REAL ESTATE TRANSACTIONS IN BANKRUPTCY:
BEFORE AND AFTER THE BANKRUPTCY REFORM ACT OF 1978
INDEPENDENT RESEARCH PROJECT
FOR DEAN RICHARD HEMINGWAY
BY:
TOM WASHBURN
SPRING 1981
833
REAL ESTATE TRANSACTIONS IN BANKRUPTCY:
BEFORE AND AFTER THE BANKRUPTCY REFORM ACT OF 1978
In November, 1978, President Carter signed into
law the Bankruptcy Reform Act of 1978. 1
The Bankruptcy
Code represented the first extensive revision of the
bankruptcy law since 1938.
2
The Bankruptcy Code became
effective October 1, 1979.
Any bankruptcy petition filed
pr~or
to that date is subject to the provisions of the old
act.
As a consequence, the cases currently being heard
include proceedings governed by the old act and those
governed by the Bankruptcy Code.
Eventually, cases
decided under the old act will disappear, and then all
judgments will be couched in terms of the Bankruptcy
Code.
3
Figures indicate that the number of persons
taking advantage of the bankruptcy laws to gain a "fresh
start" are increasing, 4 so the impact of the Bankruptcy
Code provisions will be widespread.
Not surprisingly, the
complete overhaul of the Bankruptcy Code has produced many
changes in both the procedural and substantive areas of
the federal bankruptcy law.
Until the new case law
emerges more completely, the precise effect of the changes
will remain unclear.
This paper concerns real estate
transactions and financing in the bankruptcy setting.
More specifically, we will review the provisions relating
to real estate reorganizations in bankruptcy, compare the
current provisions with those existing under the old act,
and examine how such real estate activity has been ana
might be affected by the revised bankruptcy laws.
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REORGANIZATIONS
When one thinks of bankruptcy, the image most
readily conjured up is that of liquidation of the assets
owned by the debtor, with the creditors receiving
substantially less than the full value of their claims.
That procedure is commonly known as "straight bankruptcy''
and is governed by Chapter 7 of the Bankruptcy Code. 5
Simply stated, the bankruptcy trustee gathers the debtor's
property, liquidates that estate, and distributes the
proceeds to the creditors.
6
Bankruptcy law, however,
offers the debtor an alternative to "straight
Chapter ll of the Bankruptcy Code 7
bankruptcy."
provides for the reorganization of the debtor's business
finances to allow the debtor to continue his trade or
business.
The idea is that a going concern will afford
the debtor another opportunity to meet the financial
obligations it has incurred without having to "start from
scratch," while offering the creditors some hope of a more
substantial recovery on their debts than would be produced
in a liquidation proceeding.
Basically, a debtor in
reorganization continues its business pursuant to a plan
submitted to and accepted by the creditors and confirmed
by the court.
8
Chapter ll represents a consolidation of separate
reorganization provisions under the old act -- Section
77
9
(railroad reorganizations), Chapter X
(corporate reorganizations) , Chapter XI
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835
11
10
(debt
arrangements - applicable to natural persons and
corporations), and Chapter XII 12 (real property
arrangements).
We are particularly interested in the
application of Chapter 11 to real estate reorganizations,
and thus, quite naturally, in its predecessor -- Chapter
XII.
Chapter XII was specifically designed to bar
enforcement of a security agreement by a secured
13
.
ere d 1tor.
The intent was to afford the debtor the
opportunity to devise a rearrangement of his debts secured
by real property, in
unsecured debts.
14
addition to rearranging his
Despite the existence of Chapter
XII, practitioners made little use of its provisions prior
to the collapse of the real estate market which occurred
1n 1974 and 1975. 15
Then the filings of petitions
increased dramatically. 16
As the number of debtors
availing themselves of the provisions of Chapter XII
swelled, Congress was in the process of revising the
existing bankruptcy law.
This increased activity in real
estate reorganization influenced those drafting the
Bankruptcy Code, as indicated by the similarities that
exist between new Chapter 11 and old Chapter XII.
17
Though there are similarities, there are also many
significant differences.
These dissimilarities form the
basis for mucn of the discussion to follow.
A reorganization begins when a petition
filed with the bankruptcy court by the debtor
836
is
(a voluntary
.
case ) 19 or b y ere d'1tors (an 1nvoluntary
case). 20
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18
This
initial step in the proceedings represents a change in
that Chapter XII allowed only voluntary petitioners to
instigate a real estate reorganization. 21
Filing a
petition subjects all actions against the debtor and his
property to an automatic stay. 22
The stay is very
important particularly in regards to real property becduse
it stays the commencement or the continuation of a
judicial, administrative or other proceeding against the
debtor, even if initiated before the commencement of the
bankruptcy proceeding. 23
This includes foreclosure
proceedings by a creditor against property of the debtor.
Section 362 does place eight specific limitations upon the
operation of the automatic stay, two of which are
especially applicabale to real estate.
In the first
exception the filing of the petition will not stay "any
act to perfect an interest in property to the extent that
the trustee's rights and powers are subject to such
perfection under section 546(b)
•
•
•
•
An example
of the operation of this limitation would be the
perfection by notice-filing of a mechanic's lien against
real property of the bankruptcy estate where nonbankruptcy
law permits notice-filing to perfect the mechanic's lien
against a prior judgment lien upon the same property.
The
second exception to the operation of the automatic stay
has a narrower application than the first but remains a
consideration in a real estate situation.
It permits
commencement of a foreclosure action by the Secretary of
-
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837
Housing and Urban Development upon property consisting of
five or more living units secured by an insured
mortgage.
25
The only action to which this limitation
applies is judicial foreclosure of security interests 1n
multiple housing units.
The Bankruptcy Code authorizes the court to grant
relief from the stay, however, after notice and a hearing
held upon the request of a party in interest to the
.
26
procee d 1ngs.
Relief from the stay will be granted
specifically in a Chapter 11 reorganization upon a showing
that the debtor lacks equity in the property and that the
property is unnecessary for an effective
reorganization.
27
The courts have required that
creditors prove both elements of the test before they will
grant relief from the stay.
28
The next step to be taken 1n the real estate
reorganization is the filing of a reorganization plan with
the court.
Since the purpose of a reorganization is to
permit rehabilitation of the debtor in order that all
parties -- debtor and creditors -- might be better served
by balancing their respective interests while preserving
the assets of the debtor, the plan of reorganization will
be extremely important.
