A single-asset real estate (SARE) case is defined as “real property constituting a single property or project, other than residential real property with fewer than [four] residential units, which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental thereto.”[1] In plain terms, it is a special-purpose entity that holds a single parcel or several parcels of real property upon which no real business is operating, there are no or few employees, the associated debt is secured by the real property and its rents, and there is minimal unsecured debt.
The SARE Bankruptcy
The typical SARE bankruptcy results from failed negotiations between a secured lender and its SARE borrower. When a SARE borrower is unable to pay its debts as scheduled, it will seek additional time and/or modified loan terms to get breathing room in order to figure out how to pay its debts. If the borrower is unable to achieve some relief through negotiations with its lender, a SARE borrower has the option of filing for bankruptcy and cramming down new terms on its unwilling lender through the process of a chapter 11 plan.
A plan of this nature typically includes cramming down the amount of the secured loan to the value of the property (assuming that the loan is undersecured), watering down the loan terms (i.e., increasing amortization, reducing interest rate, etc.), reducing the value of the unsecured deficiency to that of other general unsecured creditors or selling the real estate in a § 363 sale free of liens. Without going into the breadth of what constitutes a SARE, the ABI Commission to Study the Reform of Chapter 11 issued recommendations that could, if enacted by Congress, impact SARE bankruptcy cases generally going forward.[2] These recommendations are discussed below.
New Value[3]
Despite a debtor’s ability to cram down a plan on a lender, the absolute priority rule under § 1129(b)(1) prevents a SARE debtor from keeping equity in its property unless senior classes of claims or interests are paid in full. A potential exception to this rule arises not under the Bankruptcy Code, but through decades of developed case law. The “new value exception,” as it is coined, allows equityholders to keep some or all of their equity in a debtor if they contribute new value to the reorganized entity. Over the years, arguments have developed over how much of a contribution is required, whether the right is exclusive to the debtor and whether others may propose likewise contributions to “buy” the equity from the debtor.
The U.S. Supreme Court provided some round-about guidance on the new value exception in the case of Bank of America Nat’l Trust and Savs. Assn. v. 203 N. LaSalle St. P’ship.[4] Although the Court did not plainly acknowledge the exception, it did state that “[a] debtor’s pre-Bankruptcy equity security holders may not, over the objection of a senior class of impaired creditors, contribute new capital and receive ownership interests in the reorganized entity, when that opportunity is given exclusively to the old equity security holders under a plan adopted without consideration of alternatives.”[5] In other words, the reorganized debtor must offer the equity to the free market if it proposes to contribute new value and keep it for itself. A plan with a new value contribution cannot be confirmed if the equityholders do not allow the market to bid.
The ABI Commission discussed the new value exception and balanced its benefit to a debtor’s estate by allowing a free market bid, with the need to formalize a process that allows pre-petition equityholders to retain some stake in the reorganized debtor.[6] This issue becomes particularly important in cases where the pre-petition equityholders’ continued association with a business is critical or valuable to the reorganized debtor, underscoring the very purposes of reorganization in a chapter 11. The Commission noted that in some instances, the pre-petition equityholders are the only — or most viable — source of funding for a chapter 11 plan, in which case the new value exception and the market-test component are easily satisfied.[7] The Commission recommended codifying the new value exception to the absolute priority rule and identified the following key elements of new value to enhance and clarify the confirmation process: (1) new money or money’s worth; (2) in an amount proportionate to the equity that has been received or retained by pre-petition equity security holders; and (3) that would be subject to a “reasonable” market test.[8]
Secured lenders might argue that the codification of the market-bidding component of the exception is important because by very definition these cases are not dependent on a principal’s continued association with a going-concern business. Bidding on the reorganized debtor is simply bidding on real property. On the other hand, SARE borrowers may place more weight on the codification of what constitutes new money and how it relates to the expertise and knowledge they hold with respect to the asset. Realistically, the impact of codification of the new value exception depends on the complexity of the asset. The more complex the asset, the more important the management’s historical knowledge and expertise becomes. The simpler the asset, the more important an open market-bidding process becomes for the SARE equity in the assets.
