United States: Ninth Circuit Reverses Course On Measure Of Collateral Value In Cramdown Confirmation Of Chapter 11 Plan

Last Updated: October 4 2017
Article by Anna M. Wetzel

In First Southern Nat'l Bank v. Sunnyslope Hous. LP (In re Sunnyslope Hous. LP), 2017 BL 216965 (9th Cir. June 23, 2017), the U.S. Court of Appeals for the Ninth Circuit held en banc that, in determining whether a chapter 11 plan may be confirmed over the objection of a secured creditor, the creditor's collateral must be valued in accordance with the debtor's intended use of the property, even if the property would realize more in a foreclosure sale because of the existence of restrictive covenants. According to the Ninth Circuit, this conclusion was mandated by section 506(a)(1) of the Bankruptcy Code and U.S. Supreme Court precedent.

Valuing a Secured Creditor's Collateral in a Cramdown

Section 1129(b) of the Bankruptcy Code provides that a chapter 11 plan may alter the payment terms of an objecting secured lender's loan if, among other things, the plan's treatment of the dissenting secured creditor's claim is "fair and equitable." In such a "cramdown" confirmation, section 1129(b)(2) provides that "fair and equitable" means that: (i) the dissenting secured creditor retains the lien on its collateral and receives deferred payments totaling at least the allowed amount of its secured claim at an appropriate rate of interest; (ii) the collateral is sold and the creditor's lien attaches to the sale proceeds; or (iii) the creditor receives the "indubitable equivalent" of its secured claim.

The Bankruptcy Code does not mandate any specific method for valuing collateral. However, section 506(a)(1) provides that the value of collateral must be "determined in light of the purpose of the valuation and of the proposed disposition or use of such property." In Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997), the U.S. Supreme Court held that, to confirm a chapter 13 plan over the objection of a dissenting secured creditor, section 506(a)(1) requires a "replacement value," rather than a "foreclosure value," standard.

Under a replacement value standard, the value of the collateral equals "the cost the debtor would incur to obtain a like asset for the same 'proposed . . . use.' " Id. at 965 (quoting section 506(a)(1)). By contrast, under a foreclosure value standard, value is determined on the basis of the amount a creditor would realize upon immediate foreclosure and sale of the property. In nearly all cases, replacement value will exceed foreclosure value.

According to the Supreme Court in Rash, only a replacement value standard takes into account the debtor's "proposed disposition or use of such property" because the debtor—by virtue of its bankruptcy filing—opted to avoid foreclosure. The Court also emphasized that the replacement value standard protects creditors from the "double risks" they face when a defaulting debtor opts to retain and continue using collateral instead of allowing the creditor to repossess it. If a debtor retains collateral instead of surrendering it to the secured creditor, the creditor risks: (1) another default by the debtor; and (2) a decline in the value of the property because of extended use. Neither risk is present, the Court noted, if a creditor can repossess the property and immediately realize its value.

Sunnyslope Housing presented the Ninth Circuit with an unusual scenario: mortgaged real property owned by the debtor was subject to certain covenants that reduced the value of the property if the debtor retained ownership, but could be shed in a foreclosure sale.

Sunnyslope Housing

Sunnyslope Housing Limited Partnership ("Sunnyslope") owned an apartment complex in Arizona. Capstone Advisors, LLC ("Capstone") provided $8.5 million in construction financing for the complex. The Capstone loan, which had an annual interest rate of 5.35 percent, was secured by a first-priority deed of trust on the complex and guaranteed by the U.S. Department of Housing and Urban Development ("HUD"). In order to obtain the HUD guarantee, Sunnyslope entered into a regulatory agreement mandating that the complex be used for affordable housing. Sunnyslope also entered into other agreements with state and city agencies that required portions of the complex to be reserved for low-income housing. These covenants ran with the land but terminated upon foreclosure.

In 2009, Sunnyslope defaulted on the Capstone loan. HUD acquired the Capstone loan shortly thereafter and later sold it to First Southern National Bank ("First Southern") for $5.05 million. Although HUD terminated its regulatory agreement as part of the sale, the other low-income housing covenants remained in effect.

First Southern initiated foreclosure proceedings, and a state court appointed a receiver for the apartment complex. A proposed sale of the complex for $7.65 million was pending when Sunnyslope's general partner filed an involuntary chapter 11 petition for Sunnyslope in January 2011 in the District of Arizona.

Sunnyslope proposed a chapter 11 plan under which it would retain the apartment complex and modify the terms of First Southern's secured loan. First Southern objected to the proposed treatment of its claims.

Sunnyslope and First Southern disputed the value of the apartment complex for purposes of confirmation of a cramdown chapter 11 plan. The bankruptcy court ruled that, even though the restrictive covenants lowered the property's value, that value should be "the value of the property as it is owned by the Debtor, which means as low-income property." After the bankruptcy court made its valuation determination, First Southern elected to treat the entirety of its claim as fully secured under section 1111(b) of the Bankruptcy Code.

