Two Sides of the Coin
January 14, 2008
New Jersey Law Journal, Bankruptcy Law
Real estate developers face both financial destruction and huge investment opportunities
Financial titans like Countrywide, Merrill Lynch,Citigroup and Wachovia already have written off tens of billions of dollars in subprime mortgage-related losses. Hundreds of thousands of homeowners nationwide are facing an unprecedented and increasing wave of foreclosures, even by Depression-era standards. Boards of Directors are discovering that management has exposed their companies and shareholders to serious financial risk with limited options. Congress is poised yet again to rewrite the bankruptcy laws to address this recent crisis. It therefore is hard to imagine what the other shoe - in this subprime mortgage and credit crunch debacle - will look like when it drops. But rest assured: it will drop and it will hurt.
Phase Two of this industry-created financial morass, unfortunately, has all the makings of a slow-moving train wreck, evoking fear of prolonged and sustained agony. Real estate developers and investors, perhaps more than any other affected group, will soon confront the proverbial two sides of the same coin: the very real potential of facing, at once, utter and complete financial destruction and, simultaneously, tremendous investment opportunities in a depressed housing market.
If there is a lesson to be learned in this sordid saga, it's to run for the hills when acronyms predominate and characterize the mechanism used for extending extraordinary sums of debt financing. SIVs, structured investment vehicles, are nothing more than a business-created entity designed to keep risky investment loans off the books of otherwise healthy financial institutions. MBSs, mortgage backed securities, and CDOs, collateralized debt obligations, are simply fancy terms to describe the collateral package - for those ill-fated ARMs, Alt-As, IOs and similar subprime or "B/C" loans that comprise the massive debt held by SIVs. Hidden beneath these innocuous terms is an iceberg of poor lending practices, risky investments, inflated asset values, and a collateral base destined for unprecedented defaults on loans that never should have been made. This phenomenon, coupled with a depressed housing market, rising interest rates,tightening credit standards and risk management practices, and dramatically reduced consumer spending, portends a perfect storm disaster - the other shoe falling - as parties begin the tedious process of liquidating the real estate that undergirds this erstwhile house of cards.
In the inevitable liquidation of the underlying real estate assets that secure these predatory and often misguided loans, holders and potential developers of real estate will face daunting challenges. While it is clear that many of the valuations of the real estate used to secure these massive debt obligations were inflated, less clear is the extent to which any of this disaster was caused by intentional fraud, including the double and triple pledging of assets to secure multiple loans and the lack of marketable title and other traceable security documentation to allow for an orderly liquidation of realty. Moreover, the traditional rules governing these matters are shifting, as Congress and the president jockey for cover in the rush to enact laws to address these mostly unintended consequences, resulting in potentially significant changes to the field on which foreclosures and bankruptcies traditionally are played out (one bill pending in Congress, for example, would amend the Bankruptcy Code to allow courts to rewrite mortgage obligations to address perceived bargaining inequality that spawned the subprime debt in the first place). To be sure, whether developers are liquidating or buying, the rules of the last five years, earmarked by easy credit, have changed for both buyers and sellers.
Many developers currently hold real estate in yet another acronym-labeled vehicle: the LBA (Land Bank Agreement). Like the SIV, an LBA is a special purpose entity created for a homebuilder/developer to avoid direct ownership of the land to be developed, thus removing the debt associated with the acquisition and development cost of the land from a developer's balance sheet. In theory, the practice is less risky for the developer and more manageable for the lender to realize value from the underlying assets, in the event of a default. Its essence is contractual: the developer makes payments to the land banker which, in turn, makes the mortgage payments to the investor as the developer periodically draws down the funds to develop the property. Unable to refinance their way out of a financial problem or gain additional time to perform due to pressures on lenders, land developers necessarily will turn to the terms of an LBA for a way out.
Depending upon which side of an LBA a party lands, either as a developer or lender, and depending upon whether the objective is to quickly liquidate the underlying real estate to meet cash obligations or, as a potential buyer, to seize undervalued investment opportunities, it is likely that - in Phase Two of this financial crisis - the sale of these assets will take place in Chapter 11. There are some obvious and sound reasons for this. First, in this industrywide distressed housing market, and now severely restricted lending environment, the out-of-court restructurings that permeated the financial landscape over the past few years are simply no longer workable. Those restructurings were driven, in large part, by an abundance of readily available credit, a condition that no longer exists today. Second, legitimate title concerns, under- or over-valued assets, and potential fraud problems, such as double and triple pledging of a package of assets that comprise a CMO or MBS, all can be readily and definitively addressed with a Section 363 sale order in a bankruptcy proceeding. Finally, and arguably most importantly, is "recharacterization," a legal concept grounded in the equitable powers of the Bankruptcy Code's Section 105. Essentially, a party seeks to have the Bankruptcy Court disregard form over substance and recharacterize certain transactions, depending upon the potential benefit to various parties from the recharacterization. LBAs are perfect candidates for recharacterization, because they straddle that gray legal area between being an executory contract governed by Section 365 of the Bankruptcy Code and a disguised financing vehicle, one which is subject to potential modification in Chapter 11. The latter includes the ability to cram down the secured portion of the loan to the value of the underlying real estate collateral with the balance of the loan being deemed unsecured and potentially dischargeable.
Recharacterization as a legal concept has its roots in the sale/lease back transactions of personal property, such as heavy equipment, aircraft and computers. Recently, it has found renewed relevance in bankruptcy cases where the underlying transaction entails real estate. A trilogy of decisions in the United Airlines, Inc., bankruptcy case, during 2005 and 2006, make clear the potentially far reaching consequences attendant to recharacterization. In each of the decisions, the court was called upon to characterize very complex transactions by which United Airlines obtained funds to acquire, build or improve airports at three major cities. After articulating a test which looks at multiple criteria under applicable state law, such as whether the underlying payments are market value, whether the contract terms include a nominal purchase option or a "hell or high water clause," and whether the underlying realty reverts in ownership once all periodic payments are made, the court concluded that two of the transactions were true financing deals and one was an executory lease that could be rejected in bankruptcy. Thus, one case, one bankruptcy court, three financing transactions and two significantly disparate results for the parties. It takes little imagination to envision the potential litigation and bargaining strategies afforded by recharacterization.
Real estate developers, those in financial crisis and those flush with cash eyeing investment opportunities, will likely look back on the next two years and observe, as Charles Dickens did in A Tale of Two Cities, "it was the best of times, it was the worst of times." One thing is certain: prepackaged bankruptcies, single asset real estate filings seeking to realign debt to market valuations, Section 363 sales to enable assets to quickly return to market, and the good old-fashioned Chapter 11 reorganization will be the tools used by sellers and buyers alike to maximize recoverable values in the liquidation of the real estate that underlies these presently unsound business loans. Just as the bankruptcy courts were called upon to resolve massive environmental and asbestos liability and class action law suits, it is the optimum forum in which to sell realty free and clear of liens, to clear title, to remedy fraud and, ultimately, to furnish a market place for the efficient sale of encumbered assets.
This article is reprinted with permission from the JANUARY 14, 2008 Issue of the New Jersey Law Journal @2008 ALM Properties,lnc. Further duplication without permission is prohibited. All rights reserved.