Do Not Shake Hands to Fail to Fly a Flag on a Ship of Fools: Violation of SPE Rules by Non-Borrowers Exposes Non-Borrowers to Potential Tort Liability | Cadwalader, Wickersham & Taft LLP

A recent New York Supreme Court decision may strengthen lenders’ ability to file lawsuits against third parties for involvement in a borrower’s breach of Single Purpose Entity/Insolvency Remote Loan Document Covenants.

The case, Sutton 58 Associates LLC, Complainant against Philip Pilevsky, et al., respondents, concerned a development project in the Sutton Place neighborhood of Manhattan. The lender provided mortgage and mezzanine loans totaling $147,250,000 to the project owner and its sole member. The loans were not repaid when due and the lender attempted to foreclose on its mezzanine loan. Prior to the proposed UCC foreclosure, the mezzanine borrower filed a voluntary Chapter 11 bankruptcy filing, which was followed by the mortgagee’s voluntary Chapter 11 bankruptcy filing. In a separate lawsuit in state court, the plaintiff lender alleged that prior to the bankruptcy filings, defendant Philip Pilevsky arranged for an affiliate to loan the mezzanine borrower $50,000 in order to hire a law firm to file for bankruptcy, leading to a violation of the loan document resulted in requirements for special purpose entities. The plaintiff further alleged that defendants Michael Pilevsky and Seth Pilevsky arranged for an affiliate to transfer three residences to the mortgagee in violation of the loan document’s requirements for a special purpose entity and to prevent the mortgagee from being a single-asset real estate company is for the purposes of the Bankruptcy Act, which would deprive the lender of procedural advantages in the event of bankruptcy. The lender also alleged that a Pilevsky company purchased a 49% interest in the mezzanine borrower’s parent company, which also violated the loan documents. Based on the foregoing, the lender sued the Pilevsky defendants in state court for tortious interference with contractual relationships. At the trial court level, the defendants sought summary judgment, arguing that the lender’s claims were anticipated by federal bankruptcy law. The district court rejected the application. The defendants appealed and the original appeals court overturned and granted the defendants’ motion. The lender then appealed to the Court of Appeal. The Circuit Court of Appeals ruled by a narrow 4-3 majority that the lender’s claims of tortious interference were not prejudiced and that those claims could be tried in a New York state court.

The majority wrote that the federal bankruptcy law suggests no intention of Congress to interfere with a state court’s authority to provide tort relief for claims made by a person who is not a debtor in the bankruptcy proceeding against persons who are also non-debtors in the bankruptcy proceedings due to interference in contractual relationships that exist independently of the bankruptcy proceedings. The majority found that the claims against the defendants are based on conduct that took place before the opening of the bankruptcy proceedings, does not call into question the regularity of the bankruptcy proceedings and does not risk interfering with the bankruptcy court’s control over the debtor’s estate.

The dissent, on the other hand, contended that because the plaintiff’s claims stem from the bankruptcy filings and seek damages, the plaintiff lender “recast as causes of action under state law what actually are complaints of bad faith filings and abuse of the bankruptcy system.” In addition, the dissent expressed concern that the majority decision will affect debtors’ access to bankruptcy rights (particularly debtors with limited funds), as the prospect of litigation in state courts could discourage attorneys and secondary lenders from assisting debtors. Accordingly, the dissent concluded that the claims were anticipated by federal bankruptcy law and could not be asserted in a state court proceeding.

The case did not involve claims under a recourse carve-out guarantee or other loan documents. The subject of the expert opinion was the lender’s claims against third parties who, according to the facts stated in the court decision, were apparently involved in the project as part of an emergency scenario. The Court found that, in the circumstances of this case, the insolvency code did not protect those third parties against claims by the lender that they had tortiously interfered with the contractual relationship between the borrowers and the lender. Therefore, it can be seen as strengthening the potential remedies a lender can have against third parties who put themselves in distress and helping the borrower to defeat the lender protections contained in the loan documents. Although nothing in the statements indicates that the Pilevsky defendants were previously associated with the borrowers, there is no reason to believe the court would have ruled differently had affiliates of the borrowers engaged in similar actions that might expose them to liability although these affiliates themselves may not have been parties to any recourse carve-out guarantee or other loan documents. However, it is important to note that the Court of Appeals did not address the sufficiency of the lender’s allegations to support a cause of action based on tort, nor did it address the prospects that the lender could actually enforce such claims. It merely found that the federal bankruptcy code did not, in the circumstances, prevent the lender from pursuing such claims in state courts independently of the bankruptcy proceedings.

The facts in this case appear suspicious at best. It was an apparent attempt by a “friend” of the borrower to provide funds to fund the borrower’s dispute with its lender and through transactions not permitted under the loan documents to prevent a lender from claiming protection for a single property transaction according to the bankruptcy law. The transactions orchestrated by the third party were clearly prohibited by the loan documents and do not appear to have been entered into for an independent business purpose based on normal commercial objectives. Rather, the transactions appear to have been driven by the impact they would have on the borrower’s plight and its “battle” with its lender. It’s unclear if this third party wanted to capitalize on a difficult situation and eventually become the majority owner of the fortune – but others should be warned of the implications of this decision. This decision is a welcome finding that could deter other third parties from allegedly helping borrowers violate negotiated restrictions on their loan documents.

Previous Banks and insurers in Iowa are preparing for an even more digitized world
Next What is APY? – Forbes Advisor