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

The Bankruptcy Court for the District of New Jersey (Kaplan, J.) recently held that hotel revenues (including revenues generated from room occupancy, food and beverage sales, catering, gift shop purchases, spa, and related hotel services) do not constitute “rent” within the meaning of the Third Circuit decision of In re Jason Realty, L.P., 59 F.3d 423 (3d Cir. 1995).  Therefore, even if they are absolutely assigned to the secured lender, hotel revenues can be used by the debtor as cash collateral to pay its ordinary and necessary operating expenses and to reorganize.  In re Ocean Place Dev., LLC, No. 11-14295 (Bankr. D.N.J. Mar. 31, 2011).

Ocean Place Development, LLC (“Debtor”) owned a 254-room beachfront resort in Long Branch, New Jersey, which included a large conference center, three restaurants, a bar/lounge, a full-service spa, and numerous other amenities.  Ocean Place owed approximately $58 million pursuant to the terms of its loan agreement with AFP 104 Corp., as successor to Barclays Capital Real Estate Inc. (“AFP”).  Repayment of the loan was secured by, among other things, a Mortgage and an Assignment of Rents and Leases (the “Assignment of Rents”).  Both the Mortgage and Assignment of Rents defined the term “rents” broadly, to include all “… revenues and credit card receipts collected from guest rooms, restaurants, bars, meeting rooms, banquet rooms and recreation facilities, all receivables, customer obligations, installment payment obligations and other obligations now existing or hereafter arising or created out of the sale, lease, sublease, license, concession or other grant of the right of the use and occupancy of the property or rendering of services by Borrower [Debtor] or any operator or manager of the hotel . . . .”

Following the Debtor’s default under the loan, AFP obtained a foreclosure judgment.  The Debtor filed a Chapter 11 petition before the scheduled foreclosure sale, and sought authority to use cash collateral consisting of hotel revenues.  AFP objected, and cross-moved for an order dismissing the Debtor’s case as a bad faith filing or, alternatively, for relief from the automatic stay to proceed with the foreclosure sale.  The Bankruptcy Court granted the Debtor’s request to use cash collateral, and denied AFP’s motion.

In a case of first impression, the Bankruptcy Court commenced its opinion with an analysis of whether hotel room revenues constitute property of the estate within the meaning of Section 541 of the Bankruptcy Code.  The Court framed its task as two-fold: (i) first, it had to decide whether a security interest in hotel room revenues constitutes an interest in realty or an interest in personalty that must be perfected and enforced under Article 9 of New Jersey’s version of the Uniform Commercial Code (“UCC”); and (ii) second, even if such interest was deemed personalty, whether the Debtor’s use of hotel revenues was consistent with Jason Realty. 

Article 9 governs transactions which create security interests in personal property or fixtures.  The Court found that the loan transaction in this case clearly was a “secured” transaction, as the loan documents granted the lender a security interest in the rents and leases and further stated that “Borrower [Debtor] intends for the security instrument to be a ‘security agreement’ within the meaning of the UCC.”  Additionally, the loan documents provided other indications of a secured transaction as they allowed: (i) the Debtor to collect rents as long as it was not in default of the mortgage; (ii) AFP to use post-default rents only to reduce the Debtor’s obligations to AFP; and (iii) for automatic termination of the Assignment of Rents after repayment of the loan. 

The Court then noted that Article 9 does not extend to interests in or liens on real property, including a lease or rents thereunder.  However, based on a case from the Bankruptcy Court for the Southern District of New York, In re Kearney Hotel Partners v. Richardson, 92 B.R. 95 (Bankr. S.D.N.Y. 1988), the Official Comments to the UCC and an examination of New Jersey statutes, the Bankruptcy Court concluded that hotel room revenues are “accounts” or “payment intangibles,” and not “rents.”  In so ruling, the Court adopted the distinction from those authorities between guests in hotel rooms, who are simply licensees, and tenants under a lease.  Thus, Judge Kaplan held that despite the definition of “rents” in the loan documents, hotel revenues are personal property included in the definition of property of the estate.

The Court then examined whether classifying hotel room revenue as personal property conflicts with the Third Circuit’s precedent in Jason Realty.  After discussing the background of Jason Realty, Judge Kaplan noted that case involved an absolute assignment of rents due from tenants of a two-story retail and office building, and not the assignment of receipts from a debtor’s operation of a hotel, restaurant or spa.  Additionally, the Court distinguished Jason Realty on the basis that the Third Circuit was tasked with assessing the “treatment of an assignment under New Jersey property law and the ensuing rights of an assignee arising under an absolute assignment of rents.”  Judge Kaplan, to the contrary, had to determine whether hotel room revenues should be treated as real property interests.  Because he determined that interests in hotel revenues should be treated as personalty under Article 9, he was not required to address whether “the assignment of rents absolutely vested title in AFP.”  Indeed, Judge Kaplan did not even necessarily dispute that the loan transaction evidenced both a security agreement and an absolute assignment of rents.  Based on his distinction of Jason Realty from the case before it in Ocean Place, Judge Kaplan declined to extend Jason Realty to personal property security interests, and allowed the Debtor to use its hotel room revenues as cash collateral so long as AFP remained adequately protected.

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In In re Montgomery Ward, LLC, 634 F.3d 732 (3d. Cir. 2011), the Court of Appeals for the Third Circuit clarified the principles of res judicata in the context of a bankruptcy proceeding and further defined the scope of 11 U.S.C. § 1111(b). The decision is significant because it is the first appellate decision to determine what constitutes privity for res judicata purposes in the context of a bankruptcy proceeding and also because it held that section 1111(b) transforms non-recourse claims into recourse claims only for distribution purposes.

