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American Bankruptcy Institute

Strategies in Real Estate Workouts Including Valuation Issues, Section 111(b) Elections, Single Asset Real Estate Issues and Other Cutting Edge Issues

Hon. Gregg W. Zive United States Bankruptcy Court for the District of Nevada

Annette W. Jarvis Dorsey & Whitney LLP

Daniel F. Dooley MorrisAnderson & Associates, Ltd.

Jeffrey M. Reisner (Moderator) Irell & Manella LLP

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I. SINGLE-ASSET REAL ESTATE ISSUES1

A.

History of the single asset real estate case. 1. The Bankruptcy Reform Act of 1994 added provisions to create special treatment for debtors with assets constituting "single asset real estate." "Single asset real estate" ("SARE") was newly defined in 11 U.S.C. § 101(51B). If a case qualified as a single asset real estate case, provisions were added in 11 U.S.C. §362(d)(3) to provide leverage for lenders (who were usually the only significant creditors) to expedite the disposition of the case. These changes were made "to put additional responsibility on a single asset real estate debtor and prevent a perceived abuse of the bankruptcy process on the part of these ventures." In re 652 West 160th LLC, 330 B.R. 455, 460 (Bankr. S.D.N.Y. 2005) (citing S. Rep. No. 168, 103d Cong., 1st Sess. (1993)). 2. "Single asset real estate" was originally defined as limited to cases where the noncontingent, liquidated, secured debt was $4 million or less. Amendments to Section 101(51B) in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 eliminated the $4 million cap, making this definition apply to much larger real estate projects.

B.

How is a case designated as a single asset real estate case? 1. 11 U.S.C. § 101(51B) defines "single asset real estate" as "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

Materials on Single-Asset Real Estate Issues prepared by Annette W. Jarvis and Scott A. Cummings of Dorsey & Whitney LLP, 136 So. Main St, Suite 1000, Salt Lake City, Utah 84103.

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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." 2. The debtor may indicate on its voluntary petition that the nature of the business is "Single Asset Real Estate as defined in 11 U.S.C. § 101(51B)." If this indication is made, then the time periods of 11 U.S.C. § 362(d)(3) automatically apply. However, if the debtor does not indicate this on its voluntary petitions, a party in interest may file a motion asking the court for a determination of whether the debtor is a SARE entity. C. What determines whether a debtor is a single asset real estate entity? 1. The definition in 11 U.S.C. § 101(51B), as elaborated on by the Fifth Circuit in In re Scotia Pacific Co., 508 F.3d 214, 220 (5th Cir. 2007), sets forth a three-pronged test that must be met for a debtor to be determined to be a SARE entity: "(1) the debtor must have real property constituting a single property or project (other than residential property with fewer than 4 residential units), (2) which generates substantially all of the gross income of a debtor, and (3) on which no substantial business is conducted other than the business of operating the real property and activities incidental thereto." Id. a. Real Property Constituting a Single Property or Project A single parcel of real estate, other than residential property with fewer than four residential units, would qualify. The more complicated question is when multiple parcels of land can qualify as a "single property or project."

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Where multiple parcels of property are present, the movant must demonstrate that the parcels are "linked together in some fashion in a common plan or scheme involving their use." In re McGreals, 201 B.R. 736, 742 (Bankr. E.D. Pa. 1996); see also In re Webb Mtn, LLC, 2008 WL 656271 (Bankr. E.D. Tenn, March 6, 2008) (determining five parcels constitute SARE). b. Real Property Generating Substantially All of the Gross Income of Debtor If the debtor's primary source of income is the sale of real property or the business of operating the real property, this requirement is met. If the debtor also generates income from the operation of amenities or other operations related to the real property, courts generally look at the issue of whether the real property generates substantially all of the gross income by comparing the relative income generated by the real property with the income generated by the operation of amenities or other operations related to the real property to determine the meaning of "substantially all." See Kara Homes v. National City Bank (In re Kara Homes, Inc.), 363 B.R. 399, 404-05 (Bankr. D. N.J. 2007) (subsidiary companies holding and developing real estate constituted SARE entities because the business operations of each debtor subsidiary merely incidental to the selling of real estate); compare In re CGE Shattuck LLC, 1999 WL 33457789, at *7 (Bankr. D. N.H. 1999) (significant income generated from golf pro shop