It will present the proposed
rearrangement of the debts of the debtor 1n an effort to
gain the acceptance of the requisite number of creditors
.
.
.
29
an d part1es 1n 1nterest.
Acceptance is desired
because without it a Chaper 11 reorganization can be
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93°
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converted to a Chapter 7 liquidation. 30
1121
31
Section
governs which parties may file a plan.
Basically, the debtor has the exclusive right to formulate
and present a plan during the first 120 days following the
commencement of the reorganization proceeding. 32
Any
party in interest may, however, file a plan of its own
within those first 120 days if a trustee had been
33
.
d 1n
.
appo1nte
t h e case
or 1. f t h e court by order
shortens the 120 day period of debtor exclusivity.
34
Otherwise, the parties in interest may file a plan only if
the debtor failed to file a plan within the 120 day
period
35
or no plan filed by the debtor was accepted
within 180 days from the commencement of the case.
36
The Bankruptcy Code details with much specificity
37
.
.
t h e 1tems
t h at a p l an must con t a1n.
The deta1ls in
section 1123 may be categorized into three elemental
functions:
(l) classification of claims against the
debtor's estate,
(2)
specification of the treatment to be
accorded each class of creditors, and (3) execution of the
rehabilitative plan of the debtor.
We will examine these
major functions individually.
l.
CLASSIFICATION OF CLAIMS
The purpose underlying the classification of
claims held by creditors within the Bankruptcy Code
originated with provisions of the old Chapter XII
reorganizations -- to permit the plan to provide for each
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839
class of creditors in accordance with the nature of its
.
.
c 1 a1ms
an d 1ts
secur1. t y, 1. f any. 38
The fundamental
separation of claims occurred between secured and
unsecured creditors.
Ordinarily, creditors with claims of
the same legal nature, of equal rank, and against the same
property were placed in the same class. 39
Within the
division of secured claims, further classification might
occur.
Creditors with security interests of equal rank,
but secured by different property, would be placed 1n
separate classes.
40
Likewise, first and second mortgage
claims upon the same piece of property would be separately
c 1 ass1. f.1e d • 41
Finally, a plan should distinguish
between claims upon the same property when they consist of
different legal natures, such as mortgagees and mechanic's
lien holders.
42
In a typical real estate reorganization
there may be many classes with only one creditor in each
class, each item of property having a first mortgage
h~ld
by one creditor, a second mortgage held by another
creditor and so forth.
43
Unsecured claims generally
fall into a single class regardless of their form, whether
they be claims upon a contract, personal notes, or
whatever other form they might take.
The unsecured nature
of the claims causes their rank to be equal.
Nevertheless, the Bankruptcy Code provides, as did the old
44
.
.
f or certa1n
.
.
act, pr1or1ty
types o f unsecure d c 1 a1ms,
and priority status of a claim qualifies it for separate
class1. f.1ca t.1on. 45
In classifying claims and creditors,
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the plan must be rational and neither arbitrary nor
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.
46
a1scr1m1natory.
Proper classification is important to
47
the plan
because of the role the classes play in
acceptance and subsequent confirmation of the plan. 48
A simple example might help illustrate how claim
classification would operate and affect the creditors.
Assume Debtor owned only one item of real estate worth
$200,000.
Creditor 1 held a first mortgage on the
property 1n the amount of $125,000; Creditor 2, a second
mortgage of $100,000; Creditor 3, a third mortgage of
$50,000; and unsecured creditors as a group held debts
totalling $50,000.
Creditors 1, 2, and 3 held claims of a
similar nature upon the same property but with unequal
rank.
Creditor 1 possessed a priority claim over all
other creditors, and, unlike the other creditors, there
was sufficient equity in Debtor's real estate to cover
Creditor l's claim.
Therefore, his circumstances dictated
that he be placed in a separate class.
was inferior to the claim of Creditor 1.
Creditor 2's claim
After
satisfaction of the first mortgage $75,000 remained of the
Debtor's equity.
That amount would be applied toward
Creditor 2's secured claim, leaving an unsecured portion.
Creditor 2 would be classified differently than Creditor
1, who was wholly satisfied, and Creditor 3, who was
wholly unsatisfied.
Clearly, with the equity in Debtor's
property now totally consumed, Creditor 3 has, in effect,
been relegated to the status of an unsecured creditor.
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The rank of the claims of these three creditors and the·
inadequate equity of the property securing those claims
make it obvious that conflicts exist between the interest
of these creditors, necessitating their separate
classifications.
On the face of the facts as stated, the
distinction between Creditor 3 and the unsecured creditors
has disappeared.
Therefore, if no other conflict had
arisen between Creditor 3 and the unsecured creditors,
Creditor 3 may have been joined to the unsecured creditors
under the reorganization plan.
Thus, the simple
illustration of a Chapter XII creditor classification.
Section 1122 of the Bankruptcy Code has
maintained the practice of creditor classification as
established under old Chapter XII.
classification very generally.
Section 1122 addresses
Other sections influence
the classification of a creditor.
49
Additionally,
subsection (b) of section 1122 allows the fixing of a
single class of all unsecured claims based upon the small
size of each claim composing that class.
That is merely a
codification of the prior practice under the old act.
2.
50
SPECIFICATION OF CREDITOR TREATMENT
Following classification of the creditors, the
debtor moved to the heart of the reorganization
procedure -- deciding how to revise and satisfy the debts
owed to the creditors.
The debtor's original obligations
are supplanted by the newly restructured obligations.
In
devising a plan, the Chapter XII debtor had to decide how
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it would treat each creditor class, while
contemplatin~
the nature of the effect that each class would experience
because of the reorganization. 51
Then the debtor needed
to secure acceptance of the plan by the creditors before
the court would confirm it.
The plan had to be accepted
by creditors accounting for two-thirds of the amount of
.
.
52
t h e c 1 a1ms represented 1n each class.
Thus, referring
to our earlier illustration wherein some classes contained
only one creditor, it would appear that rejection of the
plan by one creditor would prevent the debtor from
receiving the required approval.
However, the old act provided for just such a
contigency.
