1. New York Law School
Topic 4: Eligibility
Real Estate work outs, foreclosures
and bankruptcy
Prof. David R. Kuney
dkuney@sidley.com

2. Overview of the Bankruptcy System:
Friday: 9:00 am to 9:45 a.m.
2

3. Topics
• How does bankruptcy change the outcome and
bargaining leverage of the parties?
• Why do companies file for bankruptcy?
• Are you eligible under federal bankruptcy law.
• Are you eligible under state law.
• Are you eligible but subject to early dismissal.
• Does the appointment of a receiver stop you
from filing?

4. Manhattan Office Building.
• Downtown office building generates $10m/yr in
net operating income (“n.o.i.”)
• Net operating income is free cash flow after all
operating expenses (without deduction for debt
service).
• Value of building: investors want 6% return.
• Inverse of 6% is 1/6 = 17
• 17 times $10 million =$170 million.
• 6% of 170 million = $10 million.

5. Mortgage
• Prudent lender invests 80% of fair market
value.
• 80% of $170 million = $136 million= first
mortgage on the Building.
• 7% interest = $9,520,000
• N.o.i= $10,000,000 [not much room for loss]
• Note: this loan is non-amortizing.

6. Borrower
• Borrower is single purpose entity, typically an LLC
under Delaware law.
• Two “members” and one independent director.
• Operating agreement– power to remove
directors?
• Requires unanimous consent for “major
decisions.”
• Director’s duty of loyalty is governed by fiduciary
standards of a Delaware corporation.

7. Guarantor
• Guarantor is sponsor or other credit worthy
entity.
• Loan is non recourse generally.
• But there is a “bad boy” carve out which means
guaranty “springs” in case of certain conduct.
• Conduct includes the filing of a bankruptcy
petition.
• Is this proper or against public policy?

8. Distress arrives!
• Major tenant walks or files for bankruptcy.
• Net operating income falls to $9.0 million.
• Cap rates go up to 9% because of overall
economy.
• 1/9 = 11
• Value is now 11 times $9.0 m = $99 million.
• Loss of value is $71 million (was $170 million).
• Loan cannot be refinanced!
• Owners cannot service debt.

9. Notice of default and acceleration
• Notice of default.
• No cure.
• Acceleration.

10. Why do companies file
• Section 362– the automatic stay.
• Breathing room
• Debtor in possession- freedom to manage the
business.
• Section 1129: ability to propose “plan of
reorganization” which restructures debt (e.g.,
extends time; reduces principal).

11. Core elements of bankruptcy
• What makes bankruptcy unique from state law?
• Preemptive power based on Constitutional grant
of authority.
• Ease of entry.
• Retention of management power.
• Automatic stay.
• Majority rule; control over dissidents.
• Power to modify and extinguish secured and
unsecured contracts and liens.
11

12. Bankruptcy 101
• Fundamental lesson: the basic rule of bankruptcy
concerning secured lender’s rights:
– A secured lender’s right to possession of collateral or
enforcement of its loan documents is stayed and
suspended and replaced by the Code’s system of
adequate protection.
• See, United States v. Whiting Pools, Inc., 462 U.S. 198
(1983).
12

13. 13
Understanding the cram down risk.
Cram down creates four discrete risks:
– Reduction of principal.
– Reduction of interest rate.
– Extension of term.
– Elimination of covenants.
• “In cases like this involving secured interests. . . The court’s authority
to modify the number, timing or amount of the installment payments
is perfectly clear.”
– Till v. SCS Credit, 124 S.Ct. 1951 (2004).

