When “Loan to Own” Becomes “Own a Loan” – How a Recent Fifth Circuit Decision Rejecting the Artificial Impairment Doctrine Increases Risks for Distressed Real Estate Investors

Chapter 11 of the U.S. Bankruptcy Code provides debtors with a number of tools to restructure comprehensively their debts and other liabilities as well as immediate protection from secured and unsecured creditors. In single asset real estate (“SARE”) cases, secured lenders (i.e., mortgage holders) typically have greater protections against aggressive equity owners seeking to use chapter 11 to deprive lenders of their contractual and state law remedies, including foreclosure. However, the Fifth Circuit’s recent decision in Western Real Estate Equities, L.L.C. v. Village at Camp Bowie I, L.P. (Matter of Village at Camp Bowie I, L.P.), No. 12-10271 (5th Cir. Feb. 26, 2013) may have turned the tables on these dynamics in favor of distressed property owners, and secured lenders may now have to consider alternative strategies to counter this changed dynamic. Otherwise, distressed investors could end up being forced by bankruptcy courts to continue lending substantial sums of money to SARE debtors on a long-term basis and on below-market terms.

Background -

The debtor in Camp Bowie owned a mixed-use development in Fort Worth, Texas and filed for chapter 11 in the United States Bankruptcy Court for the Northern District of Texas the night before the foreclosure sale initiated by the debtor’s secured mortgage lender, Western Real Estate Equities, L.L.C. (“Western”), who had acquired the loan from Wells Fargo at a significant discount. As of the filing, the debtor owed approximately $32 million to Western on the mortgage as well as a total of $60,000 to 38 different general unsecured creditors. Early in the case, Western sought relief from the automatic stay to foreclose on the property. The bankruptcy court denied Western’s motion, finding that Western was oversecured (i.e., the value of the property exceeded the outstanding mortgage debt).

The debtor proposed a non-consensual “cramdown” chapter 11 plan that sought to force Western to accept a new five-year note with a 5.83% interest rate and a balloon payment to be made upon the new note’s maturity. Under the plan, the debtor’s general unsecured creditors would be paid in full, but over a three month period, without interest, and the existing equity owners would retain the property. Western objected to confirmation on a number of grounds, arguing, among other things, that the plan’s de minimis impairment of general unsecured creditors constituted “artificial impairment” and, therefore, precluded the debtor from satisfying the requirement in Bankruptcy Code section 1129(a)(10) that at least one impaired class of creditors vote to accept a “cramdown” plan. Western also argued that the debtor’s contrived scheme to manufacture a minimally impaired class of creditors with comparatively little economic exposure to the debtor demonstrated that the plan was not proposed “in good faith” as required by Bankruptcy Code section 1129(a)(3).

Please see full alert below for more information.

LOADING PDF: If there are any problems, click here to download the file.