On May 14, 2012, the United States Court of Appeals for the Third Circuit upheld a ruling by the Bankruptcy Court for the District of New Jersey that the fair market value of a creditor’s collateral as of the plan’s confirmation date is the proper method of valuing a secured creditor’s claim pursuant to section 506(a) of the Bankruptcy Code. The Third Circuit also adopted a “burden-shifting framework,” finding that a secured creditor will bear the ultimate burden of proving the extent to which its claims are secured pursuant to section 506(a).
Debtors Heritage Highgate, Inc. and Heritage-Twin Ponds II, L.P. entered into a series of construction loan agreements to fund the development of a residential subdivision in Lehigh County, Pennsylvania, including: (i) a senior secured loan agreement with a group of banks, outstanding in the amount of $12 million as of the petition date, and (ii) a junior secured loan agreement with the Cornerstone Investors, outstanding in the amount of $1.4 million as of the petition date. Both groups of lenders’ claims were secured by substantially all of the Debtors’ assets, which consisted mainly of the residential subdivision.
After building and selling only a quarter of the planed units at the residential subdivision, the Debtors filed voluntary petitions for chapter 11 relief on January 20, 2009.
During a contested cash collateral hearing at the beginning of the cases, the Debtors submitted an appraisal of the fair market value of the residential subdivision that was based on two well-accepted appraisal methodologies. The Bankruptcy Court accepted the appraiser’s fair market valuation of approximately $15 million, which exceeded the $13.4 million of secured debt outstanding as of the petition date.
Subsequently, the Official Committee of Unsecured Creditors filed a motion to value and determine the extent of the Cornerstone Investors’ junior secured claims pursuant to section 506(a) of the Bankruptcy Code and Bankruptcy Rule 3012. The Committee argued that the Cornerstone Investors’ secured claims should be valued at zero because interim sales had reduced the fair market value of the Debtors’ residential subdivision from $15 million to approximately $9.54 million. This amount, the Committee asserted, would be insufficient to cover the approximately $12 million outstanding senior secured claims, and would render the Cornerstone Investors’ claims unsecured.
The Cornerstone Investors objected to the Committee’s motion, arguing that the $9.54 million appraisal did not control for 506(a) valuation purposes because section 506(a) requires that the value of the collateral “be determined in light of [the collateral’s] proposed disposition or use.” 11 U.S.C. 506(a). The Debtors’ proposed plan of reorganization provided that the Debtors would continue to develop the residential subdivision and sell units, and the plan’s projected budget forecasted that the Debtors would receive sufficient value from the sale of new units to pay all secured claims in full. The Cornerstone Investors claimed that this proposed budget properly accounted for the residential subdivision’s “proposed disposition or use,” and therefore reflected a more accurate value of the collateral for purposes of section 506(a). Thus the Cornerstone Investors advocated a “wait and see” valuation approach: the Bankruptcy Court should postpone valuation of the residential subdivision until it could properly determine the increased value of the property resulting from post-confirmation development and continued sales. The parties agreed to adjourn the Committee’s motion until after plan confirmation.
On May 3, 2010, the Bankruptcy Court held a hearing to consider the Committee’s motion. Prior to the hearing, the parties stipulated that the total fair market value of the residential subdivision as of the confirmation date was $9,543,396.23, but the Cornerstone Investors again asserted that the plan budget represented the proper valuation of their collateral. The Bankruptcy Court agreed with the Committee’s arguments and ruled that the proper method for valuing the Cornerstone Investors’ secured claims was the fair market value of the Debtors’ residential subdivision as of the plan confirmation date. Accordingly, because the amount owed to the Bank Lenders exceeded the valuation of the Debtors’ residential subdivision, the Bankruptcy Court ruled that the Cornerstone Investors’ claims were unsecured.
The Cornerstone Investors appealed this ruling to the U.S. District Court for the District of New Jersey, and the district court affirmed the Bankruptcy Court’s order. The Cornerstone Investors then appealed the district court’s ruling to the United States Court of Appeals for the Third Circuit.
On further appeal from the district court, the Third Circuit upheld the Bankruptcy Court’s decision, finding that the revised appraisal accurately calculated the residential subdivision’s fair market value on the date of plan confirmation, that this valuation was appropriate for 506(a) valuation purposes, and that the claims of the Cornerstone Investors were wholly unsecured.
Section 506(a) of the Bankruptcy Code provides, in relevant 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 distribution or use of such property . . .
11 U.S.C. 506(a) (emphasis added). The Code is silent as to the appropriate valuation standard for purposes of 506(a), and thus bankruptcy courts are able to employ a flexible approach to valuation methodology based on the context of each case. In determining the proper valuation methodology, the anticipated distribution or use of the collateral is of paramount importance to the question of how to value the collateral and courts look to whether collateral is to be liquidated, surrendered or retained by a debtor at plan confirmation, rather than the distribution or use of collateral at some point down the road. Here, the Debtors’ confirmed plan provided that the Debtors would retain the residential subdivision.
In upholding the Bankruptcy Court’s decision, the Third Circuit applied the United States Supreme Court’s decision in Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997), which found that in the chapter 13 context where a debtor elects to retain collateral, the value of the property for section 506(a) valuation purposes is its replacement value, or the cost the debtor would incur to obtain a like asset for the same proposed use. The Third Circuit recognized that courts apply similar reasoning in the chapter 11 context, and that replacement value is consistent with the fair market value.
The Third Circuit dismissed the Cornerstone Investors’ proposed “wait-and-see” approach – not only has the approach never been adopted – but it would be in contravention of the Bankruptcy Code as it would deprive the bankruptcy court of its ability to divide allowed claims into secured and unsecured portions during a bankruptcy case pursuant to section 506(a), and its ability to value claims prior to plan confirmation pursuant to Bankruptcy Rule 3012. The Third Circuit Court agreed with the lower courts that the projected plan budget was merely an indication of the plan’s feasibility and irrelevant to the 506(a) valuation of the collateral. The Court found that the projected revenue indicated in the budget did not constitute “value” because it relied on the Debtors expending time and money to realize this value. Emphasizing that “valuations must be based upon realistic measures of present worth,” the Third Circuit ultimately held that the valuation of the Debtors’ residential subdivision at the time of confirmation controlled whether the Cornerstone Investors’ claims were secured or unsecured. Heritage Highgate, 2012 WL 1664174 *6.
Additionally, the Third Circuit for the first time adopted a “burden-shifting framework” to determine which party bears the burden of proof as to the value of secured claims under section 506(a). Pursuant to this framework, “the debtor bears the initial burden of proof to overcome the presumed validity and amount of the creditor’s secured claim,” but “the ultimate burden of persuasion is upon the creditor to demonstrate by a preponderance of the evidence both the extent of its lien and the value of the collateral securing its claim.” In re Robertson, 135 B.R. 350, 352 (Bankr. E.D. Ark. 1992). Here, the Cornerstone Investors failed to meet their burden of proof because they did not submit an alternative valuation or attack the court-accepted valuation.
This ruling is important for secured creditors engaged in a valuation fight – it reiterates the importance of submitting additional evidence, and having witnesses to put on testimony, that supports the actual value of a secured creditor’s collateral. Further, the ruling makes clear that in the Third Circuit, a secured lender’s claim will be entitled to the value of the collateral as determined at the date of plan confirmation regardless of whether the value of the collateral increases after confirmation.