The bankruptcy court later confirmed Sunnyslope's chapter 11 plan. Under the plan, First Southern's secured claim, valued at $2.6 million (the value of the complex as a low-income housing project), would be paid over 40 years at a 4.4 percent annual rate of interest. Any remaining balance on the claim would be paid through a balloon payment at the end of the 40-year period. The court found the plan to be fair and equitable because First Southern retained its lien, would receive market-rate interest, and maintained the right to foreclose on the property in the event of default.

On appeal, the district court affirmed the bankruptcy court's valuation of the complex. According to the district court, Rash established that "value is based on what a willing buyer in the debtor's trade, business, or situation would pay to obtain like property from a willing seller." Since a willing buyer would be able to operate the complex as affordable housing only while the restrictive covenants were in place, the district court reasoned, the bankruptcy court correctly found that the property's foreclosure value (albeit higher than the replacement value) was irrelevant to the valuation analysis under section 506(a)(1).

The district court ruled, however, that the bankruptcy court erred in omitting certain tax credits from its valuation. On remand, the bankruptcy court adjusted the value of the collateral (with the tax credits applied) to $3.9 million. First Southern then sought to modify its section 1111(b) election so that a portion of its claim would be unsecured. The court denied this request, finding the change to be immaterial and ruling that First Southern was not entitled to a "second bite at the apple" and a new opportunity to reject the plan and unwind the reorganization.

A divided three-judge panel of the Ninth Circuit reversed the bankruptcy court's confirmation order. See In re Sunnyslope Hous. Ltd. P'ship, 818 F.3d 937 (9th Cir.), vacated, 838 F.3d 975 (9th Cir. 2016). The majority ruled that: (i) Rash requires the court to use replacement value in determining the value of collateral; (ii) in accordance with section 506(a)(1), replacement cost "is a measure of what it would cost to produce or acquire an equivalent" parcel of property; and (iii) "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." Rash cannot be interpreted, the majority explained, to impose the double risks (debtor default and property deterioration resulting from extended use) on creditors while providing them with "about one-third of what the creditor could obtain if the property were surrendered." By contrast, the dissenting opinion argued that "a straightforward application" of Rash "compels valuing First Southern's collateral . . . in light of Sunnyslope's proposed use of the property in its plan of reorganization as affordable housing."

The Ninth Circuit later agreed to reconsider the panel's decision en banc and vacated the ruling.

The Ninth Circuit's En Banc Ruling

After a rehearing en banc, an 8-3 majority of the Ninth Circuit reversed course and affirmed the lower court rulings. At the outset, the majority recognized that the case was unusual, since the foreclosure value of the apartment complex exceeded the replacement value.

Writing for the majority, circuit judge Andrew Hurwitz stated that the "essential inquiry under Rash is to determine the price that a debtor in Sunnyslope's position would pay to obtain an asset like the collateral for the particular use proposed in the plan of reorganization." Under Rash, Judge Hurwitz concluded, the property must be valued at the debtor's "proposed disposition or use" even if the property could achieve a higher value if used differently.

He cautioned against using a "hypothetical" foreclosure value, because the debtor opted to retain the property in the reorganization: "We cannot depart from [the replacement value] standard without doing precisely what Rash instructed bankruptcy courts to avoid—assuming a foreclosure that the Chapter 11 petition prevented." In this instance, Judge Hurwitz explained, the valuation must take into account the restrictive covenants because the property could be used for no other purpose absent foreclosure.

Judge Hurwitz also responded to various policy arguments by noting that the primary purpose of chapter 11 is to maximize the value of the debtor's estate, not protect creditor interests. He rejected the argument that "valuing the collateral with the low-income restrictions in place would discourage future lending on like projections." According to the judge, First Southern was aware of the restrictions when it purchased the loan at a discount, and thus, the bankruptcy court's valuation subjected First Southern to "no more risk than it consciously undertook."

The majority ultimately held that Sunnyslope's chapter 11 plan was fair and equitable because First Southern would receive payments equal to the present value of its secured claim. It also ruled that the bankruptcy court committed no error by denying First Southern's request to modify its section 1111(b) election on remand because the amended plan adjusted the valuation of the collateral but did not alter First Southern's treatment.

The Dissent

Three judges dissented. According to the dissent, the majority "adopted a test that is not dictated by the letter of Rash and is contradicted by its reasoning." The dissent would instead base the valuation on the "market price of the building without restrictive covenants." Although Rash adopted a replacement value standard, the dissent explained, the Court intended that standard to be flexible and dependent on the "type of debtor and the nature of the property." Otherwise, the debtor's unique preferences could, in some instances, drastically undervalue the property to the detriment of the creditor.

Outlook

The scope and significance of Sunnyslope Housing are uncertain. It remains to be seen whether other circuits will interpret Rash as mandating that replacement value be used in valuing collateral for purposes of nonconsensual confirmation of a chapter 11 plan, even where replacement value is demonstrably less than foreclosure value. Courts not bound by the Ninth Circuit's ruling may distinguish Sunnyslope Housing because of its unusual facts. However, secured creditors should be aware of the prospect that debtors may rely on the ruling to argue that collateral must be valued on the basis of its proposed use under a plan, even if that valuation is less than foreclosure value.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions