A chapter 11 debtor sought to disallow the claim of a second mortgagee that held a nonrecourse loan that was totally underwater (i.e., the property was worth less than the first mortgage). The bankruptcy and district courts held that the claim should be allowed, and the debtor appealed to the 7th Circuit.
The debtor owned a shopping center that was subject to a first mortgage of ~$8.9 million and a second mortgage of ~$2.5 million. Although the property had not yet been valued, all parties expected that the value would be less than the amount of the first mortgage. Consequently, although the second mortgage constituted a valid lien on the property, it was not secured by any value.
The second mortgage was a nonrecourse loan. As noted by the court, this means that the lender can look only to the collateral for repayment. Outside of bankruptcy the second mortgagee would be entitled to foreclose its mortgage. However, if the proceeds of the foreclosure sale were insufficient, it would be barred from pursuing a deficiency claim.
Under Section 506(a) of the Bankruptcy Code a secured claim is generally treated as (1) secured to the extent of the value of the collateral and (2) unsecured to the extent of the deficiency. The debtor argued that the value of the second mortgagee’s secured claim was zero, and it was precluded from asserting an unsecured claim because Section 502(b)(1) provides that claims are disallowed to the extent that they are not enforceable under state law.
However, in the context of a chapter 11 reorganization, Section 1111(b)(1)(A) provides special treatment for secured claims:
A claim secured by a lien on property of the estate shall be allowed or disallowed under section 502 of this title the same as if the holder of such claim had recourse against the debtor on account of such claim, whether or not such holder has such recourse ….
The court determined that the plain meaning of this language is that there is only one prerequisite for treating a claim as though it had recourse, namely that it is secured by a lien on property of the estate. In other words, the claim does not have to be secured by any value to be treated as recourse under Section 1111(b).
Although the court reached a decision based on the plain meaning of the statute, it went on to consider legislative history (as well as treatises and other case law). In particular, Congress enacted Section 1111(b) in order to avoid the harsh result of a pre-Bankruptcy Code case in which a debtor used its cramdown powers to avoid a nonrecourse lender’s under secured deficiency claim, with the result that the debtor was able to retain the property and receive the benefit of future appreciation. This was viewed as a windfall to the debtor. (See Great Nat’l Life Ins. Co. v. Pine Gate Assocs., Ltd., 2 Bankr. Ct. Dec. 1478 (Bankr. N.D. Ga. 1976).) Given this background, the 7th Circuit reiterated that the value of the collateral is immaterial to treatment of a secured loan as a recourse loan under Section 1111(b).
The debtor argued that the court should follow a 1993 Florida bankruptcy case that concluded that a nonrecourse lender did not have a deficiency claim since it had no right to payment from the debtor or its property, and thus was not a creditor. In response, the 7th Circuit dismissed this decision as an “outlier” – commenting that the bankruptcy court did not consider treatises, legislative history, persuasive cases or controlling cases in reaching its conclusions.
Consequently the 7th Circuit held that if a nonrecourse lender has a valid and enforceable lien on property, it will be treated as though it had recourse against the debtor regardless of whether the claim is secured by any value in the collateral.
Note that this provision is applicable only in a chapter 11 reorganization case. Further it is not applicable if the secured claim class makes an “1111(b) election” or if the property is sold in a 363 sale or is to be sold under a plan of reorganization. (The carve-out in the context of a sale is justified on the basis that the lender is adequately protected by its right to do a credit bid in connection with the sale.)
Vicki R. Harding, Esq.