Bankruptcy Sale of Thistledown Racetrack Held not an “Arms-Length” Transaction

The “general rule with regard to determining value of real property (in order to calculate real estate taxes) is that the purchase price at a recent (within 3 years) “arms length sale” of the property between a willing buyer and willing seller is dispositive.  What better indication of value than the price someone is willing to pay and actually pays for the property? Of course, there are exceptions to every rule, but the recent decision of the Supreme Court of Ohio in Warrensville Hts. City School Dist. Bd. of Edn. v. Cuyahoga Cty. Bd. of Revision, Slip Opinion No. 2016-Ohio-78 is more clarification than exception.

In Warrensville Hts., the Board of Education of Warrensville Heights City School District (“Board of Education”) appealed from a decision of the Board of Tax Appeals (“BTA”) finding the tax year 2010 value of Thistledown Racetrack in Cuyahoga County to be $13,800,000, not the $43,000,000 purchase price at a bankruptcy sale six months after the tax-lien date. According to the BTA (affirmed by the Ohio Supreme Court), “sales conducted under supervision of a court order are forced sales which are not indicative of true value.”

 The facts of this case are simple enough (the ruling, not so much, in spite of first impressions). The subject property is Thistledown Racetrack, a thoroughbred-racing facility on 128 acres of land, located in Cuyahoga County, aka the home of the Ohio Derby. In 2009, the owner of the property petitioned for Chapter 11 bankruptcy relief and received authority to sell the racetrack at auction. Harrah’s Ohio Acquisition Company, L.L.C. (“Harrah’s), submitted the best and highest offer, however, a condition to the sale did not occur, which prompted a second auction. At the second auction (in 2010), Harrah’s again submitted the winning bid to purchase Thistledown. The contract basically stated that in exchange for $43,000,000, Harrah’s would assume ownership of the real property as well as equipment, intellectual property and other items. The sale was contingent on Harrah’s ability to obtain Thistledown’s racing license from the racing commission (which would also enable Harrah’s to operate lucrative video lottery terminals). The bankruptcy court approved the sale and Harrah’s filed the deed in July, 2010, after it received the racing license.

For tax year 2010, the Cuyahoga County Fiscal Officer assigned a total value of $14,264,000 to Thistledown. The Board of Education filed a complaint with the board of revision (“BOR”), seeking an increase to the purchase price established at the first auction: $89,500,000. The property owner requested a reduction to $5,500,000, claiming most of the value was attributable to the personal property and racing license, not the real estate. The BOR retained the fiscal officer’s initial valuation of $14,264,000.

The Board of Education appealed to the BTA, requesting an increase to $43,000,000, the price Harrah’s paid for the property at the second auction, and Harrah’s requested a decrease to $13,800,000. The school board relied on the 2010 sale, arguing that the $43,000,000 sale price reflected the value of the real property. The property owner reiterated her prior testimony that the sale price reflected the purchase of other assets in addition to real property.

The BTA agreed with Harrah’s valuation of $13,800,000. The BTA rejected the 2010 sale price as evidence of value, explaining that “[a]lthough it is clear that the subject property sold recent to [the] tax lien date, we do not find the sale to have been arm’s-length because it was subject to the approval of a bankruptcy court.”

The Board of Education appealed to the Ohio Supreme Court and the court affirmed the BTA’s decision.

In its analysis, the Ohio Supreme Court first looked at the applicable statute to reiterate the “general rule” at the time:

“During the tax year at issue, former R.C. 5713.03 sets forth how real estate is to be valued for tax purposes: ‘In determining the true value of any tract, lot, or parcel of real estate under this section, if such tract, lot, or parcel has been the subject of an arm’s length sale between a willing seller and a willing buyer within a reasonable length of time, either before or after the tax lien date, the auditor shall consider the sale price of such tract, lot, or parcel to be the true value for taxation purposes’.”  (Note: Pursuant to Ohio Am. Sub H.B. 487 (H.B. 487) signed into law on June 11, 2012, the revised statutory language of R.C. 5713.03 now provides that an auditor "may" (vs. shall) consider the price of a recent sale as value.)

The court then summarized R.C. 5713.04 (“[t]he price for which such real property would sell at auction or forced sale shall not be taken as the criterion of its value”)

and concluded that, “the BTA reasonably and lawfully determined that the sale price did not establish the property’s true value for two reasons…First, Thistledown Racetrack sold at auction [and]… Second, reliable and probative evidence in the record supports the finding that Thistledown sold at a forced sale within the meaning of R.C. 5713.04.”

At first glance, it appears that the court is establishing R.C. 5713.04 as a clear exception to R.C. 5713.03; however, upon further review, as well as a quick read of the decision of the Ohio Supreme Court in Olentangy Local Schools Bd. of Edn. v. Delaware Cty. Bd. of Revision, 141 Ohio St.3d 243, 2014-Ohio-4723, 23 N.E.3d 1086…, it is easy to surmise that R.C. 5713.04 is more clarification of, than exception to R.C. 5713.03.  The Olentangy Court specifically addressed this issue by asking itself:  “whether R.C. 5713.04 categorically prohibits reliance on an auction sale price as evidence of a property’s value, even when the sale satisfies former R.C. 5713.03’s requirements for a recent, arm’s-length transaction”; and answering in the affirmative, “in spite of R.C. 5713.04’s proscription, “the sale prices of parcels sold at auction are nevertheless the best evidence of value when all of the elements of an arm’s-length transaction are present.”

The court in Warrensville did pay homage to Olentangy by explaining: “In Olentangy…, we held that if the underlying transaction is an auction or forced sale, “the proponent of the sale price bears the burden to prove that the sale was nevertheless an arm’s length transaction between typically motivated parties and should therefore be regarded as the best evidence of the property’s value.”

