Bankruptcy & Restructuring Law Monitor : Bankruptcy Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Restructuring & Chapter 11

Unlike retailers and manufacturers that file for chapter 11 protection, real estate owners and developers must be mindful of the restrictions and special expedited procedures the Bankruptcy Code imposes upon debtors whose estates consist of a single property or project (“Single Asset Real Estate” or “SARE” cases). In those cases, the automatic stay, which typically gives debtors a “breathing spell” from lenders’ collection efforts, terminates ninety (90) days after the bankruptcy filing unless the debtor either files a confirmable plan of reorganization or commences monthly interest payments to its secured lenders. Set forth below is a brief discussion of the relevant statutory provisions and interpreting case law regarding SARE cases.
 

As part of the Bankruptcy Reform Act of 1994, Congress added two new sections to the Bankruptcy Code to expedite single asset real estate cases and enhance the leverage held by secured lenders. First, Congress added section 101(51B) of the Code, which defines “single asset” real estate as:
[R]eal property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of the debtor and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental thereto having aggregate non-contingent, liquidated secured debts in an amount no more than $4,000,000.
 

Second, Congress amended section 362 of the Bankruptcy Code to require that the automatic stay be terminated if the debtor does not file a plan of reorganization or commence monthly interest payments within ninety (90) days of the petition date. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”) eliminated the $4 million cap in section 101(51B), expanding the reach of the SARE provisions and making them applicable to much larger projects and entities, including the many public and private homebuilders facing today’s economic pressures.
 

The text of section 101(51B) does not elaborate as to the meaning of the phrases “substantial business” or “other than the business of operating the real property.” Courts interpreting those phrases have benefitted little from the legislative history accompanying the amendments. Without meaningful legislative guidance, courts have focused on whether the real estate is used in the operation of a business or whether it is simply held for “passive” income. Many courts interpreting the 1994 SARE amendments have determined a debtor that actively operates a business on its property, even when the operation of such business centers around the use of a debtor’s property, does not constitute a SARE. See In re CBJ Dev., Inc., 202 B.R. 467 (9th Cir. BAP 1996) (finding that hotel operations were not the mere “operation of a property” because, in addition to operating a gift shop, it required (i) a substantial number of employees; (ii) actively maintaining each of the rooms, (iii) cleaning bed sheets and towels; and (iv) providing basic amenities to guests, specifically phone service); Prairie Hills Golf & Ski Club, Inc., 255 B.R. at 228 (Bankr. D. Neb. 2000) (operation of golf and ski facilities connected to residential land developments is not merely operating the property); Larry Goodwin Golf, Inc., 219 B.R. 391 (Bankr. M.D.N.C. 1997) (operation of a golf course and pool with concession stand is not merely operating the property); In re Khemko, Inc., 181 B.R. 47 (Bankr. S.D. Ohio 1995) (marina not a single asset real estate debtor under section 101(51B) because, in addition to providing for the mooring of boats, the marina also stored, repaired and winterized boats, provided showers and a pool, sold gas, and sold concessions); and Whispering Pines Estate, Inc., 341 B.R. 134 (Bankr. D. N.H. 2006) (debtor, which operated an 89-room hotel, conducted operations in connection therewith that were “sufficiently active in nature to constitute a business other than the mere operation of property”).
 

As noted above, however, the elimination of the $4 million cap as part of the 2005 BAPCPA amendments have caused SARE issues to appear with somewhat greater frequency in more substantial cases. Of note in these troubled times for homebuilders is Kara Homes, Inc. v. Nat’l City Bank (In re Kara Homes, Inc.), 363 B.R. 399 (Bankr. D. N.J. 2007). There, a parent entity and several of its subsidiaries filed chapter 11 cases. The parent oversaw the overall residential development business and each debtor subsidiary owned real estate on which it developed residential projects. None of the debtor subsidiaries had its own employees or a separate permanent facility from which to operate. The court found each debtor subsidiary was a SARE because its business operations “[we]re merely incidental to their efforts to sell the homes or condominium[s] and thus did not constitute substantial business.”
 

In contrast, however, is In re Scotia Dev., LLC, 375 B.R. 764 (Bankr. S.D. Tex. 2007). There, the court adopted the “active-versus-passive” criterion in addressing whether a timber harvester was a SARE debtor. The court made detailed findings regarding the debtor’s activities and noted those activities are extensive and require hands-on supervision by teams of experts. Taking into account those extensive operations, the court concluded the debtor did not constitute a SARE. The court applied a “practical approach” to construing section 101(51B) of the Bankruptcy Code, and followed the approach of prior courts that “includ[ed] within its [section 101(51B)] ambit only those debtors who have no revenue from their property except the passive collection of rent from tenants and excluding from its reach those entities that undertake and pursue various sorts of active economic, commercial, and business activities on the property.”
 

In sum, the restrictions imposed by the SARE provisions of the Bankruptcy Code are meaningful and create material hurdles for real estate debtors. The ways in which courts apply those provisions will be noteworthy as more real estate entities consider chapter 11 as part of their restructuring strategies.

