SINGLE ASSET REAL ESTATE CASES
By: Trev E. Peterson
Knudsen, Berkheimer, Richardson & Endacott, LLP
Lincoln, Nebraska
I.Introduction
Among the many perceived “evils” of the bankruptcy system is the single asset real estate case. The typical single asset case involved a commercial building or apartment complex that was purchased by a limited partnership (in the 1980’s at least) where the only creditors were the lender who was secured by the real estate and a small number of unsecured trade creditors. The debtor was almost always thinly capitalized, frequently with no personal liability to the lender and the property worth less than the lender’s claim. Bankruptcy was used as a battle axe to bludgeon the lender into either delaying the foreclosure to delay the recapture of depreciation deductions for the debtor’s owners or to try and cram down the lender’s secured claim to the value of the property. A successful cram down left the debtor (and its investors) with the opportunity to enjoy any appreciation in the value of the property after plan confirmation. These cases were frequently filed on the eve of foreclosure, and there was no expectation that the debtor would ever be able to propose a plan that could be confirmed. Many of the cases were filed for the purpose of allowing the debtor to control the ownership of the property through a sale of the property under §363.[1]
Prior to 1994, the lender had limited options available to it. First, the lender could seek relief from the stay, but bankruptcy courts are reluctant to grant relief from the stay until enough time passed after the filing date to establish that the debtor could not confirm a plan. Second, the lender could seek to sequester rents from the property unless the debtor agreed to make an adequate protection payment to the lender. Depending on applicable state law, the lender’s attempt to sequester rents may or may not have been successful. Third, the lender could request adequate protection of its interest in the property under §361. Frequently the lender was undersecured and the court would order only that the debtor keep insurance in place and pay an amount sufficient to prevent the interest and penalties on the unpaid prepetition real estate taxes from increasing, and to pay the post petition real estate taxes. If the lender could prove that the property was declining in value, the court might order adequate protection payments to protect the lender from further erosion of the value of its security. The lender could rely on an election under §1111(b) to force the debtor into paying the full amount of the lender’s claim as a part of the plan of reorganization, but that remedy applies only at plan confirmation, which is at the end of a lengthy bankruptcy case. The lender could rely on the absolute priority rule[2] to contest confirmation, but that remedy applies only at the end of the case. Finally, the lender could seek to dismiss or convert the Chapter 11 to a Chapter 7 based on the debtor’s bad faith in filing the case. However, motions to dismiss or convert are difficult to win unless the debtor has grossly mismanaged its business during the case.
Most lenders' counsel used one or all of these techniques to try and force their way out of what now would be a single asset real estate case. Depending on the bankruptcy judge involved, one or more of the techniques could work, but it often took years to get to resolution, and the resolution was often a liquidation of the debtor, or the dismissal of the case.
Congress sought to redress this situation in 1994 by providing a definition for single asset real estate cases and by providing expedited treatment of those cases through special provisions in §362 that permitted the bankruptcy courts to weed out cases where the debtor had no reasonable chance of reorganization.
As defined by the 1994 amendments, “single asset real estate” meant:
[R]eal property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental thereto having an aggregate noncontingent, liquidated secured debts in an amount no more than $4,000,000.
11 U.S.C. §101(51B) (prior to 2005 amendment).
As part of the 1994 amendments, Congress also amended §362 to add §362(d)(3), which provided that the bankruptcy court had to grant relief from the stay if the debtor did not either (1) file a plan within 90 days after the entry of the order for relief (which is typically the day of the filing of the case) or such later date as the Court determined for cause by order entered within the 90 day period or (2) make adequate protection payments to each creditor (excluding judgment creditors or unmatured statutory lien creditors) whose claim is secured by the real estate equal to interest at a fair market rate on the value of the creditor’s interest in the real estate.
In 2005, the provisions of both §101(51B) and §362(d)(3) were revised.
II.THE 2005 AMENDMENT TO SECTION 101(51B)
The 2005 revision made two changes to the definition of “single asset real estate,” one of which is of minor importance and the other could be more significant. The minor change is the exclusion of real property owned by a “family farmer.” The major change is the deletion of the $4 million cap. Now, any special purpose entity (“SPE”), created exclusively for the purpose of holding title to a real estate investment is likely to be included in the definition of a single purpose real estate. As amended, §101(51B) provides that:
The term “single asset real estate” means real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental.