The vote of any class which failed to provide
the two-thirds approval margin could have been termed
unnecessary by the court if the non-approving class (l)
was not "materially and adversely affected" by the
plan 53 or
plan. 54
(2) was "adequately protected" under the
This practice of disregarding the vote of
certain non-consenting classes became known as a "cram
down."
Creditor classes that rejected the plan, or at
least failed to approve it by the vote of creditors
holding two-thirds of the total amount of the claims 1n
that class, could have the plan involuntarily applied, or
"crammed down" upon them. 55
The court could confirm a
plan, as having received the requisite acceptance, if only
one creditor in a single-creditor class votea for it, and
if all the other creditors who did not vote for it were
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determined to be either unaffected by the plan or
adequately protected by it.
Historically, courts had
required at least one creditor to consent to a proposed
56
plan.
Cases decided much later showed a trend toward
allowing confirmation of a plan even when the sole
existing creditor, a secured creditor, objected to the
57
plan.
The Bankruptcy Code expressly addresses this
situation.
It
requ~res
that before a court confirms a
plan, at least one class of creditors must accept the
plan.
58
One commentator states that this acceptance
requirement "is satisfied where there exists a class of
claims that is not impaired, excluding any class of
insider claims, since holders of unimpaired claims are
deemed to have accepted the plan." 59
One court held
that a plan could be confirmed as accepted where there was
one class of creditors whose claims were not impaired by
the plan.
60
Congress has attempted to clarify this
matter by proposing an amendment to the Bankruptcy Code.
Section 1129(a) (10) would be amended so that a plan may
not be without the acceptance by at least one impaired
class of claims, determined without including any
acceptance of the plan by any insider. 61
This change
would make it clear that the fact that an unimpaired class
is deemed to have accepted the plan
62
cannot be relied
upon to satisfy the requirement that there be acceptance
by at least one class of claims.
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Since the "cram down" provisions were available,
when a debtor formulated a plan that would affect a class
of creditors, he tended to consider whether that class was
go1ng to be adequately protected, rather than whether that
class would accept the plan.
Thus, treatment of creditors
under reorganization plans became an exercise in meeting
wnat the debtor anticipated the court would consider
adequate protection for the creditors.
The two basic
methods of restructuring consisted of (l) reducing the
amount paid on each installment while extending the payout
period and (2)
reducing the liability to an amount below
the full claim.
63
Emerging case law eventually produced
guidelines of the acceptable methods by which the debtor
could restructure the debts of real estate projects:
(1)
If the value of the property exceeded
the mortgage amount, the principal of the
mortgage could not be reduced.
(2)
64
Protection of the secured creditor
extended only to the value of his collateral.
(3)
65
A creditor inadequately secured in his
debt with only an in rem mortgage against the
debtor's property could be subjected to
distinguished treatment of his deficiency under
the plan.
(4)
66
If the debtor kept or sold the
property, the debtor or purchaser had only to pay
.
. d va 1 ue. 67
th e mor t gagees 1ts
appra1se
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(5)
A
partially secured creditor was
protected only for the value of the equity 1n the
property with the excess (unsecured) portion of
the claim subject to the treatment given
unsecured creditors. 68
(6)
The secured creditor could be wholly
treated as an unsecured creditor if the property
securing his claim was devoid of any equity. 69
(7)
The mortgage term could be extended. 70
(8)
Principal or interest payments under
the mortgage could be postponed. 71
(9)
Delayed or reduced principal and
interest payments could be added to the balance
on the mortgage.
(10)
72
The interest rate on the debt could be
adjusted to reflect the current market rates. 73
Under the Bankruptcy Code "cram down 11 has been
seen as affecting more than just the confirmation of the
plan by the court.
The existence of the "cram down"
provisions will affect the negotiations between the debtor
and the creditors in their efforts to formulate a
plan. 74
The Bankruptcy Code has recodified the "cram
down" power. 75
Differences exist between the current
provisions and the old Chapter XII "cram down."
•
p 1 an w1ll
be
II
Now, a
•
'
d7 6 c l ass o f
crammed down II upon an 1mpa1re
claims if the plan is considered to afford fair and
equitable treatment of that class.
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77
The preceaing
statement points up two changes from the old standard for
"cram down":
"impaired" instead of "affected" and "fa1r
and equitable" rather than "adequate protection."
Both
changes apply stricter requirements upon the reorganizing
real estate debtor.
The Bankruptcy Code expressly states
what constitutes fair and equitable treatment of secured
78
claims
and unsecured claims 79 •
Discussion by the courts of "impaired" and
"affected" under the old act suggested that impairment is
a more stringent criteria when applied to the debtor.
80
It appears a creditor stands a better chance of being
"impaired" than he stood of being "affected" under the old
act.
The Bankruptcy Code defines, in the negative,
"impairment."
81
Stated affirmatively, if a plan alters
the legal, equitable, or contractual rights of the
claimholder, the claim is impaired.
82
Where the
claimholder has the right to accelerated payment upon a
default by debtor, if a plan does not cure such default,
does not reinstate the prior-existing maturity of such
claim, does not compensate the holder for damages incurred
in reliance upon the acceleration clause or does alter the
holders rights in any other way, the claim is
impaired. 83
In other words, if the plan fails to comply
with any of the four elements required to defeat the
acceleration right, the claimant will be considered
impaired.
If a plan on its effective date fails to
provide cash equal to the amount of the allowed claim, the
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.
.
.
- 84
.
c l a1m 1s 1mpa1red.
h
T ese criteria make it appear
certain that alteration of debt obligations, a normal and
necessary occurrence in real estate reorganizations, will
create impaired classes of claims.
The significance of
this lies in the requirement that at least one impaired
class of creditors accept the plan. 85
No reorganization
proceeding is now likely to avoid having an impaired class
of creditors.
The change 1n the "cram down" prov1s1on from
"adequate protection" to "fair and equitable treatment"
likewise presents a stricter compliance test for the
debtor.
As with "impairment," the Bankruptcy Code has
codified the "fair and equitable" standard. 86
To be
"fair and equitable" to a class of secured claimholders, a
plan must (l) allow the claimholders to retain their liens
in the amount at which their claims were allowed and
arrange deferred cash payments to each claimholder equal
to at least the amount of their allowed claim, with the
payments having a current value equal to the current value
of the claim;
87
or (2) provide that upon the sale of
secured property free of the claimholders• liens, the
liens will attach to the proceeds from the sale;
88
or
(3) provide some other method that will give the
claimholders the "indubitable equivalent" of their
.
c l a1ms.
