged its ownership interests as security for the loan. In addition to the DVREIF loan, the debtor obtained over time approximately $216 million in construction financing from an affiliate of iStar Tara LLC (iStar), secured by a first mortgage on the property. Pursuant to an intercreditor agreement, the DVREIF loan was subordinated to the iStar loan, but DVREIF retained the right to exercise certain rights contained in the equity pledge upon occurrence of an event of default.
The opinion recites that by July 2008 the project was experiencing financial setbacks. After various remedial efforts, the iStar loan was increased by $35 million in the fall of 2009 in a separate mortgage loan transaction. On July 15, 2010, DVREIF declared a default on its mezzanine loan, exercised its pledge, and assumed control of the debtor. It also commenced an action in Pennsylvania state court alleging various lender liability claims against iStar and other claims against the debtor.
The opinion notes that most of the claims against iStar were dismissed. Following maturity of its loans, iStar commenced its own foreclosure proceedings in state court. IStar petitioned for appointment of a receiver, alleging, among other things, that the debtor did not have sufficient funds to complete construction, pay condominium fees or market the unsold units. After a two-day contested hearing, the Pennsylvania state court advised the parties of the state court's intention to appoint a receiver immediately to operate the project. The opinion states that while counsel for the parties were modifying iStar's proposed order appointing the receiver, the debtor contacted bankruptcy counsel and directed the commencement of the Chapter 11 case. The marked-up state court order was docketed in the state court action at 4:05 p.m., seven minutes after the debtor's Chapter 11 petition was filed with the Bankruptcy Court at 3:58 p.m. — the classic "race to the courthouse." But the race had just begun.
The opinion notes that while the debtor remained in nominal control of the project, nearly all operational functions were outsourced. The project manager reported directly to the head of DVREIF. The project manager's second in command, a real estate marketing specialist, was paid indirectly by DVREI F. The remaining individuals who worked daily at the project were employed by a management company paid by DVREI F.
Under the "single-asset real estate" provisions of the Bankruptcy Code, the lender receives relief from the automatic stay after 90 days unless the debtor either commences interest payments to the lender or files a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time. Here, the debtor had no regular income to make payments. It filed a plan. The debtor's proposed plan of reorganization provided for the debtor to retain control of the project while the remaining condominium units were sold over the next three to four years. IStar would receive $517 per square foot sold. The figure was the product of dividing an assumed value of the secured portion of iStar's claim into the gross square footage of all of the remaining unsold residential units. The balance of the sale proceeds was to be held in a plan fund and used for project operating and administrative expenses. Eventually, unsecured claims, including iStar's deficiency claim, would be paid from the plan fund. No new money would be invested in the project by the equity holders. Predictably, iStar filed a motion in Bankruptcy Court to dismiss the case for bad faith, or in the alternative, for relief from the automatic stay to permit it to proceed with its state court foreclosure proceeding.
Extensive hearings and briefing ensued. Ultimately, the Bankruptcy Court granted the motion to dismiss. The court began its analysis by noting that when considering whether a bankruptcy case should be dismissed for bad faith, there is some disagreement as to whether a court must find not only the presence of subjective bad faith, but also that the debtor has no realistic chance of reorganization. The court concluded that in the 3rd Circuit, both issues must be adjudicated. The court then considered both the debtor's subjective bad faith and the objective futility of its goals. To do this, the court reviewed the circumstances surrounding the filing and whether the debtor's plan could be confirmed.
Subjective good faith in the business bankruptcy context requires a valid bankruptcy purpose of either attempting to preserve and rehabilitate a going concern or to maximize the value of a debtor's estate for the benefit of creditors through an orderly liquidation. Conversely, a case filed merely to obtain a tactical litigation advantage lacks good faith. Because a debtor is unlikely to acknowledge bad faith, court decisions have identified 14 objective factors to consider in reviewing subjective good faith.
The court noted two of these factors stood out in this case: (1) the petition effectively allowed the debtor to evade court orders, and (2) the debtor filed its petition solely to create the automatic stay. Here, the Bankruptcy Court concluded that the case was filed solely to avoid the impending order of the state court appointing a receiver. The opinion states that the filing of the bankruptcy case seven minutes before docketing of the state court receiver order was pre-planned and "a transparent, and particularly blatant, litigation tactic, which in turn is highly probative of the debtor's subjective intent and is, indeed, suggestive of bad faith."
