When a DST Sponsor Files Chapter 11: What Investors Own and What They Can Expect

Chapter 11 reorganizes the sponsor; the trust was built so that the sponsor's creditors cannot reach its building

Under 11 U.S.C. section 541(a)(1) the estate comprises all legal or equitable interests of the debtor in property as of the commencement of the case. A DST sponsor's interests are typically its management and advisory contracts, its fee receivables, its retained interest in trusts still being sold, its ownership of the master tenant and other affiliates, and any guaranty it signed. Section 541(d) adds the limit that matters to you: property in which the debtor holds only legal title becomes property of the estate only to the extent of that legal title.

Delaware law points the same way. Under 12 Del. C. section 3805(g) no creditor of the trustee may exercise remedies against trust property for claims against the trustee in its individual capacity, and section 3808(b) provides that a trustee's bankruptcy does not dissolve the trust unless the governing instrument says otherwise. The building, the lease and the loan stay where they were; why the master tenant's failure is the more direct threat is on sponsor or master tenant bankruptcy.

Many affiliates file at once, so the first job is to find out which entities are debtors and whether your trust is one of them

A sponsor rarely files alone; the operating company, the master tenants it owns, the guarantor and dozens of single-purpose entities may file together and be jointly administered. The trust holding your property is usually not among them, because it is a separate Delaware statutory trust with its own trustee and lender. Check the petition's list of debtors for the trust's exact legal name and for the master tenant's, since a master tenant that is a debtor is a very different case.

If the master tenant is a debtor, 11 U.S.C. section 365(d)(3) requires it to perform the lease on time until it assumes or rejects, and section 365(d)(4) allows 120 days from the order for relief, plus one 90-day extension for cause, before the lease is deemed rejected. Rejection leaves the trust an unsecured claim capped by section 502(b)(6) at the greater of one year's rent or 15 percent of the remaining term, not exceeding three years.

If the trust itself has filed, which can happen when a sponsor uses a petition to stop a foreclosure, the automatic stay in section 362(a) halts lien enforcement, but section 362(d) requires the court to lift it for cause or where the debtor has no equity in the property and it is not necessary to a reorganization; rents become cash collateral under section 363(a) that cannot be spent without the lender's consent or a court order.

Who runs the sponsor during the case: the debtor in possession, a committee, and possibly a trustee or examiner

Under 11 U.S.C. section 1107(a) the debtor in possession has the rights and powers of a trustee, so the sponsor's existing management keeps operating, signing investor reports and dealing with lenders under the supervision of the court and the United States trustee. Section 1102(a)(1) requires a committee of unsecured creditors, and section 1102(a)(2) lets the court order additional committees, including one of equity security holders.

Management can be displaced. Section 1104(a) requires the court to appoint a trustee for cause, including fraud, dishonesty, incompetence or gross mismanagement, or where appointment is in the interests of creditors and equity holders. Where no trustee is appointed, section 1104(c) requires an examiner if that serves the estate or if the debtor's qualifying unsecured debts exceed $5,000,000; an examiner's report is often the first independent account investors get of how the sponsor was run. Neither becomes the trustee of your DST; see who controls a DST.

The property's loan reacts to the filing on its own terms, and a filed DST loan treats a guarantor's bankruptcy as a default

The lender on the trust's property is not a creditor of the sponsor, but the sponsor usually sits inside the loan documents as guarantor and as owner of the master tenant. A loan and security agreement for a multifamily DST on file with the SEC makes a bankruptcy event of the borrower an automatic default that accelerates the loan, defines bankruptcy event to include a voluntary filing by the master tenant, and treats a guarantor bankruptcy event as a default unless a qualifying replacement guarantor is supplied within 90 days.

The same agreement starts a cash management period on any event of default, sweeping collected rents to a lender account, and lets the lender terminate the master lease when a material master lease default coincides with a loan default. Rev. Rul. 2004-86 forbids the trustee from renegotiating the debt, so a cure usually requires a successor manager to step into the guaranty, or a conversion to an LLC that can refinance. Otherwise the path runs through a receiver to foreclosure, covered on DST receivership explained, with your equity exposed in full.

Claims, the bar date and the plan: what an investor can file, and what a plan must give a creditor who votes no

As a beneficial owner you are generally not a creditor of the sponsor; your interest is in the trust. You become a creditor only if a debtor owes you something directly: a guaranty of master lease rent, a repurchase or liquidity commitment in the offering documents, or damages for misrepresentation. Those claims are unsecured, must be filed by the bar date the court sets, and are paid under the plan with every other unsecured claim.

11 U.S.C. section 1121(b) gives the debtor the exclusive right to file a plan for 120 days after the order for relief and 180 days to obtain acceptance, extendable for cause to outer limits of 18 and 20 months. Under section 1129(a)(7) each holder of an impaired claim who has not accepted must receive at least what a Chapter 7 liquidation would pay, and under section 1129(b)(2)(A) a dissenting secured class must keep its lien and receive payments worth its claim, have its collateral sold with the lien attaching to proceeds, or receive the indubitable equivalent.

Hypothetical, in round figures: the sponsor's guaranty covered $600,000 a year of master lease rent on your trust and payments stopped when it filed. The trust files an unsecured claim; the plan, two years later, pays unsecured creditors a small fraction of face, and your 5% share of the recovery is a few thousand dollars against a $500,000 interest. The real question was always the building's own rent and loan, so ask your CPA to model the trust's income without the guaranty before you read the plan.

What to do in the first weeks: get on the service list, read the first-day filings, and separate the trust's calendar from the sponsor's

Chapter 11 cases are public. The docket shows the petition, the list of debtors, the first-day declaration explaining why the sponsor filed, motions to use cash collateral, and later the schedules of assets and liabilities. The first-day declaration is usually the most candid document a sponsor ever publishes about its finances. Use your Delaware information right to ask the trust's trustee, in writing, for the lender's notices and the reserve balances; if the offering documents contain a sponsor promise to you, calendar the claims bar date, and if they do not, your attention belongs to the lender's timetable, which the sponsor's case does not stay.

Then reassess the interest on its own merits. How to evaluate and compare DST sponsors sets out the balance sheet questions; DST illiquidity and exits explains why selling during a sponsor's case is rarely practical; and the complaint and arbitration routes against the selling firm are on my DST stopped paying distributions. Confirm the claim and tax questions with your attorney and CPA.