The U.S. Court of Appeals for the Ninth Circuit recently held that for cram-down valuations, 11 U.S.C. § 506(a)(1) requires the use of "replacement value" based upon the adoption of the replacement value standard in Associates Commercial Corp. v. Rash, 520 U.S. 953, 956 (1997).
In so ruling, the Ninth Circuit interpreted Rash to instruct that valuation of collateral in a cram-down must be based on the debtor's desires (i.e., the proposed use of the collateral in the debtor's plan of reorganization), and without consideration of the value that the secured creditor would realize in an immediate sale.
Accordingly, this ruling effectively shifts the risk in cram-down valuations to the secured creditor regardless of the type of debtor and the nature of the property.
A copy of the opinion is available at: Link to Opinion
A real estate developer ("Developer") obtained financing from various lenders to fund the development of an apartment complex in Phoenix, Arizona. The bulk of the financing came from a loan that was guaranteed by the United States Department of Housing and Urban Development ("HUD"), and funded through bonds issued by the Phoenix Industrial Development Authority. The City of Phoenix and the State of Arizona provided the balance of the funding secured by junior liens.
To secure financing and tax benefits, Developer entered into agreements requiring the apartment complex be used for affordable housing.
Developer defaulted on the loan with HUD and a bank ("Bank") purchased the loan from HUD. In connection with the sale, HUD released its regulatory agreement. However, the loan sale agreement confirmed that the property remained subject to the other "covenants, conditions and restrictions."
Bank began foreclosure proceedings and a receiver was appointed. The receiver agreed to sell the apartment complex to a third party in December 2010. But, before the sale could close, Developer filed a Chapter 11 bankruptcy petition. Over Bank's objection, Developer sought to retain the complex in its proposed plan of reorganization, exercising the "cram-down" option in 11 U.S.C. § 1325(a)(5)(B).
As you may recall, a successful cram-down allows the reorganized debtor to retain collateral over a secured creditor's objection, subject to the requirement in § 506(a)(1) that the debt be treated as secured "to the extent of the value of such creditor's interest" in the collateral. The value of that claim is "determined in light of the purpose of the valuation and of the proposed disposition or use of such property." Id.
The central issue in the reorganization was the valuation of Bank's collateral – i.e., the apartment complex. Developer argued that the complex should be valued as low-income housing based on its intended use, while Bank argued that the complex should instead be valued based on its replacement value, which was a higher value because the complex would no longer be used as low-income housing after foreclosure.
Bank's expert valued the complex at $7.74 million, under the assumption that a foreclosure would remove any low-income housing requirements. Bank's expert also opined that the value of the property was only $4,885,000 if those requirements remained in place. Developer's expert valued the property at $2.6 million with the low-income housing restrictions in place, and at $7 million without.
The bankruptcy court held that under § 506(a)(1), the value of the property was $2.6 million because Developer's plan of reorganization called for continued use of the complex as low-income housing. The bankruptcy court also declined to include in the value of the complex the tax credits available to Developer. Bank then elected to treat its claim as fully secured under 11 U.S.C. § 1111(b).
The bankruptcy court confirmed the plan of reorganization, which provided for payment in full of Bank's claim over 40 years. The reorganization plan required the junior lienholders to relinquish their liens, but provided for payment of their unsecured claims in full, without interest, at the end of the 40 years.
The bankruptcy court found the plan fair and equitable under 11 U.S.C. § 1129(b)(1) because Bank retained its lien, would receive an interest rate equivalent to the prevailing market rate, and could foreclose (and therefore obtain the property without the restrictive covenant) should Developer default on the reorganization. And, based on Developer's financial projections, the bankruptcy court found the plan feasible under 11 U.S.C. § 1129(a)(11).
After confirmation, a third party ("Investor) invested $1.2 million in the complex. Bank then obtained a stay of the plan of reorganization from the district court pending appeal. The district court affirmed the bankruptcy court's valuation of the complex with the low-income housing restrictions in place, but held that the tax credits should have been considered. Both parties appealed.