The opinion states that several other factors were implicated that did not favor the debtor. In addition to noting the project was the debtor's sole asset and the debtor had few employees and no going concern stream of income to operate its business, the court concluded the case was essentially a two-party dispute. The opinion notes that the three largest unsecured creditors (who were members of the creditors' committee) supported iStar's motion to dismiss the case, and stated they could not understand why the case was in bankruptcy to begin with and would vote against the debtor's plan if it came to a vote.
Furthermore, the court concluded certain insider claims were not legitimate loans but appeared to have been post-hoc inventions of the claimants, or the debtor, or the two acting in concert. Once the three creditors' claims, questionable insider claims, and another insider claim were discounted, the remaining unsecured prepetition debt totaled approximately $620,000, or one-fourth of 1 percent of the amount owed to iStar/DVREIF. Ultimately, the court found that most of the factors evidencing bad faith were present, "some to a particularly egregious degree," and concluded the case had been filed in subjective bad faith.
The court then analyzed whether the case was objectively futile. The court found three independent deficiencies, which rendered the plan unconfirmable. First, the plan violated the absolute priority rule. The absolute priority rule prevents confirmation of a plan over the objections of a senior class of creditors if a junior class will receive any property unless the senior class is paid in full or votes to allow the junior class to receive a distribution.
In this case, the debtor's plan called for the debtor's equity interest holders to retain their interests. IStar argued, and the court agreed, that the equity holders' retention of project control and ability to invade the sale proceeds for operating and administrative expenses represented a bundle of property rights, and the retention of those rights violated the absolute priority rule. The opinion noted that the debtor's argument that retention of control without actual economic distributions did not constitute property rights has been rejected by the U.S. Supreme Court.
Second, the Bankruptcy Court held iStar would not receive adequate protection of its collateral because the plan would not provide iStar with the indubitable equivalent of its secured claim. Specifically, iStar would receive no payments other than $517 per square foot from sales, if any, until the effective date of the plan, and then monthly interest payments thereafter and no amortization of principal except from sale proceeds if and when sales occurred. Meanwhile, the debtor would be free to spend the remaining sale proceeds held in the plan fund in which iStar held a first priority secured interest.
The court noted the debtor's plan radically and adversely altered iStar's bargained for contractual rights, effectively converting its construction term loan into a revolving line of credit, without providing the indubitable equivalent of its collateral property interests in the units and proceeds. The opinion noted that the 3rd U.S. Circuit Court of Appeals has made clear in a prior decision that "Congress ... did not contemplate that a creditor could find its priority position eroded, and as compensation for the erosion be offered an opportunity to recoup dependent on the success of a business with inherently risky prospects." That says it all. If that was not enough, and it probably was, the opinion observed that the debtor acknowledged the value of the project today was $140 million, that iStar's claims exceeded $200 million, and the lender liability claim asserted against iStar in state court, even if successful, alleged damages not in excess of $10 to $20 million. The Bankruptcy Court opinion did the math. Finally, the court concluded that the debtor's plan was unconfirmable because it failed to provide for an impaired accepting class of creditors. Section 1129(a)(10) of the Bankruptcy Code states that a plan may only be confirmed if at least one class of impaired creditors accept the plan, other than acceptance by an insider. The debtor's plan included a separate class composed only of the claim held by the Condominium Homeowners Association and separately classified that class from other unsecured creditors. The association acted by homeowner votes. Given that 107 of the approximately 140 units remained unsold, the association was controlled by the debtor. The court concluded that separate classification of the association was an impermissible attempt to create a creditor class that would vote in favor of the debtor's plan. Furthermore, the court concluded that the association was an insider of the debtor under Section 101(31) of the Bankruptcy Code, and therefore its vote could not satisfy the requirements of Section 1129(a)(10).
The other issues analyzed by the court, although worthy of discussion, exceed the space allotted for today's already lengthy article. The opinion concluded: "In summary, whether the court evaluates this case based on an overfly of the forest or a walk through the thicket of trees, its impression remains the same. The debtor's good faith in the initiation of this case was legitimately placed at issue." This case provides an example of the steep burden a debtor must overcome to use the bankruptcy process to stay a mortgage foreclosure by a substantially undersecured mortgage lender where the plan is simply a battle over who will sell the collateral and how quickly the real property will be sold. The matter has now gone back to state court while the debtor pursues an appeal of the Bankruptcy Court's decision to the U.S. District Court for the Eastern District of Pennsylvania.
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