Loan to Own Variation: Bankruptcy May Not Provide The Answers

In re SR Real Estate Holdings, LLC, 506 B.R. 121 (Bankr. S.D. Cal. 2014) –

A group of lenders moved to dismiss the debtor’s bankruptcy case on the basis that it was filed in bad faith, or in the alternative asked the court to find that the debtor was a “single asset real estate” and then to grant the lenders relief from the automatic stay.

The debtor’s predecessor (Sargent) bought 6,400 acres of undeveloped real estate financed through a $15 million loan at 15% interest secured by a first deed of trust on the property.  The first loan was increased to $25 million, and Sargent borrowed an additional $15 million at 31% interest secured by a second deed of trust.  Both loans were fractionalized and sold to investors.

Sargent then borrowed an additional $3 million secured by a third deed of trust.  This loan was also fractionalized and sold to investors.  Many of the investors in the third loan were “friends and family” who chose to enforce the note for a number of years.  Eventually the first lienholders directed the third lienholders to foreclose.  However, Sargent filed bankruptcy before they could hold a foreclosure sale.

In this first bankruptcy, the court determined that Sargent was a single-asset real estate (SARE) debtor.  To assist in its Chapter 11 reorganization, Sargent retained an investment banker that provided a new CEO and several managing directors.  After Sargent was in bankruptcy for a year without progress, the court approved a Chapter 11 trustee, and six months later converted the case to a Chapter 7 liquidation.  The Chapter 7 trustee promptly abandoned the property so that it was no longer part of Sargent’s bankruptcy estate.

Six months later, the third lienholders conducted a foreclosure sale and took title to the property.  They created a new entity and transferred the property to that entity.  The parties attempted to reach a global settlement that would have transferred the property to the first lienholders and included a payment waterfall for the property’s proceeds.  However, a majority of the first lienholders decided to proceed with a foreclosure sale instead.  The new entity filed bankruptcy the day before the scheduled sale.

The new debtor’s schedules valued the property at $15 million.  No payments had been made on the first or second loans for ~13 years.  As a result, the estate had secured claims totaling ~$548 million at the time the debtor filed.

The court determined that this second bankruptcy was also a single-asset real estate case, and thus was subject to shorter deadlines for moving forward.  The case was transferred to another judge, and before the SARE order could be entered, the debtor filed an emergency motion seeking to vacate the order because it would be a waste of resources to require it to prepare a confirmable plan (as a result of the accelerated SARE time table) before pending dispositive motions were addressed.

Under Section 1112(b), a court has discretion to convert or dismiss a case for cause – which includes filing a bankruptcy case in bad faith.  The bad faith finding is based on a variety of factors.  In particular, it is bad faith if “it is obvious that a debtor is attempting unreasonably to deter and harass creditors in their bona fide efforts to realize upon their securities,” although it is not a problem “if it is apparent that the purpose is not to delay or defeat creditors but rather to put an end to long delays, administration expenses … and to invoke the operation of the [bankruptcy law] in the spirit indicated by Congress in legislation, namely, to attempt to effect a speedy efficient reorganization, on a feasible basis …”

Fact patterns that suggest bad faith include:

  • the debtor has one asset, such as undeveloped land, that is subject to creditors’ liens;
  • no employees except the principals;
  • little or no cash flow and no sources of income to support a plan or adequate protection payments;
  • few, small unsecured creditors;
  • property in foreclosure;
  • “new debtor syndrome” where new entity is created on the eve of bankruptcy to isolate the insolvent property.

A particular indication of bad faith is the use of a Chapter 11 bankruptcy case “to create and organize a new business, not to reorganize or rehabilitate an existing enterprise.”   In this case the court concluded that the debtor’s plan would necessarily create a new business to develop the property at the expense of the first lienholders (emphasis added):

Even if Debtor could present a successful plan that provides surviving lienholders everything they’re entitled to in bankruptcy, it will still deprive them of their right to sell the Property and credit bid to obtain its possession.  If Debtor’s plan fails, the First Lienholders will have suffered considerable delay.  And to what end?  So that a third party can – through the rights of the former Third Lienholders – engage in a speculative real estate adventure?

The court noted the history of failed attempts to develop the property and did not see any reason to believe that the third lienholders would do any better.  The fact that the debtor was attempting to implement a failed prepetition deal that would benefit unsecured creditors also did not persuade the court.

The court noted the great disparity between the value of the property and the secured claims, the $500 million in debt resulting from accrual of interest at 15% and 31% over 13 years, the fractionalized interests in the debt that were locked in a power struggle, and the history of multiple bankruptcies and failed attempts to develop the property.  Under the circumstances, the court found that the bankruptcy was filed to hinder and delay the first lienholders and thus was filed in bad faith and granted the motion to dismiss.

The court stated that it was not making any findings on whether the debtor would be able to reorganize.  However, it would not be surprising if the court’s decision was drive by its skepticism about the debtor’s ability to propose a confirmable plan of reorganization using a $15 million property encumbered by over $500 million in debt.

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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