An important component of commercial real estate mortgage lending is the requirement that a borrower be, and remain, structured as a special purpose bankruptcy remote entity, which requires, among other things, that the borrower only own the property being mortgaged to the lender. Lenders have required borrowers to implement such structures in order to reduce the likelihood that their borrowers would be put into bankruptcy as a result of the bankruptcy of the borrower's affiliates.

Although being a special purpose bankruptcy remote entity will not prohibit a borrower itself from filing for bankruptcy, the requirement that a borrower own only a single asset (i.e., the mortgaged property) could result in the borrower being a single asset real estate debtor under bankruptcy law,[1] which may enable the lender to have an expedited process for having the automatic stay lifted. [2]

Furthermore, lenders protect themselves by including in their loan documents provisions to the effect that failure of the borrower to maintain its status as a special purposes bankruptcy remote entity or the filing of bankruptcy by the borrower will trigger an event of default of the loan and, typically, cause the guarantor of the loan to be liable to the lender for the full amount of the debt.

A recent decision by the Appellate Division, First Apartment—Sutton 58 Associations v. Philip Pilevsky, et al. (2019 NY Slip Op 00210, decided on Jan. 10, 2019)—however, engendered a good deal of alarm in the New York commercial real estate lending community as more than a few worried that the decision would deprive lenders of the protections afforded to them by having special purpose bankruptcy remote and single asset borrowers.

'Sutton 58' Background

The plaintiff lender in Sutton 58 is a lender that made secured loans to a developer constructing a tower consisting of primarily luxury residential apartments at Sutton Place and 58th Street in New York City. The loans consisted of senior and subordinate financing totaling an aggregate of $147.25 million. The senior loan was secured by a mortgage on the property while the subordinate loan was secured by a pledge of equity interests in the property owner. The borrower under each loan defaulted by not repaying its respective loan at maturity. As the lender commenced exercising its remedies, one of the defendants, the lender alleged, caused another of the defendants to loan $50,000 to the subordinate borrower, which loan was used to retain an attorney to prepare a bankruptcy petition for the subordinate borrower.

The subordinate borrower, in fact, filed for bankruptcy the day before foreclosure of the subordinate loan was to have occurred. The lender alleged that this loan caused the subordinate borrower to breach certain covenants set forth in the loan document including covenants not to file bankruptcy, not to incur non-permitted indebtedness and to remain a special purpose bankruptcy remote entity. The lender additionally alleged that two of the defendants caused one of the defendants to transfer three rental apartments in Lynbrook, New York, to the senior borrower and to pay senior borrower $150,000. In consideration of the apartments and such funds, the applicable defendant obtained a 49 percent equity interest in the senior borrower.

The lender further alleged that the transfer of the apartments to the senior borrower (i) was made specifically to cause the senior borrower, which also filed for bankruptcy, to no longer be a single asset real estate debtor which prevented the lender from seeking relief from the automatic stay on an expedited basis and (ii) caused the senior borrower to breach several contractual covenants, including not to file bankruptcy, not own any real property or assets other than the mortgaged property, not to transfer any indirect interest in senior borrower and to remain a special purpose bankruptcy remote entity.

The defendants in Sutton 58 were third parties unrelated to the senior and subordinate borrowers and such borrowers were not parties to the case. Accordingly, the lender sued the defendants for compensatory and punitive damages under the claim of tortious interference with a contractual relationship. At trial, the defendants moved for summary judgment based on the theory, among other things, that federal bankruptcy law preempted the state law tort claims. The trial court denied defendants motion for summary judgment. The appellate court, however, reversed and granted the motion because “[p]laintiff's claims, in which the sole damages plaintiff claims are losses resulting from the delay of a real estate project due to the bankruptcy filing of two nonparty entities, are preempted by federal law.”

No Threat, For Now

After the Sutton 58 decision was issued, many in the real estate lending community were concerned that the decision could pose a threat to the protections afforded by the special purpose nature of borrowers and whether the enforceability of guaranties triggered upon borrower bankruptcy filings and the preservation of borrowers' special purpose bankruptcy remoteness would be preempted by federal law.[3] Although arguments can be made, we believe that courts are not likely to take such a position. The issue of the enforceability of guaranties that subject guarantors to liability in the event of a borrower bankruptcy or the substantive consolidation of borrower's assets in connection with the bankruptcy filing of an affiliate was not before the court.

In fact, the borrowers and the guarantors of the subject loans were not parties to the litigation. The Sutton 58 decision, as brief as it was, solely related to the tort claim against the non-loan parties with no contractual relationship with the plaintiff; the court's holding did not suggest that the federal preemption doctrine would be similarly applied to contract claims against loan parties.

Therefore, lenders should not, at this time, fear that the Sutton 58 decision has rendered valueless the special purpose bankruptcy remote and recourse provisions of their loan documents, which provisions lenders should expect to be enforceable to the same extent as they were prior to the decision. However, the court did effectively sanction, as a matter of state law, the assistance of unrelated third parties in facilitating the bankruptcy of loan parties. We will have to wait and see if the bankruptcy courts will offer some kind of check to a borrower's ability to use such assistance.

Jeffrey B. Steiner and Dino Fazlibegu are partners at McDermott Will & Emery. John Bauco and Ian Sebastian Gall, associates at the firm, assisted in the preparation of this article.

ENDNOTES:

[1] “The term 'single asset real estate' means real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental thereto.” (11 U.S.C. §101 (51B))

[2] A secured creditor in a single asset could petition to have the bankruptcy court lift the automatic stay “unless, not later than the date that is 90 days after the entry of the order for relief (or such later date as the court may determine for cause by order entered within that 90-day period) or 30 days after the court determines that the debtor is [a single asset real estate debtor], whichever is later (A) the debtor has filed a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time; or (B) the debtor has commenced monthly payments that—(i) may, in the debtor's sole discretion…be made from rents or other income generated before, on, or after the date of the commencement of the case by or from the property to each creditor whose claim is secured by such real estate (other than a claim secured by a judgment lien or by an unmatured statutory lien); and (ii) are in an amount equal to interest at the then applicable nondefault contract rate of interest on the value of the creditor's interest in the real estate.” 11 U.S.C. §362(d)

[3] See “Latest Sutton 58 Court Decision Could 'Upend' Construction Financing,” by Mack Burke and Cathy Cunningham, Commercial Observer, Jan. 11, 2019.