A creditor appealed a bankruptcy court order valuing a secured claim at $3.9 million for purposes of a Chapter 11 plan. The district court affirmed, but the Court of Appeals panel reversed and remanded. Then the 9th Circuit granted a rehearing en banc. The primary issue was how to value property subject to low-income housing restrictions. The court also addressed the proper “cramdown” rate and feasibility of a 40-year balloon payment plan.
The debtor owned an apartment complex. Construction was funded primarily through an $8.5 million HUD guaranteed loan with interest at 5.3% that was secured by a first priority deed of trust and funded through bonds issued by a development authority. The city and state also provided loans secured by second and third priority liens respectively.
To obtain financing the debtor entered into five affordable housing regulatory agreements:
- Regulatory agreement with HUD requiring that the apartments be used for affordable housing.
- Regulatory agreement with the development authority requiring the debtor to preserve the tax-exempt status of the project and use 40% of the units for low-income housing. These restrictions bound all owners, but terminated on foreclosure.
- Regulatory agreement with the city mandating that 23 units be set aside for low-income families. This also bound all owners, but terminated on foreclosure.
- Declaration of covenants, conditions, and restrictions required by the state department of housing that set aside 5 units for low-income residents for 40 years. This agreement bound all owners, terminated upon foreclosure, and was expressly subordinate to the HUD agreement.
- To receive federal tax credits, the debtor also agreed with the state department of housing that the entire complex would be low-income housing. Restrictions and tax credits terminated on foreclosure.
After the debtor defaulted and HUD took over the guaranteed loan, the loan was sold to a bank for $5.05 million. HUD released its regulatory agreement in connection with the sale but confirmed that the property remained subject to other restrictions. After the bank began foreclosure proceedings, the state court appointed a receiver, and the receiver agreed to sell the project to a third party for $7.65 million.
However, before the sale could close the debtor filed bankruptcy. The debtor proposed a plan of reorganization in which it proposed to retain the apartment complex and to obtain confirmation of the plan using a cramdown.
Under section 506(a)(1) of the Bankruptcy Code the debtor was required to treat the bank’s debt as secured “to the extent of the value of such creditor’s interest” in its collateral. The debtor contended that the property should be valued as low-income housing, while the bank argued that it should be valued without regard to the restrictions since they would terminate upon foreclosure.
The bank’s expert valued the property at $7.74 million without the low-income housing restrictions and only ~$4.9 million with the restrictions. The debtor’s expert valued the property at $7 million without restrictions and $2.6 million with restrictions. The bankruptcy court used the value of $2.6 million because the plan contemplated continued use as low-income housing, and the court declined to include the value of the tax credits.
At this point the bank elected to treat its claim as fully secured under section 1111(b). Consistent with that election, the court confirmed a plan of reorganization that called for payment in full over 40 years at a rate of 4.4% with a balloon payment at the end without interest. The city and state liens were extinguished, but they received payment of their unsecured claims in full but without interest at the end of the 40 years.
The bankruptcy court found this treatment to be fair and equitable since 4.4% was the prevailing market rate and the bank could foreclose (thus receiving the property without the restrictions) if the debtor defaulted. It also found the plan to be feasible based on the debtor’s restrictions, noting that when the loan became due the property would become even more valuable since it would be free of the affordable housing restrictions.
Appeals followed. After remand from the district court, the bankruptcy court valued the tax credits and added $1.3 million to the value. It then re-confirmed the plan and the bank again appealed.
The district court affirmed and then a divided 9th Circuit panel reversed, holding that the property should have been valued without regard to the affordable housing restrictions. The majority held that replacement cost was the appropriate measure, and the replacement value should not take into account the restrictions. The dissenting opinion relied on Supreme Court precedent that it argued compelled valuation based on the proposed use of the property under the plan as affordable housing.
The case was then reheard en banc. On rehearing, the court agreed with the dissenter that the value of a claim must take into account the proposed use or disposition of the collateral. If a debtor proposes to retain the property subject to a lien, the foreclosure value is not relevant.
The court noted that this approach was consistent with all but one Circuit – the 5th Circuit – which adopted a foreclosure-value standard. However, the 5th Circuit’s decision was reversed by the Supreme Court, which adopted a replacement-value standard with the value of the collateral as “the cost the debtor would incur to obtain a like asset for the same ‘proposed… use.'” The Supreme Court emphasized that the value was to be based on the proposed disposition or use. Thus, if the debtor will continue to use the collateral valuation must the based on the actual use, which is not a foreclosure sale.
Although the bank argued that the property should be valued at its highest and best use, absent foreclosure the property was subject to affordable housing restrictions. The court held that valuation cannot be based on a hypothetical foreclosure, but must reflect the “actual use.” The bank attempted to distinguish this case on the basis that the foreclosure value was greater than replacement value (in contrast to the normal case where it would be lower). However, the court concluded this did not provide a basis for deviating from the Supreme Court’s direction.
The court also rejected the bank’s argument that the restrictions did not apply once HUD released its agreement since the other agreements were subordinate. Rather, the court noted that the restrictions continued to be applicable absent foreclosure.
Finally, an argument was made that considering the restrictions in valuing the collateral would discourage future lending. In response, the court noted that the primary purpose of a Chapter 11 is successful reorganization of the debtor and maximization of the value of the estate. In addition, the bank bought the loan at a substantial discount knowing the risk that the property would be subject to the affordable housing restrictions. Valuing the collateral with those restrictions in place would not subject the lender to any more risk than it already accepted.
On another issue, a cramdown requires that the secured creditor receive payments with a present value equal to the secured claim. In determining the discount rate, the court noted Supreme Court precedent endorsing a “formula approach,” which begins with a national prime rate and adjusts up or down according to the risk of the plan. The court reviewed the bankruptcy court’s analysis of the risk factors, including the justification for adopting a rate lower than the contract rate, and concluded that there was no clear error.
The court did not find objection with the bankruptcy court’s conclusion that the plan was feasible since projections showed the debtor would be able to make its payments, and expert testimony confirmed the project would remain useful for 40 years. In addition, the bankruptcy court determined that the balloon payment was feasible because it was secured by property whose value exceeded the value of the remaining claim.
Accordingly, the court vacated the panel decision and affirmed the district court.
A dissenting opinion adopted by three judges took issue with the decision to value the property subject to the low-income housing restrictions: “Today’s opinion claims to ‘take the Supreme Court at its word,’ but fetishizes the Court’s words at the expense of its logic. This cramped formalism produces a strange result: even though the Court has told us the cramdown valuations are supposed to limit the secured creditor’s risk, we’ve adopted a new valuation standard that turns entirely on the debtor’s desires – creditors be damned.”
It is interesting that relatively basic questions on topics such as proper valuation for a cramdown plan remain unsettled 40 years after adoption of the Bankruptcy Code. One can also feel sympathy for the bank since 40 years is a long time to wait for payment.
Vicki R Harding, Esq.