The court in Olentangy, however provided more detailed guidance in determining what an “arms-length” transaction is. “Three factors are relevant to deciding whether a transaction occurred at arm’s length: whether the sale was voluntary; i.e., without compulsion or duress, whether the sale [took] place in an open market, and whether the buyer and seller act[ed] in their own self interest.”

In Olentangy (a residential foreclosure case), the auction sale was deemed arms length because of the following: “open-market elements”: the foreclosing lender listed the property on the open market for nine months before the auction; the auction was publicly advertised for a significant period of time, it was well attended, and there were multiple bidders for the property; the highest bid was 92 percent of the property’s final MLS list price; and the lender accepted this bid, although it had retained the right to reject it.

In contrast, according to the Warrensville court, the Thistledown sale was a “hurried sale by a debtor because of financial hardship or a creditor’s action.” In fact, “Harrah’s bought the racetrack at a bankruptcy sale … which authorizes sale of property … other than in the ordinary course of business.” “The bankruptcy court supervising the sale found ‘compelling circumstances’ to consummate the sale because there is substantial risk of depreciation of the value of Purchased Assets if the sale is not consummated quickly. Further, the transaction was not between typically motivated parties—the bankruptcy court approved the sale after finding that time was of the essence in order to maximize the value of the bankruptcy estate’s assets and that it was in the best interests of Magna Entertainment and its creditors and other parties in interest.”

Ohio Assembly Enacts Shift in Receivership Environment after Six Decades of Inactivity

Reprinted with permission from author Christopher D. Caspary, Staff Attorney, Cuyahoga County Court of Common Pleas. 

(This article was originally printed in the September 2015 Cleveland Metropolitan Bar Journal)

Introduction

            The last time the Ohio Assembly modified Ohio Revised Code (“R.C.”) §2735, Dwight D. Eisenhower was President, a gallon of gasoline cost twenty cents, and Mickey Mantle was in his third season as the starting centerfielder of the New York Yankees.

Moving beyond mere facilitation of judgment collection, the receivership remedy has evolved into a common, expedient, and generally cost-effective means to effectuate a defunct company’s dissolution or resolve ongoing issues within an insolvent organization. Due to these developments, R.C. §2735, the cornerstone of Ohio receivership law, was in drastic need of revision and expansion.

            Due to a patch-work of court decisions addressing issues that were not covered by statute or existing precedent, certain crucial aspects of receivership law were subject to conflicting interpretations. A statutory framework was needed to help standardize results in receivership actions. The current amendment to R.C. §2735 in House Bill 9 (“H.B. 9”) codifies certain best practices that are familiar in Cuyahoga County without restraining the court’s ability to appropriately tailor relief and receivership orders.

The Law

            H.B. 9 was enacted December 19, 2014 and has an effective date of March 23, 2015. Though the changes present in H.B. 9 are extensive, the legislature did not modify R.C. §2735.03 (Oath and Bond), R.C. §2735.05 (Examination), or R.C. §2735.06 (Investment of Funds by Receiver). 

Key Changes to R.C. §2735

·         R.C. §2735.01(C) expounds upon §2735.01(A)(6), which combine to specify that receivers “may be appointed to manage all the affairs” of the applicable business entity.

·         R.C. §2735.04(B) codifies substantive powers of the receiver such as entering into lease or sale contracts that do not impact lien priority, executing construction contracts, and conveying real or personal property. The subsection also authorizes the commonplace practice of opening a deposit account.

·         R.C. §2735.04(C) codifies and potentially expands upon existing case law on lien priority for receiver fees and expenses. See, e.g., Dir. of Trans. of Ohio v. Eastlake Land Dev. Co., 177 Ohio App. 3d 379, 388-389, 2008-Ohio-3013, 894 N.E.2d 1255 (8th Dist.) (allowing expenses from a mortgage sale to extinguish receivership fees with mortgagee acquiescence and full participation in the matter); see also, Ohio v. Tokmenko, 112 Ohio App. 42, 43, 165 N.E2d 804 (8th Dist. 1960) (noting that receivership expenses are generally payable out of the “corpus of the property”); but see, Wilkens v. Boken, Inc., 8th Dist. Cuyahoga No. 64230, 1993 Ohio App. LEXIS 6202, ¶ 16-19 (Dec. 23, 1993) (requiring that “unusual or substantial” expenditures provide notice, an opportunity to be head, and receive eventual court approval).

·         R.C. §2735.04(D) definitively establishes a comprehensive procedure allowing a receiver to dispose of real property.

·         R.C. §2735.04(D)(1)(a) and §2735.04(D)(3) codify existing case law on a receiver’s ability to sell property “free and clear of liens” (with limited exceptions). See Huntington Nat’l Bank v. Motel 4 BAPS, Inc., 191 Ohio App. 3d 90, 94-95, 2010-Ohio-5792, 944 N.E.2d 1210 (8th Dist.).

·         R.C. §2735.04(D)(1)(b)-(c) allows the court to order the receiver to provide evidence of the value of the property or solicit and consider additional offers prior to executing a conveyance.  

·         R.C. §2735.04(D)(2) sets forth specific procedures that must occur before a receiver can dispose of real property. This subsection specifically requires that the receiver file a motion with the court regardless of whether a specific offer to purchase has been received and provide at least ten-day written notice to all interested parties (defined in the Statute). If an objection is filed, a hearing must take place that allows all parties to be heard. Finally, an order of sale must be issued by the court.

·         R.C. §2735.04(D)(7) requires that the court create a redemption deadline allowing a party to act and void the sale. This period cannot be shorter than three days.