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operations and other non-real property sources results indetermination that debtor not a SARE entity). c. Real Property on which No Substantial Business is Conducted Other than the Business of Operating the Real Property and Activities Incidental Thereto. In situations where the debtor is operating hotels, resorts, golf courses, restaurants or food and beverage outlets, or marinas with significant income, these independent businesses, if significant, are not considered to be the operation of activities incidental to the business of operating the real property. Thus, the debtor will not be a SARE entity. See, e.g., Centofante v. CBJ Dev., Inc. (In re CBJ Dev. Inc.), 202 B.R. 467, 473 (B.A.P. 9th Cir. 1996) (hotel gift shop, restaurant bar and bus tours); In re Whispering Pines Estate, Inc., 341 B.R. 134 (Bankr. D. N.H. 2006) (operating hotel); In re Prairie Hills Golf & Ski Club, 255 B.R. 228 (Bankr. D. Neb. 2000) (golf, ski areas, and liquor sales); In re Larry Goodwin Golf Inc., 219 B.R. 391 (Bankr. M.D. N.C. 1997) (golf course, pool, concessions); In re Kkemko Inc., 181 B.R. 47 (Bankr. S.D. Ohio 1995) (marina); In re Club Golf Ptnrs, LP, 2007 WL 1176010 (Bankr. E.D. Tex. 2007) (golf course); In re CGE Shattuck LLC, 1999 WL 33457789 (Bankr. D. N.H. 1999) (golf pro shop and golf related services)If the debtor's interest in these other businesses is only a passive ownership, the debtor may still qualify as a SARE entity. See Kara Homes v. National City Bank (In re Kara Homes, Inc.), 363 B.R. 399,

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405-406 (Bankr. D. N.J. 2007); see also In re Scotia Pacific Co., 508 F.3d 214, 221-23 (5th Cir. 2007) (using active versus passive criteria). D. What special constraints are placed on SARE entities? 1. 11 U.S.C. § 362(d)(3) provides: (3) with respect to a stay of an act against single asset real estate under subsection (a), by a creditor whose claim is secured by an interest in such real estate, 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 subject to this paragraph, whichever is later-- (A) (B) the debtor has filed a plan of reorganization that has a reasonable possibility of being confirmed within a reasonable time; or the debtor has commenced monthly payments that-- (i) may, in the debtor's sole discretion, notwithstanding section 363(c)(2), 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 un-matured statutory lien); and (ii) are in an amount equal to interest at the then applicable non default contract rate of interest on the value of the creditor's interest in the real estate. 2. In accordance with Section 362(d)(3), a creditor with a lien on the SARE may obtain relief from the stay unless, within the expedited time period, either monthly payments of interest at the non-default rate based on the value of the secured creditor's interest are commenced or a reorganization plan with a reasonable possibility of being confirmed is filed. "SARE debtors are carved out and subjected to stringent

requirements in § 362(d)(3) which expedite the time for SARE debtors to file a plan of reorganization or commence making monthly payments, failing which the automatic stay is promptly lifted." In re Scotia Pacific Co., 508 F.3d 214, 225 (5th Cir. 2007). Section 362(d)(3) was added to the Bankruptcy Code "to terminate the

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stay when the debtor neither proposes a viable plan nor makes payments to the secured party." 3 Collier on Bankruptcy ¶ 362.07[5] (15th ed. rev. 2005) (citing NationsBank, N.A. v. LDN Corp. (In re LDN Corp.), 191 B.R. 320, 326-27 (Bankr. E.D. Va. 1996). 3. The questions arises as to how 11 U.S.C. § 1121(b) (giving the debtor the exclusive right for 120 days to file a plan of reorganization) interplays with 11 U.S.C. § 362(d)(3) (requiring the filing of a plan of reorganization within 90 days in a SARE case). However, if the debtor has not marked the SARE designation when filing its petition, the period set under Section 362(d)(3) may actually extend beyond the 120 day period in Section 1121(b) because the time limitation for filing a plan of reorganization in Section 362(d)(3) will not commence until 30 days after the court determines the debtor is a SARE entity. Thus, if the designation is not made by the debtor upon filing, the secured creditor should move quickly to have the court make that determination to keep the debtor on this statutory fast track. Note that Section 362(d)(3) does allow for an extension of the 90-day period to a later date "as the court may determine for cause by order entered within that 90-day period. . . ." (emphasis added.) 4. Under Section 362(d)(3)(B)(i), the debtor can avoid the granting of relief from the stay if it commences monthly payments of interest at the non-default rate within the designated period. See In re Cambridge Woodbridge Apartments, LLC, 292 B.R. 832, 839-40 (Bankr. N.D. Ohio 2003). This requirement excepts out debts secured by a judgment lien or an un-matured statutory lien. See In re 652 West 160th LLC, 330 B.R. 455, 462 (Bankr. S.D.N.Y. 2005). If the debtor commences monthly interest

