Bankruptcy cases involving an entity whose sole asset is a single piece of real estate – the so-called “single asset real estate case” – are among the most challenging cases to successfully reorganize.
Following the real estate crash of the late 1980s, Congress amended the U.S. Bankruptcy Code to make it more difficult to successfully reorganize a single asset real estate case. Typically, the case involves a secured creditor with a mortgage on the real estate and an assignment of rents. The property does not generate sufficient cash flow to service the secured debt and is worth less than the amount of the secured debt. The remaining debt, generally the unsecured trade creditors, is modest.
Filing bankruptcy is always a last resort, but the early detection of financial problems and appropriate planning for a potential bankruptcy are simply good business practices. Indeed, early planning may make the difference between a successful and a failed single asset real estate case. Early planning for a bankruptcy, if done appropriately, does not increase the chances of a bankruptcy, but increases the chances of success should a bankruptcy become necessary.
In bankruptcy, the secured creditor is entitled to a secured claim equal to the value of the property and an unsecured deficiency claim for the balance of the amount owed to the secured creditor.
In a Chapter 11 plan of reorganization, creditors are placed in classes with other similar claims. Each class of claims is entitled to vote on the plan. A class of claims accepts the plan if two-thirds in amount and one-half of the number of creditors vote to accept the plan.
Confirmation of a plan requires, among other things, that all classes of claims either accept the plan or receive payment in full of the claims in such classes. In a single asset case this presents a problem because the secured creditor usually will control two classes – its own class of claims, in which it is generally the only creditor and therefore the only vote, and the unsecured class of claims where the size of its unsecured deficiency claim is usually sufficient, due to the modest amount of trade debt, to prevent two-thirds of the amount of claims from voting to accept the plan.
Unless the secured creditor and all other unsecured claims are paid in full, a circumstance that is unlikely in most distressed real estate cases, the secured creditor can therefore block confirmation of the plan.
There is, however, an exception to this general rule. Under a so-called “cram-down” plan, a plan can be confirmed if less than all of the classes of claims accept the plan. A cram-down plan requires that at least one “impaired” class of claims – a class where the claims are not being paid in full – accepts the plan and that the plan is “fair and equitable” with respect to each class of claims.
For a plan to be “fair and equitable” to a class of secured claims, the holders of the secured claims must retain their liens and receive deferred cash payments equal to the present value of the property securing those claims. For a plan to be “fair and equitable” to a class of unsecured claims, the holders of the unsecured claims must receive property equal to the present value of their claims, and the holders of junior claims or interest will not receive or retain any property under the plan on account of such interests.
Most contested single asset real estate cases proceed on the basis of a cram-down plan. The key to a cram-down plan is to have an impaired class of creditors voting to accept the plan. The Bankruptcy Code prohibits plan gerrymandering – the creation of a class of friendly creditors solely for the purpose of obtaining an impaired class to vote in favor of the plan.
Remember that the secured creditor will likely control its own secured class of claims and the unsecured class of claims. A single asset real estate debtor rarely has many more types of creditors other than secured claims, a secured creditor’s unsecured deficiency claim and unsecured trade creditors. Most commercial loan agreements specifically permit the secured creditor to pay outstanding real estate taxes, thus giving the secured creditor the ability to remove real estate taxes as a potential separate class of secured claims.
Most single asset real estate debtors do not consider bankruptcy or consult with a bankruptcy professional until the debtor’s financial condition is precarious and, generally, its relationship with its creditors has deteriorated.
The debtor is generally in default of its loan agreements with the secured creditor, the loan has been transferred to the secured creditor’s troubled loan department and foreclosure proceedings have either been commenced or are imminent. A series of forbearance agreements with the secured creditor, and the accompanying fees, has stripped the debtor of its cash and have accomplished nothing other than to delay the inevitable. The debtor’s unsecured creditors have not received payment for some time. The debtor’s equity holders have either exhausted the funds they could contribute to the debtor or are unwilling, given the debtor’s financial condition, to invest more funds. In short, the debtor attempts to hang on until the last minute, a time when the debtor’s options are severely limited.
Contrast that situation with the situation where a potential financial problem has been diagnosed and consultation with a bankruptcy professional has occurred. At the early stages of a financial problem, the debtor’s relationship with its secured creditor is more flexible. Generally, the loan officer who originated the loan is still overseeing it. The originating loan officer has an incentive to maintain the loan as a performing loan. This incentive is absent when a loan is transferred to a secured creditor’s troubled loan department.
The chances of reaching an amicable resolution with the secured creditor are more likely at this stage. The debtor’s unsecured creditors can be folded into and, indeed, may contribute to such a settlement. At this stage the debtor and the debtor’s equity holders have more to contribute to a global resolution, not just an agreement that buys another 60 days from the secured creditor. Lastly, at this stage it may be possible to plan for a bankruptcy proceeding in which a friendly impaired class of creditors exists to vote in favor of a cram-down plan.
The cost of a few hours of time from an experienced bankruptcy professional is a modest investment for a single asset real estate debtor, one that can pay future dividends if a financial problem becomes dire. Nowhere is the old adage truer that “an ounce of prevention is worth a pound of cure.” The early detection of financial problems and the early planning for a bankruptcy proceeding will increase the chances that the single asset real estate case will be successful.