11 U.S.C. §101(51B).
Under the 2005 amendment, there are four criteria that must exist for a bankruptcy case to qualify as a single asset real estate case within the scope of §101(51B). First, the real property must be a “single property” or a “project” other than residential real property with fewer than 4 residential units. Second, the real property must generate substantially all of the income of the debtor. Third, the debtor must not be a family farmer. Fourth, the debtor must not be involved in any substantial business other than the operation of the real property and activities incidental thereto. See In re KaraHomes, 363 B.R. 399, 2007 WL 748470 (Bankr. D.N.J. 2007); In re Philmont Development Co., 181 B.R. 220 (Bankr. E.D. Pa. 1995). The final general comment about single real estate asset cases is that the cases are all fact and circumstance dependant. There is probably no single factor that will either make the case a single asset case or keep the case from being a single asset case.
A.The “single property” or “project” requirement.
The leading case on the “single property” or “project” requirement is In re Philmont Development Co., 181 B.R. 220 (Bankr. E.D. Pa. 1995). The case involved Chapter 11 cases filed by three limited partnerships and their corporate general partner. The lender filed a motion for relief from the automatic stay 103 days after the bankruptcy cases were filed. The bankruptcy court concluded that the general partnership was not a single asset real estate case because the general partnership’s assets were limited to two undeveloped lots and its ownership interest in the three limited partnerships.
The three limited partnerships each owned what the court referred to as “semi-detached houses” that each of the limited partnerships bought from the general partner. Each of the limited partnerships owned more than four residential units. The bankruptcy court concluded that the limited partnerships fell directly within the scope of former §101(51B), unless the semi-detached houses were not part of a single project. The bankruptcy court noted that:
In determining whether or not the limited partnerships' semi-detached houses are the type of real property which constitute a “single property” or “single project,” the Court has considered the many cases which discuss the common type of single asset real estate case, as that phrase was used colloquially, before the enactment of section 101(51B). That common situation, i.e., typically an apartment building, office building, or “strip” shopping center owned by an entity whose sole purpose was to operate that real estate with monies generated by the real estate, clearly falls within the criteria enumerated in section 101(51B).
Id. at 223-24. Concluding that each of the three limited partnerships were single asset real estate cases, the court noted that it was:
[S]trongly influenced by the drafters decision to include two separate classifications of real property within the purview of section 101(51B). Under section 101(51B), real property includes “single property” as well as “single project[s].” The Court is convinced that even if the Debtor limited partnerships' real property does not fall within the scope of a “single property,” because it consists of a string of semi-detached dwellings, the term “single project” can reasonably be interpreted as broad enough to encompass the series of semi-detached houses owned by the limited partnerships. In In re KKEMKO, Inc., 181 B.R. 47 (Bankr.S.D.Ohio 1995), the Court discussing section 101(51B) said that any “residential real property with more than four residential units is certainly single asset real estate.” Id. at 50. The KKEMKO court went on to say that “apartment buildings and residential projects are within the [scope of section 101(51B)].
Id at 224 (emphasis added).
The bankruptcy court discounted the debtors’ argument that because each of the houses had separate mailing addresses, they did not constitute a single project. “[T]he drafters of section 101 (51B) defined single asset real estate cases to include two separate classifications: single properties and single projects.” Id. Because the limited partnerships had not filed Chapter 11 plans within the 90 day limitation under §362(d)(3), the bankruptcy court granted relief from the stay in the limited partnership cases.
In re The McGreals, 201 B.R. 736 (Bankr. E.D. Pa. 1996) involved a debtor who owned two parcels of real estate that abutted each other in part. The debtor filed a motion for an order declaring[3] that the single asset real estate provisions did not apply to the case. The properties were acquired at the same time, but from different grantors. One of the properties contained a refrigerated manufacturing plant and the second parcel was vacant land. The vacant land was owned by the tenant who occupied the manufacturing plant at the time of the sale. The debtor signed two loans for the acquisition of the properties, each of which was secured by a mortgage on both of the lots. The debtor also obtained second loans on both parcels from another lender. The debtor’s only income was from the rents on the plant and the debtor did not, at any time, conduct any business of its own on the property other than the operation of the properties themselves. There was no access from the plant to the vacant lot, even though the lot and the plant shared a common border. There was a drainage ditch on the vacant lot that made access to the manufacturing plant impractical. The properties had separate parcel numbers, were taxed separately and the debtor’s principal testified that there was no intent that the properties would be used together—the vacant property being held for a “warehouse condominium” project that never materialized.