14. Chapter 7 v. Chapter 11
Chapter 7:
- Debtor turns over property to trustee.
- Trustee liquidates estate.
- Generally no operation of the business.
- No control by management or equity holders.
Chapter 11:
- Property is held by the “estate.”
- Debtor in possession has full rights to manage and use the property.
- Debtor may get discharge if it continues in business and has a confirmed plan
of reorganization.
14

15. Involuntary bankruptcy
• Section 303(b)(1) --- an involuntary case may be commenced under chapter 11 by three or more entities,
each of which is the holder of a claim that is not contingent as to liability or the subject of a bona fide
dispute, if such claims in the aggregate total at least $14,425 more than the value of any lien on property
securing such claim.
• If there are fewer than 12 creditors, then one person may file an involuntary.
• TEST: Is the debtor “generally” paying such debtor’s debts as such debts become due unless such debts
are the subject of a bona fide dispute as to liability or amount.
• NOTE: even a dispute as to “amount” means debtor may prevail.
15

16. 16
The automatic stay
• The most basic debtor tool of bankruptcy is the automatic stay
• Section 362 of the Code provides that the commencement of the case
operates as a stay against all entities of:
– the commencement or continuation of any judicial proceeding against
the debtor. . .
– Any act to obtain possession of property of the estate. .
– the enforcement of a judgment
– any act to perfect a lien

17. 1177
Examples of stay violations
• Notices of default
• Acceleration
• Threats.
• Letters.
• Law suits.
• Actions against property of the estate, such as foreclosure
– See U.S. v. Whiting Pools, 462 U.S. 198 (1983); (secured lender in possession of
collateral stayed from conducting sale).
• Set off.

18. What the stay does not cover:
• Actions against third party guarantors:
– But consider section 105 injunctions.
– Consider effect of foreclosure on fee interest under
N.Y. law where guarantor must be named in order to
preserve claim.
• Draws on letter of credit.
– But consider issue if l/c acquired within preference
period.
• Decision not to continue to provide goods and services to
debtor (provided there is no existing contract in place
and no threat implied).
18

19. 19
Eligibility to be a debtor.
Section 109: “Only a person . . may be a debtor. . .”
One does not have to be good, smart, or broke to file
for bankruptcy: it is enough to be a “person.”
D. Kuney, ALI-ABA conference
"It is not bad faith to seek to gain an advantage from
declaring bankruptcy--why else would one declare it?"
– In re James Wilson Assocs., 965 F.2d 160 (7th Cir. 1992).

20. Eligibility issues for limited liability
companies
• In re Avalon Hotel Partners, 302 B.R. 377 (Bankr. D.
Or. 2003).
• Filing must be authorized by law and must be
consistent with the terms of the operating
agreement.
• If operating agreement requires unanimous consent
for “major decisions” then most courts will require
unanimous consent of members to authorize a filing.
20

21. LLC Operating agreement prohibits filing?
• Can operating agreement state that the limited liability company will not
file for bankruptcy?
– In re DB Capital Holdings, LLC, 463 B.R. 142 (10th Cir. B.A. P. Dec. 6, 2010).
• Paragraph (v) on page three of that May Amendment expressly bars
Debtor from filing a bankruptcy petition, as follows:
• The Company (v) to extent permitted under applicable Law, will not
institute proceedings to be adjudicated bankrupt or insolvent; or consent
to the institution of bankruptcy or insolvency proceedings against it; or file
a petition seeking, or consent to, reorganization or relief under any
applicable federal or state law relating to bankruptcy....13
•

22. Dismissal for bad faith filing
• The bankruptcy code does not have a “good faith” filing requirement in the text of the Code.
• The bankruptcy courts have added this as a judicial gloss if they find the filing was not for a
valid reorganization purpose. The standard varies.
• Second circuit: test requires both objective and subjective bad faith.
• “[A] bankruptcy petition will be dismissed if both objective futility of the reorganization
process and subjective bad faith in filing the petition are found.”
• “[A] bankruptcy petition should be dismissed for lack of good faith only sparingly and with
great caution.”
– In re General Growth Properties Inc., 409 B.R. 43,56 (Bankr. S.D. N.Y. 2009)
22

23. Bad faith factors:
Third Circuit
• Single asset case.
• Few unsecured creditors.
• No ongoing business.
• Petition filed on eve of foreclosure.
• Two party dispute.
• No cash or income.
• Improper pre petition income.
– In re Primestone Inv. Partners, L.P., 272 B.R. 554, 557 (D. Del. 2002), citing with
approval in In re JER/Jameson Mezz Borrower II, LLC, 461 B.R. 292 (Bankr. D.
Del. 2011).
• KEY: What is the key factor? How does court distinguish terminal
euphoria from valid reorganization purpose?
23

24. In re General Growth Properties
• Consider: did the court announce a different
standard?
• Does the objective/subjective test differ?
• What does the statutory language imply—why is
there no threshold statutory test of good faith?

