Classification of Mortgage Deficiency: The Difference Between a Veto Right and Disenfranchisement

In re 18 RVC, LLC, 45 B.R. 492 (Bankr. E.D.N.Y. 2012) –

A chapter 11 debtor proposed to place a mortgagee’s deficiency claim into a separate class from general unsecured claims so that the deficiency claim could not prevent the unsecured class from accepting a proposed plan of reorganization.  The debtor argued that separate classification was justified by the fact that the mortgagee had the benefit of a guaranty from the debtor’s principal.

The debtor’s sole asset was a commercial building.  The sole tenant in the building was the medical practice of a doctor who was the managing member of the debtor’s managing member.  A bank held a mortgage on the property securing a debt of $1,145,839.39.  The doctor personally guaranteed the mortgage loan.

The debtor filed a chapter 11 bankruptcy on April 17, 2012 in order to prevent foreclosure of the bank’s mortgage.  On May 3, the bank filed a motion for relief from the automatic stay, or alternatively dismissal of the case, asserting that it was filed in bad faith solely to prevent foreclosure.

As a related point, the bank argued that the stay should be lifted under Section 362(d)(2) of the Bankruptcy Code because the debtor had no equity in the property and it could not confirm a plan of reorganization.  In particular, Section 1129(a)(10) requires that at least one class of impaired creditors must vote in favor of a plan.  The bank contended that its deficiency claim was large enough to block approval by the unsecured class so that the debtor could not meet this requirement.  (Acceptance requires 2/3 in number and a majority in amount of the claims in a class.)

The court deferred ruling on the motion for relief from the stay to give the debtor an opportunity to file a plan of reorganization, which it did on August 17, 2012, followed by an amended disclosure statement and plan on October 1, 2012.

As noted before (see Chapter 11 Secured Loans: “Lien Stripping” Lives), a secured claim is treated as secured to the extent of the value of the collateral and unsecured to the extent of any deficiency.  In this case the debtor treated the mortgage claim as consisting of a secured claim of $820,000 (purported value of the property) and an unsecured claim of ~$326,000.  Under the plan:

  • Class 1 was the bank’s $820,000 secured claim, which was to be paid over 5 years with 6% interest based on 20 year amortization and a balloon payment of ~$694,000.
  • Class 2 was the bank’s deficiency claim, which was to receive a 5% distribution (~$16,300).
  • Class 3 was minimal priority tax claims, which were to be paid in full.
  • Class 4 was miscellaneous unsecured creditors, which were to receive a 5% distribution (~$27,850).

The bank objected to the separate classification of its deficiency claim.  If the bank’s claim was combined with the other unsecured creditors, it could block acceptance of the plan (since it held more than 1/3 in amount of the claims).  Otherwise, the unsecured creditors could constitute an accepting class.  The issue was whether the deficiency claim was “substantially similar” to the other unsecured claims, so that they should be combined in the same class, given that the mortgage loan was also personally guaranteed, while the other creditors did not have recourse against the doctor.

Although only the disclosure statement was before the court, not the plan itself, the court found that a disclosure statement should not be approved if the plan is incapable of confirmation.  The debtor conceded that the plan could not be confirmed unless the court upheld separate classification of the bank’s deficiency claim.

Under Second Circuit law, an unsecured deficiency claim cannot be separately classified unless the debtor presents “credible proof of any legitimate reason” for the separate classification.  The Second Circuit was not concerned about whether separate classification would give the mortgagee undue influence, but rather “that the ‘over-whelmingly  largest creditor’ should not be disenfranchised by the debtor’s ability to separately classify that claim.”  Disenfranchising the largest creditor through separate classification “is simply inconsistent with the principles underlying the Bankruptcy Code.  A key premise of the Code is that creditors holding greater debt should have a comparably greater voice in reorganization.”

The debtor found one case holding that a personal guaranty in favor of the mortgagee was sufficient to permit separate classification.  However, the RVC court noted that the majority of courts have held that a personal guaranty by itself is not a sufficient basis for separate classification.  The court was persuaded by these cases and found that the proposed separate classification was improper gerrymandering with no other legitimate reason.  Consequently, the court did not approve the disclosure statement and granted the bank’s motion for relief from the stay.

The result in this case is by no means universal.  There are some jurisdictions where separate classification of a mortgage deficiency claim will likely be permitted.

On the one hand, a real estate debtor that is considering a chapter 11 bankruptcy will need to carefully review the state of the law in the jurisdiction where it intends to file a bankruptcy case to determine whether it will be able to come up with a confirmable plan.  On the other hand, a mortgagee cannot count on a quick resolution of the issue.  In this case, the bank filed its motion for relief from the stay at the beginning of May, and did not get a decision until more than 5 months later.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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