·         R.C. §2735.04(D)(10) requires that the receiver file and serve a certificate of sale and report that outlines important transactional details for property conveyance conducted under the auspices of R.C. §2735.04(D)(2)(a)(ii), which governs sales with a specific offer to purchase the real property in question. This allows a receiver to avoid having to obtain court approval for a contract sale twice.

Observations and Challenges Moving Forward

·         Receivership case law in Ohio remains dynamic and growing, yet at times, incomplete.

·         The most substantial amendment found in H.B. 9 addresses the disposition of real property by a receiver and the ability to do so “free and clear of liens.” Property rights can be difficult to protect in the current bad asset environment, where title reports are complicated, lengthy, and at times inaccurate.

·         R.C. §2735.04(D)(2)(b) sets forth notice requirements that must be met before a receiver can dispose of real property. The statute notes that either a preliminary judicial report or a title commitment is acceptable for determining the parties that must be noticed.

·         Case law interpreting the changes present in H.B. 9 will take time to fully develop. Although the amendment codifies important receivership precedent, certain gap-filling decisions were not specifically addressed by the General Assembly, and their continued applicability may be in question. For example, though R.C. §2735.04(C) empowers the court to “require an additional deposit” (to be deposited by the requesting or consenting parties) “to cover funds” that will be expensed pursuant to a R.C. §2735.04(B)(4) contract, the Statute does not specifically address whether a court can require the original movant (or acquiescing and full participating party) to cover all receivership costs not extinguished by the receivership estate.  

·         R.C. §2735.02 adds language that a court should afford “priority consideration…to any of the qualified persons nominated by the party seeking the receivership,” but cautions that “[n]o nomination of qualified persons for the receivership is binding upon the court.” Though the Statute is clear that the court retains ultimate discretion in deciding who to appoint, the law now views receiver nominations by the movant favorably.

·         Whether courts, in interpreting R.C. §2735.04(C), will maintain the aforementioned “unusual or substantial” standard for expense authorization and priority despite such a distinction not being present in the Statute.

Conclusion

            The amendment of R.C. §2735.01 et seq. provides needed statutory guidance and predictability to the  receivership environment and is a net positive for receivership practitioners as the lack of predictability in receivership orders was one of the largest disadvantages when utilizing state court remedies. The amendment specifically codifies certain receivership powers that have become commonplace in many jurisdictions, such as disposing of real property “free and clear of liens,” scheduling hearings and allowing an opportunity to be heard before entering certain receivership orders, and creating a blanket rule of receivership fee and administrative expense priority.

            H.B. 9 does not inhibit the ability of the court to tailor the order appointing a receiver to the specific facts of the matter at hand and allows the receivership remedy to continue to be an important, powerful, and flexible resource available for attorneys in bad asset liquidation or business salvage environments. Mickey Mantle would be proud; the General Assembly has just hit a homerun. 

Disclaimer: The contents of this article are not intended to serve as legal advice. Appropriate legal counseling or other professional consultation should be obtained prior to undertaking any course of action related to the topics explored by this article.

Christopher D. Caspary serves as the Staff Attorney to Judge Nancy A. Fuerst in the Cuyahoga County Court of Common Pleas. Mr. Caspary completed his undergraduate studies at The Ohio State University and received his JD/MBA from Cleveland State University. Mr. Caspary has an interest in the diverse area of business law. 

U. S. Supreme Court Issues Decision in Favor of Bank of America in Chapter 7 Lien Stripping Case

The U.S. Supreme Court issued its decision today in the consolidated cases of Bank of America, N.A., Petitioner v. David B. Caulkett, and Bank of America, N.A., Petitioner v. Edelmiro Toledo-Cardona, declining 9-0 to void the junior mortgage liens on the respondents’ homes when the senior lienholder’s debt exceeds the property’s value. This decision reverses the judgments of the Eleventh Circuit.

The facts in each of these cases are essentially the same. The debtors, respondents David Caulkett and Edelmiro Toledo-Cardona, each had 2 mortgages on their respective homes. The petitioner, Bank of America, holds the junior mortgage lien on each of the homes. The junior mortgage liens are completely underwater as the amount outstanding on the senior mortgage liens exceeds the current value of the homes. The debtors moved to have the junior mortgage liens voided, i.e., ‘stripped off”, under §506(d) of the Bankruptcy Code.

Section 506(d) states that “[t]o the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” Therefore, the secured claim can be stripped off only if its right to repayment from the debtors is not an allowed secured claim. With minor exceptions that do not apply in these cases, a claim filed by a creditor is deemed “allowed” under Section 502 of the Bankruptcy Code if no interested party objects or, if an interested party objects, the bankruptcy court makes the determination that secured claim should be allowed. The parties in these cases had agreed that Bank of America’s claims were “allowed” claims. Their disagreement was over whether Bank of America’s claims were “secured” claims as defined under §506(d) of the Bankruptcy Code.

A straight reading of §506(d) of the Bankruptcy Code would tend to support the debtors’ construction of a secured claim. However, back in 1992, in Dewsnup v. Timm (502 U.S. 410), the Court came to a different interpretation that defined the term “secured claim” under §506(d) to mean a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim. This interpretation essentially limited §506(d)’s application to voiding only those liens where the claim it secures has not been allowed. 

To remain consistent with its prior decision, the Court reversed the lower court decisions and refused to void Bank of America’s junior mortgage liens. The Court noted that it was not being asked to overrule its decision in Dewsnup and noted to decide as requested by the debtors, it would in the same term having more than one definition and would leave an “odd statutory framework in its place.” One has to wonder what the Court’s decision would have been if it was in fact asked to overrule Dewsnup.