89
Unsecured creditors are considered treated
fairly if (l)
the plan gives each such creditor or keeps
for his account property with a value, as of the effective
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date of the plan, equal to the amount of his allowed claim
or
(2) under the plan a claimholder junior to the class of
unsecured creditors will not receive nor be creaited on
account any property.
9
°
Considering these revised
criteria for "cramming down," of the methods mentioned
91
.
.
ear l 1er
as recogn1zed by the courts as acceptable
methods of reorganizing real estate projects, the
following methods may no longer be acceptable:
(l)
The in rem mortgagee cannot be
compelled to take the value of his security
interest only; he may opt to have his entire
claim treated as though he had recourse against
the debtor for the full amount.
(2)
92
The partially secured creditor may not
be forced to accept a reduction in his claim to
reflect only the secured portion and be treated
as an unsecured creditor as to the excess; unless
he consents to such change. 93
This conclusion is reached by virtue of the
protection granted the secured creditor requiring both
retention of security interests equal in value to his
allowed claim and deferred payments that must have a
present value equal to the value of his allowed claim.
3.
EXECUTION OF THE REHABILITATIVE PLAN
The Bankruptcy Code expressly requires that a
plan shall provide adequate means for execution of the
plan.
95
The provision continues with a list of
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94
suggested methods of execution. 96
This paragraph is a
codification of executory means previously recognized
under Chapter XII reorganizations, leaving this final
fundamental aspect of reorganization planing unchanged
from the old act.
EXECUTORY CONTRACTS AND UNEXPIRED LEASES
One power given to a bankruptcy trustee under the
substantive provisions of the Bankruptcy Code -- the
option to assume or reject any executory contract 97 or
unexpired lease of the debtor 98 -- is also applicable to
the reorganizing debtor.
Section 1123, which, as we have
already discussed, details the contents of the
reorganization plan, expressly permits the plan to include
provisions for the assumption and rejection of executory
.
- 1 eases. 9 9 Th e exerc1se
.
.
con t racts an d unexp1red
o f t h 1s
power in a reorganization setting is subject to the
general provisions of section 365, but the existence of
this option should be very important to the real estate
debtor seeking to rehabilitate his operations.
The power
to assume or reject belongs to the trustee, subject to
court approval.
100
If, in a Chapter 11 reorganization,
a trustee is not appointed, then the debtor in
possession
trustee.
101 has the rights and powers of a
102
As a general rule, the trustee must assume
. d 1 ease 10 3 w1t
. t y d ays or e 1 se th e
. h.1n s1x
th e unexp1re
. d eeme d reJecte
.
d • 104
1 ease 1s
. a
Th e trus t ee 1n
reorganization may make the election any time prior to
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850
confirmation of the plan, unless, upon request of any
party to the lease, the court orders a determination made
within a specified period whether the lease will be
assumed or rejected. 105
Special provisions apply to the assumption of a
lease under which a default has occurrect. 106
Before the
trustee may assume a defaulted loss, he must (1) cure the
default, or provide adequate assurance that the default
107
will be cured;
(2) compensate, or provide adequate
assurance of prompt compensation to a party to the lease
other than the debtor, for any actual pecun1ary loss
caused by the default;
108
and (3) give adequate
assurance of future performance under the lease. 109
While section 365 does not define "adequate
assurance"
110
in the general situations, it does specify
standards for adequate assurance of future performance of
. a s hopp1ng
.
a lease of real property 1n
center. 111
A trustee may not assume a lease if applicable
law excuses another party to the lease from accepting
performance by one other than the debtor and such other
.
112
party does not consent to such assumpt1on.
N
or may a
trustee assume a contract to make a loan or extend other
debt financing to, or for the benefit of, the
debtor. 113
This provision makes it clear that where a
debtor has a construction loan agreement or a permanent
loan commitment, the trustee may not assume that contract
and compel the lender to fund a construction project.
- 18 -
One
writer noted that the Bankruptcy Code does not clearly
define the obligations of such lenders upon an outstanding
commitment where the bankruptcy petition was filea after
construction had begun.
He then queries whether a lender
could be compelled to perform its obligations 1n a Chapter
11 reorganization.
114
That question remains
unanswered.
Another aspect of bankruptcy law changed by the
Bankruptcy Code concerns the so-called "bankruptcy" or
"ipso facto" clauses commonly placed in leases.
The "ipso
facto" clause purports to terminate or modify the lease 1n
the event of bankruptcy or insolvency.
The old act
specifically recognized and gave effect to such
clauses.
115
The Bankruptcy Code expressly invalidates
these clauses.
116
The courts have had no difficulty
applying this provision in a straight-forward manner,
holding such clauses invalid. 117
The Bankruptcy Code
expressly invalidates another type of clause - an
anti-assignment clause.
A provision in an unexpired lease
prohibiting or conditioning the assignment of the lease
does not prevent the trustee from making an
assignment.
118
Nevertheless, before a trustee may
assign the lease, he must assume the lease and provide
adequate assurance of the assignee's future performance of
the lease.
119
The express invalidation of such a clause
.
.
.
36 S(f) ( 3 ) . 120
1s
state d 1n
sect1on
This provision would
permit enforcement of most executory contracts and leases
- 19 -
852
by the trustee despite contractual provisions to the
contrary.
Of course, an exception exists in the
Bankruptcy Code for executory loan obligations. 121
While most of the preceding discussion has
focused on the trustee's assumption of the unexpired
lease, the trustee has the alternative option of rejecting
122
the lease.
Should the trustee reject the unexpired
lease, the Bankruptcy Code expressly provides for the
rights and actions that would follow rejection.
Under the
old act, when the lessor became the debtor, the trustee
could reject the lease, but the rejection by the
debtor-lessor could not "deprive the lessee of his
estate."
123
This provision created consternation in the
courts trying to interpret the provision.
One
interpretation suggested that a trustee could renounce all
landlord obligations other than the duty to provide
possess1on while restructuring the tenant obligations,
especially the rental amount.
124
Meanwhile,
commentators held the view that the lessor's trustee could
not change any of the tenant's obligations but could alter
"burdensome" obligations of the lessor.
Penn Central Transportation Co.,
126
125
In In re
the lessor's
trustees sought to repudiate the lessees' obligations to
pay the existing rents.
