It is common practice for owners of commercial real estate to create a separate entity to own each real estate project. That practice has led to changes in the bankruptcy law that affect those entities. Those changes and recent case law highlight the need for both owners and lenders to understand how single asset real estate is treated under the U.S. Bankruptcy Code.
What is a SARE?
The term "single asset real estate" (or SARE) refers to real property that consists of a single property or project that generates substantially all of the gross income of a bankruptcy debtor, whose only substantial business activity is the operation of that property. The term excludes family farming operations and residential real property with fewer than four units.
As an example, consider an LLC that owns a downtown office building. If that LLC derives substantially all of its income from leasing the property and does not own other real property, then the LLC is likely a SARE debtor. However, if the LLC uses the property as part of other business operations (for instance, as office space for a telemarketing business from which it derives most of its income) then the owner is likely not a SARE debtor.
Treatment in Bankruptcy
Before 2005, some SARE debtors filed for bankruptcy to delay a pending foreclosure for as long as possible, hoping that the market would improve enough to allow investors to recover some of their equity. To counteract that practice, Congress enacted stringent requirements on SARE debtors. Now a secured creditor can quickly pursue foreclosure against a SARE unless, within 90 days of the bankruptcy filing, the debtor has (i) filed a plan of reorganization that is reasonably likely to succeed or (ii) resumed making monthly interest payments at the non-default rate. For many cash-strapped SARE debtors, complying with those requirements can be difficult.
Recent Case Law Regarding Affiliated SAREs
In reality, many SARE debtors are part of much larger organizational enterprises that include numerous properties and entities. A recent bankruptcy case before the Ninth Circuit Court of Appeals addressed the question of whether there is an "enterprise" exception for such SARE debtors. In that case approximately fifty related entities filed for bankruptcy protection and requested that they be lumped together because of their common and consolidated management structure. In asking for such treatment, they hoped to avoid the stricter requirements imposed on SARE debtors.
The Ninth Circuit decided that unless the bankruptcy court orders "substantive consolidation" (i.e., combines the assets and liabilities of separate debtors into one common pool, and disregards the debtors' separate legal identities), there is no “enterprise” exception to the SARE requirements. An in-depth discussion of substantive consolidation is beyond the scope of this client alert but, as a general matter, an order for substantive consolidation requires significantly more than a consolidated management team and cash management system.
The recent Ninth Circuit case highlights the importance for real estate investors and developers to carefully evaluate their circumstances before putting their SARE entities into bankruptcy. Likewise, lenders must pay careful attention to the organizational structure and operations of their borrowers, to avoid losing the bankruptcy protections which the SARE provisions were intended to provide.
Bankruptcy raises numerous issues for real estate investors, developers and secured creditors alike. The Bankruptcy & Troubled Loans practice group can help clients understand, plan for, and navigate bankruptcy issues involving real estate assets and/or entities. For more information on this Client Alert or for help evaluating your current situation, contact any of the attorneys in the Bankruptcy & Troubled Loans practice group (for a listing, click here).