The end result is Bank of America’s junior liens remain in place on the homes.  Bank of America won the battle in protecting its future interest as a junior lien holder. However, if the bankruptcy courts were to grant a motion for the senior lenders to proceed with foreclosure actions, Bank of America’s junior liens could still be stripped if the winning bids at sheriff’s auction are not high enough to cover both the senior and junior liens.
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Use Real Estate Leases Effectively in Chapter 11 Situations

Reprinted with permission by author: Joel H. Schneider, Senior Vice President, Hilco Real Estate, LLC

Owner-occupied real estate can be an untapped source of balance-sheet value for bankrupt companies. Such real estate assets provide a potential catalyst for exiting bankruptcy successfully or a financial carrot to motivate prospective strategic or financial buyers.

Currently, real estate investors are clamoring for stabilized properties occupied by creditworthy tenants. The competition for income-producing real estate assets has caused capitalization rates to nosedive in recent years. Today, properties in many real estate categories, such as industrial, are priced at cap rates below the 2007 peak.

This article reviews two cases where bankrupt companies enhanced the value of their owner-occupied real estate. Through new lease agreements that included higher rents, reimbursement of expenses, and multiyear lease terms, substantial cash flow streams were created. The properties were then marketed via auctions to maximize recoveries, and sale proceeds were used to expedite the reorganization process, satisfy creditors, and/or hasten the successful sale of the go-forward enterprise.

A Reorganization

Giordano’s, the Chicago-based deep dish pizza retail chain, filed Chapter 11 bankruptcy in 2011 after defaulting on approximately $45.5 million in loans.

As part of the filing, the company listed 20 parcels of owned real estate associated with corporate and franchised restaurants. Of the 20 parcels, 10 were considered operationally significant to the go-forward business, including a high profile 139,000-square-foot mixed-use property that served as the company’s corporate headquarters and flagship restaurant location. One of the keys to this situation was to position the Giordano’s real estate to take advantage of a re-capitalized corporate balance sheet to encourage buyer interest in buildings occupied by a ”reconstituted” Giordano’s.

Hilco Real Estate worked with the debtor to restructure the company’s leases to make them more attractive and marketable, while concurrently crafting a plan to market the properties to the largest possible real estate investment market. Prior to the lease restructurings, initial bids for the real estate had yielded offers around $20 million. When the newly leased properties went to auction, 14 qualified bidders were at the table. After 13 hours of spirited and contentious bidding, the properties sold for more than $30 million. Proceeds from the real estate sale along with the sale of the operating business yielded nearly $66 million, which enabled the estate’s secured creditor to be paid in full.

A Sale Scenario

The degree of interest in acquiring a bankrupt company, either by a strategic buyer such as a competitor or a financial buyer such as a private equity firm, is often influenced by real estate. In many cases, the potential acquirer plans to maintain operations in the buildings, but does not want to be in the real estate business or simply does not want to use additional capital to buy the buildings.

By structuring new leases based on go-forward tenancy in the building, a valuable asset for the estate is created, which enables the debtor or the acquirer to offer a fully leased building to the investment marketplace.

Based in suburban Chicago, Qualteq was a market leader in manufacturing plastic credit and gift cards for companies such as American Express, Visa, and MasterCard. The owner’s personal financial difficulties forced Qualteq into Chapter 11 in 2013. The bankruptcy trustee and his financial advisers first stabilized the company, then sold the business to Brazil-based Valid S.A. through a Bankruptcy Code Section 363 bankruptcy sale. However, Valid had no interest in purchasing the four buildings Qualteq occupied.

Working in tandem with the bankruptcy trustee and advisers, Hilco structured new, five-year leases on each of the four buildings with Valid as the tenant, based on the strong balance sheet that was created with Valid’s purchase, enabling Qualteq to continue operations in their current facilities.

Prior to the finalization of the new leases and with no certain commitment from Valid to remain as a tenant, there was no immediate interest from the real estate investment community for four potentially vacant industrial buildings. Once the new leases were finalized, the leased buildings were then put through a sale process by Hilco, which garnered significant interest from third-party investors. Stalking horse bidders were obtained for each property, followed by an auction. Hilco estimated the four buildings, on an empty basis, were valued at approximately $10.5 to $12.5 million. When the gavel came down, the auction resulted in total sales of almost $19 million for the four fully occupied buildings.

Utilizing the real estate as a vehicle to enhance value further ensured that the estate achieved maximum value of the Qualteq business/assets and helped to secure a successful transaction with Valid. Furthermore, the added value created by selling buildings occupied by a quality credit tenant resulted in sufficient proceeds to fully pay all mortgage holders.

Whether a company in Chapter 11 reorganizes and exits from bankruptcy on its own or is acquired by a strategic or financial buyer, the real estate occupied by the business can be transformed into a value enhancer. By recasting leases with a strong tenant and aggressively marketing the properties, a significant amount of incremental cash can be generated to benefit the bankruptcy estate in a reorganization and/or a going-concern sale. In bankruptcy, debtors and creditors should regard companies’ real estate as a value-creation tool, not an illiquid liability.

Joel H. Schneider is senior vice president, dispositions, for Hilco Real Estate, LLC, a unit of Hilco Global. You can contact Joel at jschneider@hilcoglobal.com.

Hilco Real Estate (www.hilcorealestate.com) advises and executes strategies to help both healthy and distressed clients maximize the value of their real estate assets. Their extensive property valuation knowledge, lease renegotiation experience and innovative sales strategies are leveraged by substantial access to capital, a vast network of tenants/landlords and motivated buyers/sellers. Services include real estate lease repositioning and advisory solutions; extensive real estate disposition services through an expert brokerage team as well as high-performance accelerated property auctions-live, online, sealed bid; a sale/leaseback advisory practice with unique deal structuring; and, real estate investments including acquisition deals for vacant, value-add, or stable income-producing properties as well as joint venture transactions. Hilco Real Estate is part of Northbrook, Illinois based Hilco Global (www.hilcoglobal.com), a world-wide leading authority on maximizing the value of business assets by delivering valuation, monetization and advisory solutions to an international marketplace. Hilco Global operates more than twenty specialized business units offering services that include asset valuation and appraisal, retail and industrial inventory acquisition and disposition, real estate and strategic capital equity investments.

