In Heritage Highgate, the secured claims of a group of investors were valued at zero for purposes of treatment in a plan of reorganization, with the result that their mortgage loans were treated as unsecured claims. This is despite the fact that an appraisal offered at the beginning of the case in connection with use of cash collateral supported a conclusion that the claims were fully secured. How did this happen?
Section 506(a) of the Bankruptcy Code provides that a creditor with a secured claim will be treated as having a secured claim to the extent of the value of its interest in the collateral and an unsecured claim for the balance. Value is determined based on the purpose for which it is used, taking into account the proposed use or disposition of the collateral.
In this case the debtor was developing a subdivision with townhouses and single family detached homes financed by a series of construction loans. A bank group held loans of approximately $12 million secured by the project, and a group of investors referred to as the “Cornerstone Investors” held loans of approximately $1.4 million secured by liens on the project that initially were on parity with the bank liens, but subsequently were subordinated. At the time value was considered at the beginning of the case, the debtor presented an appraisal showing that the project was worth approximately $15 million, which was enough to cover both the bank loans and the Cornerstone Investor loans.
The debtor proposed a plan of reorganization pursuant to which it would complete development of the subdivision, with creditors to be paid from the proceeds. To support the plan, it included projections which showed it would be able to pay the banks and the Cornerstone Investors in full and return a dividend of approximately 45% to unsecured creditors.
The unsecured creditors’ committee contended that the Cornerstone Investors secured claims should be valued at zero dollars, arguing that the value of the project was less than the amount of the first lien debt of the bank group. The parties agreed that the initial appraisal as adjusted for subsequent sales led to a project valuation of approximately $11 Million as of confirmation, which supported the creditors’ committee position. However, the Cornerstone Investors countered that their claims should be valued in light of the plan projections that showed they could be paid in full over time.
The Heritage Highgate court concluded that it was proper to value the secured claims based on the fair market value of the project in its present state as of confirmation. The debtor would have to spend time and money to realize additional value at a later date, and the court did not give the Cornerstone Investors the benefit of the future value generated by the debtor’s development efforts. Using the appraisal as adjusted, the court valued the Cornerstone Investors secured claims at zero.
Note that the Cornerstone Investors based their argument solely on the plan projections, contending that there should be a “wait-and-see” approach that calculated their secured claims over time, as opposed to offering an alternate appraisal using different valuation assumptions. It is not clear whether this would have made a difference, but an alternate appraisal could have addressed at least some of the court’s issues by providing a value at the time of confirmation that took into account the net present value of the future development efforts.
Cornerstone Investors also argued that “lien stripping” (not allowing them to retain their liens and treating their claims as unsecured) was not permitted, citing Dewsnup v. Timm, 502 U.S. 410, 112 Sup. Ct. 773, 116 L. Ed.2d 903 (1992). In Dewsnup, a Chapter 7 trustee sold collateral for more than the secured creditor’s claim had been valued earlier in the case, and argued that the secured creditor was not entitled to the proceeds resulting from the increase in value between the time of valuation and the sale. “Guided by the principle that liens pass through bankruptcy unaffected,” the Supreme Court rejected the argument that a mortgagee could be forced to accept the lower judicially determined value when the trustee’s sale produced more, However, most courts – including the Heritage Highgate court – have interpreted Dewsnup as limited to Chapter 7 liquidation proceedings.
The process of lien stripping is ingrained in Chapter 11 reorganization cases. If this seems unfair, as noted by the court in passing in a footnote, Section 1111(b) of the Bankruptcy Code provides at least some relief. (This section was enacted by Congress to overturn a case in which a lender was deprived of post-confirmation appreciation of collateral.)
Under this section undersecured creditors can elect to have their entire claims treated as secured – in effect trading the right to an unsecured deficiency claim for a lien for the full amount of the claim. However, this is not a panacea since the election (1) must be made by a class of secured creditors, as opposed to allowing creditors to make their own individual elections, (2) is not available if the interests of the creditors in the collateral are “inconsequential,” and (3) under Bankruptcy Rule 3014 must be made prior to the conclusion of the hearing on the plan disclosure statement, unless the court fixes a different date.
The bottom line in this case was that as a result of their secured claims being valued at zero, the Cornerstone Investors claims were included with the other unsecured creditors, who then also shared in the $1.4 million that had been allocated to the Cornerstone Investors claims. Assuming the projected dividend of 45% to unsecured creditors, that meant that the Cornerstone Investors had to share approximately $770,000 pro rata with the other unsecured investors. An unhappy result from their perspective.