January 1, 1900

by Eric P. Kelner

In a recent decision in the Kara Homes, Inc. bankruptcy case, the New Jersey Bankruptcy Court was required to make a ruling as to whether the Debtors were “single asset real estate entities”, subsequent to the filing of motions for summary judg- ment by the secured lenders and the debtors’ cross-motion for summary judgment. This determination would effect whether the expedited stay relief provisions for single asset real estate entities would apply to the debtors, which require the debtors to begin making interest payments to the secured lenders ninety (90) days after the commencement of the bankruptcy case unless the debtor has filed a plan of reorganization that has a reasonable probability of being confirmed.

Background

In Kara Homes, Inc., a real estate builder filed a voluntary petition under Chapter 11 of the bankruptcy code along with 32 Debtor Affiliates (the “Affiliates”). The Affiliates owned separate real estate development projects for the construction of single family homes and condominiums. Kara Homes, Inc. owns ninety percent of each of the Affiliates and the principal of the corporation owns the remaining ten percent interest. On each of the Affiliates’ voluntary petition the Affiliates placed a check in a box identifying the case as a “single asset real estate case”. Each Affiliate also listed itself as a single asset real estate entity in response to a question on each Statement of Financial Affairs, which required the debtor to identify which of the debtor entities, if any, are single asset real estate entities. Subsequently thereto, each of the Affiliates amended their Statement of Financial Affairs to reflect that they were not, in fact, single asset real estate entities. The Affiliates then filed against each of the secured construction lenders, an adversary complaint for declaratory judgment seeking a determination that the Affiliates are not single asset real estate entities. The secured construction lender then filed motions for summary judgment seeking a determination that Affiliates were single asset real estate entities and the Affiliates cross-moved for summary judgment with respect to the same issue.

What are Single Asset Real Estate Entities?

Prior to the Bankruptcy Reform Act of 1994, the Bankruptcy Code lacked any express provision for a single asset real estate case. Then once the 1994 Act was enacted, there was a specific provision for the treat- ment of single asset real estate by defining the term “single asset real estate” in the Bankruptcy Code and by placing single asset real estate cases on an expedited reorganization track. This expedited reorganization track requires that the debtor begin making interest payments to the secured lenders ninety (90) days after the entry for the order of stay relief or the debtor has filed a plan for reorganization that has a reasonable possibility of being confirmed. If the debtor in a single asset real estate case is unable to comply with either of these provisions then the secured lender is entitled to stay relief.

The definition of single asset real estate first included a limitation to debtors with secured debts of no greater than $4 million. The $4 million cap was removed as part of the 2005 Bankruptcy Code revisions. Thus, the Bankruptcy Code currently defines “single asset real estate” as:

real property constituting a single property or project, other than residential real property with fewer than 4 residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental.

Applicable Caselaw

The Bankruptcy Court in rendering its opinion adopted the standard set forth In re Philmont Development with respect to whether the Affiliates’ cases are single asset real estate cases. The four criteria which must exist before a bankruptcy case falls within the ambits of the provisions for a single asset real estate case are the following: (1) real property must constitute a single property or project, other than residential real property with fewer than four residential units; (2) real property must generate substantially all of the income of the debtor; (3) the debtor must not be involved in any substantial business other than the operation of its real property and the activities incidental thereto and (4) the debtor's aggregate non-contingent liquidated secured debt must be less than $4,000,000. The court acknowledged that the last provision is inapplicable in accordance with the change of the Bankruptcy Code.

The court found that it was undisputed that the Affiliates operations met the first two requirements as set forth in Philmont. Thus, the disputed issue was with respect to whether the debtor was involved in any substantial business other than the operation of its real property and the activities incidental thereto.

Analysis

The court in reaching its determination took a practical approach as to whether the Affiliates engaged in any substantial business other than the operation of its real property and felt that what needed to be considered was “whether the nature of the activities are of such materiality, that a reasonable and prudent business person would expect to generate substantial revenues from the operation activities-separate and apart from the sale or lease of the underlying real estate.”

The Court offered a comparison of a country club, hotel or casino to the Affiliates’ business of selling homes. In the example, the country club, hotel or casino are the operating entities where they would generate revenue from such functions as catering, operating restaurants or selling merchandise. These functions would generate income separate and apart from the land owner’s income generated by leasing the real estate. Meanwhile, in the Kara matter, the Affiliates, even if they provided ancillary functions such as building homes or marketing the properties, these functions were merely incidental to the Affiliates’ efforts to sell these homes rather than an independent income stream such as in the country club example. Thus, the Court held that the Affiliates’ cases were in fact single asset real estate cases as the Affiliates were unable to meet the requirements as provided for in Re Philmont.

Conclusion

The Court in Kara Homes, Inc. bankruptcy case has set forth a pragmatic standard for determining whether a debtor’s case is a single asset real estate case. Prior to this decision, bankruptcy courts in other jurisdictions have analyzed this issue, have applied the third criteria as set forth in Philmont and utilizing similar fact patterns and reached a different result as there was no clear test as to what qualified as a “business other than operation of its real property.” However, the ruling set forth in Kara Homes, Inc. now provides a defined test as to whether the debtors were involved in any substantial business other than the operation of its real estate and will most likely result in more consistent decisions in single asset disputes. 

Eric P. Kelneris an associate of Hill Wallack LLP where he is a member of the Real Estate Division and Creditors’ Rights/Bankruptcy Practice Group.