The Bottom Line

In a decision that addresses the value to apply to a secured creditor’s collateral facing cramdown, the Ninth Circuit, sitting en banc, reaffirms that, in determining cramdown value, a secured creditor is only entitled to the replacement value of the collateral, not the hypothetical value that would be derived from a foreclosure sale, even if foreclosure value would result in a higher value. The Ninth Circuit applied the Supreme Court’s decision in Associates Commercial Corp. v. Rash even though the facts of this case were “atypical” (in that foreclosure would have eliminated certain restrictive use covenants that, when applied to the collateral “in use,” lowered value).

What Happened?

In In re Sunnyslope Hous. Ltd. P’ship, No. 12-17241, 2017 WL 2294746 (9th Cir. May 26, 2017), the Debtor (“Sunnyslope”) constructed an apartment complex in Phoenix, Arizona, funded by several secured loans. Each of the loans – from Capstone Realty Advisors, LLC, the City of Phoenix, and the State of Arizona – was secured by a deed of trust. The Capstone loan was guaranteed by the United States Department of Housing and Urban Development (“HUD”). To secure certain financing and tax benefits, Sunnyslope entered into agreements with HUD, the Phoenix Industrial Development Authority, the City of Phoenix, and the Arizona Department of Housing to use the apartment complex as low-income housing. After Sunnyslope defaulted on the Capstone loan, HUD (as guarantor) took over the loan and sold it to First Southern National Bank (“First Southern”). In connection with the loan sale, HUD released its regulatory agreement. The Loan Sale Agreement confirmed, however, that the property remained subject to the other “covenants, conditions and restrictions” requiring that the apartment complex be used for low-income housing. These remaining restrictions would terminate, however, in the event of a foreclosure.

First Southern commenced foreclosure proceedings, which were stayed before completion by the commencement of Sunnyslope’s Chapter 11 case. During the case, Sunnyslope proposed a cramdown plan where it would retain the complex and provide that First Southern’s debt would be treated as secured “to the extent of the value of such creditor's interest” in the collateral, in accordance with 11 U.S.C. § 506(a)(1). This led to a dispute as to how to value First Southern’s collateral (the apartment complex). Sunnyslope asserted that the complex should be valued as low-income housing (subject to the existing restrictions on use), while First Southern contended that the low-income housing requirement should be disregarded for § 506(a)(1) valuation purposes and that the property freed from such restrictions would have a much higher value.

The bankruptcy court held that the correct value of the property under § 506(a)(1) was the value of the complex as low-income housing – the lower of the values put forth by Sunnyslope’s expert. The court also declined to include the tax credits available to Sunnyslope in the valuation of the property. The bankruptcy court subsequently confirmed the plan of reorganization.

First Southern appealed, and 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 also have been included in the total value. First Southern again appealed, and Sunnyslope cross-appealed. A divided panel of the Ninth Circuit reversed the bankruptcy court’s order approving the plan of reorganization, holding that the court should have valued the apartment complex without regard to the affordable housing requirements that restricted use and, in turn, lowered value. Subsequently, the Ninth Circuit granted Sunnyslope’s petition for rehearing en banc, and the panel opinion was vacated.

The central issue on rehearing was whether the bankruptcy court erred by valuing the apartment complex assuming its continued use after reorganization as low-income housing. Reversing the three-judge panel, the en banc court held that the district court did not err in applying the lower value.

The en banc court reasoned that value of a secured claim is “determined in light of the purpose of the valuation and of the proposed disposition or use of such property.” The court based its ruling on the Supreme Court’s decision in Assocs. Commercial Corp. v. Rash, 520 U.S. 953 (1997), which held that “§ 506(a) directs application of the replacement-value standard,” rather than foreclosure value. Rash, 520 U.S. at 956. The Supreme Court in Rash emphasized that, in a reorganization involving a cramdown, the debtor will continue to use the collateral; therefore, valuation must be based on the same proposed use – not a hypothetical foreclosure sale. Id. at 963. The en banc Ninth Circuit pointed out that the Supreme Court intentionally did not adopt a rule requiring valuation of collateral at the higher of its foreclosure value or replacement value, and instead stressed the § 506(a)(1) requirement that the property be valued in light of its “proposed disposition or use.” The court reasoned that “the debtor will continue to use the collateral, and valuation must therefore occur ‘in light of the proposed repayment plan reality: no foreclosure sale.’” By focusing on the “actual use” of the property, the court reasoned that the potential to invalidate the low-income housing restrictive use would not apply since foreclosure was the very result being avoided by the bankruptcy plan. As a result, the potential benefits of a foreclosure that would avoid the continued use restrictive covenant were not applicable.

Additionally, the en banc court held that the plan of reorganization was fair and equitable, that the plan was feasible, and that the bankruptcy court did not err in failing to allow First Southern, on remand, to make a second election to have its claim treated as either fully or partially secured under 11 U.S.C. § 1111(b).

In a dissenting opinion, Judge Kozinski, joined by Judges O’Scannlain and Friedland, wrote that the majority’s opinion “fetishizes a selection of the [Supreme] Court's words at the expense of its logic.” Sunnyslope, No. 12-17241 at *8. The dissent pointed out that even though cramdown valuations are supposed to limit a secured creditor’s risk, the majority’s valuation standard turns entirely on the debtor’s desires, ignoring the Supreme Court’s expressed desire to reduce the risks that cramdowns pose for creditors. The dissent would hold that the appropriate value is the market price of the building without restrictive covenants, which, in this case, is best approximated by foreclosure value.

Why This Case is Interesting

The case represents an interesting situation where a continuing “going concern” use results in a lower value than a market foreclosure value. This is due to the potential for a secured creditor in foreclosure to invalidate a “low-income housing” restrictive use provision relating to the apartment complex. Typically, foreclosure value is lower than replacement value which assumes using the property as a going concern. Here, the Ninth Circuit majority confirmed that even in instances where the reverse is true (and foreclosure might yield a higher value), replacement value is still the appropriate standard to apply under § 506(a)(1) and §1129(b). In doing so, the court focused on a central tenet of Chapter 11: the debtor’s successful reorganization as a going concern and continuing use of its property in a comparable manner. The court also addressed the potential impacts of its decision on future lending, rejecting an argument that valuing the collateral with the low-income restrictions in place would discourage future lending to similar projects. The court reasoned that First Southern bought the Sunnyslope loan at a substantial discount, knowing of the risk that the property would remain subject to the low-income housing requirements. Therefore, valuing First Southern's collateral with those restrictions in mind subjects the lender to no more risk than it consciously undertook.