New Bankruptcy Legislation Strongly Impacts Real Estate-Related Bankruptcies

Sunday, January 1, 2006 - 00:00

In addition to the much-publicized changes to consumer bankruptcy laws, the Bankruptcy Abuse and Consumer Protection Act of 2005 contains key changes applicable to real estate chapter 11 cases. Among the significant modifications to the old law are those that: amend the rules related to single asset cases, add an exception to the automatic stay for property tax liens and increase the rights of landlords.

Single Asset Real Estate Cases

In the early nineties, real estate cases dominated the dockets of bankruptcy courts. As a result, in 1994, the Bankruptcy Code was amended to include special rules for "single asset real estate" cases. The 1994 amendment was enacted because secured creditors felt that their legitimate collection rights were being unduly delayed where the debtor had no possibility of reorganizing. These cases, essentially two-party disputes often filed in order to avert a foreclosure sale, were placed on a faster track. However, a property only qualified for treatment as a "single asset" case if secured debts aggregated less than $4 million. Many cases that would otherwise qualify for "single asset" treatment exceeded this ceiling and were left off the fast track. As a result, secured creditors continued to suffer the delay associated with a traditional chapter 11 case.

The Act amends the Bankruptcy Code by eliminating the $4 million cap, which had become unreasonably low. Thus, a "single asset case" is now any case involving a single real property or project from which the debtor derives substantially all of its revenue, other than residential real property with fewer than four units. In these cases, the automatic stay is terminated unless a reasonable plan has been filed within 90 days of the bankruptcy filing or the debtor has begun making monthly payments to the secured creditor. The amount of these payments must be equal to the interest on the secured claim at the applicable non-default contract rate. The later alternative regarding interest payments is another change from prior law. In cases under the old Bankruptcy Code, interest was paid at the current market rate, which allowed some debtors to argue for lower interest payments than were required under their mortgage. Under the Act, fully secured creditors will at least be guaranteed their contractually bargained for interest rate. However, the payments to the secured creditor may, without regard to the restrictions on the use of cash collateral, be made from rents or other income generated from the property post-petition.

Changes To The Automatic Stay

Since certain debtors have abused the bankruptcy system by, among other things, filing multiple bankruptcies using different corporate entities for the same real estate, the Act includes new provisions that provide for relief from the automatic stay in such circumstances. Specifically, unless exceptional circumstances exist, the court must grant relief from the automatic stay to a secured creditor where the debtor's use of the bankruptcy filing was part of a scheme to delay, hinder or defraud creditors through either (i) a transfer of ownership (whether complete or partial) or other interest in the real estate without the consent of the secured creditor or without court approval or (ii) there have been multiple bankruptcy filings with respect to the same real estate.

Another amendment provides an important exception to the automatic stay for the creation or perfection of a statutory lien for taxes and assessments to real property that come due after the bankruptcy filing. Under the prior law, only ad valorem tax liens were subject to this exception. Thus, governmental units should have an easier time collecting property taxes that are owed by a debtor, whether or not the bankruptcy is a single asset real estate case.

The Act also provides a new provision, Section 362(j), which authorizes the court to issue a "comfort order" to a party to confirm that the automatic stay has in fact terminated. While such orders have become commonplace in bankruptcy cases, the prior law had no specific statutory basis for their issuance.

Increased Rights For Landlords

In addition to limiting the time in which a debtor may assume or reject a commercial lease, the legislation modifies the Bankruptcy Code to clarify that "so-called" use restrictions must be honored when leases are assumed and assigned. For example, under the old law, bankruptcy courts commonly would permit a debtor to assign a lease, which requires the tenant to operate a specific type of business, to a new tenant that does not intend to operate that type of business. In recent years, many large retail operations have filed chapter 11, such as K-Mart, Ames Department Stores, Trak-Auto and Winn-Dixie. In many of these cases, the debtors attempted, with differing levels of success, to assign leases to new tenants, which did not intend to comply with use restrictions in the lease. Retailers in chapter 11 will no longer be able to ignore these important contractual provisions without the landlord's consent.

The Act also clarifies the need to cure existing non-monetary defaults at the time of assumption. Where the non-monetary default is impossible to cure based upon failure to comply with a lease, performing under the lease going forward will now cure the default. The landlord must also be compensated for losses suffered as a result of the tenant's failure to operate in accordance with the lease. An example is where a debtor "went dark" pre-petition in violation of a lease. A split of authority existed under the old law with respect to whether non-monetary defaults needed to be cured or even could be cured. Because proving damages associated with non-monetary defaults may be difficult, landlords may begin to structure leases to include liquidated damages clauses to cover such defaults.

Conclusion

The new bankruptcy law includes important changes for real estate debtors, as well as all other business debtors. How these changes play out in the courts is yet to be seen, but in the event of another boom in real estate bankruptcies, the Act is certain to have a dramatic impact.

H. Jason Gold, Chair of WRF's Bankruptcy & Financial Restructuring Practice, has more than 24 years of experience counseling clients on restructuring and insolvency matters. He can be reached at (703) 905-2825. Dylan G. Trache, an Associate with the group can be reached at (703) 905-2829.

Please email the authors at jgold@wrf.com or dtrache@wrf.com with questions about this article.