Wednesday, May 30, 2012

FYI: 3rd Cir Holds Commercial Second Lien Holder Unsecured Based on Appraisal, Not Projected Plan Revenue

The U.S. Court of Appeals for the Third Circuit recently held that a creditor with a second lien mortgage in a Chapter 11 proceeding was properly determined to be an unsecured creditor under Section §506(a) of the Bankruptcy Code where: (1) the appraised value of the debtor's collateral was less than the first position lender's claim; and (2) the debtor's reorganization plan projected enough revenue from the future sale of the collateral to pay off both the first and second liens in full.
A copy of the opinion is available at:
Debtors were real estate developers who had obtained a series of construction loans that they ultimately defaulted on.  Debtors filed a voluntary petition for Chapter 11 bankruptcy.  A group of banks (the "First Lenders") had first position mortgage liens on all property owned by the Debtors with an approximate balance due of $12,000,000.  An investment group (the "Second Lender") had a second position mortgage lien on the debtor's property with an approximate balance due of $1,400,000.  
Debtors submitted a reorganization plan that was confirmed by the bankruptcy court.  The parties stipulated that "[b]ased on the Appraisal, the total fair market value of the Project as of the Confirmation Date [wa]s $9,543,396.23."  Additional assets held by Debtors raised the total value of the collateral securing liens to $11,165,477.15.  As a result, the total value of Debtors collateral as of the Confirmation Date was less than the balance due to the First Lenders. 
However, Debtors final plan included a projected budget that anticipated full payment of both the First Lenders and Second Lender through the development and sale of lots with completed townhouses and single-family homes over the course of  47 months.   According to the budget, unsecured claimants would receive distributions amounting to approximately 45% of their claims.
The Official Committee of Unsecured Creditors (the "Unsecured Creditors Committee") filed a motion to value the secured claims of the Second Lender pursuant to 11 U.S.C.  § 506(a) and Federal Rule of Bankruptcy Procedure 3012.  The Unsecured Creditors Committee argued that the Bankruptcy Court should value the secured claims at zero because the collateral securing the Second Lender was worth less than the First Lenders' senior secured claim.  As proof of the collateral's worth, the Unsecured Creditors Committee submitted the aforementioned appraisal previously accepted by the Bankruptcy Court.
The Second Lender contended that the appraisal did not control because § 506(a) requires that the value of property "be determined in light of [its] proposed disposition or use" and the plan budget demonstrated that the Debtors would be able to pay their claims in full over time as more homes were sold.  The Second Lender also urged the court to adjudicate its claims fully secured, arguing that to deprive them of Project revenue to be generated over and above the appraisal value would constitute impermissible lien stripping.   
Both the Bankruptcy Court and the District Court agreed with the Unsecured Creditors Committee, and ruled that the Second Lender's collateral was valued at zero putting the Second Lender into a class of unsecured creditors.
The Third Circuit affirmed.  Central to the Third Circuit's resolution of this case was the text of § 506(a), which as you may recall provides in pertinent part:
"An allowed claim of a creditor secured by a lien on property in which the estate has an interest . . . is a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property . . . and is an unsecured claim to the extent that the value of such creditor's interest . . . is less than the amount of such allowed claim.  Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property . . . ."
The Third Circuit rejected the Second Lender's argument that the Debtors plan budget constituted a determination of collateral value "in light of the disposition or use of the property."  Rather, the Court noted that both the Bankruptcy Court and the District Court accurately characterized the budget as simply a set of projections offered in support of the plan's feasibility, i.e., to demonstrate  that the plan would have a "reasonable probability" of success.  The Third Circuit noted that the plan was not intended to function as anything more, and most certainly not as a determination of the value of the Second Lender's interest in the Project.  A "probability" of realizing the budget is not a certainty of its realization.  In sum, valuations must be based upon realistic measures of present worth.
The Third Circuit further noted that the appraisal's determination of the discounted fair market value of the property as of the confirmation date, best approximated just how secure the liens held by creditors  — namely, the First Lenders and Second Lender — were at the relevant point in Debtors' bankruptcy.
The Third Circuit also rejected Second Lender's argument that denying them future lot sale proceeds that exceed the Project's  judicially determined value as of confirmation constitutes a form of lien stripping disallowed by the Supreme Court's  decision in Dewsnup.  In Dewsnup, the Supreme Court considered "some ambiguities" in § 506 and its relationship to other provisions of the Bankruptcy Code when a Chapter 7 debtor's property increases in value between the time of its judicial valuation and the time of its foreclosure sale.  Guided by the principle that liens are to pass through bankruptcy unaffected, the Dewsnup Court rejected the notion that a mortgagee could be forced to accept the judicially determined value, even if the foreclosure sale produced more.
The Third Circuit held that Dewsnup is only applicable to Chapter 7 bankruptcy cases.  The Court explained that the rationales advanced in the Dewsnup opinion for prohibiting lien stripping have little relevance in the context of rehabilitative bankruptcy proceedings under Chapter 11 -- Chapter 7 liquidation proceedings involve the sale of liened property; Chapter 11 reorganizations involve the retention and use of that property in the rehabilitated debtor's business.  The Code makes that clear: "the process of lien stripping is ingrained in the reorganization provisions of the Bankruptcy Code to such an extent that any attempt to extend the holding in Dewsnup to Chapter 11 cases would require that numerous provisions of the statute be ignored or construed in a very convoluted manner."
Lastly, even though it was not an issue raised by the parties, the Third Circuit addressed the burden of proof for valuing secured collateral under Section 506(a).  Neither the Code nor the Federal Rules of Bankruptcy Procedure allocates the burden of proof as to the value of secured claims under § 506(a).  Although the courts have divergent opinions on who is to bear the burden of proof, the Third Circuit held that the initial burden should be on the party challenging a secured claim's value, because "11 U.S.C. § 502(a) and Bankruptcy Rule 3001(f) grant prima facie effect to the validity and amount of a properly filed claim." 
The Court reasoned that it is only fair, then, that the party seeking to negate the presumptively valid amount of a secured  claim — and thereby affect the rights of a creditor  — bear the initial burden.  If the movant establishes with sufficient evidence that the proof of claim overvalues a creditor's secured claim because the collateral is of insufficient value, the burden shifts.  The purportedly secured creditor thereafter bears "the ultimate burden of persuasion . . . to demonstrate by a preponderance of the evidence both the extent of its lien and the value of the collateral securing its claim."

Ralph T. Wutscher
McGinnis Tessitore Wutscher LLP
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Chicago, Illinois 60602
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