25. General Growth Properties
Motion to Dismiss
• Filings were premature because SPE debtors were
solvent, producing sufficient cash flow, not in
default and were made only to protect parent.
• GGP filed in subjective bad faith because it
removed and replaced independent directors.
• SPE cases were objectively futile because of lack
of impaired assenting class.
25

26. Court ruling on motion to dismiss
• Motion to dismiss denied.
• No objective bad faith; appropriate to consider
interests of entire integrated enterprise. Ability to
restructure parental debt would be undermined
unless operating subsidiaries were protected.
“Corporate family” theory is sanctioned.
• No objective futility: lack of impaired class not
fatal early in case because lenders may vote for
plan despite assertions to the contrary.
26

27. General Growth on use of
independent directors
• Removal and replacement of directors proper; done in accordance with terms of
SPE’s organizational do documents.
• New board members carefully reviewed status of each SPE and voted based on
reasoned assessment.
“However, if Movants believed that an “independent” manager can serve on a
board solely for the purpose of voting “no” to a bankruptcy filing because of the
desires of a secured creditor, they were mistaken.”
In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009).
27

28. 28
The automatic stay prevents
enforcement of loans despite typical
CMBS structures:
Judge Gropper, on why the separateness covenants were not binding in
bankruptcy-
“Let me turn now to the remaining specific objections of certain lenders, and
particularly the objection that covenants and conditions in the loan
documents -- the pre petition loan documents -- should not be overridden by
virtue of the bankruptcy filing of their borrower or borrowers. It is absolutely
standard black letter law that covenants and conditions are inevitably
breached in bankruptcy. Even agreements designed to govern actions in
bankruptcy are generally unenforceable. . . .The most basic covenant is to pay
on time. The breach of this covenant in some bankruptcy cases is total.”

29. 29
Independent director –
In re Kingston Square Associates, (Bankr. S.D. N.Y. 1997)
• By laws required unanimous consent of board
of directors for bankruptcy filing.
• Independent director would have refused to
consent.
• Principals solicited friendly creditors and filed
involuntary petitions.
• Mortgage lenders moved to dismiss
involuntary on grounds that there was
“collusion” in the involuntary filing between
owners and friendly creditors.

30. 30
Ruling in Kingston Square:
involuntary bankruptcy permitted
“I conclude that although the debtors plainly
orchestrated the filing of the involuntary petitions,
they had reason to believe that reorganization was
possible and did not circumvent any court-ordered
or statutory restrictions on bankruptcy filings such
that, absent any evidence of objective futility of the
reorganization process, the cases ought not be
dismissed now.”

31. General Growth-bankruptcy
court questioned efficacy of independent
directors
• Removal and replacement of directors proper; done in accordance with
terms of SPE’s organizational do documents.
• New board members carefully reviewed status of each SPE and voted
based on reasoned assessment.
“However, if Movants believed that an “independent” manager can serve
on a board solely for the purpose of voting “no” to a bankruptcy filing
because of the desires of a secured creditor, they were mistaken.”
In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009).
31

32. 32
The friendly or “collusive” involuntary filed by friends and family:
In re Kingston Square:
Can insiders use an involuntary to get around
restrictions in the LLC operating agreement?
“I conclude that although the debtors plainly
orchestrated the filing of the involuntary petitions, they
had reason to believe that reorganization was possible
and did not circumvent any court-ordered or statutory
restrictions on bankruptcy filings such that, absent any
evidence of objective futility of the reorganization
process, the cases ought not be dismissed now.”