The Bankruptcy Appellate Panel for the Sixth Circuit Court of Appeals1 recently issued an opinion of importance in bankruptcy cases involving commercial real estate as the debtor’s only asset, such as a shopping center or office building. In an appeal from an earlier decision handed down by a bankruptcy court in Kentucky, the Court held that a mortgagee of commercial real estate holding an assignment of rents as additional security for the debt was not “adequately protected” by the Chapter 11 debtor’s grant of a replacement lien in after-acquired rents to permit the debtor to use those rents to pay post-bankruptcy operating and other expenses where the debtor has no equity in its property. In re Buttermilk Towne Center, LLC, 2010 Bankr. LEXIS 4563 (BAP 6th Cir. 2010).
This decision severely limits the ability of a fully liened debtor to avoid foreclosure of the mortgage and to reorganize its business under Chapter 11 of the Federal Bankruptcy Code.
Commercial real estate financing in its simplest terms involves the lending of funds to a commercial real estate owner secured by a mortgage in that realty and the assignment of rents generated from that property. Most state laws establish procedures whereby the assignee of rents may perfect these assignments and enforce them upon the assignor’s default. In the absence of a bankruptcy case of the owner/mortgagor, a mortgagee in a default situation will often foreclose on its mortgage lien and take action to collect the assigned rents directly from tenants.
In the recession of 1989 to 1991, many “single asset real estate” debtors, in order to stave off mortgage foreclosure and collection of assigned rents, commenced Chapter 11 cases to stay those enforcement actions and propose a reorganization plan providing for an extended payout to the mortgagee of the value of its collateral, which was in most instances a number less than the debt. Because most mortgagees were undersecured, the plans would normally provide for some distribution on the mortgagees’ unsecured deficiency claims. Many of these plans were confirmed by bankruptcy courts during this time period2, which resulted in much pushback by commercial real estate lenders. As a result of their lobbying efforts, Congress amended the Federal Bankruptcy Code in 1994 to require single asset real estate debtors who wished to avoid foreclosure and reorganize under Chapter 11 to do one of the following early in the case: (i) to file a reorganization plan “that has a reasonable possibility of being confirmed within a reasonable time”; or (ii) to begin making monthly payments of interest to mortgagees “at the then applicable nondefault contract rate of interest on the value” of the mortgages’ liens.3
Because of this statutory amendment and the general prolonged uptick in commercial real estate values after 1994, the previous wave of mortgage loan defaults receded to a trickle and the incidence of Chapter 11 filings of single asset real estate cases virtually disappeared – until now. These cases are once again coming into vogue because of the precipitous drop in commercial real estate values and the general sidelining of commercial mortgage lending after 2008.
The Buttermilk Towne Center, LLC Decision
In the Buttermilk Towne Center Chapter 11 case, the borrower obtained construction financing from a predecessor of Bank of America in 2004, the proceeds of which were used to fund the purchase of $34 million in taxable industrial revenue bonds. The bank owned 100 percent of these bonds, which would have been repaid in the normal course through lease payments made by the borrower to the Kentucky municipality that held title to the real estate. These lease payments would, in turn, be funded by sublease rental payments made to the borrower by its commercial tenants. As security for repayment of the bonds, the bank held a mortgage in the real estate and an assignment of all rents payable to the borrower.
On Dec. 31, 2009, the obligations of the borrower to repurchase the bonds from the bank matured and, when the borrower failed to buy back the bonds, it defaulted on its contractual obligations owing to the bank. Four months later, the borrower filed a Chapter 11 petition and sought to use rent collections as “cash collateral” during its bankruptcy case. After a hearing on the borrower’s request to use cash collateral, the bankruptcy court found that the bank was adequately protected, granted the motion and permitted the borrower to use these rents. As a measure of adequate protection, the bankruptcy court granted the bank a replacement lien on all future rents generated during the Chapter 11 case. The bank then appealed from this order.
On appeal, the bank argued that this replacement lien on future, net rents already subject to the Bank’s lien could not as a matter of law provide adequate protection when there was no “equity” in the borrower’s property. The Bankruptcy Appellate Panel agreed with this argument and reversed the bankruptcy court’s decision, citing Stearns Bldg. v. WHBCF Real Estate (In re Stearns Bldg.), 165 F.3d 28, 1998 WL 661071 (6th Cir. Sept. 3, 1998), which the panel found to be directly on point.
The lesson to be learned by undersecured mortgage lenders from the Buttermilk Towne Center case is that they need to be prepared to establish at hearings on motions to use cash collateral in single asset real estate Chapter 11 cases that the value of the collateral is less than the debt, which could result in prohibiting the debtors from using net rents during their Chapter 11 cases to fund operations and pay professional fees. This proof must be presented in the form of appraisal testimony at the hearing on the debtor’s cash collateral motion. If the bankruptcy court denies the debtor’s request to use net rents, the reorganization case will effectively come to a halt and may only proceed with the consent of the holder of the rent assignment, who can then usually dictate the terms of any reorganization plan that is able to be confirmed in the case.