Mortgage Defaults: What Is the Most Effective Path for Resolving Troubled Properties?

In re Big Dog II, LLC, 602 B.R. 64 (Bankr. N.D. Fla. 2019) –

A mortgagee sought relief from the automatic stay for cause on the grounds that (1) it was not adequately protected, and (2) the debtor did not have any equity in the property and the property was not necessary for an effective reorganization. Among other things, the debtor argued that there was an equity cushion that provided adequate protection.

The debtor was a single asset real estate debtor that owned property subject to a mortgage and an assignment of rents. The debtor got into financial trouble after a prior tenant defaulted and failed to vacate the property. Its current tenant never defaulted, but the rent was insufficient to service the debt. The shortfall was being made up by members of the debtor.

The lender commenced a state court foreclosure action in August 2018. In October the state court entered an order requiring the tenant to pay rent directly to the lender. The debtor and lender then entered into a stipulation pursuant to which the debtor had until March 18, 2019 to pay the debt in full.

If the debtor failed to pay, the lender had an option to (1) submit an agreed final judgment of foreclosure to the state court for entry, or (2) record one or both of the quitclaim deeds that were placed into escrow. Three days before the due date, the debtor filed bankruptcy – thus, preventing the lender from moving forward with the relief provided for in the stipulation.

The lender argued that the “eleventh hour” filing was evidence of bad faith that constituted cause for either dismissal or relief from the stay. Alternatively, it alleged that the debtor was unable to confirm plan within a reasonable time. The debtor responded that it had an honest intention to reorganize by re-amortizing the debt and using the rents to fund payment, and an equity cushion provided adequate protection.

The debtor provided testimony that it had been actively pursuing refinancing for a year. “Inexplicably” the debtor’s representative could only identify one bank that it had contacted or that was willing to consider refinancing. “Regardless,” the witness expressed confidence that the debtor could refinance within 60 days.

As a part owner, the debtor’s representative testified that the property was worth ~$6.4 million and estimated that the outstanding debt was between $5.4 and $5.6 million. However, he did not know at what rate interest was accruing, and neither party provided evidence as to whether the interest was accruing at the contract rate or the default rate.

The debtor also presented an expert witness that appraised the property at $6.57 million. However, on cross-examination the expert admitted that he had been disciplined in connection with a violation of competency under the USPAP rules. To counter this valuation, the lender’s expert witness testified that the property had a value of $5.4 million.

The court began its analysis by noting that “cause” is a broad and flexible concept that is inherently fact sensitive. To show a lack of adequate protection, a creditor must show that it needs protection from a decrease or threatened decrease in the value of its collateral as a result of the automatic stay.

The court identified a number of reasons why there might be a decline in value, including “a decline in the market value of the collateral, non-payment of interest accruing on a senior lien, or nonpayment of property taxes having priority over the creditor’s lien.” Further examples of when a threatened decline might occur included “lack of insurance, failure to maintain the collateral, failure to permit periodic inspections, or failure to report information affecting the collateral.”

One method of addressing adequate protection is to establish that there is an equity question. However, it is not enough to simply show that there is some equity, but rather the debtor must show that the equity is sufficient to preserve the status quo. Based on a review of case law, the court concluded that generally (1) an equity cushion of 20% or more is sufficient, (2) a cushion of 0% to 11% is insufficient, and (3) opinions are divided on whether a cushion of 12% to 20% provides adequate protection. Considering the valuation evidence provided by the parties, the equity cushion could range from 0% to 14.69%. The value settled on by the court resulted in a small cushion of 3.62%.

In determining whether a smaller cushion might be sufficient, the court noted testimony that the roof needed repairing, there was a sinkhole in the parking lot, and 4 of 12 air conditioning units needed to be serviced or replaced. Given the need to use rents to do required maintenance and the fact that there was already a shortfall, the court questioned the debtor’s ability to maintain the property. There were also unpaid sales taxes and property taxes. Consequently, the court concluded that regardless of whether there was a 3% or 14% equity cushion, the lender was not adequately protected.

However, the court found the testimony regarding the ability to refinance the debt to be credible. So, the court conditionally denied the motion for relief from the stay to give the debtor 90 days to refinance. The debtor was required to make monthly adequate protection payments equal to interest on the value of the creditor’s interest in the property at the nondefault contract rate, and if the debtor did not complete refinancing and payoff the lender’s debt within 90 days, the stay was to be automatically lifted.

On the face of it, it seemed curious that the court found the refinancing testimony to be credible since the witness (who was a part owner and presumably a guarantor) could only remember one bank that had been contacted during the year-long effort to refinance. However, when viewed from the perspective of results, the court’s solution provided an effective and timely resolution of the bankruptcy.

Since ultimately the debtor was unable to refinance the debt, the parties entered into a revised settlement stipulation. The lender took over expenses and was entitled to all of the rents effective September 1; the debtor voluntarily turned over the property; and the court entered an order confirming that relief from the stay was granted effective October 16. Thus, the bankruptcy was resolved and the lender obtained the property in seven months.

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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