After the various appeals were consolidated, the Ninth Circuit initially reversed the bankruptcy court's order approving the plan of reorganization, holding that the court should have valued the apartment complex without the affordable housing requirements. In re Sunnyslope Hous. Ltd. P'ship, 818 F.3d 937, 940 (9th Cir. 2016). More specifically, the Ninth Circuit initially held that under § 506(a)(1), replacement cost "is a measure of what it would cost to produce or acquire an equivalent price of property" and that "the replacement value of a 150-unit apartment complex does not take into account the fact that there is a restriction on the use of the complex."
The Ninth Circuit then granted Developer's petition for rehearing en banc to resolve three issues: (1) whether the bankruptcy court erred by valuing the apartment complex assuming its continued use after reorganization as low-income housing, (2) whether the plan of reorganization was fair, equitable, and feasible, and (3) whether the district court errored in now allowing Developer to withdraw its § 1111(b) election.
First, the Ninth Circuit analyzed the bankruptcy court's valuation with the restrictive covenants.
The Ninth Circuit previously established that, "[w]hen a Chapter 11 debtor or a Chapter 13 debtor intends to retain property subject to a lien, the purpose of a valuation under section 506(a) is not to determine the amount the creditor would receive if it hypothetically had to foreclose and sell the collateral." In re Taffi, 96 F.3d 1190, 1192 (9th Cir. 1996) (en banc). "The foreclosure value is not relevant" because the creditor "is not foreclosing." Id. In Taffi, the Ninth Circuit noted that its decision was consistent with the approached of all but one circuit – the Fifth Circuit — which had adopted a foreclosure-value standard in In re Rash, 90 F.3d 1036 (5th Cir. 1996) (en banc). See In re Taffi, 96 F.3d at 1193.
The Supreme Court of the United States in In re Rash reversed the Fifth Circuit, holding consistent with Taffi, that "§ 506(a) directs application of the replacement-value standard," rather than foreclosure value. Rash, 520 U.S. 953, 956 (1997). In so ruling, the Supreme Court held that the value of collateral under § 506(a)(1) is "the cost the debtor would incur to obtain a like asset for the same 'proposed … use.'" Id. at 965.
Thus, according to the Ninth Circuit, in Rash the Supreme Court held that, in a reorganization involving a cram down, the proper guide was the replacement value. Therefore, the essential inquiry is to determine the price that a debtor in Developer's position would pay to obtain an asset like the collateral for the particular use proposed in the plan of reorganization. Id.
However, Bank alternatively argued that the property should be valued at its "highest and best use" – that is, housing without any low-income restrictions.
The Ninth Circuit rejected the argument because absent foreclosure, the very event that the Chapter 11 plan sought to avoid, Developer cannot use the property except as affordable housing, nor could anyone else. In fact, Rash expressly instructed that a § 506(a)(1) valuation cannot consider what would happen after a hypothetical foreclosure—the valuation must instead reflect the property's "actual use." Id., at 963.
Next, Bank attempted to distinguish Rash by arguing that foreclosure value is greater than replacement value in this case. But, as the Ninth Circuit explained, Rash implicitly acknowledged that this outcome might occasionally be the case, and the Supreme Court nonetheless adopted a replacement-value standard. Id., at 960. Thus, following the Supreme Court's guidance in Rash, the Ninth Circuit was unconvinced that the foreclosure value should be used in place of replacement value.
Bank also argued that the low-income housing requirements do not apply to its security because HUD released its regulatory agreement, and all other covenants are junior to its lien. The Ninth Circuit again disagreed because while the junior liens were subordinate to Developer's, it was undisputed the restrictions they impose continue to run with the land absent foreclosure. Thus, according to the Court, the low-income housing requirements were properly considered in determining the value of the collateral.
