Not Just the Usual Suspects: Court of Appeals Allows Lender’s Suit Against Parties that Financed Hostile Bankruptcy

A recent decision by the New York Court of Appeals adds teeth to the ability of real estate lenders to dissuade borrowers from filing bankruptcy and highlights the risks faced by borrowers that choose bankruptcy – and those that assist them.

The decision, Sutton 58 Associates LLC v. Pilevsky, permits a lender to pursue a tortious interference suit against investors who were not parties to the loan documents but who financed an attempt by borrowers to stave off a foreclosure through bankruptcy. It also provides a road map for lenders in how to prepare a complaint that will survive a motion to dismiss

Background

This case grew from an attempt to develop and construct a megatower in the tony Sutton Place neighborhood of Manhattan. The lender entered into acquisition and building loan agreements with the property owner as well as a mezzanine loan agreement with property owner’s parent company, and received mortgages on the project realty plus a pledge from the parent/mezzanine borrower of its equity in the property owner. When the loans matured, the lender started a UCC foreclosure on the mezzanine loan, and the mezzanine borrower filed a chapter 11 petition.

The mezzanine borrower/debtor had been set up as a bankruptcy remote vehicle, with no assets other than equity in the property owner/mortgage borrower. Before filing the bankruptcy petition, the mezzanine borrower and its principals took several steps in preparation for the bankruptcy case that allegedly violated “bankruptcy remote” covenants in the loan documents and the mezzanine borrower’s LLC agreement, which steps later formed the basis of the tortious interference suit. They brought in new investors (“New Investors”) with an indirect 49% interest in the project, and received in return money to be used to fund a retainer for bankruptcy counsel and interests in unrelated property.

The lender’s motion to dismiss the bankruptcy case as a “bad faith filing” was denied. This gave the mezzanine borrower/debtor a window of opportunity to look for new project financing and to launch litigation against the lender, seeking a determination that the lender’s claims were inflated. However, the debtor was unsuccessful. It was unable to obtain new financing over the following months, and the bankruptcy court rejected the debtor’s accusations of lender wrongdoing. The bankruptcy court then permitted the lender to file a plan of reorganization that it had negotiated with the creditors committee. Under this plan, which the court subsequently confirmed, the lender bid in its debt and acquired the property.

Tortious Interference Suit

The lender then sued the New Investors in state court, alleging that the New Investors had induced the parent/mezzanine borrower to breach its “bankruptcy remote” covenants, and asserting that the lender had been damaged because the parent/mezzanine borrower’s actions added to the cost and duration of the bankruptcy case. The trial court denied the defendants’ motion to dismiss the case, which was based on the argument that the tortious interference suit was preempted by federal bankruptcy law. On appeal the Appellate Division reversed. On further appeal the Court of Appeals ruled for the plaintiff/lender in a split decision.

The dissent argued that the lender was trying to relitigate its “bad faith filing” motion in state court, and that the bankruptcy court should have exclusive jurisdiction over the propriety of bankruptcy filings. The majority, however, found decisive that the alleged tortious conduct consisted of pre-bankruptcy actions rather than the filing of the bankruptcy petition, and upheld the lender’s right to sue non-debtors for their pre-bankruptcy conduct.

Conclusions

The tortious interference suit in Pilevsky is distinct from the suit that was brought by the lender to enforce a “bad acts” guaranty given by the principals of the borrowers. The tortious interference suit was brought against subsequent investors who were not in the picture when the loan was structured and who thus were not parties to the loan documents. The tortious interference suit thus complements the “bad acts” guaranty by adding to the targets a lender can sue.

Pilevsky creates a road map for lenders in preparing complaints for such circumstances. Such a complaint should focus on prepetition acts taken in violation of covenants, although the subsequent bankruptcy case may be relevant for damages. Pilevsky also highlights the importance of including broad “bankruptcy remote” covenants in the loan documentation.

The issue in Pilevsky was implied preemption, because the tortious interference suit did not violate any express provision of bankruptcy law or of a bankruptcy court order. The defendants were not debtors, so the suit did not affect the scope of a bankruptcy discharge. Furthermore, because the bankruptcy plan of reorganization had been drafted by the lender, the plan did not contain any releases or injunctions that might inhibit the suit.

Pilevsky highlights the high stakes of a bankruptcy case. The debtor proposed a plan of reorganization that would have barred actions against the New Investors like the one that was actually brought. But the debtor’s plan was predicated upon a successful challenge to the lender’s claims, and when those challenges were unsuccessful the debtor lost, among other things, the ability to dictate the releases and injunctions to be included in the plan.

The decision notes that it is not at all clear how successful the tortious interference suit will be on the merits. However, the potential exposure created by Pilevsky may act as a disincentive to future investors regardless of the result of this particular litigation.

The implied preemption issue considered in Pilevsky is not the same as the one considered by the Second Circuit Court of Appeals in the Tribune decision discussed in our prior alert. Tribune held that a statutory bar on the bringing of certain clawback actions by a bankruptcy trustee should be deemed to preempt the bringing of similar clawback actions by creditors under state fraudulent conveyance laws. Pilevsky, on the other hand, involved the preclusive effect not of a specific statutory provision but instead of the bankruptcy system and laws in general