In sophisticated real estate financing transactions, most prudent lenders attempt to deter borrowers from filing for bankruptcy before loans are paid in full by providing in loan documents that such a filing constitutes an event of default. Many lenders will insist that their borrowers remain “bankruptcy remote” in the form of a so-called “single asset real estate” entity during the term of the loan.

The recent New York case, Sutton 58 Associates LLC v. Phillip Pivelsky, et al. (“Sutton”), provides two important, corresponding lessons: (1) public policy considerations allow borrowers to strategically file for bankruptcy notwithstanding contrary restrictions in their loan documents, and (2) lenders must thoroughly and diligently underwrite the borrower’s principals and individual guarantors (or guarantor principals) to ensure maximum recovery in the event of a strategic bankruptcy filing.

In Sutton, a real estate developer faced a UCC foreclosure of a large condominium project in Manhattan when the developer/borrower failed to repay a mezzanine loan upon maturity. A prominent real estate investor tried to help the developer by using the U.S. Bankruptcy Code to delay the foreclosure. Under bankruptcy law, if a borrower is not a “single asset real estate” company and files for bankruptcy, then the bankruptcy filing can delay a foreclosure for many months. But a “single asset real estate” borrower will generally find the chapter 11 bankruptcy process leads to liquidation and not reorganization.

The developer’s loan documents, like nearly all similar loan documents, required the borrower to remain a “single asset real estate” company during the term of the loan. That was problematic because it meant the developer could not, without some additional creativity, use bankruptcy to avoid its financial obligations to the lender under the loan documents.

To solve the problem, the investor transferred three apartments and cash to the borrower in exchange for an ownership share in the project. Thus, when the borrower filed for bankruptcy to stop the foreclosure, the investor owned four assets (the original collateral plus three apartments) instead of one. Because the bankruptcy case took several months, the foreclosure was delayed by almost a year.

In addition, the bankruptcy filing constituted a breach of the borrower’s loan documents and made the developer’s principal, as a guarantor, liable for the full amount of the loan. A court enforced the guaranty, awarding the lender a judgment against the guarantor.

Not satisfied with this outcome alone, in a separate action, the lender sued the borrower’s principal directly for tortious interference with contract on the basis that the borrower’s principal intentionally and improperly coerced the borrower to breach the loan documents to the detriment of the lender. The borrower moved for summary judgment, arguing that the lender’s claims where preempted by federal bankruptcy law. The trial court denied the motion as the lender persuaded the court that if the investor prevailed, then this would likely, in the court’s words, “upend the way contracts are written here in New York City and upend the whole development industry.” The borrower appealed, and the appellate court dismissed the litigation. The lender appealed that decision to the New York Court of Appeals, which recently held in a narrow 4-3 opinion that: (1) the lender’s tortious interference claims were not preempted by federal bankruptcy law, (2) summary judgment was not appropriate in this case, and (3) the matter should proceed at the trial court level. The ultimate disposition of the lender’s tortious interference claims will be decided in the coming months.

Accordingly, Sutton provides a simple but important cautionary lesson to real estate lenders: know your borrower and guarantor. Lenders must have a fulsome understanding of the financial health of the borrower’s principal(s) (as well as that of a guarantor if the guarantor is not an individual) to ensure the lender can be made as close to whole as possible in the event of a strategic bankruptcy filing.