The trustees sought to re-set the
rents at the higher current market level and evict the
lessees should they fail to pay the increased rents.
-
20 -
Recognizing the lack of a definitive precedent on the
127
matter,
the court denied the trustees' act1ons based
upon the equity of the situation. 128
In ruling as it
did upon equitable considerations, the court failed to use
the opportunity to expressly state that the "lessee's
estate" included the possessory right at the rent
originally agreed upon.
The Bankruptcy Code does not rectify the
problem.
Rather than speaking in terms of the "lessee's
estate," the Bankruptcy Code provides that should a
lessor's trustee reject an unexpired lease, the lessee may
treat the rejection as terminating the lease or,
alternatively, may remain in possession for the remainder
of the lease term.
129
If the lessee remains 1n
possession, he is entitled to offset against the rent
reserved under such lease and paid after the rejection any
damages that he may 1ncur as a result of the lessor's
130 Th e o ff se t
.
. l ease o bl'1gat1ons.
nonperformance o f h1s
is limited to damages occurring after the trustee's
rejection, and the lessee is entitled to no recovery
against the estate for his damages, other than the offset
provided.
131
The following is an example of the
operation of the lessee's rights.
The lease requires the
lessee to pay rent of $1,000 per month and requires the
lessor to provide heating and cooling.
If the lessor's
trustee rejects the lease and ceases to provide the
heating and cooling, then the lessee can either view the
- 21 -
lease as terminated and walk away, or he can remain 1n
possession and deduct, from the rent payments he will
continue to make, any amount he expends in providing the
heating and cooling.
Another aspect of a lessor in bankruptcy
the possibility of a leasehold mortgage.
conc~rns
This situation
would exist where the lessor merely leased land to the
lessee who in turn financed construction of the building,
g1v1ng the lender a mortgage on the ground lease.
If the
lessor's trustee rejects the ground lease, what becomes of
the leasehold mortgagee's security?
Probably nothing 1n
the situation where the ground lessee remains 1n
possession since the typical ground lease imposes no duty
upon the lessor other than to give the lessee possession.
It is not entirely clear, however, what treatment might
occur if the lessee terminates the lease.
No cases have
been reported as having decided this issue under the
provisions of the Bankruptcy Code.
The Fifth Circuit
Court of Appeals has held in In re Garfinkle
132 that
rejection of the ground lease would not divest the
leasehold mortgagee of its interest in the leasehold.
However, in Garfinkle, the debtor was the ground lessee.
While this decision may be argued 1n support of the
leasehold mortgagee's position for a lessor bankruptcy,
the lender might do well to include a clause in the
mortgage requiring the mortgagee's consent before the
lessee may exercise the option to terminate.
- 22 -
')r-r:
t~:-1~-J
What becomes of the leasehold mortgagee if the
lessee becomes the debtor 1n bankruptcy?
Since Garfinkle
is more analogous to this situation, it can be argued that
that decision should protect the mortgagee's interest.
Another situation that a leasehold mortgagee might face 1s
a reorganization under Chapter 11 by the debtor-lessee.
Since the plan may alter the debtor-lessee's obligations
to the mortgagee, the mortgagee could be harmed by
receiving less than its full claim.
This is so even if
the mortgagee rejects the plan because the plan could
still be "crammed down" upon the mortgagee. 133
An additional situation with ramifications for
real estate projects in bankruptcy involves leased
buildings owned by the landowner and in which the
construction lender holds a security interest.
This
arrangement presents the circumstance that the mortgage
claims will be superior to the leases.
Commentators have
argued that the building lessor's trustee should not be
allowed to revise the rent.
134
Refusing the trustee the
right to alter the rent could harm the debtor-lessor's
mortgagee.
If the building is leased at amounts below the
current market value, then the value of the building
itself could be depressed.
If the debtor is attempting a
reorganization, he might be able to "cram down" upon the
mortgagee a plan that gives the mortgagee cash or extended
payments equal only to the present value of the
building.
135
Increasing the rental of the tenants would
- 23 -
1ncrease the value of the building and offer the mortgagee
a better security interest on its loan.
No cases which
present this issue have as yet been decided.
Perhaps the
136
Penn Central case
may shed some light on the issue;
if so, it could only be a faint flicker.
The court there
suggested that, where an owner of a commercial building
project is the debtor, and the leases within the project
are subject to the mortgages upon the project, it might
allow the trustee to recast the rent.
However, this is
purely dicta since the mortgagees in Penn Central were all
subordinated to the leases.
The issue is not resolved 1n
the Bankruptcy Code, either.
INSTALLMENT LAND SALE CONTRACTS
A final real estate transaction affected by a
bankruptcy proceeding is an executory contract for the
sale of real property.
If the trustee rejects the
contract and the purchaser is in possession, the purchaser
may remain in possession or treat the contract as
terminated. 137
.
. possess1on,
If the pure h aser rema1ns
1n
he may offset from his payments any damages incurred
following rejection, but may not otherwise recover for
damages.
138
The purchaser will receive title from the
debtor when the payment schedule for the land sale is
complete.
139
Delivery of title relieves all other
140
.
.
obl1gat1ons
to per f orm under t h e con t rae t •
If th e
purchaser terminates the contract or if a party has an
executory contract to purchase real property from the
-
24 - 8r;~~~
..
,.
'
~
debtor rejected before the party is 1n possession, then
the terminating purchaser or the rejected, non-possessory
party has a lien on the debtor•s interest in the real
property for recovery of the amount of the purchase price
a l rea d y pa1. d • 141
CONCLUSION
The Chapter XII provisions for rehabilitating
bankrupt real estate development projects were only
beginning to be understood and appreciated as a valuable
bankruptcy tool when the old act was replaced.
Owners of
a project benefitted by receiving at least some value v1a
reorganization when a straight bankruptcy liquidation
would have provided them nothing in satisfaction of their
claims.
Chapter 11 of the Bankruptcy Code continues the
process begun under Chapter XII but with provisions
possibly less favorable to junior creditors and debtors.
Obviously, the procedural aspects have changed,
particularly with regard to the more stringent
requirements for a successful "cram down" and for class
approval before confirmation.
Also, fewer methods of
rehabilitation will be available for the debtor•s use 1n a
plan of reorganization.
