November 06, 2005
In an environment marked by rapidly escalating real estate values, readily available and cheap financing and quick sales, it is difficult to imagine, let alone to plan for, a real estate collapse. Yet, that is precisely the concern of some industry experts. Even Alan Greenspan has commented on what he considers an overheated real estate market and the potential for a bursting of the bubble. Although the precise timing and extent are unknown, a correction in the real estate market is inevitable.
When it occurs, there are several things that will be associated with or a consequence of a real estate "correction". The current run up in values has been facilitated by a prolonged period of cheap money. As interest rates trend up, the cost of ownership will increase and this will impact both owners and prospective purchasers. Particularly for owners and investors who have paid top dollar in an inflated market and financed with minimal, if any, equity, it will not take much of a shift to trigger payment defaults and resulting conflict with lenders. Foreclosures and other enforcement actions will spike and owners, faced with the loss of their investment, will turn to bankruptcy for the protections that it affords, however temporary they may be.
Not only will this “new world” likely increase the sheer number of bankruptcies, it will have a bearing on the strategies utilized and leverage in bankruptcy cases. The following paragraphs focus on some of the pre-reorganization plan implications of a real estate slowdown.
Pace of Real Estate Reorganizations
Courts already tend to move real estate cases at a faster pace than other cases. This is particularly true for cases that involve raw land or partially completed projects. It is not unusual in real estate cases for bankruptcy judges early on to establish a tight schedule for submission and consideration of reorganization plans. Indeed, debtors in "single asset real estate" cases [defined in Bankruptcy Code (“Code”) § 101(51B) generally to involve small projects with debt of no more than $4 million], run the risk of losing bankruptcy protection if, within 90 days, they have not either (1) filed a reasonably viable reorganization plan or (2) commenced payments to the secured creditor based on current interest rates and the value of the real estate collateral [Code § 362(d)(3)]. The recent amendment of the Code enacted in the Bankruptcy Abuse Prevention and Consumer Protection Act goes so far as to require bankruptcy courts to conduct status conferences to assure prompt and economical resolution of bankruptcy cases. When these statutory provisions are taken together, it is clear that real estate debtors have been and will continue to be under pressure to perform promptly or lose the potential benefit of bankruptcy. In a market in which interest rates are increasing and values declining, that pressure undoubtedly will be intensified as judges require debtors, in effect, to "put up or shut up".
Automatic Stay Litigation
Bankruptcy does provide protection for the financially distressed debtor. Code § 362 automatically stays foreclosures by secured creditors. That "automatic stay" continues until the conclusion of a case unless, on motion, a bankruptcy court terminates it either (1) for cause, including lack of “adequate protection”, (2) because there is no equity in the collateral and it is not necessary for a reorganization or (3) as to single asset real estate cases only, failure within 90 days of a bankruptcy filing to satisfy one of the statutory requirements described in the preceding paragraph.
Code § 363(c)(2) prohibits use of cash collateral without either the consent of the secured creditor or court approval. If a real estate secured creditor’s lien reaches to rents issues and profits generated by the applicable real estate collateral, barring an agreement the debtor cannot use the cash without court authorization which normally requires an offer of adequate protection. Under Code § 363(e), a Bankruptcy Court, on motion, can require adequate protection as a condition to continued use of the real estate collateral itself. Under Code § 361, adequate protection may be provided through periodic cash payments measured to fully compensate for any anticipated decrease in the value of the secured creditor’s interest in the collateral. Adequate protection payments compensate for lost use of collateral and, as such, take into account current market interest rates. As those rates escalate, the cost to a debtor of providing adequate protection will mount.
The erosion or disappearance of an equity cushion in a declining real estate market will have an equally telling impact on stay relief litigation. Lack of equity is a separate basis for stay relief under Code § 362. It must, however, be coupled with a showing that a property is not necessary for a reorganization. In the past, debtors resisting stay relief under section 362(d)(2) have argued that, by definition, there cannot be a reorganization in a real estate case if the real estate collateral is foreclosed. However, courts have interpreted the phrase "necessary for reorganization" to require consideration of whether there is reasonable prospect for a viable reorganization. See, e.g., Matter of Sutton, 904 F.2d 327 (5th Cir. 1990). As property values drop, judges will decline to accept unsubstantiated promises and will require tangible proof of prospect of a timely reorganization.
Recovery of Interest and Costs
Declining values also potentially impact a real estate secured creditor's recovery of post-bankruptcy interest and costs. Code § 506(b) restricts allowance and recovery of post-filing interest and reasonable fees if a claim is secured by property the value of which is less than the amount of the debt. Phrased otherwise, if there is no equity cushion there is no right to interest or costs even if they are provided for by contract. In a real estate market in which values are declining, this will lead to careful evaluation of strategy. Recognizing that the secured creditor may not be compensated for delays in retrieving its collateral and may not be reimbursed for the fees incurred in seeking relief from the automatic stay, opposing a debtor's reorganization plan or otherwise contesting a debtor's reorganization. This risk may incent some secured creditors to reach an early agreement with a debtor rather than deal with the delay and cost incident to reorganization.