Sutton 58 Associates LLC v. Pilevsky: Preemption You Cannot Take To The Bank(ruptcy)
Bankruptcy is a matter of federal law. Tortious interference with contract is a matter of state law. So where does that leave a tortious interference claim related to a bankruptcy petition? The New York Court of Appeals shed some light on that thorny issue just before Thanksgiving last week, giving law geeks a lot to be thankful for in a meaty decision stuffed with tons of juicy legal reasoning. The short answer: if a tort claim does not implicate a borrower, then it is probably not preempted.
The facts of Sutton 58 Associates LLC v. Pilevsky are the stuff of New York City real estate developer nightmares, and bankruptcy and real estate finance lawyer dreams. The gist of the matter is that the plaintiff was a lender with deep pockets who loaned more than $100M to a couple of related entities who were trying to develop a real estate project in Manhattan. Significantly, none of the borrowers were defendants in the action that led to the Court of Appeals decision.
As part of the loan agreements, the borrowers agreed to certain common terms restricting their ability to take on other debt, to acquire other assets, and to transfer any interest in themselves. The loan agreements also contained provisions obligating the borrowers to become, and remain, “single-asset real estate entities.” These provisions were put in place to ensure that, in the event of the borrower’s bankruptcy (foreshadowing…), the lender/creditor could take advantage of the Bankruptcy Code’s expedited treatment of filings made by such entities. One requirement of “single-asset real estate entities” is that they cannot own more than three residential units.
As you might have guessed, the borrowers couldn’t pay back the loan when it matured and defaulted. What followed was a strategic litigation dance between lender and borrowers that resulted in one of the borrowers filing for bankruptcy in order to prevent the lender from foreclosing on the property. Critically, before (foreshadowing…) filing for bankruptcy, defendants in the Court of Appeals action loaned one of the borrowers $50,000 in order to retain bankruptcy counsel, transferred three residential properties to one of the borrowers, and transferred an interest in the borrowers to an entity that they controlled.
All of this activity had two direct and indisputable consequences: the borrowers would lose their status as “single-asset real estate entities,” and they would be in breach of the various provisions that they had agreed to in the loan documents that obligated them to, among other things, not take on additional debt, not transfer interests in themselves to anyone else and, of course, remain single-asset real estate entities.
When the dust eventually settled on the bankruptcy proceedings, much later than it presumably would have had the borrowers retained their status as single-asset real estate entities, the property had depreciated and the lender fell significantly short of its investment. Seeking to recover some of its losses, the lender sued the third-parties who had facilitated the borrowers’ pre-filing moves that resulted in the loss of single-asset real estate entity status and related breaches of the loan agreement for tortiously interfering with the lending agreement.
The alleged tortfeasors then moved for summary judgment on the grounds that the lender’s claims were preempted by the Bankruptcy Code. The trial court denied summary judgment, the Appellate Division reversed, and onwards to the Court of Appeals.
There is no question that bankruptcy is exclusively within the jurisdiction of the federal courts (it’s right there in the Constitution). Federal law can preempt state law either expressly by statute, or implicitly through so-called “field” preemption (in which federal law so comprehensively occupies a certain “field” so as to leave no room for state action) or conflict preemption (in which it is impossible to comply with both state and federal law, or state law would present an obstacle to achieving the objectives of federal law). There is a presumption against preemption that grows stronger when the state law at issue stems from the states’ “historic police powers.”
Defendants argued that plaintiff’s tort claims were preempted because they would otherwise undermine the objectives of the Bankruptcy Code. Essentially, defendants argued that state courts cannot be put in a position where they have to adjudicate the merits of a bankruptcy case, and cited a number of cases in which other state courts had found that tort claims alleging some form of wrongdoing by a party in connection with a bankruptcy filing were preempted.
In Sutton 58 Associates, the Court of Appeals identified the Bankruptcy Code’s focus as being on the debtor’s ability to obtain a “fresh start,” and determined that there is no risk of conflict where a tort claim is related to a bankruptcy filing, but is brought by a non-debtor against another non-debtor on the basis of alleged wrongdoing that happened prior to the bankruptcy filing, and would not affect that debtor’s estate.
At the end of the day, the Court of Appeals reasoned that, while the tortious interference claims were, of course, related to the borrowers’ bankruptcy filings, that relationship was “simply too tenuous to trigger preemption.”
Sutton 58 Associates does not address the interesting question of the merits of the tortious interference with contract claims. In New York, such a claim requires a showing that the plaintiff had a valid contract with a third-party, the defendant knew of the contract, the defendant intentionally and improperly interfered with the contract, and the plaintiff sustained damages as a result of the interference. The usual scenario involves a competitor of the plaintiff inducing customers or suppliers to leave the plaintiff and contract with him instead. It will be interesting to see how the tort claims in this case play out.