Closing The Bankruptcy Court’s Doors

CRE Finance World, Summer 2013

Closing The Bankruptcy Court’s Doors How a recent decision constricts the bankruptcy option for many CRE borrowers recent opinion, In re Castleton Plaza, L.P.,1 from the U.S. Court of Appeals for the Seventh Circuit, may constrict the option of bankruptcy for many underwater commercial real estate borrowers, dampening the appeal of filing after several years of surprise Chapter 11s. At the heart of the case is the absolute priority rule, which prohibits an equity owner of a debtor from retaining any benefit or interest unless all unsecured creditors are paid in full first. In In re Castleton Plaza, L.P. , the Seventh Circuit held that selecting the new equity holder of a debtor is a benefit that violates the absolute priority rule. This holding can limit the ability of single asset real estate debtors in bankruptcy from keeping control of their property if an undersecured lender objects. Although the CMBS market continues to rebound and new investors are increasingly placing capital in commercial real estate, newly originated CRE loans are not perfect. Borrowers will default. Special servicers and lenders will need to manage troubled assets and seek workouts and foreclosures. However, despite “bad boy” guaranties that prohibit bankruptcy filings, borrowers have opted for bankruptcy in recent years with various success. Through bankruptcy, borrowers have been able to write down debt, extend payments for several years, and reduce interest rates, all while maintaining control of their real estate. Servicers and lenders who elect to fight these efforts often expend a lot of cash only to have a bankruptcy court grant each of the borrower’s requests. This leaves lenders and CMBS investors sitting on long-term debt they never bargained for. The Castleton Plaza case could change some of these dynamics. I. Borrower’s Default The story behind In re Castleton Plaza, L.P. should be familiar to many lenders and servicers. Castleton Plaza, L.P. was an entity with a single asset, a retail strip mall located in Indianapolis, Indiana. The equity interests of Castleton Plaza, L.P. were controlled by one individual. In August 2010, when a balloon payment became due and adequate refinancing was not available, Castleton Plaza defaulted. In early 2011, Castleton Plaza filed for chapter 11 reorganization in the Bankruptcy Court for the Southern District of Indiana, staving off a potential foreclosure. CRE Finance World Summer 2013 70 The equity owner was no stranger to the bankruptcy courts, previously using bankruptcy to write down the debt for a similar property: Greenwood Point, L.P. In bankruptcy, Greenwood Point proposed a plan that wrote off nearly one million dollars of debt, reduced the interest rate, and locked the lender into ten-year note. The only “sacrifice” to Greenwood Point was a proposed transfer of Greenwood Point’s equity, without marketing or valuation, from the equity owner to his wife. The transfer of equity to the equity owner’s wife implicated the so-called “absolute priority rule,” which is defined at Section 1129(b)(2)(B)(ii) of the Bankruptcy Code. In layman’s terms, the absolute priority rule prevents equity holders from retaining any benefit or interest until all unsecured creditors are paid in full. If the equity owner had retained the equity without marketing, there would be a clear violation of the absolute priority rule, and Greenwood Point’s plan could not be confirmed. However, with the proposed transfer to the equity owner’s wife, Greenwood Point believed it was avoiding any issues with the absolute priority rule. The bankruptcy court agreed, confirming Greenwood Point’s plan, despite the secured lender’s objections. No appeal was filed, and the Greenwood Point case provided a framework for Castleton Plaza to modify its loan. II. Loss in the Bankruptcy Court In the case of Castleton Plaza, in the same bankruptcy court where the Greenwood Point case was heard albeit with a different judge, the debtor’s plan of reorganization again proposed to sell the equity interests to the equity owner’s wife without valuation or marketing of any kind, at a price determined by the equity owner. The lender objected to Castleton Plaza’s plan on multiple fronts. The lender argued that the absolute priority rule required that the new equity interests of the “reorganizing” Castleton Plaza be exposed to a bidding process. Otherwise, the lender argued, the equity owner’s wife could be taking a potentially valuable asset from the bankruptcy estate and providing minimal value for it. This would have been to the detriment of unsecured creditors, who could have received higher distributions if the new equity were sold for a higher amount. A David M. Powlen, Esq. Partner Barnes & Thornburg LLP Jonathan D. Sundheimer, Esq. Associate Barnes & Thornburg LLP Alan K. Mills, Esq. Partner, Lead Counsel, In re Castleton Plaza, LP Barnes & Thornburg LLP


CRE Finance World, Summer 2013
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