TICs: Maybe the Protection of Bankruptcy Will Be the Available If Needed, and Maybe Not

In re Fairfield TIC, LLC, 594 B.R. 852 (Bankr. E.D. Va. 2018) –

The debtor and its co-owners bought a shopping center as tenants-in-common. After the debtor filed bankruptcy, the noteholder secured by a mortgage on the property and a receiver appointed to manage the property moved to dismiss the debtor’s bankruptcy for cause.

The debtor’s only asset was a 66.2296% tenant-in-common interest in the shopping center. The debtor bought its interest in the property as a tenant-in-common (TIC) so that its ownership interest would qualify for 1031 like-kind exchange treatment under federal tax law.

The rest of the tenant-in-common interests were held by three other TICs that remained out of bankruptcy. The TIC agreement contained standard provisions, including a requirement that there be unanimous consent of the tenants-in-common on matters such as a change in the management company or sale of the property.

The TICs bought the property for ~$22.5 million funded by investments by the TICs and a $19 million loan. A couple of years later the property was appraised at almost $38 million. Based on that valuation, the TICs refinanced with another loan of $30 million.

The original exit strategy was to sell the property to a REIT controlled by a principal of the debtor (as was done with other properties he managed). However, after the debtor’s principal lost control and was ousted from the REIT, the REIT decided against purchasing the shopping center.

Having lost their planned exit strategy and with an approaching maturity date, the TICs unsuccessfully attempted to negotiate an extension of the loan or a sale or refinance of property. After the loan matured, the noteholder went into state court and obtained appointment of a receiver to manage the property. In the meantime, a third party (Nikki) filed a lawsuit relating to an agreement to sell an out parcel portion of the property.

The noteholder set a foreclosure sale. The TICs discussed filing bankruptcy, but the noteholder canceled the sale before any of them filed a petition. The noteholder did negotiate a deed in lieu of foreclosure agreement with one of the other TICs, and then rescheduled the foreclosure sale. A couple of days before the sale, the debtor (but not the other TICs) filed bankruptcy.

At the time the debtor filed bankruptcy, the property was valued at no more than $27 million, the receiver remained in control, and the Nikki litigation was stayed. The noteholder and receiver moved to dismiss the case for cause pursuant to section 1112(b) of the Bankruptcy Code on the grounds that the petition was not filed in good faith. Alternatively, the noteholder sought relief from the automatic stay.

Section 1112(b)(4) contains a laundry list of specific items that constitute “cause” – such as gross mismanagement of the bankruptcy estate, failure to comply with court orders, and failure to pay taxes or file tax returns. However, this list is not exclusive, and the Fourth Circuit has held that a debtor is implicitly required to file its petition in good faith so that a “bad faith” filing constitutes cause for dismissal.

In the Fourth Circuit’s view, dismissal is proper only if the debtor acted both objectively and subjectively in bad faith. The debtor “must not have any objectively reasonable possibility of reorganization,” and the filing must be with the intent to abuse the reorganization process, or cause hardship or delay to creditors without an intent or ability to reorganize. Courts are directed to consider the “totality of the circumstances.”

Similar to other cases, after reviewing a number of the specific facts the bankruptcy court found that this case met him the objective futility test because:

  • it involved a single asset debtor with an interest in real property that was fully encumbered,
  • the debtor had limited access to revenue from the shopping center,
  • the ownership interest was in the nature of an investment with no going concern to protect, and
  • the debtor could not propose a valid plan of reorganization without the support of the other TICs.

With respect to subjective bad faith, based on many of the same facts the court found that the totality of the circumstances indicated bad faith. The court commented that although this indicated some level of wrongdoing, it was not necessarily a finding of ill will, but only a lack of a good faith filing.

On the issue of timing, the court noted that the debtor filed bankruptcy less than a week before the scheduled foreclosure sale and after failing to block appointment of the receiver. The court recognized that bankruptcy is often used to prevent impending foreclosure action and that this fact by itself is insufficient to establish bad faith.

However, in this case, the debtor also failed to block the receivership action. With no control over the property or proceeds and having failed in other efforts to stop the foreclosure, the timing showed an intent to delay the noteholder’s attempt to enforce its rights that supported a finding of bad faith.

The court also focused on the debtor’s inability to act on behalf of the other TICs. It was likely that a change in management and/or sale of the property would be necessary. However, that required unanimous consent of the TICs. So, the court viewed the debtor’s plans as showing an intent to disregard the rights of the other TICs.

Overall the court found that the debtor could not reorganize but rather sought to hold the property hostage with the intent to use the protection of bankruptcy to obtain risk-free speculation on future appreciation of the property at the expense of the creditor.

Accordingly, the court granted the motion to dismiss the bankruptcy case for cause.

Any time a matter requires a detailed review of facts leading to an assessment of the totality of the circumstances, the outcome will be difficult to predict. There are various aspects of a TIC ownership structure that make it particularly susceptible to a finding that a bankruptcy filing is in bad faith. The risk that bankruptcy will not be an option is something to consider when entering into a TIC transaction in the first place.

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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