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payments under Section 362(d)(3) to avoid the granting of relief from the stay to the creditor with a lien on the SARE, those interest payments are measured under Section 362(d)(3)(B)(ii) by the "value of the creditor's interest in the real estate," which may be less than the full claim of the creditor. If there is disagreement on the value of the creditor's interest in the real property, evidence on this point will have to be presented to the court for a determination. Note that Section 362(d)(3)(B)(i) allows these payments to be made from rents or other income generated by or from the property to the secured creditors. 5. Under Section 362(d)(3)(A), the debtor can avoid the granting of relief from the stay if, within the designated period, it files a plan of reorganization that "has a reasonable possibility of being confirmed within a reasonable time. . . ." See In re 652 West 160th LLC, 330 B. R. 455 (Bankr. S.D.N.Y. 2005). The issue of "reasonable

possibility of being confirmed" is left to the courts to determine. However, as Section 1112(b) uses the term "reasonable likelihood that a plan will be confirmed", it seems clear that the standard in Section 362(d)(3)(A) is something less than the Section 1112(b) standard. E. Did 11 U.S.C. § 362(d)(3) Overrule Prior Caselaw on Bad Faith Filings for SARE entities? 1. Most courts consider a list of factors in determining whether a bankruptcy case has been filed in "bad faith" and therefore, should be dismissed. See e.g., C-TC 9th Ave. P'ship v. Norton Co. (In re C-TC 9th Ave. P'ship), 113 F.3d 1304, 1311 (2d Cir. 1997); Crown Village Farm, LLC v. Arl, L.L.C. (In re Crown Village Farm, LLC),

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415 B.R. 86, 92 (Bankr. D. Del. 2009). Generally, the first factor listed is whether the debtor has only one asset. See id. 2. In State Street Houses, Inc. v. New York State Urban Dev. Corp. (In re State Street Houses, Inc.), 356 F.3d 1345, 1347 (11th Cir. 2004), the Eleventh Circuit explicitly stated that the "bad faith" factors, including the consideration of whether the debtor is a single asset debtor, survived the 1994 amendments. The enactment of Section 362(d)(3) in 1994, however, means that single asset real estate cases are not "per se impermissible." In re LCGI Fairfield, LLC, Case No. 09-48466, 2010 WL 702815 at *5 (Bankr. N.D. Cal. 2010); see also In re Cambridge Woodbridge Apartments, L.L.C., 292 B.R. 832, 838 (Bankr. N.D. Ohio 2003).

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II. SECTION 1111(b) ELECTION2

A.

The History of Section 1111(b) Section 1111(b) of the Bankruptcy Code3 was enacted in response to the decision in In re

Pine Gate Associates, Ltd., 2 B.C.D. 1478, 1976 U.S. Dist. LEXIS 17366 (Bankr. N.D. Ga. 1976) ("Pine Gate").4 The Pine Gate case concerned a Georgia limited partnership, Pine Gate Associated, Ltd. ("PGA"), whose sole asset was the Pine Gate Apartments located in Gwinnett County, Georgia. The Pine Gate Apartments were constructed by PGA using the proceeds of loans from Great National Life Insurance Company ("National") and All American Life and Casualty Company ("American"). Both loans were nonrecourse loans5 and were secured by first priority mortgages on portions of the Pine Gate Apartments. In December 1975, PGA commenced a bankruptcy case under the Bankruptcy Act and subsequently proposed a plan of arrangement. Under the plan, National and American's claims would be included in Class I. The plan proposed to restructure the Class I debt such that PGA would repay the majority of the remaining principal but none of the accrued interest. Class I did not accept the plan. In order to confirm the plan of arrangement over Class I's objection, PGA proposed to pay National and American the appraised value of their collateral pursuant to

The presenters gratefully acknowledge the assistance provided by The 1111(b)(2) Election: A Primer, BANKR. DEV. J. (Vol. 13, Winter 1996), written by Steven R. Haydon, Steven R. Owens, Thomas J. Salerno and Craig D. Hansen, (the "1111(b) Article") in the preparation of these materials. The presenters specifically thank the authors for permitting the reproduction of portions of the 1111(b) Article in these materials and recommend that practioners interested in this topic read this article in full.

