By some accounts, there is over $300 billion of commercial real estate debt set to mature over each of the next four years. As a result of a lack of demand, a lack of liquidity and lackluster valuations, a significant portion of this debt will go into default. In many cases, bankruptcies will ensue for both the projects and their owners.
At issue in many real estate-related bankruptcies is the ability of a bankrupt investor or developer to sell its ownership interest in a non-bankrupt real estate project, often under the guise of a "free and clear" sale using Section 363 of the Bankruptcy Code.
While not unique to real estate developments, as a result of lender requirements most commercial real estate projects are structured as special purpose entities, or SPEs. An SPE may be thought of as a business formed exclusively to accomplish some specific task or, as the name suggests, some special purpose. In the commercial real estate context, that special purpose may be the acquisition, development and/or management of a real estate project. The SPE most often takes the form of a limited liability partnership, a limited partnership or a limited liability company.
When an SPE investor files for bankruptcy, a tension arises between (1) the bankruptcy goal of maximizing value for the investor's assets and (2) the restrictions on transfer that are inherent in the SPE structure. While this conflict has played out in the bankruptcy courts to some degree, we anticipate much more activity in this area over the next few years.
Under the Bankruptcy Code, a debtor's interest in property becomes property of the estate notwithstanding a provision in an agreement that restricts the transfer by virtue of the debtor's insolvency or financial condition. In other words, if the SPE organizational documents provide for forfeiture of an investor's interest upon bankruptcy, that provision will generally be unenforceable. The more nuanced dispute relates to the bankruptcy estate's ability to subsequently transfer the investor's interest to third parties in contravention of applicable non-bankruptcy law that, for example, requires consent of the other investors or vests the other investors with a right of first refusal.
As the issue has played out in the bankruptcy context, the relationship between investors in an SPE has been viewed as a combination of (1) a property interest in the profits and surplus of the SPE and (2) an executory contract with respect to the governance of the SPE property. The courts have generally authorized the sale of the bankrupt investor's economic interest in the SPE (at the same time enforcing rights of first refusal when on market terms). However, the courts have generally refused to authorize the transfer of a bankrupt investor's participation interest, treating the SPE governing agreements as non-assignable executory contracts.