Cramdown Interest Rates[9]
When a secured lender and SARE debtor fail to negotiate acceptable loan modification terms outside of bankruptcy, a SARE debtor has the opportunity in bankruptcy to cram down new terms on a secured lender through the plan process. Section 1129(b)(2)(A)(i) permits the secured creditor to retain its lien if the debtor provides it with deferred cash payments having a present value equal to the amount of the secured creditor’s allowed secured claim. Although this option of receiving cash payments is relatively straightforward, its application has proved challenging.
The primary issue is the selection of a new discount rate to for calculating the present value of deferred cash payments. The applied discount rate affects the amount and timing of deferred cash payments required to satisfy § 1129(b)(2)(A)(i). Over the years, courts have wrestled with the appropriate discount rate to use in satisfying § 1129(b)(2)(A)(i), including the “formula” approach (also referred to as the “prime plus” approach), the “coerced loan” approach, the cost-of-funds approach and the “presumptive contract rate” approach.[10] In 2004, the Supreme Court adopted the formula approach for purposes of a chapter 13 plan in Till v. SCS Credit Corp.[11] Thus, for purposes of calculating the present value of deferred cash payments to a secured creditor in a chapter 13 case, the court is required to use the risk-free rate of interest, adjusted by 100 to 300 basis points to account for the risk of default, the nature and quality of the collateral, and the duration and feasibility of the plan.[12] Since Till, the application of the formula approach to chapter 11 cases has been varied. Some courts argue that it is too simplified to take into account the complexities of a chapter 11, while other courts have argued that despite its simplification, it adds predictability to the process.
The ABI Commission analyzed the options, including using the simple Till formula, a market-based comparables approach or a hybrid approach that would establish a formula but would also consider variables more relevant to chapter 11 cases.[13] Ultimately, the Commission concluded that courts should use a market-based approach that takes into account the complexities of a chapter 11 case.[14] The Commission recommended that courts consider the evidence presented by the parties at confirmation and the cost of capital for similar debt issued to companies comparable to the debtor as a reorganized entity.[15] This process will take into account the size and creditworthiness of the debtor, as well as the nature and condition of the collateral. If such a market rate is not available or the court determines that an efficient market does not exist, the court should use an appropriate risk-adjusted rate that reflects the actual risk posed in the case of the reorganized debtor, considering factors such as the debtor’s industry, projections, leverage, revised capital structure, and obligations under the plan. The Commission voted to reject the “prime-plus” formula adopted Till.[16]
SARE lenders will likely embrace this new market-based approach as achieving a greater approximation of the risk that a lender is required to take with a reorganized debtor. However, the cost to obtain such risk-based interest rate might not be free. It is possible that lenders will encounter more litigation to prove what is the “market,” as this approach will be less predictable and more susceptible to varied interpretation by the parties. A SARE debtor facing a market-rate discount rate rather than a prime-plus rate might reconsider a cramdown plan if the long-term costs are too high and the real property rents cannot support a market-based rate.
Class Acceptance under § 1129(a)(10)[17]
Under § 1126, impaired creditors are entitled to vote to accept or reject a debtor’s plan based on the classification of their claims. How creditors’ claims are classified largely determines whether a creditor’s cramdown plan will be successful. Section 1122(a) provides that “a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to the other claims or interests of such class.”[18] Under § 1126(c), a class of substantially similar claims is deemed to have accepted a plan if at least two-thirds in amount and more than one-half in number of the class has accepted the plan. Under § 1129(a)(10), a debtor must find one impaired class of claims to accept the plan to achieve confirmation. SARE debtors commonly face the problem of obtaining an impaired accepting class to accept a plan because a lender’s large deficiency claim cannot be separately classified from other unsecured claims, and the deficiency often swamps the size requirement under § 1126(c). The result is that a lender is able to block the confirmation of a SARE debtor’s plan because typically a SARE debtor lacks other unsecured creditors with enough voting power to overcome the size of a lender’s deficiency.
