Debt Recharacterization, Etc.: Standing, Standing and More Standing

Elswick Co., LLC v. Comm2013 CCRE12 Crossings Mall Road LLC (In re Tara Retail Group, LLC), 595 B.R. 215 (Bankr. N.D. W.Va. 2018) –

An unsecured tenant creditor brought an adversary proceeding to recharacterize or equitably subordinate a $17 million claim filed by the assignee of a deed of trust. The secured creditor moved to dismiss for lack of standing.

The debtor owned a multitenant mall. The unsecured creditor was a tenant that operated a 24 hour, seven day a week fitness center. The only public access to the mall was across a bridge over a creek.

The mall was refinanced using securitized debt secured by a deed of trust. Under the loan documents rents (including the unsecured tenant creditor’s rents) were deposited in a lockbox under the sole dominion and control of the secured creditor and its servicer.

The lockbox account was swept daily into a cash management account, which was also under the dominion and control of the secured creditor and its servicer. The cash management account had various subaccounts, including a capital expenditures fund to pay for expenditures approved by the secured creditor.

In January 2016 the debtor’s management company obtained a quote to replace a culvert at the entrance to the mall with the warning that if the issue “is not resolved immediately the only entrance to the center could collapse.” The servicer responded by questioning why collected rents were below expected levels.

The servicer never did approve release of the requested repair funds, and in June 2016 the bridge providing the only access to the mall was washed away in a flood. The debtor then advised that a new bridge would cost between $750,000 and $1 million, which the secured creditor refused to fund.

According to the tenant, the loss of the bridge caused numerous individuals to be stranded in the mall together with significant business losses for tenants. The tenant initially filed a proof of claim for $1 million, which it subsequently amended to list the amount as “undetermined.”

In the meantime the debtor objected to the secured creditor’s proof of claim, arguing that it had an obligation to fund repairs which gave rise to liability on numerous grounds, including breach of contract, breach of the duty of good faith and fair dealing, breach of fiduciary duty, and tortious interference with business relationships with respect to the debtor’s tenants. The debtor’s claims were based on substantially the same facts as those asserted by the tenant in its adversary proceeding.

With this as background, the bankruptcy court considered the tenant’s constitutional, prudential, and statutory standing:

Constitutional standing “requires that there be an injury-in-fact, traceable to the alleged conduct of the defendant, and which is subject to redress by the courts.”

Prudential standing “limits the exercise of federal jurisdiction for reasons related to such considerations as orderly management of the judicial system.”

Statutory standing is different in that it is not a threshold question but an element of the cause of action. It is a “‘useful shorthand’ for the proposition that the ‘plaintiff must fall within the class of plaintiffs to whom Congress has made the cause of action available in order to recover.'”

The court turned first to the tenant’s claim that the debt should be recharacterize and treated as equity. Since unsecured claims are paid in full before equity interests, the court concluded that the tenant had constitutional standing because (1) it asserted an unsecured claim which could be reduced by the alleged secured claim, (2) its potential loss of receiving less than a 100% payment was directly related to the classification of the secured creditor’s claim, and (3) a court could redress the injury by exercising its equitable power to recharacterize the secured claim as equity.

Similarly, the court held that the tenant had prudential standing on the grounds that it was asserting rights associated with its direct damages resulting from loss of access, and the court had the power to recharacterize the secured creditor’s debt so that the tenant could receive a greater distribution.

The issue of statutory standing was more complicated. Although there is no explicit statutory cause of action for recharacterization, it is essentially an objection to a debt claim on the grounds that it is an equity interest. On the one hand, a creditor is a party in interest that is authorized to object to another creditor’s proof of claim under section 502(a) of the Bankruptcy Code. On the other hand, a chapter 11 debtor-in-possession has the duties of a trustee, which includes objecting to claims that are improper.

The court concluded that the tenant had statutory standing because it was allowed to object to claims under the Bankruptcy Code, but the real question was who should be allowed to pursue the objection given the “concerns of an orderly and expeditious administration of the Debtor’s estate.” The court noted that in this case there was no trustee, no creditors committee, and to date the debtor (1) had not objected that the tenant was interfering and (2) had not specifically mentioned recharacterization in the context of its own objection.

The court’s solution was to deny the secured creditor’s motion to dismiss on the grounds of standing and to direct the tenant to file a motion in the main bankruptcy case with notice to the debtor requesting authority to pursue its recharacterization claim in the adversary proceeding.

The court went through a similar analysis of the claim for equitable subordination. On the issue of statutory standing, the court noted that equitable subordination is governed by section 510(c) of the Bankruptcy Code. Although that section does not specify who can assert an equitable subordination claim, the court turned to the general principle that “[t]o avoid hijacking a cause of action that belongs to a bankruptcy estate, the general rule is that a creditor may assert rights that are personal to the creditor but not matters that are generalized for the bankruptcy estate.”

The tenant attempted to assert that it had particularized injury relating to use of amounts it was required to pay under its lease and the impact on its business resulting from the flood and loss of access. However, the court noted that 80 proofs of claim had been filed, most of which related to damages relating to loss of the bridge. Further, the debtor had already filed an objection asserting, among other things, that the secured claim should be equitably subordinated on grounds substantially similar to those asserted by the tenant.

So, the court also directed the tenant to file a motion in the main bankruptcy proceeding for authority to pursue its equitable subordination claim in the adversary proceeding.

Standing is certainly not a foregone conclusion and can be a rather convoluted issue in some cases. However, often the more significant issue is whether a claim should be considered part of the bankruptcy estate. And if so, will the claim be effectively prosecuted – particularly in cases where the debtor has conflicting incentives.

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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