New Year, New Ohio Real Estate Legislation

CTI Commercial Title Update Reprinted with Permission from Linda M. Green, Esq., Underwriter, Chicago Title Insurance Co.

Happy New Year to all and to start the New Year we want to make you aware of two important bills that were passed by the Ohio legislature at the end of 2014.

Amended Substitute House Bill 201 requires lenders on both residential and commercial property to record a satisfaction of mortgage within 90 days from the receipt of funds sufficient to satisfy the mortgage debt.  If the mortgage is not satisfied within 90 days, the current owner of the property may provide the lender with a written notice of lender's failure to file a satisfaction. If after 15 days of the receipt of the notice the lender has still failed to record a mortgage satisfaction the owner may bring a civil action to recover reasonable attorney fees and costs incurred in filing the action plus damages of $100 for each day of lender's non-compliance, not to exceed $5,000 in damages.

Substitute House Bill 9 creates a statutory framework for a receiver to sell real property by private sale, private auction or public auction, including the sale of real property free and clear of all liens except for a lien for real estate taxes and assessments.  Before authorizing a receivership sale the court may require the receiver to provide evidence of the value of the property and market the property for sale.  The bill also provides that any receivership sale can be made only after the following have occurred:

    a.    An application is made by either the receiver or the first mortgage holder to sell the property and either the specific terms of the offer to purchase are disclosed or the procedure for the conduct of the sale is outlined.

    b.    10 days prior to the application, a written notice of the intent to sell is served on all parties having an interest in the property as determined by a preliminary judicial report or a commitment for an owner's policy of title insurance.

    c.    An opportunity for a hearing is given to all interested parties.

    d.    The court has issued a final appealable order of sale of the real property.

This is just a brief synopsis of these two bills.  If you would like any further information or copies of either of these bills please contact Linda Green at linda.green@ctt.com

 Chicago Title has been serving Ohio for over 50 years. Through their nationwide network, they provide title insurance, underwriting, escrow and closing services to every spectrum of the real estate industry. For more information, visit them at :  www.cticnow.com

Protecting Claims for Indemnity Obligations When a Commercial Tenant Files Bankruptcy

As a landlord of commercial property, one of the more frustrating situations to endure is a tenant in bankruptcy. While the bankruptcy code provides more protections for commercial landlords than in the residential context, there are still many gray “no man lands” that can trap a landlord.

 

One area that can create issues for a landlord is the indemnity obligation a tenant may owe the landlord under a lease.  Consider a scenario where tenant signs a lease and proceeds to initiate a very expensive build out of the premises only to file bankruptcy before the construction is completed and the contractor paid.  Contractor proceeds to file a mechanics’ lien on the property. The landlord can be forced to spend significant amounts of money in litigation and settlement costs with the contractor to resolve and remove the lien, not to mention the litigation costs in bankruptcy court over the priority of its related indemnification claim against the tenant debtor.

 

This was the situation the landlord, WM Inland Adjacent LLC (MW Inland), found itself in after its tenant, Mervyn’s LLC (Mervyn) filed for relief under chapter 11 of the Bankruptcy Code.

 

MW Inland requested that its claim was entitled to priority treatment under section 365(d)(3) of the Bankruptcy Code while Mervyn objected claiming it should be treated as a general unsecured claim.  Section 365(d)(3) of the Bankruptcy Code provides that the debtor much timely perform all of its obligations under an unexpired lease until that lease is assumed or rejected.

 

Critical to the bankruptcy court’s decision in favor of MW Inland was the distinction of an “obligation,” which is “something one is legally required to perform under the terms of the lease” from a “claim,” which is “an unmatured right to payment.” (WM Inland Adjacent LLC v. Mervyn’s LLC (In re Mervyn’s Holdings LLC), No. 08-11586, Adv. Pro. No. 09-50920, 2013 WL 85169 (Bankr. D. Del. Jan. 8, 2013)) The court further found that the obligation arose when the contractor recorded the mechanics’ liens and sued WM Inland to foreclose upon the liens (prior to rejection of the lease), which entitled WM Inland’s claim to treatment as WM Inland had requested under section 365(d)(3).

 

The takeaway for a commercial landlord is to consult competent commercial bankruptcy counsel as soon as possible after a tenant files for relief in the bankruptcy court to develop a useful strategy for preserving pre-and post-petition claims it might have related to the tenant’s lease obligations.

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CMBS "Bad Boy" Clauses: More Fallout From Court Decisions

As we have addressed in prior blog posts about “bad boy” clauses in a CMBS loan, if any of these provisions are violated, the nonrecourse nature of the loan will be partially or completed negated depending on which provision is violated.

 

Courts typically interpret these clauses very strictly and that has come back to bite both the borrowers and guarantors and the lenders.  For example, in Euclid Housing Partners, Ltd., et al. vs. Wells Fargo Bank, NA, as Trustee, 2012 Ohio Misc. Lexis 16 (Ohio Ct. of CP 2012), the guarantor had loaned funds to the borrower, likely in a vain attempt to keep the borrower and mortgaged property solvent and prevent a payment default. However, the loan agreement prohibited the borrower from incurring any other debts and the guarantor’s loan was made without obtaining lender’s prior consent. Because guarantors are often majority owners of the borrowers, it’s not surprising that the guarantor in this case provided the funds to the borrower.  However, that one action cost the guarantor more than he bargained for. It violated one of the “bad boy” provisions and subjected him to full recourse liability. Ironically, had he just put the money into the borrower as a capital contribution instead of a loan, the loan would have remained nonrecourse.

