When Lenders are the Losers in Bankruptcy Court...Well, Not so Fast

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photo of Krystyna M. BlakesleeLast October, I wrote about a scheme employed, in three separate bankruptcy cases, by debtors seeking to evade the absolute priority rule in order to keep the real property owned by the debtor in the hands of the ‘family’ at the expense of the debtors’ creditors.

The scheme went like this: The single asset real estate (“SARE”) debtor owned a retail shopping center on which it had taken out a secured loan. The debtor defaulted and before the lender could realize upon its collateral, the debtor filed for bankruptcy. The debtor’s chapter 11 plan contemplated that the debtor’s principal’s wife would purchase the debtor’s assets in exchange for a cash infusion, thereby keeping the property in the ‘family’. In the end, the cram down plan was confirmed.

In one case, In re Castleton Plaza, L.P., the owner owned the equity interest (98% directly and 2% indirectly to be exact) in the SARE debtor that owned a retail shopping center in Indiana, on which it had taken out a $9,500,000 loan. The court confirmed a plan of reorganization in which (A) the equity in the debtor was transferred to the owner’s wife in exchange for a $375,000 (actually, the offer was $75,000 initially) cash infusion, (B) the lender’s secured loan would be extended 30 years, with little to be paid until 2021 and the interest rate cut from 8.37% to 6.25% (not to mention, the cash management provisions would be deleted), (C) the management contract between the principal and the manager would be continued, giving ‘the family’ an additional $500,000 in revenue, and (D) promised to pay unsecured claims 15 cents on the dollar over 5 years. While the bankruptcy court did find that the principal’s wife was an insider and any proposed sale to the missus, therefore, was subject to a higher degree of scrutiny (for an explanation of the Absolute Priority Rule please refer to the original post), the court held that competition was unnecessary (i.e., there was no reason to hold a competitive bidding process to let the market decide the fair value for the equity in the debtor) and confirmed the plan. To make matters worse, the court confirmed the plan despite the fact that the lender had offered $600,000 for the equity in the debtor and promised to pay all other creditors 100 cents on the dollar. The lender appealed.

On appeal, the United States Court of Appeals for the Seventh Circuit holding that “[c]ompetition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider” reversed the judgment of the bankruptcy court and remanded the case with directions to open the plan to competitive bidding. The appellate court found that the Absolute Priority Rule did in fact apply since the principal would indeed receive value from the equity purchased by his wife: (i) the principal would continue to receive income, as the CEO of the management company, (ii) the principal would receive an indirect benefit from his wife’s ownership of the equity interests (and indirectly, her ownership of the property), and (iii) the principal (not to mention the entire family) received value in an amount equal to the difference between $375,000 (the price the wife paid for the equity interests) and the price that a market bidding process would have fetched (at least $600,000, the lender’s bid).

The Appellate Court’s decision is exactly what we had hoped for. Insider relationships should be closely scrutinized, and insiders should not be allowed to use their (uneven) bargaining power to the detriment of creditors. Now, hopefully, the two other ‘sister’ cases, discussed here and here, will be similarly resolved. One step at a time, I guess.

 

Topics:  Absolute Priority Rule, Chapter 11, Commercial Bankruptcy, Debtor-Creditor, Debtors, In re Castleton Plaza, Lenders, Single-Asset Debtor

Published In: Bankruptcy Updates, Finance & Banking Updates, Commercial Real Estate Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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