New York Law SchoolTopic 4: Eligibility

Real Estate work outs, foreclosures and bankruptcy

Prof. David R. Kuneydkuney@sidley.com

Overview of the Bankruptcy System:Friday: 9:00 am to 9:45 a.m.

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Topics

• How does bankruptcy change the outcome and bargaining leverage of the parties?

• Why do companies file for bankruptcy? • Are you eligible under federal bankruptcy law.• Are you eligible under state law. • Are you eligible but subject to early dismissal.• Does the appointment of a receiver stop you from

filing?

Manhattan Office Building.

• Downtown office building generates $10m/yr in net operating income (“n.o.i.”)

• Net operating income is free cash flow after all operating expenses (without deduction for debt service).

• Value of building: investors want 6% return.• Inverse of 6% is 1/6 = 17• 17 times $10 million =$170 million.• 6% of 170 million = $10 million.

Mortgage

• Prudent lender invests 80% of fair market value.

• 80% of $170 million = $136 million= first mortgage on the Building.

• 7% interest = $9,520,000• N.o.i= $10,000,000 [not much room for loss]• Note: this loan is non-amortizing.

Borrower

• Borrower is single purpose entity, typically an LLC under Delaware law.

• Two “members” and one independent director.• Operating agreement– power to remove

directors?• Requires unanimous consent for “major

decisions.”• Director’s duty of loyalty is governed by fiduciary

standards of a Delaware corporation.

Guarantor

• Guarantor is sponsor or other credit worthy entity.

• Loan is non recourse generally.• But there is a “bad boy” carve out which means

guaranty “springs” in case of certain conduct.• Conduct includes the filing of a bankruptcy

petition.• Is this proper or against public policy?

Distress arrives!

• Major tenant walks or files for bankruptcy.• Net operating income falls to $9.0 million.• Cap rates go up to 9% because of overall

economy.• 1/9 = 11• Value is now 11 times $9.0 m = $99 million.• Loss of value is $71 million (was $170 million).• Loan cannot be refinanced!• Owners cannot service debt.

Notice of default and acceleration

• Notice of default.

• No cure.

• Acceleration.

Why do companies file

• Section 362– the automatic stay.• Breathing room• Debtor in possession- freedom to manage the

business.• Section 1129: ability to propose “plan of

reorganization” which restructures debt (e.g., extends time; reduces principal).

Core elements of bankruptcy

• What makes bankruptcy unique from state law?

• Preemptive power based on Constitutional grant of authority.

• Ease of entry.• Retention of management power.• Automatic stay.• Majority rule; control over dissidents.• Power to modify and extinguish secured and unsecured

contracts and liens.11

Bankruptcy 101

• Fundamental lesson: the basic rule of bankruptcy concerning secured lender’s rights:

– A secured lender’s right to possession of collateral or enforcement of its loan documents is stayed and suspended and replaced by the Code’s system of adequate protection.

• See, United States v. Whiting Pools, Inc., 462 U.S. 198 (1983).

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Understanding the cram down risk.

Cram down creates four discrete risks: – Reduction of principal.– Reduction of interest rate.– Extension of term.– Elimination of covenants.

• “In cases like this involving secured interests. . . The court’s authority to modify the number, timing or amount of the installment payments is perfectly clear.”

– Till v. SCS Credit, 124 S.Ct. 1951 (2004).

Chapter 7 v. Chapter 11 Chapter 7:

- Debtor turns over property to trustee.- Trustee liquidates estate.- Generally no operation of the business.- No control by management or equity holders.

Chapter 11:- Property is held by the “estate.”- Debtor in possession has full rights to manage and use the property.- Debtor may get discharge if it continues in business and has a confirmed plan of reorganization.

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Involuntary bankruptcy

• Section 303(b)(1) --- an involuntary case may be commenced under chapter 11 by three or more entities, each of which is the holder of a claim that is not contingent as to liability or the subject of a bona fide dispute, if such claims in the aggregate total at least $14,425 more than the value of any lien on property securing such claim.

• If there are fewer than 12 creditors, then one person may file an involuntary.

• TEST: Is the debtor “generally” paying such debtor’s debts as such debts become due unless such debts are the subject of a bona fide dispute as to liability or amount.

• NOTE: even a dispute as to “amount” means debtor may prevail.

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The automatic stay• The most basic debtor tool of bankruptcy is the automatic stay

• Section 362 of the Code provides that the commencement of the case operates as a stay against all entities of:– the commencement or continuation of any judicial proceeding against

the debtor. . .– Any act to obtain possession of property of the estate. . – the enforcement of a judgment– any act to perfect a lien

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Examples of stay violations• Notices of default

• Acceleration

• Threats.

• Letters.

• Law suits.

• Actions against property of the estate, such as foreclosure– See U.S. v. Whiting Pools, 462 U.S. 198 (1983); (secured lender in possession of collateral

stayed from conducting sale).

• Set off.

What the stay does not cover:

• Actions against third party guarantors:– But consider section 105 injunctions.– Consider effect of foreclosure on fee interest under N.Y.

law where guarantor must be named in order to preserve claim.

• Draws on letter of credit.– But consider issue if l/c acquired within preference

period. • Decision not to continue to provide goods and services to

debtor (provided there is no existing contract in place and no threat implied).

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Eligibility to be a debtor.

Section 109: “Only a person . . may be a debtor. . .”

One does not have to be good, smart, or broke to file for bankruptcy: it is enough to be a “person.”

D. Kuney, ALI-ABA conference

"It is not bad faith to seek to gain an advantage from declaring bankruptcy--why else would one declare

it?" – In re James Wilson Assocs., 965 F.2d 160 (7th Cir. 1992).

