New York’s Highest Court Finds That Federal Bankruptcy Law Does Not Preempt State Law Tortious Interference Claims in Important Case Litigated by Kramer Levin

On Nov. 24, 2020, the State of New York Court of Appeals ruled in favor of Kramer Levin client Sutton 58 Associates LLC (Sutton), an affiliate of Gamma Real Estate, in its $100 million lawsuit brought against real estate investor Philip Pilevsky, his sons and related entities. The 23-page majority opinion held that federal bankruptcy law did not preempt Sutton’s state law claims for tortious interference with contract. This landmark decision from New York’s highest court reversed a decision of the Appellate Division, First Department, which had imperiled the enforceability of “bankruptcy remote special purpose entity” loan structures and “bad boy” springing loan guarantees. The decision thus preserves these two common real estate financing tools that are crucial to many Kramer Levin clients.

Sutton’s suit seeks more than $100 million in damages for defendants’ tortious interference with Sutton’s loan agreements with the original developer of a proposed residential tower on Sutton Place and 58th Street in Manhattan. Sutton alleges that the defendants intentionally caused the borrowers to breach numerous loan covenants, including by upsetting the single-purpose structure of the borrower entities. The defendants loaned $50,000 to one borrower entity to retain counsel for bankruptcy filings and transferred three occupied cooperative apartments to another borrower entity in exchange for an ownership stake in the borrower’s parent entity. The borrower entities defaulted on their loans, filed for bankruptcy and prevented Sutton from recovering its collateral at auction for nearly a year. Notably, the apartment transfer allowed the borrower entity to file for bankruptcy without qualifying as a single-asset real estate entity, which would have expedited the bankruptcy proceedings.

The defendants contended that their conduct was designed to facilitate borrowers’ bankruptcies and that it was therefore protected under federal preemption law and could not be the subject of state court claims. Justice Shirley Werner Kornreich, the since-retired Manhattan Commercial Division justice, rejected this argument. She remarked at oral argument that dismissing the case would “upend the way contracts are written here in New York City and upend the whole land development industry.” Justice Kornreich noted that the single-purpose entity provisions in the borrowers’ loan agreements “are similar to loan papers I see all the time.”

Last year, the First Department reversed Justice Kornreich’s decision and dismissed the case. The First Department found that Sutton’s damages resulted from the borrower’s bankruptcy filings and that Sutton’s claims were therefore preempted by the federal Bankruptcy Code.

The First Department’s decision raised the alarming prospect that commonplace single-purpose entity loan provisions would be unenforceable. Such provisions are intended to assure lenders that their borrowers will remain simple entities and that lenders can exercise their remedies quickly if a borrower defaults, including in the event that a borrower entity files for bankruptcy. The First Department’s decision signaled to the lending community that lenders could no longer enforce single-purpose entity provisions, since state law claims based on breaches of such provisions would be preempted by federal bankruptcy law. By logical extension, since personal liability of borrower principals under springing guarantees also is triggered by conduct taken to facilitate a bankruptcy, the decision also threatened the viability of those guarantees. The First Department decision thereby jeopardized two cornerstones of real estate and other types of finance, causing great concern in the real estate finance industry, as was reported at the time.^[1]

Supported by amicus briefs submitted on behalf of the American College of Mortgage Attorneys and the New York Bankers Association, Kramer Levin raised these policy concerns with the Court of Appeals, which ultimately put lenders’ worries to rest. Associate Judge Leslie E. Stein, writing for the majority, wrote that “Plaintiff’s tortious interference claims – asserted against defendants who were not debtors in the bankruptcy proceedings and which are premised upon conduct that occurred prior to those proceedings – are peripheral to, and do not impugn, the bankruptcy process.” The Court found that the “resolution of plaintiff’s claims in state court does not risk interference with the Bankruptcy Court’s control over, or disposition of, the bankruptcy estate insofar as the present suit does not impair the debtors’ estates.” Accordingly, the court held that the plaintiff’s claims “will not encroach upon the province of the bankruptcy court” and are not preempted. This noteworthy decision was a huge victory, not only for Kramer Levin client Sutton, but for the entire real estate finance industry.^[2]

Sutton’s suit will now proceed in the lower courts, and lenders may continue to rely upon routine special-purpose entity provisions and springing guarantees.

^[1] _{See Mack Burke and Cathy Cunningham, “Latest Sutton 58 Court Decision Could ‘Upend’ Construction Financing Deals: Ruling in Gamma Real Estate’s Sutton 58 project OKs the circumvention of special-purpose entities and could make construction financing more expensive,” Commercial Observer, Jan. 11, 2019, https://commercialobserver.com/2019/01/latest-sutton-58-court-decision-could-upend-construction-financing-deals/.}

^[2] _{See Tom McParland, “Court of Appeals Revives $100M Lawsuit, Finding Tortious Interference Claims Not Preempted by Bankruptcy Law,” New York Law Journal, Nov. 25, 2020, https://www.law.com/newyorklawjournal/2020/11/25/court-of-appeals-revives-100m-lawsuit-finding-tortious-interference-claims-not-preempted-by-bankruptcy-law/; Rich Bockmann, “Court overturns ruling that would have upended ‘the whole land development industry,’” The Real Deal, Dec. 3, 2020, https://therealdeal.com/2020/12/03/court-overturns-ruling-that-would-have-upended-the-whole-land-development-industry/.}