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CRE Finance World, Summer 2013

“Owners should be more reluctant to invest the significant costs associated with filing for bankruptcy and fighting lenders through the reorganization process.” A publication of Summer issue 2013 sponsored by CRE Finance World Summer 2013 71 Closing The Bankruptcy Court’s Doors After a three-day confirmation hearing, the bankruptcy court ruled in favor of Castleton Plaza. The bankruptcy court held that the transfer of ownership of the new equity to an insider without competitive bidding or a market test does not violate the absolute priority rule. This result was similar to the result in Greenwood Point. If the lender had agreed to cut its losses at this point and accept Castleton Plaza’s plan, the Castleton Plaza case may have become the blueprint for underwater CRE owners to file for bankruptcy and write off debt. Any debtor sitting on underwater property could file for bankruptcy, re-value the property, eliminate any deficiency, extend loan payments for another ten years, and continue to control the reorganized entity (by passing ownership to an insider) without any issue. However, the lender here sought to appeal the bankruptcy court’s ruling directly to the U.S. Court of Appeals for the Seventh Circuit. III. Appeal to the Seventh Circuit The Seventh Circuit granted the direct appeal, allowing the lender to skip over the local federal district court.2 In the Seventh Circuit, Castleton Plaza again argued that because the equity owner’s wife was purchasing the new equity interests, the equity owner was not retaining any property interests. Thus, the absolute priority rule did not apply even if control of the reorganized debtor stayed “within the family”. The lender argued that, pursuant to the Castleton Plaza plan, the equity owner retained several valuable property interests in violation of the absolute priority rule: (i) the exclusive opportunity to determine who the new equity owner would be; (ii) the exclusive opportunity to set the price of the new equity; (iii) control over Castleton Plaza, as the management company operating the property will continue to operate the property and the equity owner was the COO of the management company; and (iv) through marriage, the equity owner retained a contingent interest in Castleton Plaza. It was the lender’s position that any one of these four property interests retained by the equity owner would have violated the absolute priority rule. At oral argument in December 2012, the Seventh Circuit, led by Chief Judge Easterbrook, seemed to question the purpose of the absolute priority rule: “It would certainly leave the absolute priority rule as meaning essentially nothing,” said Chief Judge Easterbrook. “All the old equity holder has to do is make sure that all the interest goes to a close relative and, bingo, absolute priority vanishes.” On February 14, 2013, the Seventh Circuit issued its opinion: Castleton Plaza’s plan violated the absolute priority rule. In a seven-page opinion, debtors were prohibited from passing equity ownership to an insider absent a market test. “A plan of reorganization that includes a new investment must allow other potential investors to bid.... Competition is essential whenever a plan of reorganization leaves an objecting creditor unpaid yet distributes an equity interest to an insider.”3 The Seventh Circuit further cited the benefits the equity owner would retain by keeping the equity with his wife, including a continued salary with his management company and an increase in familial wealth.4 “This reinforces our conclusion that competition is essential.”5 IV. Applying the Seventh Circuit’s Opinion to Practice The lender and Castleton Plaza are back in the bankruptcy court, where the case remains pending. Nonetheless, the Seventh Circuit’s opinion may have potentially significant ramifications on bankruptcy for CRE borrowers. As a result of this opinion, a bankruptcy case often may be similar to a foreclosure process for single asset real estate entities. In bankruptcy, the owners will be required to put up their new equity for auction, allowing competition. For the large majority of single asset real estate entities, there is one major lender with several small trade creditors, providing services such as landscaping, property management, and maintenance. This was the same for Castleton Plaza. In order to invoke an auction, the lender must hold an unsecured claim.6 At an auction of the equity interests, the primary lender can bid any amount of cash, regardless of how it values the equity interests. The winning bid amount will be funds used for the reorganized entity after a plan is confirmed. If the lender is the winning bidder, the lender will be responsible for paying the trade creditors, but their debts are not


CRE Finance World, Summer 2013
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