In re Heritage Highgate, 679 F.3d 132 (3d Cir. 2012)

CASE SNAPSHOT

The junior secured creditor objected to the motion of the unsecured creditors committee to reduce the value of the junior secured creditor’s claim to zero in this chapter 11 reorganization case, arguing that to do so improperly valued the collateral, and constituted impermissible lien stripping. The committee offered appraisal evidence proving that the fair market value of the property was less than the amount of the first priority lien holder’s claims. The junior creditor argued that the valuation of the collateral should not be fixed at the current value as of the confirmation date, because the debtor’s estate would continue to generate revenues. The Third Circuit clarified the burdens of proof and persuasion for section 506(a) valuations and held that a junior creditor’s liens may be stripped in a chapter 11 reorganization.

FACTUAL BACKGROUND

Heritage Highgate borrowed money from several lenders in order to develop a residential subdivision. A bank lender was the senior secured lender, and Cornerstone Investors was the junior secured lender. In 2009, Heritage filed for chapter 11, proposing to pay senior and junior secured creditors in full. The debtor’s appraisal of the property during early cash collateral hearings, to which no party objected, was $15 million, which was enough to cover all of the secured debt.

Subsequently, at the time of the plan confirmation, the senior lender was owed $12 million, and Cornerstone was owed $1.4 million. However, the value of the property had dropped to $9.5 million since the time of the earlier appraisal, as a result of certain sales that had occurred in the interim. Cornerstone stipulated that the $9.5 million fair market value was correct, but argued a "wait and see" approach to valuation based on the debtor’s plan projections that the property would be worth more than enough to pay all secured claims in full within the next four years.

The unsecured creditors committee moved to reduce the value of Cornerstone’s secured claims to zero, because the collateral securing the liens now was worth less than the amount owed the secured creditors. Cornerstone objected. The bankruptcy court agreed with the unsecured creditors committee and stripped Cornerstone’s liens. On appeal, the district court affirmed, after which Cornerstone appealed to the Third Circuit Court of Appeals.

COURT ANALYSIS

Cornerstone argued that the lower courts erred in two respects: (i) section 506(a) of the Bankruptcy Code required that property be valued "in light of … [its] proposed disposition or use," i.e., in light of anticipated post-confirmation projected values; and (ii) by fixing the value at the time of confirmation, resulting in impermissible lien stripping.

First, the Third Circuit clarified the valuation standards of 506(a). It rejected Cornerstone’s "wait and see" approach, holding that plan projections were not "valuations." The appraisals, not the plan’s projections, were the proper measurement of current fair market value, and the appraisals appropriately considered projected uses of property in their valuations, and thus satisfied section 506(a)’s requirements.

The Third Circuit also established a burden-shifting evidentiary framework for section 506(a) valuations: the objecting party had the initial burden of proof to overcome the validity of the secured party’s liens, but the secured party had the ultimate burden of persuasion to prove, by a preponderance of the evidence, both the extent and the value of its lien.

Second, having found that the value of the property was insufficient to secure the junior creditor’s liens, the Third Circuit rejected Cornerstone’s arguments that its liens could not be stripped. The court held that, although lien stripping was not permissible in chapter 7 liquidation cases (where secured creditors should receive the full value of later foreclosure sales), there was no similar prohibition of lien stripping in chapter 11 cases. The Third Circuit identified the framework of 1129(b) and the 1111(b) election process as examples of the Bankruptcy Code’s acceptance of lien stripping in chapter 11 cases.

PRACTICAL CONSIDERATIONS

A junior creditor in chapter 11 cases must be prepared for the possibility of its liens being stripped. Junior creditors should not rely on plan projections or statements by the debtor to "establish" the value of properties or hope that the court will wait for improved economic circumstances to value the properties. Instead, the junior creditor should obtain independent appraisals to counter any appraisals that estimate the value of property as insufficient to cover the junior creditor’s liens. Ultimately, the burden to establish the validity and extent of a junior creditor’s liens will fall on the junior creditor, and it should obtain as much evidence as it can to establish its liens.