Options for an Underwater Mortgagee: The Mysteries of an 1111(b) Election

In re River Canyon Real Estate Investments, LLC, 495 B.R. 526 (Bankr. D. Colo. 2013) –

A chapter 11 debtor’s plan of reorganization placed two secured creditors in the same class.  (No one objected to this classification.) One of the creditors attempted to make an election under Section 1111(b) of the Bankruptcy Code to have its entire claim treated as secured, and the debtor objected.  The court concluded that the election was not valid.

The debtor was the developer of a gated community and golf club project.  Ravenna Metropolitan District (RMD) and United Water & Sanitation District (United) were both special districts formed to finance construction of infrastructure.  United worked in conjunction with RMD to issue several series of bonds.  To repay the bonds, they imposed fees on the property owners, including water tap fees, facility acquisition fees and water resource fees.  RMD also imposed sewer and operations fees.  Each district filed a proof of claim for over $10 million that it contended was secured by a statutory lien, which was more than the total value of the property as determined by the court.

As background, under Section 506(a) of the Bankruptcy Code generally an undersecured mortgage claim is treated as (1) a secured claim in an amount equal to the value of the collateral, and (2) an unsecured claim for the amount of the deficiency.  However, under Section 1111(b)(2) a class of secured creditors can elect to have the full allowed amount of the claim secured.

Section 1111(b) was enacted to protect the interests of secured creditors from the result in Pine Gate Associates, Ltd., 2 B.C.D. 1478 (Bankr. N.D. Ga. 1976) – a case under the Bankruptcy Act that in effect allowed the debtor to preserve for itself the value of post-confirmation appreciation of collateral without paying the secured debt in full.

As explained by the bankruptcy court, if an 1111(b) election is made (1) the creditor is still only entitled to receive cash payments with a present value equal to the value of its collateral as determined in connection with confirmation of the plan, and (2) it waives the unsecured deficiency claim.  However, the creditor emerges from bankruptcy with a lien securing the full amount of the allowed claim.  (As an aside, note that the election is not available if the property is sold under the plan of reorganization or in a sale under Section 363 because the creditor’s right to credit bid its debt was viewed as adequate protection against the Pine Gate result.)

The court put a total value of $9.9 million on the debtor’s property, which it allocated to each of the lots for purposes of possible Section 1111(b) elections.  The court concluded that the election had to be made on a lot by lot basis because (1) United did not have a blanket lien, but instead had liens (if at all) on a lot by lot basis, (2) there were tax liens senior to the district liens that in some cases left no or virtually no equity (so that the election was not available), and (3) with respect to 36 lots, the debtor had already paid the water tap fee, which could mean that the liens for other fees were fully secured.

United made an 1111(b) election for 130 of the 166 lots, and RMD did not file any elections.  However, the court noted that the Bankruptcy Code required that the election be made by a class as a whole, which meant that it must be approved by creditors holding at least two-thirds in amount and more than half in number of the claims in the class.  Accordingly, United was not able to make an election by itself since, regardless of the amount of its claim, it would not constitute a majority in number.

The court suggested that the class approval requirement normally does not create an issue because most plans separately classify each secured creditor.  While that is probably true, the process may still be complicated by the fact that often the unsecured deficiency claims are not only combined in one class, but may also be in the same class as unsecured trade creditor claims.

Under Bankruptcy Rule 3014, generally the election must be made before the conclusion of the hearing on the plan disclosure statement.  At that point, there is often a significant degree of uncertainty about how a plan of reorganization will play out.  The election can be a difficult strategic decision for an undersecured mortgagee, and the difficulties will be exacerbated if there are multiple secured creditors in the same class so that the mortgagee may not be able to control the decision in any event.

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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