The economic conditions in the
present real estate market suggest that many more projects
may be experiencing financial difficulties.
If the
reorganization procedures have been made too disfavorable
for the debtor under the Bankruptcy Codes, then he may
more readily opt for straight bankruptcy.
-
25 -
That would
defeat the progress being enjoyed under Chapter XII.
Hopefully, Chapter 11 will not fall into the disuse that
plagued Chapter XII before the real estate crunch of the
early Seventies.
- 26 -
1•
Pu b • L. No • 9 5- 5 9 8 , 9 2 S tat • 2 5 4 9 ( 1 9 7 8 )
(codified in Title 11 of the Unites States Code Bankruptcy).
In an effort to avoid stigmatizing the
Reform Act, this writer will refrain from using the word
"new" to describe the Reform Act and its provisions
[hereinafter referred to in the text as the Bankruptcy
Code] •
2.
The Chandler Act of 1938, Pub. L. No. 696, 52
Stat. 84 (formerly codified at 11 u.s.c. §§ 501-676,
801-926 (1976) [hereinafter referred to in the text as the
old act] •
3.
For the twelve months ended June 30, 1980,
prior to October 1, 1979, 67,517 cases were filed under
the old act; and after that date, 293,443 cases were
commenced under the Bankruptcy Code.
1980 Annual Report
of the Director of the Administrative Office of the United
States Courts.
4.
The 360,960 cases reported as of June 30,
1980, see note 3 supra, represented an increase of 59.4%
over the prior year and an increase of 41.8% over the
previous record highest year which occurred in 1975.
Id.
Bankruptcy Judge Bill H. Brister noted that business
filings for Chapter 11 reorganizations in his court
increased 300% in 1980.
Lubbock Avalanche-Journal,
April 21, 1981, at 1, col. 6 {evening ed.).
5.
See 11
u.s.c.
§§
701-766 (1979).
6.
These simplistic steps are suggested by the
title of Subchapter II of Chapter 7 - "Collection,
Liquidation, and Distribution of the Estate" 11 u.s.c.
§§ 721-728.
u.s. c.
7.
ll
8.
See generally 11
§§
1101-1174 {1979).
u.s.c.
9.
Bankruptcy Act, 11
{repealed 1979).
10.
Id. §§ 501-676.
11.
Id. §§ 701-799.
12. Bankruptcy Act, 11
{repealed 1979).
1121-1129.
§§
u.s.c.
§
u.s.c.
§§
205 (1976)
801-926 (1976}
13.
Practising Law Institute, The Bankrupt Real
Estate Partnetsn1.p:
Ptacn-ce and Proceffiffe 237 ( 197 7} •
14.
Id.
- 27 -
860
l5. Macey & Macey, The Chapter XII Chrysalis, 52
Am. Bankr. L.J. 121, 131 (1978)
-
----
rmm
16.
In rePine Gate Assocs. Ltd., 2 Bankr. Ct.
Dec. 1478, 1481 n.l2 (N.D. Ga. 1976).
17. Keeping in mind that Chapter 11 is a
consolidation of former Chapters X, XI, and XII and
therefore contains provisions that encompass a much
broader usage than that intended by Chapter XII,
provisions regarding the formulation of the plan, the
negotiations with the creditors, and the confirmation by
the court are very similar between the new and old. For a
complete discussion of Chapter 11 procedures, see King,
Chapter 11 of the 1978 Bankruptcy Code, 53 Am.-sankr. L.J.
107 (1979)
~
18.
11
19.
Id.
u.s.c.
§
§
101 (31)
(1979).
301.
20.
Id. § 303. Although Chapter 11 is the
reorganization-chapter and its sections, see note 7 supra,
apply to proceedings conducted thereunder~uch
proceedings are also subject to the provisions of Chapters
1, 3, and 5 where they do not conflict with anything
provided in Chapter 11.
Id. § 103(a).
21. Bankruptcy Act, 11
(repealed 1979).
22.
11
23.
Id.
u.s.c.
§
§
u.s.c.
§
821 (1976)
362 (1979).
362(a) (1).
24.
Id. § 362(b) (3). Section 546(b) subjects the
powers of the~rustee to any general law that allows
subsequent perfection of a lien against a bona fide
purchaser of real property.
Id. § 546(b).
u.s.c.
25.
11
26.
Id.
§
362(d).
2 7.
Id.
§
3 6 2 (d) ( 2) •
§
362(b) (7)
(1979).
28.
In re Sulzer, 1 C.B.C.2d 451 (S.D.N.Y. 1980)
and In re 18t~Ave. Dev. Corp., 1 C.B.C.2d 698 (S.D. Fla.
1979).
29.
See note 52 infra and accompanying text.
- 28 -
30.
11 U.S.C. § 1112 (1979}.
Inability to
effectuat~ a ~lan is specifically mentioned as a cause
that may ]ust1fy conversion to Chapter 7.
Id. §
1112(b} (2}.
31.
11
32.
Id.
u.s.c.
§
§
1121 (1979}.
1121 (b).
33.
Id. § 112l{c) (1); In re Vincent, 2 C.B.C.2d
186 (M.D. Tenn. 1980}; In re Hotel-xssocs., Inc., 1
C. B.C. 2d 7 3 3 (E. D. Pa. 19 8 0) •
34.
11
u.s.c.
§
112l{c) (4)
(1979).
35.
Id. § 112l(c} (2}; In re Cloud Nine, Ltd., 1
C.B.C.2d 589 (D.N.M. 1980).
----
u.s.c.
36.
11
37.
Id. § 1123.
38.
5 Collier on Bankruptcy ,, 1122.03 (15th ed.
§
112l{c) (3}
(1979).
1979}.
39.
In re Iacovoni, 1 C.B.C.2d 331 (D. Utah
1980); 6 Collier-on Bankruptcy ,, 9.10 at 1601 (14th rev.
ed. 1978) ; L. NorEOn, Real Property Arrangements, Part 18
(1977) [hereinafter cited as Norton].
40.
6 Collier on Bankruptcy
rev. ed. 1978).
--
~
9.10 at 1602 (14th
41.
Id. at 1601-02.
42.
Id. at 1602.
43.
Norton, supra note 39, at Part 18,
§
18-1.
44.
11 u.s.c. § 507 (1979).
