REAL ESTATE ASSETS IN A BANKRUPTCY/RESTRUCTURING – SELECTED ISSUES
When an entity in financial distress is declared bankrupt, or placed under a court-supervised rescue mechanism under the Restructuring Law, among the many legal consequences are those pertaining to real estate assets that it owns. The inclusion of such assets in the bankruptcy or restructuring estate can prove a blessing or a burden. The interests of the distressed entity, its various creditors, but also third parties come into play. This article looks at selected issues involved.
I. Mortgages and lease agreements
A mortgage or mortgages may exist on a property or properties belonging to the entity being placed under restructuring, established as security for obligations to third parties. It is worth noting, first, that not all such mortgages remain effective in a restructuring proceeding.
Under the Restructuring Law, any collateral, including mortgage, that was not established in direct connection with the receipt of a benefit by the debtor, established by the debtor in the 12 months before they filed for restructuring, is ineffective.
Also ineffective is the part of any collateral established in the 12 months before the debtor filed for restructuring whose value on the day it was established – together with accessory performances – exceeded by more than 50% the value of the benefit received by the debtor.
Another important issue is the admissibility of establishing new mortgages on the debtor’s properties after the initiation of the restructuring proceeding. The Restructuring Law stipulates that the mortgaging (or otherwise encumbering) of the debtor’s assets to secure claims that arose before the restructuring proceeding was initiated is inadmissible, unless the application to mortgage (or otherwise encumber) was filed at least six months before the proceeding was initiated.
Thirdly, it should be noted that in principle, the rights of mortgage-secured creditors are not limited by debt repayment arrangements concluded as part of a restructuring proceeding. In other words, unless the creditor agrees for the mortgaged property to be incorporated into the restructuring estate, the property cannot be used to satisfy other creditors.
An entity declared bankrupt may have leased or rented out a property or properties it owns to third parties. What happens to such agreements when its bankruptcy is declared? They remain binding, as long as the property in question was handed over to the lessee or tenant before the bankruptcy was declared.
II. Satisfaction of mortgage-secured creditors, exclusions from estate
Claims secured with a mortgage are satisfied from funds raised through the sale of the mortgaged property, net of costs of the proceeding, which however cannot exceed 10% of the sale proceeds. But before the creditor is satisfied, proceeds from the sale must be used to repay any maintenance allowances or sickness/disability/incapacity benefits that the debtor may owe.
Second, the Restructuring Law says that creditors may form groups with other creditors in the same situation ahead of the vote on a debt repayment arrangement. In the case of mortgage-secured creditors, however – where they are covered by the arrangement proposal – the formation of a group is obligatory.
A property that is part of the bankruptcy estate may prove difficult to sell. In such cases, the Bankruptcy Law permits it to be excluded from the estate (and returned to the failed entity). The receiver has to make several unsuccessful attempts to sell the property – lowering the asking price each time – before they can exclude it from the bankruptcy estate. This is an extreme and rare measure, however, for it is more advantageous for creditors to sell off a property even for a fraction of its value.
It is worth adding that a similar institution exists in restructurings, for it is possible to exclude a property from a debt repayment arrangement. In such a case, the property must be used to satisfy the creditor in full, and the text of the debt repayment arrangement has to be very precise about the scope of the exclusion.
A debt repayment arrangement may also be concluded as part of a bankruptcy proceeding. Importantly, in contrast to the restructuring proceeding – in which the creditor has to positively agree to an anticipated reduction of their claim in such an arrangement – here the creditor’s consent is presumed unless a positive objection is made.
III. Limits to creditor satisfaction, obligations on new owners
Foreclosure of a mortgaged property may or may not lead to the expiry of personal rights and claims, liens and easements over the property. The following do not expire: necessary-right-of-way easement; transmission easement; and easement established in connection with trespass during construction. The same applies to the right of perpetual usufruct and life estate, where they take precedence over all mortgages (subject to the fulfillment of certain additional conditions specified in the law); as well as to any other land easements that the judge-commissioner (i.e., the magistrate in bankruptcy) rules should remain in force.
With respect to properties leased or rented out to third parties, when such a property is sold, the new owner takes over as lessor. They can terminate the lease agreement, subject to statutory notice periods – but not if the agreement is for a definite period, was concluded in writing and with a certified date, and the property was already handed over to the lessee.
In an attempt to balance the housing needs of the debtor (and their immediate dependent family members) and the financial interest of the creditor, the Bankruptcy Law stipulates that, out of the proceeds received from the sale of the debtor’s house or apartment (where such a house or apartment is part of the bankruptcy estate), an amount has to be deducted and transferred to the debtor equal to the average 12-month or 24-month housing rent in the same or neighboring locality. (The provision thus is not meant to ensure that the debtor is offered substitute premises of the same or similar standard, but to make sure their housing needs, and their dependent family members’, are met.)
In a restructuring proceeding, a partial debt repayment arrangement – i.e., covering less than 100% of all liabilities – can be concluded. A mortgage-secured debt can be included in such an arrangement even without the consent of the creditor, provided that the debtor offers the creditor full repayment of their claim within a time period specified in the arrangement, or at least a level of repayment not lower than what the creditor can expect in pursuing satisfaction of their claim from the mortgaged property.
There is a difference of opinion as to whether a mortgage-secured claim can only be satisfied through a cash payment, or whether other forms of satisfaction are also possible, including conversion of the claim into equity. It is the opinion of this author that the former view – that only cash payment is acceptable – is at odds with the creditor’ right to choose remedies, and runs counter to the very essence of novation; and that other forms are therefore acceptable.
By Jan Akimenkow, trainee attorney-at-law
Originally published in PMR Construction Insight: Poland, No. 8 (257), August 2022