 

On the flip side, in GECCMC 2005-C1 Plummer Street Office Limited Partnership vs. NRFC NNN Holdings, LLC, 204 Cal. App. 4^th 998, 2012 Cal. App. LEXIS 366 (2012), it was the lender that had to live strictly by the loan terms and was unsuccessful in seeking full recourse against the guarantor.  The mortgaged property was leased to Washington Mutual Savings and Loan (“Washington Mutual”). When Washington Mutual went out of business and abandoned the property, the lender foreclosed on the mortgage and then pursued the guarantor for the deficiency balancing claiming that Washington Mutual’s leaving the property was tantamount to a termination of the leases without lender’s consent, a violation that would trigger full recourse against the borrower and the guarantor. The court disagreed, finding the lender’s interpretation to be stretching it a bit. The borrower did not take action to terminate the lease, and the court found that the lease continued to exist despite the tenant’s abandonment.

 

Despite the significant consequences if these “bad boy” clauses are not followed, many borrowers and their attorneys give inadequate attention to their terms. Worse, some CMBS lenders are putting these critical loan provisions in their term sheets, and the borrowers and guarantors are signing the term sheets before bringing their lawyers into the deal. This effectively ties the lawyers’ hands and prevents them from taking steps to protect the borrowers and guarantors.

 

Buyer Risks With Deliquent Property Tax Sales

When acquiring property through a property tax sale, there are risks to the buyer if the property owner becomes a debtor in bankruptcy.  Under the Bankruptcy Code a transfer might be avoided if the debtor was insolvent (or becomes insolvent due to the transfer) and received less than reasonably equivalent value for the property.  If that transfer took place within the look back period (either 2 or 4 years depending on the bankruptcy filed, Chapter 7, 11 or 13) and the sale price was not “reasonably equivalent value” for the property, then the transaction might be challenged as a fraudulent transfer.

The U.S. Supreme Court in 1996 held that in a foreclosure sale, if state law for the foreclosure process was followed, then the price obtained as a result of that foreclosure sale constituted reasonably equivalent value as a matter of law. However, the court noted that there might be exceptions to the rule in other contexts, such as a forced sale to satisfy tax liens.   

In tax sales where the only reason for the sale was to pay the delinquent property taxes, if there is a significant disconnect between the sale price and the value of the property, and if there was no opportunity for competitive bidding, then it’s an open question whether the sale price will be considered a fair value.  If the sale were to be timely challenged in a subsequent bankruptcy, the court may well decide to avoid the sale as a fraudulent transfer.

If that happens, the bankruptcy court could recover the fraudulent transfer from the initial transferee and even the next transferee who acquired the property from the initial transferee (unless buyer #2 can assert a successful defense as a good faith purchaser).

Bottom line. . . when purchasing properties through forfeiture procedures, such as a property tax sales, that do not include competitive bidding, buyers need to be aware that their liability doesn’t end with the transfer deed.

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New Provision in Ohio Law May Help Secured Lenders Protect Their Mortgage Lien During Bankruptcy

In the past couple of years, I’ve written about the cost to lenders when there are technical errors in their recorded security documents, such as mortgages, and how they chose to correct those errors. See “Mortgage Execution in Ohio: the Twilight Zone where a person can both ‘know’ and ‘not know’ the same information” and “Lenders Beware: Mortgage Errors Can Really Cost You.”  

 

Bankruptcy trustees have filed numerous adversarial proceedings in Ohio seeking to remove a secured lender’s preference on mortgaged real property by asking the court to void mortgage on a technical defect in the acknowledgement clause. Courts have frequently sided with the bankruptcy trustees in these cases, holding that the defective acknowledgement in the mortgage due to its failure to strictly follow the requirements in RC §5301.01 renders the mortgage not entitled to be recorded (even though it was) and therefore it did not provide constructive notice (even though the trustee had actual notice). Recent legislation might just change the outcome of many of these cases.

 

The Legacy Trust Act (the “Act”) became effective March 27, 2013. Sub H.B. 479, which included the Act, also included modifications to other statutes to complement the Act.  RC §317.08 [Records to be kept by county recorder.] provides for the various types of records to be kept by the county records, which includes, among others, deeds, mortgages, leases, land installment contracts, affidavits and the like, and was amended by the Act to add a new category for transfers, conveyances or assignments of any type of “tangible or intangible personal property…”. The Act also amended RC §1301, the general provisions affecting commercial transactions to added a new section, RC §1301.401 [Effect of recording documents.]

 

RC §1301.401 provides that any document referenced in RC §317.08 and any document, the filing of which is required or allowed under Chapter 1309 [Secured Transactions], is a “public record.” This section also states that “[a]ny person contesting the validity or effectiveness of any transaction referred to in a public record is considered to have discovered that public record and any transaction referred to in the record as of the time that record was first filed with the secretary of state or tendered to a county recorder for recording.” (emphasis added)

 

It’s not unreasonable to argue that, based on the language in RC §1301.401, a bankruptcy trustee should be deemed to have had constructive notice of the mortgage at the time it was tendered to the recorder for recording.  Until a court in Ohio addresses the interplay between RC §1301.401 and RC §5301.01, we won’t know which provision will come out on top. However, look for lenders’ counsel to start using this new provision in the Act to buttress their arguments against voiding the lenders’ mortgages.

