Courts Issuing Increasing Number of Distressed Real Estate Decisions

July 1, 2024

Although interest rates may have peaked, we can still expect a large volume of distressed real estate debtors to utilize bankruptcy over the next several years. We focus here on two recent decisions regarding such debtors, both of which involve pitting the rights of real estate lenders against the proceeds of collateral other than the real estate itself. The facts set forth below are derived from the respective opinions.

In the first case, In re Savva’s Restaurant, a mortgage lender sought to recover under the debtor’s insurance policy following a property fire. The borrower filed for bankruptcy and sold the property pursuant to Chapter 11, and the lender consented and agreed that its secured claim would be reduced by the net proceeds. The lender then asserted the deficiency amount against the insurance policy.

The insurer, however, had rescinded the policy, which listed the lender as an additional insured and loss payee, because of debtor misrepresentations in its application. The insurer argued the lender could not assert a claim because rescission of the primary insured’s policy also rescinds the policy for additional insureds. The bankruptcy court disagreed, reasoning that while an additional insured’s right to collect is derivative of the primary insured’s continuing right to coverage, this lender was also a loss payee—which has a contract with the insurer independent of the agreement between the insurer and the primary insured.

The insurer also argued that when a lender successfully conducts a foreclosure sale and the proceeds are insufficient to pay its debt, the lender must pursue a deficiency claim under state law. Failure to do so waives the claim. The lender in this case did not bring such an action, and—the insurer argued—the lender had therefore waived any deficiency claim. The court rejected this argument as well, holding that federal bankruptcy law preempts state court foreclosure requirements. Here, the court had approved a stipulation between the lender and the debtor that provided for the deficiency claim, so the lender retained an insurable interest subject to the policy.

In the second case, In re Rosario, the U.S. Bankruptcy Court for the District of Puerto Rico denied a debtor’s request to use rents from leases in a commercial building pledged as collateral for a real estate loan to maintain the premises. This was a single asset real estate case, and the debtor’s only source of income was monthly rent generated by the property. The debtor’s lender held valid liens against the property and rents generated at the property as additional security for the loan. The debtor proposed to use part of the monthly rental income to maintain the premises and remit the rest to the lender, arguing that using rents to maintain the premises would provide adequate protection of the lender’s security interest. They also offered to protect the lender’s interests by granting replacement liens in future rents generated by the property. The debtor asserted that without use of the rents, it would have to cease operations.

The lender, however, objected to the use of cash collateral, arguing the debtor had grossly mismanaged its business and that litigation had lasted over a decade, during which time the lender received no payments. The debtor was confusing the lender’s right to adequate protection in the rents with its right to adequate protection in the underlying premises. The lender also asserted that replacement liens in future rents could not provide adequate protection because the lender already had a lien in those rents.

The court noted that §552 of the Bankruptcy Code governs the post-petition extent of security interests granted prior to the bankruptcy filing: property acquired post-petition becomes property of the estate free of any pre-petition security interest. However, if a debtor and creditor enter into a pre-petition security agreement, as here, that creates a security interest in property and rents, the security interest extends to rents received after the case’s commencement. The court found the lender had established a pre-petition security agreement that included the property and rents and that, since the lender held a perfected security interest in post-petition rents, the debtor was required to provide adequate protection to the lender. It denied the debtor’s request to use cash collateral.

The court reasoned that the lender’s interest in the rents was separate and distinct from the lender’s property interest, and the debtor’s proposal failed to adequately protect the lender’s interests. When there is an assignment of rents, a debtor’s diversion of any portion of the rents diminishes the lender’s interest in the rent portion of the security interest. Finally, while the court noted that the debtor had a compelling need to use the rents, that need could not circumvent clear provisions of the Bankruptcy Code.

These decisions are reminders that even when the primary asset in a bankruptcy is the debtor’s real estate, debtors and lenders must also focus on the disposition of other supporting collateral and its effect on the outcome of the bankruptcy case and disposition of creditor claims. There have been hundreds of decisions over the years adjudicating the ability of a debtor to use cash collateral to operate properties in bankruptcy, but the court’s decision in Rosario is a reminder that approval of such use should not be taken for granted.

The original piece can be found at The Legal Intelligencer.

 

Joseph N. Argentina Jr. is counsel in Faegre Drinker Biddle & Reath’s Finance and Restructuring practice group in Philadelphia and Wilmington, where he represents debtors and creditors, including Fortune 500 companies, lenders and trade creditors, creditor committees, bankruptcy trustees, and third parties in bankruptcy and corporate restructuring, liquidation and collection matters.

Andrew C. Kassner is chair emeritus of Faegre Drinker Biddle & Reath and a partner in the firm’s Finance and Restructuring practice group in Philadelphia and Wilmington. He too represents debtors and creditors, including Fortune 500 companies, lenders and trade creditors, creditor committees, bankruptcy trustees, and third parties in bankruptcy and corporate restructuring, liquidation and collection matters.