These priority
claims include debts that a going-concern business debtor
incurred between the filing of an involuntary petition and
the order for relief, certain wages earned by the debtor's
employees, certain contributions that the debtor is
required to make to employee benefit plans, and various
taxes.
Id.
4 5.
6 Collier on Bankruptcy ,, 9. 13 at 16 20-21
(14th rev. ed. 1978). -=46.
In re Gay, 1 C. B.C. 2d 790 (D. Colo. 1980}; In
re Jaco Fabrics,-rnc., 15 c.B.C. 459 (M.D. Ga. 1978}.
- 29 -
8G2
47.
Norton, supra note 39, at Part 18,
48.
See notes 53-62 infra and accompanying text.
§
18-2
n.l.
49.
Section 506, 11 u.s.c. § 506 (1979),
concerning valuation of secured claims; section llll(b),
Id. § llll(b), permitting a nonrecourse mortgage creditor
to elect to treat his claim as secured to the extent that
the value of the debtor's property so covers his claim,
and then to be placed in the unsecured creditors' group
for the amount that his claim exceeds the value of that
property; and section 1129(b), Id. § 1129(b), indicating
that a "cram down" confirmationrnust protect secured
creditors on the basis of their entire claims, not merely
their § 506(a) valuation of that secured claim.
50.
In re Winston Mills, Inc., 1 C.B.C.2d 121
(S.D.N.Y. 1979).-(1976)
51.
Bankruptcy Act, 11 U.S.C.
(repealed 1979).
52.
Id.
§
§§
861 and 407
868.
53.
Id. § 807.
The concept of material and
adverse effects upon creditors was developed in case law.
See In re Consolidated Motor Inns, 1 Bankr. Ct. Dec. 1191
(N.D-.-G~ 1975) and In re National Lock Co., 9 F. Supp.
432 (N.D. Ill. 1934)--(a-section 77B proceeding analogous
to Chapter XI I).
54.
Bankruptcy Act, 11 u.s.c.
(repealed 1979).
55.
§
864 (1976)
See generally Norton, supra note 39, at Parts
24-26.
56.
Taylor v. Wood, 458 F. 2d 15 (9th Cir. 1972);
In re Herweg, 119 F.2d 941 (7th Cir. 1941); In re
Hamburger, 117 F.2d 932 (6th Cir. 1941).
57.
In re LaMarche & Cerino, 4 Bankr. Ct. Dec.
443 (M.D. Fla-.-1978); In re Marietta Cobb Apts., 3 Bankr.
ct. Dec. 720 (S.D.N.Y.-r977) In~ Hobson Pike Assocs.,
Ltd., 15 C. B.C. 346 (N.D. Ga. 1977).
58.
11 u.s.c.
§
1129(a) (10)
- 30 -
(1979).
863
59.
Klee, All You Ever Wanted to Know About Cram
Down Under the New BankrliPtcy Code, 53 Am. Bankr. L.J.
133, 137-38~979) [hereinafter cited a~lee] ~h1s
article, as its title indicates, is a thorough examination
of the "cram down" provisions of the Bankruptcy Code.
60.
In reBel Air Assocs., Ltd., 2 C.B.C.2d 103
(W.D. Okla. 1980):
(1980)
61 • S • 6 58 , 96th Con g • , 2d S e s s • § 1 0 7 (a) ( 9)
[hereinafter cited as Technical Amendments Bill].
62.
ll
u.s.c.
63.
5 Collier
(15th ed. 1979)~~--
ll26(f)
§
~
(1979).
Bankruptcy ,, 1123. 01 at 1123-7
64.
Rader v. Boyd, 267 F. 2d 911 (lOth Cir. 1959);
Kyser v. MacAdam, 117 F.2d 232 (2d Cir. 1941); In re Pine
Gate Assocs., Ltd., 2 Bankr. Ct. Dec. 1478 (N.D-.-G~
1976).
65.
In rePine Gate Assocs., Ltd., 2 Bankr. Ct.
Dec. 1478 (N.D. Ga. 1976).
66.
Id.
67.
Id.
68.
Darvilla Housing Corp. v. Accousti, 2 Bankr.
Ct. Dec. 1093 (D. Conn. 1976).
6 9.
Id.
70. Wachovia Bank & Trust Co. v. Harris, 455 F.2d
841 (4th Cir. 1972); In re Triangle Inn Assocs., 3 Bankr.
Ct. Dec. 716 (E.D. Va. 1977).
71.
See cases cited note 70 supra.
7 2.
Id.
7 3.
Id.
7 4.
K1ee, supra note 59, at 134.
7 5.
11
76.
Id. § 1124.
77.
Id. § 1129(b) (1)
u.s.c.
§
1129 (b)
- 31 -
(1979).
864
78. ~· § 1129(b) (2} (A). See notes 87-89 infra
and accompany1ng text.
--79.
11 U.S.C. § 1129(b} (2) (B)
infra and accompanying text.
(1979). See note 90
---
80.
In re Hall Assocs., 2 Bankr. ct. Dec. 432
(E.D. Pa. 1976) and In re Consolidated Motor Inns, 1
Bankr. Ct. Dec. ll9l~N.D. Ga. 1975).
81.
11 u.s.c.
82.
Id.
§
1124(1).
83.
Id.
§
1124 ( 2).
84.
Id.
§
1124(3).
§
1124 (1979).
85.
Id. § 1129(a) (10), as proposed to be amended
by the Technical Amendments Bill, supra note 61.
86.
11 u.s.c.
87.
Id.
§
1129 (b) (2) (A) (i).
88.
Id.
§
1129(b) (2) (A) (ii).
§
1129(b) (2).
89.
Id. § 1129(b) (2) (A) (iii).
The term
"indubitable equivalent'' has not yet been construed in any
reported cases.
The only reference to it in Mr. Klee's
exposition on "cram down" comes in a footnote citing its
orgin in In re Murel Holding Corp., 75 F.2d 941 (2d Cir.
1935). Klee-,-supra note 59, at 156 n. 147.
90.
11 U.S.C.
91.
See text accompany1ng notes 64-73, supra.
92.
See note 66 supra and accompanying text.
93.
See note 68 supra and accompanying text.
94.
See note 87 supra and accompanying text.
95.
11 u.s.c.
96.
Id. Section 1123(a) (5) states that a plan
§
§
1129(b) (2) (B)
1123(a) (5)
(1979).
