There is no question that confirming a real estate case on cramdown is difficult. Typically, there is a secured creditor who not only has a large secured claim, but who will also have a controlling vote in the unsecured class. Since cramdown by definition means that no agreement on plan treatment has been reached, the plan proponent has to structure the plan so as to obtain confirmation over a plan rejection and over an inevitable objection – a difficult task under the best of circumstances. The plan proponent must then present sufficient evidence to support the cramdown confirmation requirements and, even if that is satisfied, the ultimate fate of the plan will be up to the court and the flexible “fair and equitable” standard. Indeed, something seemingly as small the court finding that even a slightly higher interest rate should apply may doom the plan, which itself may not be known until the very end of the confirmation process and after substantial economic and other resources have been expended.
The problem is complicated by today’s macro-economic situation. Without question, real estate businesses have suffered and are facing a multitude of problems. Asset values are depressed, which makes selling the asset unlikely to pay the creditor off in full. Investors have lost their investment. The creditor will not only have a large secured claim but, because of depressed asset values, is likely to also have a large unsecured claim. Lenders are not lending, even if asset values justify a loan. Refinancing is therefore also an unlikely option. Lenders are also facing their own issues, and loans such as CMBS loans make it difficult, if not impossible, for the special servicer to agree to a consensual plan. Even a traditional lender may be under pressure to liquidate a loan or a portfolio, and therefore might be more in favor of a liquidation at a steep loss over a higher return over time. Other lenders, on the other hand, may desire to take control or possession of the asset, including various hard money lenders, ‘loan to own’ lenders, or lenders who are in reality investors who acquired the debt at discount. After all, many real estate businesses are not all that complicated, and capable receivers and others exist to assist the lender with taking control of the asset, unlike factories, businesses dependent on good will, or other businesses which a lender may prefer not to directly or indirectly own and operate. The presence of third parties, with their own interests and agendas, further adds to the complication, primarily guarantors, usually insiders, who are looking for advantages that may not be compatible with the best interests of the estate. And then there are the courts, some of which do not believe that single asset real estate cases should be subject to reorganization, even though nothing in the Bankruptcy Code prevents that result and, in fact, the Bankruptcy Code specifically contemplates single asset real estate reorganization. This and other factors have led many practitioners to believe that real estate cases, especially single asset cases, have no real prospect of success and are ‘dog’ cases. And other debtors, desperate to settle, have agreed to patently unfeasible plan terms, only to buy time and inevitably fail, which has perhaps poisoned the view of professionals, lenders, and courts all the more.
Complicating the situation are two simultaneous problems. First, there have not been many successful cramdown real estate cases for many years, with the late 1980s and early 1990s being the last time that a significant number of such cases were filed. The present economic issues and change in lending structures were not prevalent then. Simply put, many professionals, practitioners, and even courts do not have significant experience with such cases, all the more so because few of them reach the level of a cramdown confirmation fight. Second, many of the cramdown standards are subject to discretion and uncertainty, including perhaps the most important cramdown element, consisting of the appropriate rate of interest to be paid under the plan. Thus the absence of experience combined with a lack of formulistic and clear case law leave many fundamental questions uncertain. There is substantial risk, more for the debtor than the lender, and it is not easy to find plan funders who, having already lost their investment, are willing to put in more money for so risky a proposition.
Yet it is precisely at this time that the fundamental purposes of the Bankruptcy Code have all the more meaning, for two aspects of the Bankruptcy Code and its predecessors are frequently forgotten. The Bankruptcy Code is, in part, the result of several prior real estate busts. Congress – wisely or unwisely – has sought to mitigate the extreme consequences of waves of liquidation which, by the very nature of liquidation and fire-side sales, leads to further asset depreciation and threatens a domino effect of asset crashes, loss of value, and potential bank failures. Even a cursory look at the 1930s shows why. On a macro level, therefore, the Bankruptcy Code seeks to minimize the social, economic, banking, and political costs of a cascade of foreclosures, liquidations, and loss of value. The second aspect is the undeniably paternalistic potential of the Bankruptcy Code; namely, a judge telling a lender that it must accept certain treatment that it does not want because such treatment is in the best interests of all, including the lender. Certainly, this potential is controversial. But, in today’s lending environment where some lenders are under pressure that leads to decisions that might not otherwise be made, or where there are complicated inter-creditor relationships which lead to gridlock or to a singular, predetermined course irrespective of economic interests, there are lenders who need to be told what to do for their own good. Indeed, there are lenders who want to be crammed down, even if they do not admit it.