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Lenders Beware: Mortgage Errors Can Really Cost You

One consequence of a struggling economy is property owners, both residential and commercial, facing financial difficulties and filing for bankruptcy.  Typically, a secured lender has additional protections in bankruptcy, but a bankruptcy trustee may try to avoid the mortgage, freeing up more potential cash for the other creditors, if he or she believes there exists grounds to do so.  When a mortgage is avoided, the secured lender is not longer ahead of the other creditors, and instead is lumped in with the other unsecured creditors and sharing any assets of the bankruptcy on a pro rata basis. I bring up the bankruptcy context because the options for protecting a secured lender are more limited. Outside of the bankruptcy context, a court would find against a bona fide purchaser of real property if the purchaser had actual knowledge of the mortgage, regardless of whether the mortgage was recorded correctly or not. Bankruptcy situations are different and for this reason, lenders and their legal counsel need to take care to protect their interests.

Last year I posted an article regarding the ability of a bankruptcy trustee to avoid a mortgage if it was not properly executed.  A mortgage may also be avoided if the legal description is insufficient so that a court could find that the mortgage was not properly in the chain of title for the real property. 

Mistakes happen, and typically, if caught soon enough, are fixable. What matters is to fix the mistake correctly.  If a mortgage is recorded and the description of property is missing a parcel or is otherwise incomplete, the safest course of action is to re-record the mortgage with the complete legal description. However, some may chose to address the error by recording a corrective affidavit. The law varies from state to state regarding the use of corrective affidavits. If your state allows this option, make sure it is followed to the letter. A failure to dot the i's and cross the t's can cost a lender dearly.
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In the Bankruptcy of a Commercial Landlord, Who Comes Out on Top in a Sale Free and Clear, the Landlord or the Tenant?

When a landlord is in bankruptcy, a tenant that is not related to the landlord and not a debtor in the bankruptcy action will be entitled to certain protections under bankruptcy law but will also have unique concerns.

Under the bankruptcy code, a trustee may reject burdensome unexpired leases and certain contracts known as executory contracts in which the debtor is a party. When this occurs, the rejection does not terminate the agreement, but rather is treated as a prepetition breach. The other party (i.e., not the debtor) cannot seek specific performance but has the right to an unsecured damage claim (cold comfort in many instances).  

Section 365(h) is a separate provision that applies to non-debtor tenants. If a trustee rejects a real estate lease of the debtor/landlord, the tenant has two options: (a) treat the lease as terminated, vacating the premises and assert a general unsecured claim against the landlord’s bankruptcy estate; or (b) if the lease term has already started, retain its rights in or appurtenant to the property for the remainder of the lease term, including remaining in possession of the property and continuing to pay rent. If the tenant chooses the second option, and the bankrupt landlord fails to perform its obligations post-rejection (e.g., paying utilities or taxes), the tenant can offset these damages from its rent but cannot pursue any rejection damage claims against the landlord’s bankruptcy estate.

These special tenant protections also extend to the tenant’s successors, assigns and mortgagees.

So far, what rights a tenant has or doesn’t have in this situation is fairly clear. Where it gets messy is when the debtor/landlord seeks to sell the leased property free and clear of interests, including the tenant's lease. 

Section 363(f) of the bankruptcy code allows a property to be sold free and clear of interests. This can conflict with the tenant’s rights under Section 365(h).  The $10,000 question is whether a Section 363 sale trumps the tenant’s rights under Section 365(n).

The answer is: maybe or maybe not. The courts are split and so far, no clarity is in sight.

If the landlord wants to sell the property free and clear of the lease, it should be addressed directly in the bankruptcy sale process, and if the tenant wants to remain in possession, the tenant should also raise the issue as early in the process as possible. There is no point in prolonging the pain and expense with no guaranty on either side of victory in the end.

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Buying Real Property Out of Receivership

When considering the purchase of real estate that’s in receivership, there are unique considerations a potential buyer has to keep in mind. 

First, the property is being acquired “as is, where is”.  A receiver, who, pursuant to authority granted by the court, will act as the seller of the real property, typically does not provide any representations or warranties other than a representation that the receiver has the legal authority to transfer title of the real property to the buyer.  Beyond that, a buyer is on his or her own. There typically will be no indemnities and no real recourse if problems arise after closing.  If the property falls apart after closing, the buyer gets to keep the pieces and parts.  Caveat Emptor, “Buyer beware!”

That said, the purchase price a buyer can negotiate in such situations is frequently better in these situations and that lower price is very tempting. The solution?  Diligence! And lots of it!

Most receivers that I’ve ever dealt with, both in the role of representing the receiver and as counsel to the buyer, are quite cooperative in providing the buyer with as much access as possible to allow a buyer walk through the property, obtain engineering and environmental reports, and conduct whatever additional diligence a buyer feels is necessary. If a buyer is being stonewalled over access and unable to conduct adequate diligence, then walk away from the property. Sometimes no deal is better than a bad one.

Second, keep in mind that receivers often have secured creditors involved who hold the mortgage liens on the real property. The secured creditor may have strong opinions as to how a sale ought to be structured, the price that ought to be obtained, the timing of the transaction, etc. A receiver will usually take all such input into consideration whether it’s welcome or not, because the receiver has to file a sale motion with the court to obtain permission to close the sale to buyer and doesn’t want the secured creditor(s) filing an objection to the motion.   

Third, when considering property that has significant environmental issues, the buyer needs to hire the best environmental consultant he or she can afford (in these situations don’t go too cheap) early on in the process.  A good consultant can help a buyer determine the best approach to environmental diligence, including when to start the process and what environmental tests are advisable or not.  All deals have some element of risk to them, but a buyer needs to take smart risks when purchasing a property that has environmental problems and no recourse for indemnification.

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Mortgage Execution in Ohio: the Twilight Zone where a person can both 'know' and 'not know' the same information

Ohio law regarding the execution of mortgages can be quite strict and the failure of lenders to follow it can have significant consequences, including the lender's loss of its position as a secured creditor in a debtor's bankruptcy.

