Collateral Valuations in Chapter 11: In re Heritage Highgate

Practical Law Legal Update 6-519-7300 (Approx. 6 pages)

Collateral Valuations in Chapter 11: In re Heritage Highgate

by PLC Finance

Background

The debtors entered into a series of construction loan agreements to finance the development of a residential subdivision in Pennsylvania. They first borrowed from a group of banks (Bank Lenders), securing the loans with substantially all of their assets as collateral. The debtors then also borrowed from several individuals and entities (Cornerstone Investors) which took a junior lien on the same collateral securing the Bank Lenders' loans.

In January 2009, after building and selling about a quarter of the planned units, the debtors filed a voluntary petition for relief under Chapter 11 of the Bankruptcy Code. In connection with a contested cash collateral hearing in the Chapter 11 cases, the debtors offered an appraisal to demonstrate the value of the collateral. The US Bankruptcy Court for the District of New Jersey accepted the appraiser's calculation of the project's fair market value which was then sufficient to cover the entirety of the secured debt.

In June 2009, the debtors filed a joint proposed plan of reorganization which provided that the debtors were to complete the project and use the sale proceeds to pay their creditors according to a set of projections contained in a budget. The Official Committee of Unsecured Creditors (Committee) then filed a motion to value the secured claims of the Cornerstone Investors under section 506(a) of the Bankruptcy Code, claiming that the value of the collateral was less than the amount owed to the Bank Lenders because interim sales of completed units had reduced the initial appraised value of the project, leaving the Cornerstone Investors as unsecured creditors. The motion was stayed until after confirmation of the plan of reorganization.

The confirmed final plan of reorganization provided that the debtors were to continue developing the real estate over time with sales of completed units generating proceeds that were to be distributed to the creditors according to their interests. The Bankruptcy Court then took up the Committee's motion and agreed with the Committee that the fair market value of the collateral was worth less than the amount owed to the Bank Lenders due to the interim sales, leaving the Cornerstone Investors to be reclassified as unsecured creditors under the plan of reorganization.

The Cornerstone Investors appealed and the US District Court for the District of New Jersey affirmed. The Cornerstone Investors then appealed to the Third Circuit.

Third Circuit Appeal

Before the Third Circuit, the Cornerstone Investors argued that:

The lower courts erred in valuing the collateral at the time of the plan confirmation.
Denying them the proceeds from the future sales constitutes a form of lien stripping disallowed by the US Supreme Court in Dewsnup v. Timm.

Burden of Proof

Before turning to either argument, the Third Circuit clarified which party bears the burden of proof in valuing secured claims under section 506(a) of the Bankruptcy Code. Neither the Bankruptcy Code nor the Federal Rules of Bankruptcy Procedure specify which party has the burden of proof in section 506(a) valuations. Although the question was not considered by the lower courts, the Third Circuit first discussed three competing approaches that courts have applied in determining where the burden of proof lies. These approaches allocate the burden of proof for determining the value of secured claims:

To the secured creditor.
To the party (usually the debtor) challenging the value of a claim.
Initially to the debtor to overcome the presumed validity and amount of the secured creditor's claim, but if the evidence shows that the proof of claim overvalues the secured creditor's claim because the collateral is of insufficient value, the burden shifts to the creditor to demonstrate the extent of its liens and the value of the collateral securing its claim.

The Third Circuit found the third approach, with its burden-shifting framework, to be the most appropriate in the section 506(a) valuation context because, by placing the burden on the party challenging the validity and amount of a secured claim, it gives prima facie effect to a properly filed proof of claim.

Valuation Analysis

On appeal to the Third Circuit, the Cornerstone Investors argued that the lower courts erred in valuing the collateral at the time of the plan confirmation because the proper valuation standard under section 506(a) of the Bankruptcy Code requires the value to be "determined in light of the proposed disposition or use of such property." They argued that this meant the value should be based on the development of the project and sale of lots over time. Because the plan of reorganization provided for the continued development and sale of the real estate, the Cornerstone Investors argued that the valuation should reflect the value of those eventual sales and not just the fair market value of the real estate at the time of confirmation.

The Third Circuit disagreed, stating that this "wait-and-see" valuation approach had not been used by any other courts and would in fact defeat the bankruptcy court's obligation to determine value under section 506(a).

The Third Circuit acknowledged that section 506(a) does not dictate a specific valuation method, but rather allows for a flexible approach based on the particular circumstances of the case. In this instance, however, the Third Circuit found that when a debtor retains collateral, the value of those assets should be calculated based on the amount the debtor would spend to obtain similar assets for similar purposes, in other words, their replacement value.

Therefore, the value of the real estate in this case is for the undeveloped land and does not include the future income from its eventual sale after development. The future value included in the budget in the final plan of reorganization was not intended as a new appraisal of the collateral's value but rather simply to show that the plan was feasible.

The Third Circuit affirmed the Bankruptcy Court's finding that the fair market replacement value of the collateral as of the plan's confirmation date was less than the Bank Lenders' secured claims, leaving the Cornerstone Investors' claims wholly unsecured.

Lien Stripping under Dewsnup

The Third Circuit next addressed the Cornerstone Investors' argument that denying them the proceeds from the future sales would constitute a form of lien stripping that was disallowed by the US Supreme Court in Dewsnup v. Timm.

Dewsnup involved a Chapter 7 liquidation proceeding in which the debtor's property increased in value between the initial valuation and the time of its foreclosure sale. The Supreme Court ruled that because liens pass through bankruptcy unaffected, a creditor should not be forced to "lose the benefit of any increase in the value of the property by the time of the foreclosure sale." The Third Circuit joined the majority of courts that have held that the rationale in Dewsnup does not apply in the Chapter 11 reorganization context. It therefore agreed with the Bankruptcy Court's ruling that the valuation at the time of the plan confirmation did not constitute impermissible lien stripping.

Practical Implications

This case clarifies that the burden-shifting approach applies in the context of allowing secured claims under section 506(a) of the Bankruptcy Code. It highlights the importance for secured creditors of properly filing a proof of claim, which is presumed valid under the Bankruptcy Code unless another party assumes the burden of proof and can successfully challenge its validity.

This case also reaffirms that in a Chapter 11 reorganization context, the value of the collateral retained by the debtor should be calculated under section 506(a) at the time of the plan confirmation, even if the debtor is viewed as receiving a windfall if the value of the collateral increases after plan confirmation. This demonstrates the importance of the creditor presenting additional evidence of value, and relying on its own analysis and experts in valuation disputes, rather than relying on the debtor's appraisal.

Collateral Valuations in Chapter 11: In re Heritage Highgate | Practical Law