Oftentimes in bankruptcy, when one entity files for bankruptcy relief, the subsidiaries or affiliates also file. Sometimes these entities are "substantively consolidated" for bankruptcy purposes, thus combining the assets and liabilities into a single pool and attributing them to a single entity. Substantive consolidation has been permitted when, for example, debtors have abused corporate formalities or creditors have treated the separate entities as a single economic unit and their affairs were hopelessly entangled. If the debtors are not substantively consolidated, however, courts tend to "jointly administer" the cases for convenience and efficiency purposes, but each debtor is treated as a separate and distinct entity.

In In re Meruelo Maddux Properties, Inc., the parent-debtor, along with 53 subsidiary-debtors filed separate chapter 11 petitions. The United States Court of Appeals for the Ninth Circuit held that although there was a finding by the Bankruptcy Court that the entities operated as a single "whole enterprise," the one subsidiary that owned a single piece of real estate should have been treated as a "single asset real estate" case. This meant that the lender-bank of that real estate property should have been granted relief from the automatic stay to pursue foreclosure against that one debtor in state court.

Deeming a case a "single asset real estate" case has consequences. For example, in a multiple asset case, a creditor must seek relief from the "automatic stay" by showing "cause" under section 365(d)(1), e.g., lack of adequate protection. Alternatively, a creditor can also seek relief under section 365(d)(2) by showing that the debtor has no equity in the property and that the property is not necessary for an effective reorganization.

In a single asset case, however, the creditor has an additional avenue to seek relief from the stay. If the debtor's case qualifies as a "single asset real estate" case under section 362(d) of the Bankruptcy Code, the court must grant relief from the automatic stay unless the debtor has filed a plan that has a reasonable possibility of being confirmed or the debtor is making monthly payments. The debtor must file the plan or make the monthly payments within 90 days of the filing of the petition or 30 days after the court determines that the case is a single asset real estate case, whichever is later. In short, a lender who is a mortgagee on that single real estate asset can request relief from the automatic stay from the Bankruptcy Court and, if such relief is granted, pursue its state law foreclosure rights. That is what happened in In re Meruelo Maddux Properties, Inc.

FACTS OF THE CASE

Meruelo Maddux Properties, Inc. (the "Parent") owned and developed real estate in Los Angeles through a network of approximately 53 subsidiaries. One of those subsidiaries included Meruelo Maddux Properties-760 S. Hill Street LLC (the "Subsidiary"). The entire business operated as a whole and on a consolidated basis; a general operating account was used to sweep all revenues each day and pay the expenses of the Parent and all the subsidiaries. In addition, the Parent and the subsidiaries filed consolidated tax returns. The Subsidiary was the holder of a single piece of real estate property -- a 92-unit apartment complex known as the "Union Lofts." Bank of America (the "Bank") loaned approximately $28.72 million in 2006 to renovate the Union Lofts, taking a mortgage in the real estate.

After the Parent and the 53 subsidiaries each filed their own chapter 11 petition, the Subsidiary filed a motion with the Bankruptcy Court seeking a determination that it was not subject to the "single asset real estate" provision of the Bankruptcy Code. The Bank responded by seeking relief from the automatic stay in order to pursue state law foreclosure. The Bankruptcy Court denied the motion and held that there was a "whole enterprise" exception to the "single asset real estate" provision due to the consolidated, interrelated nature of the business operations of the various debtors. The Bank appealed and the District Court reversed the Bankruptcy Court, finding that the "single asset real estate" provision applied. The United States Court of Appeals for the Ninth Circuit also disagreed with the Bankruptcy Court and held that there was no "whole enterprise" exception in the Bankruptcy Code.

COURT'S DECISION IN REJECTING THE "WHOLE ENTERPRISE" EXCEPTION

In rejecting the "whole enterprise" exception, the Ninth Circuit looked to the definition of "single asset real estate" under section 101(51B) of the Bankruptcy Code and indicated that it is defined as real property that must meet the following three criteria: (1) the property must be a single property or project, other than residential real property, with fewer than four residential units; (2) the property generates substantially all of the gross income of a debtor who is not a family farmer; and (3) there is no substantial business being conducted by a debtor other than the business of operating the real property and incidental related activities.

In evaluating the definition of "single asset real estate" under the Bankruptcy Code, the Ninth Circuit concluded that the Union Lofts property was: (1) a single property; (2) that generated all or substantially all of the Subsidiary's gross income; and (3) the Subsidiary's only commercial activities involved operating and collecting rents from Union Lofts. The fact that the Subsidiary may have also generated income by other subsidiaries by virtue of its sweeping system was of no consequence to the Ninth Circuit -- there was no reason to treat these entities as substantively consolidated entities.

The Ninth Circuit also looked to the automatic stay provisions of section 362(d) of the Bankruptcy Code and further explained that the plain language of those provisions does not carve out a "whole business enterprise" exception. According to the Ninth Circuit, absent an order substantively consolidating these entities in bankruptcy, they should have been treated as separate and distinct entities. Accordingly, the Court granted the Bank's motion for relief from the automatic stay.

WHAT REAL ESTATE CONGLOMERATES AND BANKS NEED TO KNOW

Both real estate-related entities and mortgagees of real estate-related entities can identify issues that may arise in future bankruptcy cases as a result of the Ninth Circuit's decision in In re Meruelo Maddux Properties, Inc. Potential real estate debtors should evaluate the nature of each debtor's assets and liabilities in advance of filing petitions on behalf of parents, subsidiaries and affiliate entities. In the event an entity's bankruptcy case may be treated as a "single asset real estate" case, substantive consolidation may be necessary or, in the alternative, the filing of a plan early on in the case or paying the total amounts owed may be required. Lenders, on the other hand, should be mindful of the fact that although obtaining relief from the automatic stay on a "single real estate asset" case may create leverage in the bankruptcy case, such a strategy may create difficulty for the enterprise as a whole to reorganize and, therefore, potentially impairing creditors' rights. These issues should be vetted with reorganization professionals in order to determine the ideal strategy.