Additionally, Bank's amici argued that valuing the collateral with the low-income restrictions in place would discourage future lending on like projects.
The Ninth Circuit disagreed because "while the protection of creditors' interests is an important purpose under Chapter 11, the Supreme Court has made clear that successful debtor reorganization and maximization of the value of the estate are the primary purposes." In re Bonner Mall P'ship, 2 F.3d 899, 916 (9th Cir. 1993). Allowing the debtor to "rehabilitate the business" generally maximizes the value of the estate. Id.
Here, Bank bought the Developer's loan at a substantial discount knowing the risk that the property would remain subject to the low-income housing requirements. Thus, the Ninth Circuit concluded that valuing Bank's collateral with those restrictions in mind did not subject the lender to more risk than it consciously undertook.
Next, the bankruptcy court ruled that Developer's plan was fair and equitable because Developer retained its lien and received the present value of its allowed claim over the term of the plan.
As you may recall, the cram-down provision in 11 U.S.C. § 1129(b) requires that the reorganization plan be "fair and equitable." The secured creditor must retain its lien, § 1129(b)(2)(A)(i)(I), and receive payments over time equaling the present value of the secured claim, § 1129(b)(2)(A)(i)(II).
The interest rate chosen must ensure that the creditor receives the present value of its secured claim through the payments contemplated by the plan of reorganization. Till v. SCS Credit Corp., 541 U.S. 465, 469 (2004).
The question before the Ninth Circuit was whether the plan provided payments equal to the present value of the secured claim.
Bank argued that it did not receive the present value of its secured claim because the interest rate adopted in the plan, 4.4%, is lower than the original rate on its loan. However, the bankruptcy court determined that the 4.4% interest rate on the plan payments would result in Bank receiving the present value of its $3.9 million security over the term of the reorganization plan. The relevant national prime rate was 3.25%, and the bankruptcy court adjusted that rate upward to account for the risk of non-payment. The bankruptcy court also heard testimony that the market loan rate for similar properties was 4.18%.
Additionally, plan confirmation requires a finding that the debtor will not require further reorganization. 11 U.S.C. § 1129(a)(11). The debtor must demonstrate that the plan "has a reasonable probability of success." In re Acequia, 787 F.2d 1352, 1364 (9th Cir. 1986).
In this case, the record showed that Developer would be able to make plan payments, and expert testimony confirmed that the collateral would remain useful for 40 years – the term of the plan. The bankruptcy court also found that the balloon payment feasible because it was secured by property whose value exceeded the value of the remaining Developer's claim.
Thus, the Ninth Circuit affirmed the bankruptcy court determination with respect to plan fairness and feasibility.
Turning to Bank's final argument regarding its § 1111(b) election, the Appellate Court found no error in the bankruptcy court's ruling.
As you may recall, § 1111(b) of the Bankruptcy Code allows a secured creditor to elect to have its claim treated as either fully or partially secured. An election affects the treatment of the unsecured portion of the claim under the plan and the procedural protections afforded to the creditor. 11 U.S.C. § 1129(a)(7)(B). In absence of a contrary order by the bankruptcy court, the creditor must make this election before the end of the disclosure statement hearing. Fed. R. Bankr. P. 3014.
Bank argued that the bankruptcy court erred in not allowing it to make a second election after the district court remanded and required the tax credits to be added to the valuation. When Bank made its election, the plan provided for 40 years of payments of principal and interest providing the creditor with the present value of its $2.6 million secured claim, with a final balloon payment covering the remainder of the debt.
However, after remand, according to the Ninth Circuit, the only difference to Bank was that its annual payments will be more and the balloon payment at the end of the 40 years will be less. Thus, the Appellate Court held that allowing a second election would not only provide Bank with a second bite at the apple, it would not make a material difference in the outcome of the election.
Accordingly, the Ninth Circuit affirmed the judgment of the district court.
Ralph T. Wutscher
Maurice Wutscher LLP
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