The United States Court of Appeals for the Third Circuit recently issued an important decision on the valuation of collateral of secured creditors and “lien-stripping” in Chapter 11 cases. In In re Heritage Highgate, Inc.,1 the court held that in a Chapter 11 case, the value of a secured creditor’s collateral under §506(a) of the Bankruptcy Code2 was the fair market value of the property as established by expert testimony and it was permissible to “strip the lien” of the creditor where it was unsupported by collateral value. The court also clarified the burden of proof with respect to collateral valuations under §506(a) of the Bankruptcy Code.
The debtors were real estate developers that, in August 2005, began constructing a residential subdivision consisting of townhouses and single-family detached houses in Lehigh County, Pennsylvania (the Project). To finance the Project, the debtors borrowed funds from a group of banks (the Banks) and also borrowed money from several individuals and entities (the Investors). The loan from the Banks (the Bank Loan) was secured by a lien on substantially all of the debtors’ assets, and the loans from the Investors (the Investors’ Loan) were secured by a junior lien on the debtors’ assets. On January 20, 2009, after building and selling approximately one-quarter of the planned units, the debtors filed voluntary petitions for relief under Chapter 11 of the Bankruptcy Code. Shortly after filing for bankruptcy, the debtors filed a motion for authorization to use cash collateral, which was opposed by the Banks and the Official Committee of Unsecured Creditors (the Committee). At the hearing on the motion, the debtors offered the testimony of an experienced real estate appraiser who appraised the value of the Project at approximately $15 million based upon a “sales comparison approach” and an “income capitalization approach” (the Appraisal). The bankruptcy court accepted the Appraisal, which, at that time, was sufficient to cover the full amount of the Bank Loan and the Investors’ Loan.
On June 9, 2009, the debtors filed a joint plan of reorganization that provided that they would complete development of the Project and make distributions to their creditors according to a set of projections. Based upon the projections, the plan proposed that the debtors would first pay the Bank Loan in full, then pay the Investors’ Loan in full, and thereafter make a distribution of approximately 20 percent to unsecured creditors. On September 4, 2009, the Committee filed a motion to value the claims of the Investors under §506(a) of the Code and Fed. R. Bankr. P. 3012 (the Committee’s Motion). The Committee alleged that the Project was now worth less than the outstanding amount of the Bank Loan and, accordingly, the Investors’ Loan was completely unsecured. However, the parties agreed to postpone consideration of the Committee’s Motion until after confirmation of the reorganization plan.
On March 2, 2010, the debtors submitted their final plan of reorganization. The plan provided that the claims of the Investors would be treated as secured to the extent determined by the bankruptcy court in ruling on the Committee’s Motion. The Plan included a “projected budget” (the Projections) that anticipated the Bank Loan and the Investors’ Loan would be paid in full through development and sale of lots with completed townhouses and single-family homes over a period of 47 months. According to the Projections, unsecured creditors would receive distributions amounting to approximately 45 percent of their claims. Neither the Investors nor any other party objected to the plan, and on April 1, 2010 it was confirmed by the bankruptcy court. In so doing, the court concluded, as required by §1129(a)(11) of the Code, that the plan was feasible, i.e., that further liquidation or reorganization of the debtors was unlikely.
After the plan was confirmed, the bankruptcy court scheduled a hearing on the Committee’s Motion. Prior to the hearing, the parties stipulated that the unpaid Bank Loan totaled approximately $12 million; the Investors’ Loan totaled approximately $1.4 million; and the current fair market value of the Project, based upon the Appraisal value reduced by the value of units that had been sold in the interim, was approximately $9.5 million. Adding the value of certain additional assets that secured the Bank Loan, the aggregate value of the collateral securing the indebtedness was $11,155,477.15, which was less than the amount of the Bank Loan. At the hearing, the Committee presented the Appraisal along with evidence of the diminished value of the Project as a result of the disposition of units in the intervening time period since the Appraisal was issued. The Investors, by contrast, expressly declined to present expert testimony and relied solely upon the Projections. The bankruptcy court found that the value of the Project was its fair market value, as established by the Appraisal, reduced by the value of the sold units. The court rejected the Investors’ argument that, based upon the Projections, their claims were fully secured. The district court affirmed.
In its opinion affirming the lower courts, the Third Circuit first addressed the burden of proof in valuing secured claims under §506(a). The court held that a “burden-shifting framework” controls valuations of collateral under §506(a). Under this approach, the initial burden is on the party challenging a secured claim’s value, because §502(a) of the Code and Fed. R. Bankr. P. 3001(f) “grant prima facie effect to the validity and amount of a properly filed claim.”3 If the movant presents sufficient evidence that the proof of claim overvalues a creditor’s secured claim (because the collateral is of insufficient value), then the burden shifts to the creditor. The 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.”4 In this case, the court found that the Investors “had the ultimate burden of persuading the Bankruptcy Court that the ... Project was ... worth enough to secure their claims under §506(a).5
The court then addressed the proper method of determining value under §506(a). The Investors argued that reliance upon the collateral’s fair market value violated §506(a)’s mandate that value be determined “in light of … the proposed disposition or use of [the] property.” They further argued that “the collateral’s increase in value after the §506(a) valuation rightly accrue[d] to their benefit.”6 The Third Circuit disagreed. The court held that, where a Chapter 11 plan provides for a debtor to retain and use collateral to generate income with which to make payments to creditors, “[t]he proper measure [of value] under §506(a) must … be the collateral’s fair market value because it is most respectful of the property’s anticipated use.”7 Therefore, the lower courts had properly accepted the Appraisal as establishing fair market value. The Projections relied upon by the Investors did not equate to “value” as of the plan confirmation date given that they were premised upon the debtors expending time and money to realize such value at a later date. That future value could not be credited to the secured creditor as of the confirmation date. “A probability of realizing the budget [was] not a certainty of its realization. In sum, valuations must be based upon realistic measures of present worth.”8
The Third Circuit next addressed the Investors’ argument that denying them the benefit of the future lot sale proceeds that exceeded the Project’s judicially determined value as of the plan confirmation date would constitute a form of “lien stripping,” in contravention of the Supreme Court’s decision in Dewsnup v. Timm.9 The Third Circuit noted that the great majority of courts that had considered the issue had concluded that the holding in Dewsnup should be limited to Chapter 7 cases because the rationales advanced for prohibiting “lien stripping” in Chapter 7 cases had little relevance in the context of a Chapter 11 case. The court agreed with the majority of the courts that Dewsnup’s holding should not be applied in Chapter 11 cases. The court stated that its holding was consistent with pre-Code law. The court also stated that §1129(b) of the Code,10 §1111(b) of the Code11 and Congress’ post-Dewsnup addition of §1123(b)(5) of the Code12 all suggested that “the process of lien stripping is ingrained in the reorganization provisions of the Bankruptcy Code.”13
One practice pointer to be taken from Heritage Highgate: It is important to present competent evidence of value when litigating disputes over collateral valuation in the bankruptcy court. It appears that the Investors’ acceptance of the Appraisal submitted by the Committee as establishing fair market value and failure to present evidence through expert testimony to counter the Appraisal at the hearing on the Committee’s Motion may have been critical to the outcome of the case.