Special Purpose Entities: What Recourse Does A Lender Have When SPEs Are Consolidated Pre-Bankruptcy? … Maybe None

Fed. Nat’l Mortgage Ass’n v. Bruckner, 489 B.R. 93 (E.D. Wis. 2012) –

The debtor (Buckner) owned 36 rental projects (containing ~ 1300 rental units) through various limited liability companies.  The LLCs transferred all of the properties to Buckner a few days before he filed a chapter 11 bankruptcy.  Fannie Mae, which held mortgages on three of the properties, contended that these transfers were improper.  Consequently, it argued that it was entitled to some form of relief, such as  relief from the automatic stay, dismissal of the bankruptcy case, or a ruling that the properties subject to its mortgages were not property of the debtor’s estate.  The bankruptcy court denied the requested relief, and Fannie Mae appealed to the district court.

One of Bruckner’s largest projects had been flooded by heavy rains that affected the building foundations, which in turn required the evacuation of tenants.  The costs and lost income from this disaster had a cascade effect on his ability to meet obligations for other properties.  After he fell behind on mortgage payments, several lenders began foreclosure proceedings.  At that point Bruckner came up with the strategy of consolidating ownership of the projects and filing bankruptcy.

Presumably Bruckner held title to the individual projects through separate limited liability companies because he was required to do so by his lenders.  Typically a real estate lender will insist on a structure that facilitates a bankruptcy remote entity that will not be subject to substantive consolidation with other entities.  Requiring that separate entities own each project helps isolate claims and reduces the likelihood that there will be an involuntary bankruptcy affecting a particular project.  Not surprisingly, Fannie Mae strongly objected to the pre-bankruptcy consolidation of ownership so that its claims and collateral were mixed in with a number of other projects and claims.

Fannie Mae tried various legal theories.  First, it contended that Bruckner obtained the properties by fraud.  Various cases have held that property acquired through fraud does not constitute property of the estate.  The theory is that creditors should not benefit from a debtor’s fraud at the expense of those who were defrauded.

In particular, Fannie Mae argued that the transfers of properties from the LLCs to Buckner were fraudulent conveyances under state law.  The court questioned whether this would be sufficient since the rule appears to contemplate actual fraud, as opposed to deemed or constructive fraud.  However, the court did not need to reach that issue since Fannie Mae did not establish that the transfers constituted fraudulent conveyances.

The constructive fraud provisions relied on by Fannie Mae required a showing that (1) the LLC did not receive “reasonably equivalent value” for its transfer, and (2) it was left with unreasonably small capital or had an intent to incur debts beyond its ability to pay.   In connection with an LLC’s transfer of property to Bruckner, he assumed all of the LLC’s liabilities.  There was no attempt to show that this was not reasonably equivalent value.  (Nor did Fannie Mae make any showing that the LLC was left with unreasonably small capital or intended to incur debts beyond its ability to pay.)  So, there was no basis for finding that Bruckner obtained the properties through fraud, whether actual or constructive.

Fannie Mae’s second argument was that it was entitled to relief from the automatic stay under Section 362(d)(4), which provides for relief to a creditor secured by real property:

[I]f the court finds that the bankruptcy filing was part of a scheme to delay, hinder, or defraud creditors that involved either –

(A)    transfer of all or part ownership of, or other interest in, such real property without the consent of the secured creditor or court approval; or

(B)    multiple bankruptcy filings affecting such real property.

The bankruptcy court found that the debtor’s intent was to proceed with a plan of reorganization in good faith.  Each of the separate LLCs could have filed separate bankruptcy petitions.  However, this would have been costly and duplicative.  The court concluded that Buckner’s motive in transferring the properties to himself was to be able to file a single chapter 11 proceeding.

On review, the district court concluded that the bankruptcy court did not abuse its discretion in making these findings.  While acknowledging that Fannie Mae might prefer to deal with three separate bankruptcies rather than a global proceeding involving many creditors, the district court did not believe that the consolidation necessarily was a scheme to delay, hinder or defraud creditors.

In yet another argument, Fannie Mae argued that the case was not filed in good faith, and thus should be dismissed.  In particular, it suggested that the “new debtor syndrome” was applicable.  The typical fact pattern for the new debtor syndrome is that a person (1) creates a new entity, (2) transfers property subject to a pending foreclosure to the new entity, and (3) then causes the new entity to file bankruptcy.  This allows the person to delay the foreclosure without exposing the rest of its assets to bankruptcy creditors.  Courts often conclude that these actions constitute bad faith.  However, it is not per se bad faith, and in any event the facts in this case do not fit the fact pattern.  Bruckner’s purpose was not to keep assets out of bankruptcy, but rather to subject all of the assets of all of the LLCs to the same bankruptcy.  Again, the district court did not find an abuse of discretion by the bankruptcy court.

It is likely that Bruckner guaranteed most if not all of the project loans.  Although the guarantees could have been full recourse guarantees to begin with, it is more likely that they were “bad boy” guarantees, with full recourse liability triggered by certain events such, as a bankruptcy filing by an LLC borrower.  A bad boy guarantee can be a very effective disincentive for filing bankruptcy, if filing triggers liability for the full debt.

Bruckner’s strategy of transferring all of the assets to himself and then assuming all liabilities means that triggering full recourse under guarantees would no longer be a relevant consideration.  Bruckner’s strategy of transferring the assets pre-bankruptcy allowed him to control consolidation of assets and creditors (as opposed to being at the mercy of a judicial determination of whether substantive consolidation was justified).  This case illustrates that if a deep pocket guarantor is willing to go into bankruptcy itself, all of the planning to structure isolated bankruptcy remote projects may be for nothing.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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