Facts and Procedural History

Montgomery Ward, LLC (“Montgomery Ward”) contracted with Jolward Associates Limited Partnership (“Jolward”) to construct a department store, on land Montgomery Ward owned in Illinois that was the planned site to develop a mall. The parties entered into a ground lease and Montgomery Ward transferred a leasehold interest in the land upon which the department store was to be constructed to Jolward.

The parties also entered into a lease and sublease agreement (the “Lease and Sublease Agreement”) whereby Jolward subleased the land underlying the department store back to Montgomery Ward, and also leased the department store back to Montgomery Ward, for a period of thirty years. Jolward obtained construction financing by executing a mortgage (the “Mortgage”) in favor of State Farm Life Insurance Co. (“State Farm”). Montgomery Ward joined in the execution of the Mortgage, but assumed no personal liability. Thus, the Mortgage was without recourse to Montgomery Ward.

Some twenty years later, in 1997 and again in 2000, Montgomery Ward filed chapter 11 bankruptcy petitions. In the first bankruptcy proceeding (“Ward I”), State Farm filed a proof of claim for the outstanding balance of the Mortgage. The confirmed plan (“Ward I Plan”) provided for no distribution to State Farm on account of the Mortgage. However, State Farm retained its security interest. In addition, Montgomery Ward assumed the Lease and Sublease Agreement.

In the second bankruptcy proceeding (“Ward II”), a liquidating chapter 11, Dika-Ward, LLC (“Dika-Ward”), as assignee of the State Farm and Jolward bankruptcy claims, filed a proofs of claim for the full amount of the Mortgage and lease rejection damages based on the Lease and Sublease Agreement. Dika-Ward asserted that the Mortgage, although initially nonrecourse, had become recourse in Ward I under section 1111(b) of the Bankruptcy Code.

The Plan Administrator objected to both claims. Specifically, the Plan Administrator argued that the Lease and Sublease Agreement was merely a structured financing agreement and not a true lease. Dika-Ward argued that the confirmed Ward I Plan precluded the Plan Administrator from challenging the Lease and Sublease Agreement on principles of res judicata. The Delaware Bankruptcy Court granted summary judgment for Dika-Ward on the res judicata issue and summary judgment for the Plan Administrator on the Dika-Ward Mortgage claim. Both Dika-Ward and the Plan Administrator appealed.

The Appellate Ruling

The Third Circuit vacated the summary judgment for Dika-Ward regarding res judicata and remanded the issue to the Bankruptcy Court for a determination as to whether the Lease and Sublease agreement was a true lease or a structured financing. The Third Circuit observed that res judicata bars relitigation of a claim if there has been a final judgment on the merits in a prior suit involving the same claim and the same parties or their privies. Here, the Court focused on “whether the Ward II Plan Administrator, as successor in interest to the Ward II Estate, was the same party as, or privy of, the Ward I Debtor.” The Court found that the Plan Administrator in Ward II was not in privity with the debtor in Ward I and, therefore, was not barred by the doctrine of res judicata from contending that the arrangement was a structured financing agreement and not a true lease. The Court reasoned that the Ward I debtor was a party to the Ward I confirmation proceeding, and that upon confirmation, the Ward I debtor ceased to exist, and the reorganized Montgomery Ward succeeded to the Ward I estate. When the Ward II bankruptcy was filed, the Ward II debtor became the trustee of the new bankruptcy estate.

Moreover, the Court found that as trustee, the Ward II debtor was not the same party as the debtor in the first instance because it did not have the same incentives as the Ward I debtor had in the first proceeding. In Ward I, the debtor had an incentive not to bring the cause of action because it wanted Montgomery Ward to continue operating the store; however, in Ward II, the Plan Administrator had an incentive to challenge the lease because Montgomery Ward was liquidating, and a successful challenge would increase returns to the general unsecured creditors. Accordingly, the Court held that because the Plan Administrator was not in privy with the Ward I debtor, res judicata did not preclude the Plan Administrator from challenging the Lease and Sublease Agreement.

The Third Circuit next addressed Dika-Ward’s argument that the Mortgage had become recourse under section 1111(b) as a result of the first bankruptcy proceeding. Section 1111(b) provides that if a debtor elects to continue using encumbered property in its reorganization, the bankruptcy court will grant the nonrecourse creditor, whose claim is secured by an interest in that property, an allowed claim under section 502 as if its security interest had recourse. The Court found that “[s]ection 1111(b)’s language and purpose indicate that the recourse transformation is for distribution purposes only.” In affirming the Bankruptcy Court, the Third Circuit held that Dika-Ward possessed no claim against the Ward II debtor on account of the Mortgage because the security interest remained nonrecourse as to Montgomery Ward.

Conclusion

This case represents one of the first appellate decisions determining who constitutes a “party in privity” for res judicata purposes in a bankruptcy proceeding and establishes that in the Third Circuit for res judicata to bar relitigation of a claim in a bankruptcy proceeding the parties at issue must have aligned incentives.

In light of the Montgomery Ward decision, a trustee appointed in bankruptcy would not be barred by res judicata from challenging the actions taken by a debtor-in-possession prior to the trustee’s appointment as long the trustee can prove different incentives.

This case also represents one of the first appellate decisions finding that section 1111(b) transforms non-recourse claims into recourse claims only for distribution purposes. Affirming the Bankruptcy Court, the Third Circuit emphasized that while section 1111(b) provides recourse status to non-recourse claimants in bankruptcy, it does not alter the creditor’s legal and contractual rights outside of bankruptcy.

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