“Nobody Fell Off the Turnip Truck Yesterday”: What’s at Stake for Commercial Real Estate Lenders in Sutton 58?

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Sutton 58 Associates LLC v. Pilevsky et al., is a New York case which gets to the heart of the enforceability of classic single-purpose entity restrictions in commercial real estate lending.  At issue is how far a third-party may go to cause a violation of a borrower’s SPE covenants, and whether those covenants are enforceable at all.

A Defaulted Construction Loan and Frustrated Attempts to Foreclose:

Sutton 58 is a case involving a defaulted New York City construction loan consisting of mortgage and mezzanine debt provided by Gamma Real Estate. After a maturity default, Gamma’s attempt to foreclose on its equity collateral through a UCC foreclosure sale was hindered by the bankruptcy filings of the mortgage borrower and mezzanine borrower.

The borrowers were established as single-purpose bankruptcy-remote vehicles but subsequently acquired assets from one of the defendants (Sutton Opportunity), and took on debt from Prime Alliance (another one of the defendants – both controlled by the individual Pilevsky family defendants). Sutton Opportunity obtained a 49% indirect stake in each borrower as a result of the asset transfer.  The additional assets and debt destroyed each borrower’s status as a “Single Asset Real Estate” entity under the Bankruptcy Code (or “SPE”), and allowed both entities to file a petition for bankruptcy. Both the transfer of assets and the transfer of indirect equity interests in each borrower violated separate covenants in the mortgage and mezzanine loan documents.

Gamma’s UCC foreclosure sale was automatically stayed due to the bankruptcy petitions.  In the bankruptcy court, Gamma moved to dismiss so that it could proceed with the UCC foreclosure sale, arguing that the case was filed in bad faith, and that it arose out of a one-creditor, one-asset dispute and should thus be dismissed.  The borrowers countered that the bankruptcy should proceed because the borrowers each had multiple creditors (partially as a result of the transfers referenced above).  Gamma voluntarily withdrew its motion to dismiss, and ultimately, the bankruptcy proceedings produced a plan of reorganization for each borrower.

Consequently, Gamma filed suit in New York Supreme Court against the defendants to recover losses resulting from the delay in its planned foreclosure.  In its pleadings and oral arguments, Gamma alleged that the defendants tortiously interfered with Gamma’s contract with each borrower (i.e., the loan documents).

The Defenses:

In their motion for summary judgment, defendants made four principal arguments (each of which had been raised as an affirmative defense):

  • First, that the Noerr-Pennington doctrine, which denies claims for damages caused by prior invocation of the judicial process, prohibits a court from imposing liability on an individual or entity for providing funds to assist a debtor in filing for bankruptcy.
  • Second, that the tortious interference with contract claims are preempted by federal law, specifically, the Bankruptcy Code’s remedies for wrongful bankruptcy filings.
  • Third, that there cannot be a tortious interference with contract claim where the underlying contract is unenforceable, and that in this case, the underlying SPE provisions were unenforceable restrictions on filing for bankruptcy.
  • Fourth, that the allegations against the individual defendants was not sufficient to establish lability and the relationship between the individual defendants and the holding companies did not warrant piercing the corporate veil.

In March of 2018, the Honorable Shirley Werner Kornreich of the Commercial Division of Supreme Court, New York County denied the defendants’ motion for summary judgment from the bench, noting that a holding for the defendants “would undermine the way business is dealt with in New York City when it comes to lenders and developers” and “upend the whole development industry.”  The defendants appealed this decision to the Appellate Division, First Department.  The First Department ruled in defendants’ favor on their second argument, holding that the plaintiff’s claims and damages “arise only because of the bankruptcy filings” and are thus “preempted by federal law.”  The Court did not rule on any of the other issues raised by the defendants.

The plaintiff filed a Notice of Appeal on February 6 with respect to “each and every part of the Decision, as well as from the whole thereof.”  The Court of Appeals denied plaintiff’s motion for leave to appeal earlier this month.