(1979).
shall
(5) prov1de adequate means for the plan's
execution, such as -(A)
retention by the debtor of all or any
part of the property of the estate;
- 32 -
865
(B)
transfer of all or any part of the
property of the estate to one or more
entities, whether organized before or after
the confirmation of such plan;
{C)
merger or consolidation of the debtor
with one or more persons;
(D)
sale of all or any part of the property
of the estate, either subject to or free of
any lien, or the distribution of all or any
part of the property of the estate among
those having an interest in such property of
the estate;
(E)
satisfaction or modification of any
lien;
(F)
cancellation or modification of any
debenture or similar instrument;
cur~ng
(G)
or waiving any default;
(H)
extension of a maturity date or a
change in an interest rate or other term of
outstanding securities;
(I)
amendment of the debtor's charter; or
issuance of securities of the debtor,
or of any entity referred to in subparagraph
(B) or (C) of this paragraph, for cash, for
property, for existing securities, or in
exchange for claims or interests, or for any
other appropriate purpose . . • •
(J)
!d.
97.
The Bankruptcy Code does not define
"executory" contracts. Generally, a contract is executory
when "there ~s lack of full performance of the contract to
some extent on both sides." DeWitt, Application of the
New Bankruptcy Code to Real Estate Financing, 14 Real
Prop., Prob. & TrustJ. 410, 422 (1979) [hereinafter cited
as DeWi ttl.
u.s.c.
98.
11
99.
Id.
§
1123 (b) 2).
100.
Id.
§
365 (a).
§
365 (1979).
- 33 -
101.
Id.
§ 1101 (1).
This definition applies only
to Chapter 11 and is simply stated as meaning "the
debtor."
Id.
102.
Id.
§ 1107.
For efficiency's sake the
author will use the word "trustee" in discussing the power
to assume or reject but would remind the reader that these
provisions apply equally to the "debtor in possession."
103. Again, the author will write in terms of the
single item, the lease, but he is fully cognizant of the
fact that the Bankruptcy Code provisions apply also to
executory contracts.
Specific mention of contracts will
be made infra where the examples speak directly to
contractual matters.
104.
11
u.s.c.
§
365(d) (1)
(1979).
In re Shoppers Paradise,
!d. § 365(d) (2).
105.
Inc., 3 C.B.C.2d 484 (S.D.N.Y. 1980).
u.s.c.
365 (b)
106.
11
107.
!d.
§
365 (b) (1} (A).
108.
!d.
§
365 (b) (1} (B).
109.
!d.
§
365 (b) (1} (C).
§
(1979).
110. One court has said that the existence of
adequate assurance must be determined on a case-by-case
basis, giving due consideration to the facts and
circumstances of the case.
In re Luce Industries, Inc., 3
C.B.C. 574 (S.D.N. Y. 1980).
111.
11 u.s.c. § 365(b) (3).
Here, the trustee
must provide adequate assurance, inter alia, of the source
of rent due under the lease and that the percentage rent,
if any, due under the lease will not substantially
decline.
Id.
An article has been written specifically
detailing the application of the Bankruptcy Code to the
shopping center situation.
See Krasnowiecki & Vass,
Shopping Centers and the New Bankruptcy Code, 36 Bus. Law.
79 (1980).
u.s.c.
112.
11
113.
Id.
114.
DeWitt, supra note 97, at 423.
~
§
365(c) (1}
(1979).
365 (c) ( 2).
115. Bankruptcy Act, 11
(repealed 1979).
u.s.c.
- 34 -
§ 110
(1976)
116.
11 u.s.c. § 365(e)
(1979).
117.
In~ Nashville White Trucks, Inc., 2
C • B • C • 2d 51 2 ( M. D• Te n n • 1 9 8 0 ) ; In r e A. L • S • , Inc • , t /a
Ralph's Tr~nsmissions, 1 C.B.c.2a-s16 (E.D. Pa. 1980); In
r e Po tag e r 1. e , Inc • , 1 C . B • C • 2d 9 8 ( s • D • N • y • 1 9 7 9 ) .
118.
11 u.s.c. § 365{f) (1)
119.
Id. § 365{f) (2}.
120.
Id. § 365(f) (3).
121.
See note 113 supra and accompanying text.
122.
11 u.s.c.
and accompanying text.
§
365(a)
(1979).
(1979}; see note 100 supra
123. Bankruptcy Act 11 u.s.c.
(repealed 1979).
124.
§
llO(b)
(1976)
In re Freeman, 49 F.Supp. 163 {S.D. Ga.
1943).
125. See Kane & Ruttenberg, The Landlord-Tenant
Relationship in Bankruptcy, 12 Real Prop., Prob. ~ Tr J
482 {1977}; Creedom & Zinman, Landlord's BanRruptcy:-Laissez les Lessees, 26 Bus. Law. 1391 {1971) [hereinafter
cited as Creedom & Zinman].
126.
458 F.Supp. 1346 {E.D. Pa. 1978).
127.
Id. at 1355 n 7.
128.
Id. at 1356.
The court relied on the fact
that the increase in the rental value of the property
resulted from the economic conditions in general, rather
than the lessor's financial difficulties.
The court saw a
distinction between the creditors who extend credit and
run the risk of a financial downturn of the debtor and the
lessees here who fairly negotiated the terms of the lease
which were agreeable to the lessor and lessee when the
lease was entered.
129.
11 u.s.c. § 365(h) (1)
130.
Id. § 365 (h) ( 2).
131.
Id.
(1979).
132.
577 F. 2d 901 {5th Cir. 1978). For an
analysis of the court's decision, see Fifth Circuit Survey
~ Bankruptcy 11 Tex. Tech L. Rev. 301, 305-08 (1980).
- 35 -
868
133.
See notes 55, 75-77 supra and accompanying
134.
See Creedom and Zinman, supra note 125.
135.
See note 87 supra and accompanying text.
136.
See note 126 supra and accompanying text.
137.
11
138.
Id.
§
365(i) (2) (A).
139.
Id.
§
365(i) (2) (B).
140.
Id.
text.
u.s.c.
§
365(i) (1)
(1979).
141.
Id. § 365(j). Also, In re 18th Ave. Dev.
Corp., 1 C.B.C.2d 698 (S.D. Fla. 1980~
- 36 -