The ABI Commission scrutinized the level of approval necessary under § 1126(c) and the idea that § 1129(a)(10) was enacted to ensure that a plan had at least some creditor support.[19] Also considered was whether a debtor can artificially create or impair a separate class to overcome a lender’s large deficiency claim.[20] Ultimately, the Commission concluded that § 1129(a)(10) creates too much of an impediment to confirmation of chapter 11 plans and that the potential delay, cost, gamesmanship and value destruction attendant to § 1129(a)(10) significantly outweighed the presumptive gatekeeping role that § 1129(a)(10) plays.[21] The Commission recommended eliminating § 1129(a)(10) altogether and replacing § 1129(c) with a “one creditor, one vote” concept.[22]
The elimination of § 1129(a)(10) undeniably means lenders in SARE cases will lose their ability to block a cramdown plan as long as the debtor can find one other impaired creditor (not a class) to vote “yes.” While this might eliminate the cost and argument that is associated with creating an artificially impaired class, it may also increase the cost of a SARE debtor’s capital. A lender may demand a higher interest rate up front to compensate for the loss of its ability to block a plan later, or for the increased monitoring and service costs related to ensuring a SARE debtor does not incur other unsecured debt.
Credit-Bidding[23]
Instead of proposing a plan that reorganizes a debtor’s financial affairs, a SARE debtor may propose to sell its property free of all liens, claims and encumbrances under § 363(f). A secured creditor with a perfected lien on a SARE debtor’s property is entitled to credit-bid the amount of its debt under state law and § 363(k), which provides the following:
At a sale under subsection (b) of this section of property that is subject to a lien that secures an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property.
Until recently, a creditor’s right to credit-bid was subject to varied interpretation and occasionally limited by a debtor’s offer to provide the indubitable equivalent of a credit-bid under § 1129(b)(2)(A)(iii). Any question regarding a creditor’s right to credit-bid its debt was settled in 2012 in RadLAX Gateway Hotel LLC v. Amalgamated Bank,[24] which specifically held that “debtors may not sell their property free of liens under §1129(b)(2)(A) without allowing lienholders to credit-bid, as required by clause (ii).”[25]
In light of this broad ruling, the ABI Commission recommended further clarifying a lender’s ability to freely credit-bid its debt by noting the various instances in which a court may limit this right for “cause.”[26] For obvious reasons, “cause” can limit or eliminate a creditor’s credit-bid if the amount of a secured creditor’s claim is disputed or unliquidated.[27] The Commission noted that courts have also reined in a creditor’s right to credit-bid where the conduct of an overly-aggressive secured creditor discouraged competitive bidding.[28] The Commission also highlighted the chilling effect that credit-bidding can have on a sale of a debtor’s assets, and recommended clarifying § 363(k) to explain that the potential chilling effect of a credit bid alone should not constitute cause, but that courts should attempt to mitigate any such chilling effect by managing the process of the bidding and sale procedures of a § 363 sale.[29]
The impact of these clarifications places hazy limits on secured lenders’ otherwise broad rights to credit-bid under § 363(k). The right remains intact, except to the extent that a court finds cause based on a case’s particular circumstances. The threat of seeking cause to limit a lender’s credit-bid might be just enough to alter the balance of power in negotiations between a SARE debtor and its secured lender both pre- and post-bankruptcy.
[1] 11 U.S.C. § 101(51B).
[2] Learn more about the Commission’s work at commission.abi.org. The Final Report (“Commission Report”) can also be purchased from the Commission’s website.
[3] Commission Report, at 224-26.
[4] 526 U.S. 343 (1999).
[5] Id.
[6] Commission Report, at 226.
[7] Id.
[8] Id.
[9] Commission Report, at 234-37.
[10] Id. at 235.
[11] 541 U.S. 465 (2004).
[12] Commission Report, at 235.
[13] Id. at 236.
[14] Id. at 236-37.
[15] Id. at 237.
[16] Id.
[17] Commission Report, at 257-260.
[18] U.S.C. §112(a).
[19] Commission Report, at 247.
[20] Id. at 260.
[21] Id. at 260-61.
[22] Id. at 255.
[23] Commission Report, at 146-147.
[24] 132 S. Ct. 2065, 2067 (2012).
[25] Id. at 2072.
[26] Commission Report, at 146.
[27] Id. (citing In re RML Dev. Inc., 2014 WL 3378578 (Bankr. W.D. Tenn. July 10, 2014) (valid claims objection that could not be resolved without delaying auction was cause to limit amount of credit-bid)).
[28] Id. at 147 (citing In re Free Lance-Star Publ’g Co. of Fredericksburg, Va., 512 B.R. 798 (Bankr. E.D. Va. 20141), appeal denied, 512 B.R. 808 (E.D. Va. 2014)).
[29] Commission Report, at 146.