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All references to the Bankruptcy Code refer to 11 U.S.C. §§ 101 et seq. A more thorough discussion of the Pine Gate case can be found in the 1111(b) Article at pages 103 to

106.

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Section 461 of the Bankruptcy Act ­ thereby limiting the lenders' secured claims to the appraised value of their respective collateral, which was less than the outstanding indebtedness owed to each lender. Notwithstanding the lenders' argument that they were entitled to either full payment of the debt or the right to foreclose on the property with respect to the nonrecourse loans, the Bankruptcy Court held that the proposed treatment of the secured claims through a cash payment equal to the appraised value of the collateral was sufficient and approved the plan of arrangement. As a result of the decision reached in the Pine Gate case and similar cases, "a debtor could file bankruptcy proceedings during a period when real property values were depressed, propose to repay secured indebtedness only to the extent of the value of the collateral at that time, and preserve all potential future appreciation of that property solely for the benefit of the debtor." 1111(b) Article, p. 105. This outcome "imposed upon the secured creditor the entire risk of undervaluation of the collateral by the bankruptcy court" and "permitted the debtor or trustee to obtain for itself the exclusive benefit of any future appreciation in the value of the collateral." 1111(b) Article, p. 105-106. Section 1111(b) was, therefore, Congress's method for correcting the inequitable result which arose under the Pine Gate case. As Senator Wallop explained: The problems of the recent Pine Gate case which has given lenders pause in making real estate loans will be solved by the addition of specific guidelines as to the manner in which real estate loans can be dealt with in reorganization cases and when and how lenders will be able to foreclose properties that are part of the debtor's estate.

A creditor with a nonrecourse loan may seek repayment of its debt only from its collateral and cannot seek payment from the debtor personally. A creditor with a recourse loan, by contrast, may seek repayment of its debt from both the collateral and the debtor's other assets. See 1111(b) Article, footnotes 6-7.

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Hearings on S. 2266 and H.R. 8200 before the Subcomm. on Improvements in Judicial Machinery of the Senate, Comm. on the Judiciary, 95th Congr., 720-21, 855 (1977). B. The Elements of Section 1111(b) Section 1111(b) of the Bankruptcy Code provides two options for undersecured creditors,6 as follows: Essentially, [Section 1111(b)] of the Code provides two options for undersecured creditors when faced with a debtor's cramdown plan of reorganization. Under § 506(a), the claim of an undersecured creditor is automatically bifurcated upon the filing of a bankruptcy petition into a secured claim based upon the current value of its collateral, and an unsecured claim for the balance of the debtor on the petition date. Pursuant to § 1111(b), an undersecured creditor may elect to retain the secured and unsecured claims that resulted from the bifurcation under § 506(a), or, pursuant to § 1111(b)(2), the creditor may elect to forego its unsecured claim and have the entire amount of its claim treated as fully secured by the collateral. This statement, however, is deceptively simple. To begin to understand this section's effect and ramifications, one must take a close look at the elements of § 1111(b). 1111(b) Article, p. 107 (internal citations omitted). In effect, Section 1111(b) permits nonrecourse creditors to be treated as recourse creditors by changing a nonrecourse obligation into a recourse obligation for purposes of a plan of reorganization. This change results in the bifurcation of the claim, just as in the case of an undersecured recourse creditor, into (1) a secured claim for the value of the creditor's collateral and (2) an unsecured claim for the remainder of the debt.7 After the claims of a nonrecourse creditor are bifurcated, the undersecured creditor must then make the election set forth in Section 1111(b)(2). If the creditor elects to retain both its

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An unsecured creditor is a creditor holding a partially secured claim.

The bifurcation of claims is subject to two limitations. First, pursuant to Section 1111(b)(1)(A)(i), no conversion occurs if the creditor makes the election available under Section 1111(b)(2) because the entire amount of the creditor's claim is treated as fully secured by its collateral. Second, pursuant to Section 1111(b)(1)(A)(ii), no

