As a matter of first impression, on November 4, 2013, the US Court of Appeals for the Seventh Circuit held, in In re B.R. Brookfield Commons No. 1 LLC, that a secured lender holding a non-recourse loan may assert an unsecured deficiency claim against a debtor in Chapter 11 bankruptcy under section 1111(b) of the Bankruptcy Code, even if the lien securing the loan becomes wholly unsecured (735 F.3d 596 (7th Cir. 2013)).

B.R. Brookfield No. 1 and B.R. Brookfield No. 2 (Brookfield) took out two loans secured by a shopping center (Property), which included:

On June 10, 2011, Brookfield filed for Chapter 11 bankruptcy and elected to reorganize while retaining ownership of the Property. This election required the bankruptcy court to judicially value the Property using independent appraisals. While this valuation was not yet carried out, all parties expected the value of the Property to be less than the amount of the first mortgage. This would result in the second mortgagee becoming wholly unsecured.

Outside of bankruptcy, state law limits a non-recourse lender's recovery to the proceeds from the sale of the collateral securing the loan. If the sale proceeds are not enough to repay the debt in full, the lender is barred from pursuing a deficiency claim against the borrower for the outstanding debt. However, in bankruptcy, under section 1111(b)(1)(A) of the Bankruptcy Code, a creditor is permitted to treat its non-recourse claim as if it had recourse if its claim is secured by a lien on property of the estate. This allows the creditor to assert a deficiency claim for any remaining unsecured debt unless the property securing the loan is either:

The question presented to the Seventh Circuit was whether the protections of section 1111(b) extend to a situation where the claim is not secured by any value in the property of the estate. While the parties did not dispute that the lien was valid and enforceable, Brookfield argued that because the lien had no value, ValStone was not entitled to an unsecured deficiency claim under section 1111(b). Conversely, ValStone argued that section 1111(b), by operation of law, converted its non-recourse loan into a recourse loan and therefore that its unsecured deficiency claim should be allowed.

Both the bankruptcy court and the district court agreed with ValStone and held that the deficiency claim was valid.

The Seventh Circuit, affirming the decision of the lower courts, began by examining the plain language of section 1111(b) of the Bankruptcy Code. Finding that the language of the statute is unambiguous, the Court:

The Seventh Circuit then considered conflicting case law interpreting section 1111(b). It rejected the debtor's reliance on In re SM 104 Ltd., which disallowed a creditor's totally unsecured non-recourse lien claim completely, calling it an "outlier" opinion because it did not consider bankruptcy treatises, legislative history or relevant case law (160 B.R. 202, 216 (Bankr. S.D. Fla. 1993)). Instead, the Seventh Circuit adopted the reasoning of In re Atlanta West IV, which analyzed the plain meaning, legislative intent and case law relevant to section 1111(b) to conclude that the statute does not require that the lien on the property be secured by actual value (91 B.R. 620 (Bankr. N.D.Ga. 1988)).

Next, the Seventh Circuit examined the legislative history of section 1111(b), which it found did not provide full guidance on the issue, and the case law that led Congress to enact section 1111(b), which it found instructive. The Court noted that section 1111(b) was enacted to avoid the harsh result in cases where a debtor retained ownership of a depressed property and cashed out non-recourse, undersecured creditors at the value of the property instead of the amount of the debt. Under this scenario, the debtor would retain the property lien free and receive the benefit of any future appreciation in the property, while the creditor would receive no payment on its undersecured deficiency claim, resulting in a windfall to the debtor at the creditor's expense. Section 1111(b) was enacted to remedy this problem and "strike a balance between debtor protections and equitable treatment of creditors."

Finally, the Seventh Circuit concluded that despite the fact that the collateral securing ValStone's claim had no value, it still had a claim secured by a valid and enforceable lien on property of the estate. This alone entitled ValStone to invoke section 1111(b) to treat its non-recourse claim as if it had recourse and assert an unsecured deficiency claim for the entire balance of the loan.

In re Brookfield Commons confirms that section 1111(b) protection is available to both wholly and partially unsecured non-recourse creditors if they hold a valid and enforceable lien on estate property. These creditors may fare better in bankruptcy than outside of bankruptcy, where under state law they have no ability to pursue deficiency claims against the borrower for the outstanding debt. However, the conflicting decisions from the Florida and Georgia bankruptcy courts suggest that the issue may not be resolved.