Ohio Revised Code section 5301.01 requires 4 separate acts to properly execute a mortgage:

    1.  the mortgage shall be signed by the mortgagor;
    2.  the mortgagor shall acknowledge his signing in front of a notary pubic, or other qualified official;
    3.  the official shall certify the acknowledgement; and
    4.  the official shall subscribe his name to the certificate of acknowledgement.

(see Drown v. GreenPoint Mortgage Funding, Inc. (In re Leahy), 376 B.R. 826 (Bankr. S.D. Ohio 2007))

If a mortgage was defectively executed, it was not entitled to be recorded, and even if it was recorded, it must be treated as though it had not been recorded. An unrecorded mortgage does not provide constructive notice of the mortgage to a bona fide purchaser, and therefore such bona fide purchaser takes priority over the mortgage.  In bankruptcy, a trustee has the rights of a bona fide purchaser regardless of his actual notice of a mortgage.

Challenges on this issue typically attack the acknowledgement.  Under Ohio Revised Code section 147.541, a certificate of acknowledgement will be recognized if it contains the words "acknowledged before me" or their substantial equivalent.  The term "acknowledged before me" means that person doing the acknowledging appeared before the person taking the acknowledgment (i.e., the notary), acknowledging that he/she executed the instrument for the purposes stated in the acknowledgment.

Ohio courts in the past have upheld acknowledgments that they found were in "substantial compliance" with ORC 5301.01, and bankruptcy courts have recognized Ohio's "substantial compliance" doctrine.  To determine whether a or not a mortgage execution substantially complies with ORC 5301.01, a reviewing court will typically consider "the nature of the error and the balance of the document to determine whether or not the 'instrument supplies within it self the means of making the correction'" (Menninger v. First Franklin Financial Corp. (In re Fryman), 314 B.R. 137 (Bankr. S. D. Ohio 2004)--quoting Dodd v. Bartholomew, 44 Ohio St. 171 1886)).

Here's where it gets confusing....a notary acknowledgment that names the wrong party has better chance of being upheld than a blank acknowledgement.  Never mind that giving an incorrect name in the acknowledgement clause may sometimes provide less assurance of the instrument's genuineness that if the acknowledgement had been left blank. (see Bank of American, N.A. v Harold Corzin, Trustee, 5:09 CV 2520, Memorandum Opinion issued on 2/2/2010 by Judge David D. Dowd, Jr., for US District Court, Norther District of Ohio, Eastern Division) [I'm not aware of a single case under Ohio law where a blank acknowledgment has been found to be in substantial compliance. If anyone knows of such a case, I'd love to hear about it.]

The end result? A debtor can validly own of the property, sign the mortgage, initial every page including the acknowledgement page, and the mortgage can be recorded and the bankruptcy trustee can have actual knowledge of all of the above, and still the mortgage will be set aside if the mortgage is not properly executed under Ohio law.

While courts have acknowledged the counterintuitiveness and even injustice of some of these decisions, it is not their job to cure the lenders' documentation issues and they will not.

Lender's need to beware and take sufficient care in documenting their loans or risk suffering grave consequences; and if you are counsel for the borrower being asked to provide a legal opinion on a mortgage loan, take care when reviewing the mortgage execution and acknowledgement.
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"Bad Boy" Guaranties Upended by Recent Court Decisions

Many commercial properties such as retail strips and apartment projects are financed with CMBS, or conduit, loans.   These loans are structured so that the key asset mortgaged to the CMBS lender is owned by a single purpose entity (SPE) so that it's isolated from other liens and indebtedness other than typical trade payables related to the asset's operations.  A key component of these loans is the lender's nonrecourse against the borrower and guarantors for deficiency balances absent an affirmative 'bad act' on the part of the borrower or a guarantor.  These are commonly referred to as "bad boy" guaranties. And the assumption would be that some affirmative 'bad act' is required in order to trigger full recourse against the borrower and guarantors.

A couple of recent decisions in Michigan (one in state court and one in Federal district court) have turned this assumption in its head. One of the 'bad boy' acts is for the borrower to no longer be an SPE. CMBS lenders and rating agencies require SPEs to remain solvent and be able to pay its debts as they come due from its own assets. The courts in Michigan have interpreted this to mean that the insolvency does not have to result from an affirmative act or omission to act by the borrower or guarantor or anyone related to them in order to trigger the 'bad boy' guaranties. This expansive view allowed the lender to pursue the borrower and guarantors for the full deficiency balance on the loans after its foreclosure of the properties despite no bad act or failure to act on their part.

What does this mean?

For borrowers and guarantors on projects located in Michigan, it means:

• if the mortgaged property is the victim of the bad economy, the resulting insolvency can be sufficient to trigger full recourse against the borrower and guarantors; 
• a nonrecourse loan subject to 'bad boy' triggers is meaningless, and borrowers and guarantors needs to be aware of their real exposure;
• when faced with a property that is kicking off sufficient cash flow, a guarantor may want to inject additional equity to prevent a trigger of the guarantor for the full loan amount;
• when faced with more recourse liability than bargained for, a guarantor may face restatement of its financials as full recourse guaranties are accounted for differently and may itself be thrown into insolvency as a result;
• there is no incentive for a borrower or guarantor to cooperate with the lender in a foreclosure unless a release will be a part of the bargain, which a lender may or may not be willing to give; and
• there is no incentive to work diligently to avoid triggering the "bad boy" provisions, as the borrower and guarantor are damned if they do and damned if they don't.

For the rest of us outside of Michigan, we need to be aware of the potential that courts in our jurisdiction will follow the Michigan courts' lead. These court decisions are the first to be decided on this issue. It is anybody's guess what will happen on appeal, but if the decisions stand, they will be included in lenders' briefs to other courts requesting full recourse on the guaranties.

The CMBS real estate loan market isn't doing so well right now and this will not help.
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