The Importance of Underwriting Loans When Bankruptcy Restrictions On Their Own Cannot Save the Day: Sutton 58 Associates LLC v. Phillip Pivelsky, et al. | Patterson Belknap Webb & Tyler LLP
In sophisticated mortgage finance transactions, the more cautious lenders attempt to deter borrowers from filing for bankruptcy before loans are fully repaid by indicating in loan documents that such a deposit constitutes an event of default. Many lenders will insist that their borrowers stay “bankrupt” in the form of a so-called “single-asset real estate” entity for the life of the loan.
The recent case of New York, Sutton 58 Associates LLC v. Phillip pevelsky, et al. (“Sutton“), provides two important and corresponding lessons: (1) public policy considerations allow borrowers to strategically file for bankruptcy despite restrictions to the contrary in their loan documents, and (2) lenders must thoroughly and diligently guarantee the borrower’s principals and individual guarantors (or principal guarantors) to ensure maximum recovery in the event of strategic bankruptcy.
In Sutton, a real estate developer faced UCC foreclosure of a large Manhattan condominium project when the developer / borrower failed to repay a mezzanine loan when due. A leading real estate investor tried to help the developer by using the US bankruptcy code to delay foreclosure. Under bankruptcy law, if a borrower is not a “single asset” real estate company and files for bankruptcy, filing for bankruptcy can delay a foreclosure by several months. But a “single asset real estate” borrower will generally find that the Chapter 11 bankruptcy process leads to a liquidation, not a reorganization.
The promoter’s loan documents, like almost all similar loan documents, required the borrower to remain a “single-asset real estate” company for the duration of the loan. This was problematic because it meant that the promoter could not, without a little extra creativity, resort to bankruptcy to avoid their financial obligations to the lender under the loan documents.
To solve the problem, the investor transferred three apartments and money to the borrower in exchange for an ownership share in the project. So when the borrower filed for bankruptcy to end the foreclosure, the investor owned four assets (the original collateral plus three apartments) instead of one. Because the bankruptcy case took several months, the foreclosure was delayed by almost a year.
In addition, the bankruptcy filing violated the borrower’s loan documents and made the promoter’s principal, as guarantor, liable for the full loan amount. A court enforced the collateral, granting the lender judgment against the guarantor.
Not satisfied with this result alone, in a separate action, the lender directly sued the borrower’s principal for tortious breach of contract on the grounds that the borrower’s principal intentionally and improperly coerced the borrower into breaching the debtor’s documents. loan at the expense of the lender. The borrower sought summary judgment, arguing that the lender’s claims were preempted by federal bankruptcy law. The trial court dismissed the petition because the lender persuaded the court that if the investor won it would likely, in the court’s words, “have overturned the way contracts are drafted here in New York and all development industry “. The borrower appealed and the court of appeal dismissed the dispute. The lender appealed this decision to the New York Court of Appeals, which recently ruled in a narrow 4-3 opinion that: (1) the lender’s claims for tort interference were not preempted by law federal bankruptcy, (2) summary judgment was not appropriate in this case, and (3) the case should be dealt with at the trial court level. The final settlement of the lender’s tort claims will be decided in the coming months.
Therefore, Sutton provides a simple but important caveat to mortgage lenders: Know your borrower and your guarantor. Lenders should have a thorough understanding of the financial health of the borrower’s principal (s) (as well as that of a guarantor if the guarantor is not an individual) to ensure that the lender can be made as loyal. as possible a strategic bankruptcy.