This Article is intended to be used by an experienced Chapter 11 practitioner. Accordingly, this Article does not address the various basics of Chapter 11 or the confirmation process. The authors of this Article, having participated in multiple real estate cases for the lender and debtor, including by obtaining confirmation on cramdown for real estate debtors, attempt to identify some of the more difficult and uncertain aspects of real estate cramdown cases, and to address how these issues are handled by the case law and their practical experience. There is no question that a real estate cramdown case involves substantial risk and costs. There is no one-size-fits-all solution. Many of the issues themselves are factual, and what may be appropriate for one case may be utterly inappropriate for, or incompatible with, a different case even if the underlying asset is similar. But, with the waive of real estate cases being filed and anticipated to be filed – as hundreds of billions of dollars of real estate loans come due – and considering some of the macro-economic issues discussed above, the importance of understanding these cases becomes all the more material.
Even before the legal analysis begins, there are some practical considerations to consider. First, who is going to fund the case and ultimately the plan? Is there a committed equity group which is prepared to put in more money, since relying solely on what is inevitably cash collateral may not work. Second, is there a viable business? Perhaps the business has suffered from asset depreciations and economic factors outside of its control, and is worth saving. Or, is the business dead and not worth saving. Third, can management be trusted? Has management or equity mismanaged the business or the assets, or have they pocketed large benefits at the expense of their creditors. Fourth, what is the exist strategy? If the business cannot even cash flow on an operational basis, then what point is there? Is there nothing but naked hope that the future situation will improve, and is it only a matter of time before the business will die? Or, with some sweat and patience, will the situation indeed improve.
These are but some of the practical considerations that should be considered prior to going through the costs, burdens, and delays of a cramdown fight. If any of these questions are answered unfavorably, then it may be impossible to obtain confirmation on cramdown and the case may indeed be a ‘dog’ case. But, if these questions are answered favorably, then the debtor, through careful plan formulation and evidentiary presentation, may be able to obtain cramdown confirmation despite all of the obstacles that are present. Yes, real estate cases are confirmed on cramdown. There is light at the end of the tunnel, for the right case and the right debtor at least.
A. GOOD FAITH
It is elemental that a court can confirm a Chapter 11 plan only if the court finds that the “plan has been proposed in good faith.” 11 U.S.C. § 1129(a)(3). Of interest, this is a requirement of confirmation even if all classes under the plan have affirmatively accepted the plan. Secured creditors frequently resort to this provision by arguing that a plan that seeks to preserve equity and cram down a secured creditor, where the secured creditor has liens in substantially all assets, is not proposed in good faith but is instead proposed to benefit equity or to benefit a guarantor or other third party. In effect, the creditor argues that the plan is an end-run around the prepetition bargain or is the equivalent of a two-party dispute within the Fifth Circuit’s Little Creek precedent.
However, the good faith requirement is a term of art that had been given meaning by the Fifth Circuit. As the Fifth Circuit has defined the standard:
The requirement of good faith must be viewed in light of the totality of circumstances surrounding establishment of a Chapter 11 plan, keeping in mind the purpose of the Bankruptcy Code to give debtors a reasonable opportunity to make a fresh start. Where the plan is proposed with the legitimate and honest purpose to reorganize and has a reasonable hope of success, the good faith requirement of section 1129(a)(3) is satisfied.
B.M. Brite v. Sun Country Dev. Inc. (In the Matter of Sun Country Dev. Inc.), 764 F.2d 406, 408 (5th Cir. 1985) (emphasis added). Accord In re Elm Creek Joint Venture, 93 B.R. 105, 109 (Bankr. W.D. Tex. 1988). Moreover, the question of good faith is a question of fact, on which the bankruptcy court will have significant discretion.
The good faith requirement recognizes that the Bankruptcy Code specifically provides for the potential of a cramdown, meaning that the Bankruptcy Code specifically permits the confirmation of a plan even though a creditor, including perhaps the largest and most important creditor, does not accept the plan. If the Bankruptcy Code specifically provides for this potential, then resorting to cramdown cannot be bad faith in and of itself. This has been recognized by the Fifth Circuit: “Congress made the cram down available to debtors; use of it to carry out a reorganization cannot be bad faith.” In the Matter of Sun Country Dev. Inc., 764 F.2d at 408. And, as Judge Hale phrased it, “[a] plan need not be one that the creditors would themselves design to satisfy the requirement of good faith.” In re Barnes, 309 B.R. 888, 893 (Bankr. N.D. Tex. 2004).