Thou Shall Not Interfere With Special Purpose Entities’ Contractual Obligations

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A recent decision of the New York Court of Appeals, Sutton v. Pilevsky held that federal bankruptcy law does not preempt state law tortious interference claims against non-debtors who participated in a scheme that caused a debtor—in this case a bankruptcy remote special purpose entity—to breach contractual obligations intended to ensure that the entity remains a Special Purpose Entity (SPE) and to facilitate the lenders’ enforcement of remedies upon a future bankruptcy filing, if any. The ruling likely has significant implications for structured finance providers and may have broader implications as well. Interestingly, in this case the defendants were strangers to SPE financing; after all, the sponsor and its related persons are usually subject to liability on the loan under standard bad acts carve-out guaranty, making it unnecessary to sue them for causes of actions outside the scope of their guaranty.

Background

The Sutton v. Pilevsky ruling arose in the context of an approximately $147 million loan made to two SPEs, a mortgage borrower and a mezzanine borrower (the “Borrowers”), secured by a Manhattan real estate and the equity of the mortgage borrower. As is common in structured real estate financings, the loan agreements included provisions intended to ensure the Borrowers were bankruptcy remote and that the mortgage borrower would qualify for the “single asset real estate,” provisions of the Bankruptcy Code which provide special rules for relief from the automatic stay as well as a very short time frame for plan confirmation. These restrictions included, among other things, that the Borrowers (i) remain “Special Purpose Bankruptcy Remote” entities and to that end; (ii) not incur any debt other than short-term trade debt; (iii) not acquire any unrelated assets or engage in another business; and (iv) not sell or transfer any direct or indirect interest in either the development site or the Borrowers themselves, without the plaintiff’s consent (collectively, the “Covenants”). The Covenants were intended to ensure that, if the Borrowers filed for bankruptcy, the bankruptcy process would, at the very least, be an expedited one.  

When the loans matured in January 2016, the Borrowers defaulted. In response, the lenders sought to conduct a UCC foreclosure sale of the collateral. Three days before the scheduled UCC sale of the mortgage borrower’s equity, the mezzanine borrower filed for chapter 11 and the mortgage borrower followed shortly thereafter. The Borrowers’ bankruptcy cases were consolidated for joint administration and the proceedings were underway in September 2016, when the lenders commenced an action in state court against the defendants –various affiliated persons and entities which had not originally participated in the financing or the development project and thus, were not bound by the financing’s underlying contracts nor were guarantors.

The lenders alleged that the defendants had tortiously interfered with the loan agreements between the lenders and the Borrowers. Specifically, the lenders alleged that the defendants had knowingly induced the Borrowers to breach the Covenants prior to the bankruptcy filings by (i) loaning $50,000 to one of the Borrowers to retain counsel; (ii) causing the transfer of three rental apartments to the mortgage borrower so that it would no longer qualify as a single asset real estate entity; and (iii) obtained an indirect interest in the Borrowers by acquiring an interest in one of their parent companies. The lenders contended that the breaches caused the Borrowers’ bankruptcy proceedings (which took roughly a year to conclude) to be more protracted than they would have been otherwise, which, in turn, resulted in a significant loss of value of the development site. 

The defendants moved for summary judgment on the ground that the lenders’ state-law claims of tortious interference were preempted by federal bankruptcy law. The lenders countered that while bad-faith filing claims and other tort claims premised upon conduct within a bankruptcy proceeding, may be preempted by federal bankruptcy law, claims premised on tortious conduct by non-debtor defendants that occurred prior to and outside of the bankruptcy proceeding were not preempted. The Supreme Court denied the defendants’ motion for summary judgment; the Appellate Division reversed.  

Discussion

In a 4-3 split decision, the New York Court of Appeals reversed the Appellate Division and held that federal bankruptcy law did not preempt, either under “field” or “conflict” preemption theories, the lenders’ state-law claim for tortious interference. The Court of Appeals recognized that in the context of a bankruptcy, there is a presumption that Congress did not intend to supplant state law and that defendants bear a “considerable burden” of overcoming that presumption, which they failed to meet. 

The Court first concluded that federal bankruptcy law was not so expansive as to preempt the lenders’ tortious interference claims on a “field” theory of preemption—when federal law occupies a “field” of regulation “so comprehensively that it has left no room for supplementary state legislation.” The Court noted that no provision of the Bankruptcy Code suggests a congressional intent to interfere with the authority of state courts to provide traditional tort remedies for claims like those at issue which were brought by non-debtors against other non-debtors for interference with contractual agreements that existed independently of a bankruptcy proceeding.

The Court then examined “conflict” preemption and concluded that allowing the claims to proceed would not undermine the Bankruptcy Code—in other words, there was no “conflict” which merited preemption. In reaching its conclusion, the Court drew a distinction between tort actions under state law brought against a debtor or creditor premised upon a bankruptcy filing itself or other alleged wrongful conduct within a bankruptcy filing and the tort actions at issue here. The Court noted that a majority of courts have held that tort claims premised upon actions within a bankruptcy proceeding are preempted because those actions risk subverting the Bankruptcy Court’s authority to adjudicate the validity of bankruptcy filings or otherwise produce inconsistent standards or outcomes between state and federal law. Further, the Bankruptcy Code provides remedies for such claims by, for example, authorizing dismissal of bad-faith filings and empowering bankruptcy courts to take measures to prevent any abuse of the bankruptcy process. The lenders’ tortious interference claims here, however, were not preempted because they would not affect the bankruptcy proceeding at all—they were brought against non-debtor defendants and arose from conduct that occurred prior to the bankruptcy proceedings. In fact, the bankruptcy case was successfully completed indicating that the action had no bearing on the bankruptcy case. 

Further, remedies under the Bankruptcy Code such as bad-faith dismissals and relief from the automatic stay could not remedy the harm alleged because they would not resolve the question of whether the defendants’ conduct was tortious or whether damages were owed by the defendants to the lenders for the defendants’ wrongdoing. Since resolution of these claims would not implicate the Borrowers’ bankruptcy estates in any way, allowing the tortious interference claims to proceed would not “conflict” with the Bankruptcy Code’s central purpose—the administration of debtors’ bankruptcy estates.

Conclusion

The ruling in Sutton v. Pilevsky makes clear that third parties who participate in subverting an SPE’s structural limitations, face significant risks of lawsuits and damage awards resulting from their conduct, even though they are not parties to the loan agreements, nor agreed to guaranty the SPE’s obligations to the lenders. There is a concern, however, as expressed by the dissent and certain amicus curiae, that the ruling could open the door for suits against professionals, funding sources and other third parties that assist debtors in their pre-bankruptcy preparations. They argue that the ruling may discourage third-party lending, the provision of bankruptcy legal and advisory services, or other assistance to debtors which could have a chilling effect upon future bankruptcy filings. The majority potentially limited the reach of its decision by repeatedly emphasizing that it allowed the lenders’ claims to proceed in this case because they were not based on the bankruptcy filing itself or conduct related to the bankruptcy proceedings. How future courts will walk this fine line, however, is yet to be seen. 

Read the opinion >> 

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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