Eligibility issues for limited liability companies

• In re Avalon Hotel Partners, 302 B.R. 377 (Bankr. D. Or. 2003).

• Filing must be authorized by law and must be consistent with the terms of the operating agreement.

• If operating agreement requires unanimous consent for “major decisions” then most courts will require unanimous consent of members to authorize a filing.

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LLC Operating agreement prohibits filing?

• Can operating agreement state that the limited liability company will not file for bankruptcy?– In re DB Capital Holdings, LLC, 463 B.R. 142 (10th Cir. B.A. P. Dec. 6, 2010).

• Paragraph (v) on page three of that May Amendment expressly bars Debtor from filing a bankruptcy petition, as follows:

• The Company (v) to extent permitted under applicable Law, will not institute proceedings to be adjudicated bankrupt or insolvent; or consent to the institution of bankruptcy or insolvency proceedings against it; or file a petition seeking, or consent to, reorganization or relief under any applicable federal or state law relating to bankruptcy....13

Dismissal for bad faith filing• The bankruptcy code does not have a “good faith” filing requirement in the text of the Code.

• The bankruptcy courts have added this as a judicial gloss if they find the filing was not for a valid reorganization purpose. The standard varies.

• Second circuit: test requires both objective and subjective bad faith.

• “[A] bankruptcy petition will be dismissed if both objective futility of the reorganization process and subjective bad faith in filing the petition are found.”

• “[A] bankruptcy petition should be dismissed for lack of good faith only sparingly and with great caution.”

– In re General Growth Properties Inc., 409 B.R. 43,56 (Bankr. S.D. N.Y. 2009)

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Bad faith factors: Third Circuit

• Single asset case.• Few unsecured creditors.• No ongoing business.• Petition filed on eve of foreclosure.• Two party dispute.• No cash or income.• Improper pre petition income.

– In re Primestone Inv. Partners, L.P., 272 B.R. 554, 557 (D. Del. 2002), citing with approval in In re JER/Jameson Mezz Borrower II, LLC, 461 B.R. 292 (Bankr. D. Del. 2011).

• KEY: What is the key factor? How does court distinguish terminal euphoria from valid reorganization purpose?

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In re General Growth Properties

• Consider: did the court announce a different standard?

• Does the objective/subjective test differ?• What does the statutory language imply—why is

there no threshold statutory test of good faith?

General Growth PropertiesMotion to Dismiss

• Filings were premature because SPE debtors were solvent, producing sufficient cash flow, not in default and were made only to protect parent.

• GGP filed in subjective bad faith because it removed and replaced independent directors.

• SPE cases were objectively futile because of lack of impaired assenting class.

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Court ruling on motion to dismiss

• Motion to dismiss denied.

• No objective bad faith; appropriate to consider interests of entire integrated enterprise. Ability to restructure parental debt would be undermined unless operating subsidiaries were protected. “Corporate family” theory is sanctioned.

• No objective futility: lack of impaired class not fatal early in case because lenders may vote for plan despite assertions to the contrary.

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General Growth on use of independent directors

• Removal and replacement of directors proper; done in accordance with terms of SPE’s organizational do documents.

• New board members carefully reviewed status of each SPE and voted based on reasoned assessment.

“However, if Movants believed that an “independent” manager can serve on a board solely for the purpose of voting “no” to a bankruptcy filing because of the desires of a secured creditor, they were mistaken.”

In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009).

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The automatic stay prevents enforcement of loans despite typical CMBS structures:

Judge Gropper, on why the separateness covenants were not binding in bankruptcy-

“Let me turn now to the remaining specific objections of certain lenders, and particularly the objection that covenants and conditions in the loan documents -- the pre petition loan documents -- should not be overridden by virtue of the bankruptcy filing of their borrower or borrowers. It is absolutely standard black letter law that covenants and conditions are inevitably breached in bankruptcy. Even agreements designed to govern actions in bankruptcy are generally unenforceable. . . .The most basic covenant is to pay on time. The breach of this covenant in some bankruptcy cases is total.”

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Independent director –In re Kingston Square Associates, (Bankr. S.D. N.Y. 1997)

• By laws required unanimous consent of board

of directors for bankruptcy filing.• Independent director would have refused to

consent.• Principals solicited friendly creditors and filed

involuntary petitions. • Mortgage lenders moved to dismiss

involuntary on grounds that there was “collusion” in the involuntary filing between owners and friendly creditors.

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Ruling in Kingston Square:involuntary bankruptcy permitted

“I conclude that although the debtors plainly orchestrated the filing of the involuntary petitions, they had reason to believe that reorganization was possible and did not circumvent any court-ordered or statutory restrictions on bankruptcy filings such that, absent any evidence of objective futility of the reorganization process, the cases ought not be dismissed now.”

General Growth- bankruptcy court questioned efficacy of independent directors

• Removal and replacement of directors proper; done in accordance with terms of SPE’s organizational do documents.

• New board members carefully reviewed status of each SPE and voted based on reasoned assessment.

“However, if Movants believed that an “independent” manager can serve on a board solely for the purpose of voting “no” to a bankruptcy filing because of the desires of a secured creditor, they were mistaken.”

In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009).

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The friendly or “collusive” involuntary filed by friends and family:In re Kingston Square:

Can insiders use an involuntary to get around restrictions in the LLC operating agreement?

“I conclude that although the debtors plainly orchestrated the filing of the involuntary petitions, they had reason to believe that reorganization was possible and did not circumvent any court-ordered or statutory restrictions on bankruptcy filings such that, absent any evidence of objective futility of the reorganization process, the cases ought not be dismissed now.”