The continued misuse of bankruptcy by SARE debtors

October 2014 | EXPERT BRIEFING | BANKRUPTCY & RESTRUCTURING

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Bankruptcy is intended to provide debtors with the opportunity of a fresh start by modifying their debt obligations. As enacted, the Chapter 11 process was designed for entities needing breathing space and a chance to work out various issues and concerns with their creditor constituencies. This process envisions multiple creditors and a business that is comprised of a true ongoing economic concern. Notwithstanding this backdrop, in the past owners of single real estate properties that are in the business of simply operating that real estate have utilised a Chapter 11 filing as a means to stave off foreclosure when all other state court delay tactics have failed. Cases filed by these entities are colloquially known as ‘SARE’ cases, Single Asset Real Estate cases. While Congress attempted to minimise these filings and limit the adverse impact on lenders by enacting the 2005 amendments to the Bankruptcy Code under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 the limitations contained therein have not stopped the filings. At best these provisions have signalled to some that these kinds of filings constitute acceptable Chapter 11 cases; at worst, these provisions prolong the legal battle and increase legal fees in cases that should have already met their end in the state court foreclosure process. At present, SARE cases continue to be filed with each debtor hoping for a ‘miracle’ in the bankruptcy court.

The goal of the SARE debtor is a loan modification through the bankruptcy process. However, the debtor cannot truly expect that during this time it will be able to successfully achieve this result. It is not as if there are other lenders ready to step in and lend against the property; if that were the case, this could have been effectuated outside of bankruptcy during the lengthy foreclosure process. Rather, with very few exceptions, the property in question is usually worth less than the amount of the debt. The debtor has filed with the unrealistic hope that in the bankruptcy they will simply force a cram down of the lender’s claims through the bankruptcy process. This article is not intended to, nor will it, delve into all the intricacies of the confirmation process and how this gambit almost always fails. Suffice it to say that in every case handled by this author with these kind of SARE debtors, the debtors have not been successful in forcing confirmation of such a plan (or any plan at all). Their only limited success has been in delaying the inevitable foreclosure, often at a cost of tremendous legal fees on both sides.

One egregious example can be found in a series of single asset bankruptcy filings in the Bankruptcy Court of the Southern District of New York all intended to ‘save’ an operating business. In an effort to stall the pending foreclosure processes (there were two separate cases as there were two adjacent parcels of land), the owner managed to file over the course of four years, no less than five bankruptcy filings in an effort to stop the process and to continue to skim money from the business. The successive filings were by different entities (the owner of the adjacent parking lot, the landlord, the operating tenant, the principal and then, again, the operating tenant) and each in turn caused significant delay in the ability of the various lenders to recover their respective properties. Moreover, some of the delay was created by the intentional failure of the principal to identify the prior affiliates’ filings causing, in some cases, the new debtors to be assigned to different judges. Quick and proactive thinking by counsel resulted in the transferring of all cases as they filed to the same judge but additional delay was encountered in facilitating this process. After relief from the stay was granted in each case to allow the foreclosure processes to continue, the case was dismissed as a bad faith filing. See, e.g., In re Loco Realty Corp., 2009 Bankr. LEXIS 1724 at * 10 (“‘The critical test of a debtor’s bad faith remains whether on the filing date there was no reasonable likelihood that the debtor intended to reorganize and whether there is no reasonable possibility that the debtor will emerge from bankruptcy’” quoting In re 68 West 127 Street, LLC, 285 B.R. 838, 846 (Bankr. S.D.N.Y. 2002)); see also United Savings Ass’n v. Timbers of Inwood Forest, 484 U.S. 365, 375-76 (1988) (noting that the Bankruptcy Code does not merely require that certain property be necessary or needed for an effective reorganisation, but that the “property is essential for an effective reorganization that is in prospect”). Thus any delay was short lived and without any meaningful result.

The critical mistake that the principal made in approaching the process in traunches as opposed to a singular filing jointly administered, was that if all of the entities had filed at the same time, then there might have been a real likelihood that the fees and expenses wasted on the delay tactics could have been used to perhaps effectuate a real consolidated plan. So too, the debtor would have also been able to show the existence of a multitude of assets and debts that needed time to reorganise not just a two party dispute. In the end, as a final desperate measure to avoid eviction in landlord/tenant court, the debtor ‘sold’ the operating business to a third party and then, for reasons unbeknownst to anyone (a tremendous tactical mistake), filed for Chapter 7 for the transferring entity. Given the delays that would have ensued in landlord/tenant court, this decision only expedited relief for the creditor: by bringing this entity and its ‘assets’ back before the same bankruptcy judge who was quite familiar with the history of the case, the debtor allowed the lender to identify the sale for the sham it was, get hard and fast relief from the Bankruptcy Judge against all parties including the alleged purchaser and actually carry out an eviction using the federal marshals on an expedited basis within the bankruptcy forum. While time was lost as a result of some of the delays, the ability to finally achieve closure was rewarding to say the least.

While filing a case, a litigation tactic is not necessarily prohibited if reorganisation is possible, see Fraternal Composite Servs. v. Karczewski, 315 B.R. 253, 256 (N.D.N.Y. 2005); In re Schur Mgmt. Co., 323 B.R. 123, 130 (Bankr. S.D.N.Y. 2005), courts have no tolerance for debtors who file for the stay but do little else. In re 652 W. 160th LLC, 330 B.R. 455 (Bankr. S.D.N.Y. 2005) (finding the case should be dismissed where after the petition was filed, the debtor then proceeded to administer its case in a manner in which statutory deadlines were missed, false creditors were created and paid and false operating reports were filed). Thankfully, many bankruptcy judges will recognise early on these cases which truly do not belong and will help expedite a quick end. Unfortunately, there is still time delay and tremendous fees wasted even in these cases.

Bankruptcy can be a powerful tool that effectively brings relief to certain debtors when it is properly used. Unfortunately, the system remains vulnerable to misuse and can produce numerous and costly delays to the entire process even if the final goal is not viable.

These inappropriate and ultimately futile bankruptcy filings continue to occur despite the previous attempts by Congress. The integrity of the system is damaged by the continued advent of these filings, by the burgeoning costs to lenders, the constant burden on the courts, and the adverse impact on any ancillary creditors caught in the process. It might be prudent for Congress to consider that these kinds of cases simply do not belong in bankruptcy and find a way to close the door with some level of finality here as the existing rules still have not staunched the flow of cases.

Leslie A. Berkoff is a partner and chair of the Bankruptcy department at Moritt Hock & Hamroff LLP. She can be contacted on +1 (516) 880 7243 or by email: lberkoff@moritthock.com.

Leslie A. Berkoff

Moritt Hock & Hamroff LLP