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secured and unsecured claim, the creditor may vote both its secured and unsecured claims and is entitled to receive distributions on account of both claims under a plan of reorganization. If the creditor elects to forego its recourse unsecured claim, the claim will be treated as fully secured. However, there are two situations in which an undersecured creditor is not permitted to make the Section 1111(b)(2) election. First, pursuant to Section 1111(b)(1)(B)(i), a creditor may not forego its unsecured claim if the creditor's interest in the collateral is of inconsequential value. "This restriction typically affects junior lienholders whose claims are either completely or virtually unsecured as a result of either the collateral's decrease in value, or the accumulation of senior liens (such as when a debtor fails to pay its property taxes or the interest on a senior lien)." 1111(b) Article, p. 117.8 Second, pursuant to Section 1111(b)(1)(B)(ii), a creditor may not make the Section 1111(b)(2) election if the loan was originally recourse and the collateral is to be sold under Section 363 or pursuant to a plan because, in that case, the undersecured creditor will have the opportunity to credit bid at the sale and therefore receives the benefit of its original bargain. C. The Intersection of Sections 1111(b) and 1129(b) The importance of the Section 1111(b) election becomes obvious in the context of a cramdown under Section 1129(b) of the Bankruptcy Code. As more comprehensively discussed in the 1111(b) Article: To be confirmed, a plan must satisfy one of the three requirements in a cramdown situation, regardless of whether the creditor selects the Election Option. If the creditor does not choose the Election Option, then the allowed amount of the creditor's secured claim is the value of the collateral. In that event, the lien secures an amount equal to the value of the collateral.

conversion occurs if the loan is nonrecourse and the collateral is to be sold under Section 363 or pursuant to a plan because the undersecured creditor will have the opportunity to credit bid at the sale.

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119.

For a discussion of the meaning of "inconsequential value" please see the 1111(b) Article at pages 117 to

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If, however, the creditor does choose the Election Option, then the creditor's secured claim is the amount of its debt and the lien secures that amount. Because of this result, in general, under the cramdown provisions of § 1129(b) the undersecured creditor who exercises the Election Option may be crammed down only if it receives deferred cash payments which are first, equal to the full amount of its allowed claim (which, pursuant to § 1111(b)(2), is now the full amount of the debt) and second, equal, on a present value basis, to the value of the collateral. One issue, however, has arisen with respect to how the creditor's allowed claim may be satisfied. That issue is whether the principal and interest payments made to the creditor may satisfy the entire amount of the allowed claim or whether the electing creditor must receive principal payments totaling the entire amount of the allowed claim before the claim is satisfied. In other words, can the interest a debtor pays on its deferred cash payments (for the purpose of providing present value to the creditor) also serve a second purpose by satisfying the total claim of the creditor? Some authorities indicate that the electing creditor must receive principal payments equaling the total amount of the creditor's claim and that the interest payments cannot serve double duty, and thereby also satisfy the principal portion of that claim. This interpretation finds some support in the legislative history which, though somewhat unclear, refers to "payments. . .of a principal face amount." Other authorities, however, indicate that interest, in addition to payments on principal, can be used to satisfy the principal portion of a claim. The view that interest payments can be applied to principal is the majority rule, reflecting the commonly accepted approach to the 1111(b)(2) Election Option. 1111(b) Article, p. 124-126 (original citations omitted; emphasis in original).9 The intersection of Sections 1111(b) and 1129(b) of the Bankruptcy Code continues to be a complex area of the Bankruptcy Code and was recently addressed by the Seventh Circuit Court of Appeals in Airadigm Communications, Inc. v. FCC (In re Airadigm Communications, Inc.), 519 F.3d 640 (7th Cir. 2008) ("Airadigm").

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Airadigm was discussed in detail in Ronald

For a further discussion of Section 1129(b) of the Bankruptcy Code, please see First Federal Bank Of California v. Weinstein (In re Weinstein), 227 B.R. 284 (9th Cir. BAP 1998) and General Electric Credit Equities,

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Barliant's article Bad Medicine: Cram Down, § 1111(b)(2) Elections and Federal Regulations, NORTON BANKR. LAW ADVISOR (July 2008) (the "Barliant Article"). Barliant Article, in Airadigm: the court clarified the requirements that a plan of reorganization must meet to be confirmed, or crammed down, over a secured creditor's rejection when that creditor has elected to have its entire claim be treated as a nonrecourse secured claim. The result, which some may find surprising, is to permit a Chapter 11 plan to eliminate a secured creditor's due-on-sale clause and effectively cash out the lien at the present market value despite the § 1111(b) election. For a more thorough discussion of Airadigm and its impact, practioners are encouraged to read the Barliant Article in full. As explained in the

Inc. v. Brice Road Developments, L.L.C. (In re Brice Road Developments, L.L.C.), 392 B.R. 274 (6th Cir. BAP 2008).

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