Hold the Hype?:

There are some important takeaways to draw from Sutton 58. Neither the preemption defense nor the Noerr Pennington defense is good news for lenders.  Some believe that the loss of the tortious interference claims on the preemption theory has the potential to disrupt the lending industry.  Others believe that any such hype is unwarranted because the enforceability of contract claims against a guarantor was not at issue in this case and in most instances, it is the exposure of a warm body guarantor to liability that keeps the borrower on the straight and narrow.

Nonetheless, this holding may encourage future borrowers to try to evade responsibility under its classic SPE requirements to facilitate a borrower bankruptcy and as we’ll argue below, that’s really not good for anyone.  In response, lenders should think about stiffening their independent director requirements by ensuring that an institutional independent director’s consent is required prior to any bankruptcy, not just on the larger loans (and that was not a requirement in Sutton 58) but for all loans, and also making sure there is a warm body on the hook for every transaction.

Evaluating the Enforceability of Typical Loan Document Bankruptcy Provisions:

Can it get worse? What happens if a future court embraces the third defense that there can be no such thing as a tortious interference of contract even though the borrower clearly took affirmative actions intending to evade its responsibilities under the loan documents?  Although unlikely, a holding on theory three would certainly exacerbate the problems of lenders in the commercial real estate lending space. And not just with respect to construction lending, or with respect to properties located in New York – keep in mind that large commercial real estate loans are usually deemed to be governed by New York law.  Such a holding would greatly impact the interpretation of existing loan documents, and would necessitate restructuring loans and potentially affect pricing.

In Sutton 58, the defendants argued that, in general, “classic special purpose vehicle covenants” constitute an unenforceable contractual waiver of a borrower’s right to file for bankruptcy.  Remember, too, that the Sutton 58 loan documents could not have been more typical with respect to bankruptcy.  The documents did not purport to prevent bankruptcy, but simply condition the means and methodology for a borrower filing bankruptcy and creating independent obligations of a guarantor when it did.  Of course, neither borrower was permitted to enter into bankruptcy without the consent of its member, but as there were no independent members, such consent was surprisingly forthcoming.

Is it possible that future courts interpreting Sutton 58 might somehow conclude the unenforceability of the loan agreements’ covenants means that no liability could be created under a third party guaranty?  Seems unlikely, but betting on the clarity of jurisprudence in our court system is not necessarily a good idea.

While the enforceability of a non-recourse carve-out guaranty was not per se at issue in this case, a future ruling on the unenforceability of the loan agreement covenants that gives rise to full recourse liability could have had game-changing consequences on the ability of a lender to collect under such a guaranty.

According to the Sutton 58 defendants, classic SPE provisions in loan documents should be deemed an unenforceable contractual restriction on a borrower’s right to file for bankruptcy.  We disagree – as has been rehashed time and time again, the SPE provisions in loan documents assure the lender of an isolated debtor-creditor relationship secured by collateral.  The purpose is not to evade bankruptcy proceedings, but instead to eviscerate the need for bankruptcy protection.

These were sophisticated borrowers.  They knew what they were doing; they knew what the loan documents said and they understood them.  To quote the very funny plaintiff’s attorney in oral arguments, “Nobody fell off the turnip truck yesterday.”  Should we worry that some judge who is sympathetic toward an unsophisticated borrower may use this case as a jumping off point to remake a borrower’s deal?  That would be bad law, and it would likely affect enforcement jurisprudence more broadly.  Such a result could only have the impact of contracting credit availability across the board as lenders would have to take on board more concerns about their ability to collect on debt.  Moreover, it would be likely to steer lenders away from non-institutional borrowers and increase barriers to entry into the real estate market in general.  This is not an ideal outcome for anyone.

So, at the end of the day, Sutton 58 was wrongly decided and we don’t think it is in accord with judicial precedent on bad faith filings.  We wish the plaintiffs in this case had pursued the bad faith filing issue in the bankruptcy proceedings, but for whatever reason, they did not.

To mitigate this bad precedent, rest assured that the plaintiffs ultimately prevailed in a separate case against the guarantor, where they won a judgment in the amount of $24 million.

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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