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The United States District Court for the District of Delaware, in Goody’s Family Clothing, Inc. et al. v. Mountaineer Prop. Co. II, LLC, et al. (In re Goody’s Family Clothing, Inc. et al.), 2009 WL 903370 (D. Del. March 31, 2009), held that “stub” rent owed to commercial landlords should be accorded administrative expense priority under Section 503(b)(1) of the Bankruptcy Code. “Stub” rent is a bankruptcy term of art that means rent due for the period from the date the bankruptcy case is commenced through the end of the month in which the case was filed. In so ruling, the District Court swiftly distinguished the Third Circuit’s decision in In re Montgomery Ward Holding Corp., 268 F.3d 205, 209 (3d Cir. 2001), and ruled that Section 365 of the Bankruptcy Code is not the exclusive remedy for commercial landlords to obtain payment of “stub” rent. The Goody’s Court ruled, however, that while the “stub” rent obligation constituted an administrative expense claim, payment did not have to be made immediately. That is, payment could be made pursuant to a confirmed Chapter 11 plan.

Section 365(d)(3) of the Bankruptcy Code provides that a debtor-in-possession must timely perform all the obligations of the debtor under an unexpired commercial real property lease arising after the order for relief is entered until such lease is assumed or rejected, notwithstanding section 503(b)(1) of the Bankruptcy Code. As to payment of “stub” rent, there is a split of authority whether such obligation should be deemed a pre-petition or post-petition obligation of the debtor-tenant. Some courts have adopted the “billing date” approach based on their view that an obligation to pay rent arises on the day that rent is due, while others have adopted the “accrual date” approach based on the days the tenant occupies the leased premises. In Montgomery Ward, the Third Circuit adopted the “billing date” approach when confronted with the issue of whether real estate taxes billed to the tenant under an unexpired lease after the bankruptcy filing had to be paid in full, even though a portion of the taxes were attributable to the pre-petition period. The Third Circuit required payment of the entire real estate tax bill because it was “billed” after the bankruptcy filing.

Technically, under Montgomery Ward’s “billing date” approach, the “stub” rent in Goody’s would have constituted a pre-petition claim. However, the Goody’s Court relied on Section 503(b) of the Bankruptcy Code to grant the commercial landlords an administrative expense claim for their “stub” rent. That statute provides that an administrative claim should be allowed for the “actual, necessary costs and expenses of preserving the estate.” The Goody’s Court held that because the debtors were occupying leased commercial premises after the bankruptcy filings and were using them to conduct “profitable” store closing sales, Section 503(b) entitled them to an administrative expense claim for the “stub” rent. This is a significant victory for commercial landlords, and one debtors’ counsel should consider when determining the date on which a bankruptcy filing should be commenced.

On April 27, 2009, the Debtors filed a notice of appeal in the District Court, invoking their right to have the Third Circuit review the Delaware District Court's decision. The Third Circuit case number is 09-2168.

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On April 8, 2009, the United States Court of Appeals for the Second Circuit, reversing a ruling by the United States Bankruptcy Court for the Southern District of New York, concluded that certain “termination premiums” due to the Pension Benefit Guaranty Corporation (“PBGC”) are not contingent pre-petition claims subject to discharge in a Chapter 11 reorganization. The Second Circuit’s decision is of great import because debtors that terminate their pension plans after filing for bankruptcy may no longer be able to escape paying significant claims to the PBGC.

Background

On February 28, 2006, the Deficit Reduction Act of 2005 (“DRA”) was enacted. The DRA requires employers that terminate qualified pension plans to pay annual “termination premiums” to the PBGC equal to $1,250 per beneficiary for three years after the termination. A “Special Rule,” however, applies to termination of pension plans in bankruptcy proceedings. That “Special Rule” provides that termination premiums begin to accrue on the date of the discharge or dismissal of the employer’s bankruptcy case.

Flatware manufacturer Oneida Ltd. commenced a Chapter 11 case in 2006. At the outset of its case, Oneida moved to terminate its three underfunded pension plans. After confirming its plan of reorganization, Oneida sought a declaratory judgment that the PBGC’s claims for termination premiums were contingent pre-petition claims that were discharged by Oneida’s plan of reorganization. The Bankruptcy Court for the Southern District of New York agreed with Oneida. The PBGC appealed the Bankruptcy Court’s ruling and the Second Circuit granted the parties’ joint request to hear the appeal directly under 28 U.S.C. § 158(d)(2).

The Second Circuit’s Decision

The Second Circuit reversed the lower court’s ruling. The Second Circuit stated that in order to have a valid bankruptcy claim, a party must have a right to payment that arose pre-petition, which right must be determined in accordance with non-bankruptcy law. The Second Circuit, relying on the “Specific Rule,” found that the PBGC’s right to payment of termination premiums does not arise until after the employer is discharged from bankruptcy. As such, the Second Circuit held that the PBGC’s termination premium claim is not a pre-petition claim subject to discharge in Chapter 11. The Second Circuit remanded the case to the Bankruptcy Court for further proceedings consistent with its ruling.

Conclusion

The Oneida ruling is the first published decision on the issue. Companies seeking to use the bankruptcy process to terminate their pension obligations must now squarely address whether termination should occur before the bankruptcy filing in view of the Oneida ruling. This decision cannot be taken lightly as pre-petition pension plan termination might adversely impact a company’s relationship with its employees.
 

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