Review these guidelines for working with distressed property transactions.
As this real estate cycle heads into its downturn, developers, investors, and lenders may face bankruptcy issues that they have not experienced in the past. Market slowdowns during the last 18 months may require these parties, as well as others, to navigate through a maze of legal and financial issues. Understanding sales processes during bankruptcy can be useful for commercial real estate professionals in such market conditions.
For those prepared to buy, there is an upside in a down market. Buying real estate in bankruptcy cases involves different issues and procedures than non-bankruptcy transactions. Among the advantageous reasons for buying real estate in bankruptcy are the cleanliness of property titles and the speed with which bankruptcy transactions can be closed. In a properly conducted bankruptcy sale, the Bankruptcy Court’s order has the effect of scraping off encumbrances from the real property that is being sold and moving them to the proceeds of that bankruptcy sale. This provides buyers with clear title to the real property pursuant to a federal court order and leaves the bankruptcy estate and its creditors to fight about entitlement to those proceeds at a later date.
For debtors, bankruptcy sales offer a method for quickly selling property without extended state court litigation to determine lien priority or validity. Additionally, since properties in bankruptcy most often are sold as-is, the negotiations, due diligence periods, and document-drafting times usually are much shorter. Both buyers and sellers can reap the benefits of the streamlined sales process and the more simplified documentation required for bankruptcy sales.
In certain circumstances bankruptcy sales are exempt from documentary stamp and similar taxes. Specifically, Section 1146(a) of the Bankruptcy Code provides that “the making or delivery of an instrument of transfer under a plan confirmed under Section 1129 [of the Bankruptcy Code], may not be taxed under any law imposing a stamp or similar tax.” In large property sales under a Chapter 11 plan, this exemption can be extremely valuable and provide substantial savings to the bankruptcy estate.
Property buyers have more control in formulating the terms and conditions of private sales than public sales. In private sales and auctions, a potential purchaser making the initial offer for real property is called the stalking-horse bidder. The bankruptcy estate benefits from a stalking-horse offer because it establishes minimum terms and conditions of a sale, including a minimum purchase price. Such initial offers are sometimes conditioned on the Bankruptcy Court’s approval of stalking-horse protections including:
- a break-up fee, or alternatively, reimbursement of actual due diligence expenses;
- a minimum overbid amount;
- minimum bidding increments; and
- other less-common protections of the initial bidder, such as limited “no shop” provisions.
The Bankruptcy Code authorizes the bankruptcy estate’s fiduciary to conduct sales that can be made subject to or free and clear of encumbrances to title. Sales free and clear of the interests of third parties are far more common, but only may be made if certain criteria are met. Specifically, Section 363(f) of the Bankruptcy Code authorizes a sale of property free and clear of any interest in such property of an entity other than the estate, only if at least one of the five following conditions is met:
- applicable non-bankruptcy law permits the sale of such property free and clear of such interests;
- the entity holding such an interest in the property consents;
- the interest is a lien and the price at which the property is sold is greater than the aggregate value of all liens on the property;
- such interests are in bona fide dispute; or
- the entity holding the lien could be compelled to accept a money satisfaction of such interest.
So long as the debtor is able to make the requisite showing that one of the five exceptions under Section 363(f) apply, the bankruptcy courts generally will authorize the sale of real property to a purchaser free and clear, with those liens, claims, and encumbrances instead attaching to the proceeds of the sale.
Single-Asset Real Estate Cases
Many real estate projects are owned by special purpose, bankruptcy-remote limited liability companies. Such single-asset real estate cases typically include apartment buildings, office buildings, shopping centers, warehouses, land, residential subdivisions, and condominiums; however, marinas, full-service hotels, golf courses, and ski resorts are not considered single-asset real estate cases.
Although single-asset borrowers are not precluded from filing bankruptcy, under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, they are subject to accelerated procedures for purposes of lifting the automatic stay, thus taking away former advantages that debtors had under bankruptcy.
Under Chapter 11, Section 101(51B), a single-asset real estate debtor is one whose real property constitutes a single property or project, other than residential property with fewer than four residential units; generates substantially all of the debtor’s gross income; and on which no substantial business is being conducted other than operating the real property.
Under Chapter 11, Section 362(d)(3), in single-asset real estate cases, the automatic stay imposed by the Bankruptcy Code against creditors will terminate either 90 days after the bankruptcy filing or 30 days after the court determines that the debtor is a single-asset debtor unless the debtor files a plan with a reasonable possibility of being confirmed or starts to make monthly interest payments to secured creditors at the applicable nondefault contract rate of interest. Additionally, secured creditors can try to terminate the automatic stay.
Finally, secured creditors can try to dismiss the bankruptcy case, and the courts will look at certain factors to determine if the single-asset debtor filed bankruptcy in bad faith. These factors include:
- the debtor has only one asset;
- the debtor has few unsecured creditors whose claims are small in relation to the claims of secured creditors;
- the debtor has few employees;
- the property is the subject of a foreclosure action as a result of arrearages on the debt;
- the debtor’s financial problems involve a dispute between the debtor and secured creditors that can be resolved in the pending state court action; and
- the timing of debtor’s bankruptcy filing shows intent to delay or frustrate the legitimate rights of the debtor’s secured creditors to enforce their rights.
While most single-asset cases typically meet these criteria, the cases are almost always subject to a motion to dismiss or to allow the secured creditor relief from the automatic stay.