Holding that the property failed the “single project” test, the court noted that:
[T]he properties must be linked together in some fashion in a common plan or scheme involving their use. The mere fact of common ownership, or even a common border, will not suffice. The requisite element of a common plan or scheme, however, is missing in this case.
Id. at 742-43.
B.The project must produce substantially all of the income of the debtor.
This requirement is fairly self explanatory. The intent of Congress in enacting the single asset real estate provisions was to force single asset real estate debtors to either file confirmable Chapter 11 plans or to “pay to play” by making interest payments to their secured creditors. In the Philmont case, the limited partnership debtors had no significant income apart from income generated from the real estate, which was a factor in the court’s holding that the single asset real estate rules applied to the limited partnerships.
In re 83-84 116th Owners Corp., 214 B.R. 530 (Bankr. E.D.N.Y. 1997), involved the issue of whether a nonprofit housing cooperative that owned units in a co-op project derived substantially all of its income from the operation of the project. The debtor sought to avoid the application of the single asset real estate case provisions by asserting that the income it derived from its members was not income for purposes of the definition of a single asset real estate case under the Bankruptcy Code. The bankruptcy court disagreed. The bankruptcy court noted that the debtor collected rents and paid those rents to the lender, and the fact that the rents were not considered as taxable income for federal income tax purposes is not determinative of whether the rental payments are income derived from the property under §101(51B). The bankruptcy court also dismissed the co-op’s argument that it was a nonprofit and therefore did not conduct business:
The debtor is, from the vantage point of the Bankruptcy Code, undeniably in the business of running the co-op apartment project. It is irrelevant, as a matter of bankruptcy law, that the expenses incurred by the co-op corporation for mortgage debt services and under service contracts with independent contractors who provide physical maintenance for the project are supposed to be passed-through to the occupants of the units without any “profit.” The point is that the debtor in possession collects those payments from the occupants of the units as rent or pro-rata maintenance, and that is its primary business activity.
Id. at 533.
What about debtors who do not earn any income from the real estate? In re OceansideMission Associates, 192 B.R. 232 (Bankr. S.D. Cal. 1996) involved a debtor who owned a parcel of raw land with liens in excess of $4 million. Most of the analysis in the case involves how to compute the $4 million cap, all of which is irrelevant in view of the removal of the cap in 2005. The Oceanside court’s discussion of income is, however, still relevant. The court noted that “[t]here is no apparent purpose for Congress to have excused debtors who own only raw land from this expedited program: If a debtor who owns an apartment complex is forced to act quickly why not a debtor who owns raw land?” Id. at 235. The court noted that it was more likely that the “gross income” clause and the “substantial business” clause were intended to exclude debtors who own real property but who are also involved in income generating businesses in addition to ownership of the real estate:
If Congress intended to exclude raw land from the definition they would have done so specifically or at least explained in the comments that the definition was meant to exclude raw land. Without such an express exclusion this court does not believe that Congress meant for “single asset real estate” to mean less than it did before the sections were enacted. Although it requires a bit of a tortured reading, based upon the statutory purpose of the new sections, the limited legislative history, the usage of the term “single asset real estate” in prior case law and the fact that excluding raw land would simply not make sense, this Court concludes that “single asset real estate” includes undeveloped real property which generates no income.
Id. at 236.
C.The family farmer exception.
This is not expected to be a major exception, since most farmers are not in the business of developing land or owning residential or commercial properties. “Family farmer” is defined in §101(18) (1) as an individual, an individual and spouse whose debts do not exceed $3,237,000 (which is indexed for inflation); (2) at least fifty percent of the debts have to be related to the farm operation; and (3) who earned fifty percent or more of their income from farming during either the year prior to the filing of the case, or during each of the second and third years prior to the filing of the case. Similar debt and income tests apply to corporations owned by one family.
D.The no substantial business other than operating the property requirement.
In re Kara Homes, Inc., 363 B.R. 399, 2007 WL 748470 (Bankr. D.N.J. 2007), discussed the single project requirement in a case involving a home builder. The debtors in KaraHomes are the principal company and thirty-two affiliated companies. Each affiliate owned separate real estate development projects for the construction of single family homes. Each of the affiliated debtors also checked the “single asset real estate” boxes on the bankruptcy petitions and on the statement of financial affairs, question 18b, which requires that the debtor identify which debtor entities are single asset real estate entities. After the filing, the debtors amended their petitions and their statement of financial affairs to “uncheck” the single asset real estate boxes.