The Ninth Circuit wrote a seminal 2-1 opinion on the reorganization of affordable housing projects in chapter 11. Repeatedly, the opinion erroneously cites Section 1325 as the governing cramdown statute, when the appeals court should have been referring to Section 1129.
Unless the result is modified on rehearing, the opinion will make reorganization virtually impossible for owners of affordable housing when the lender is bent on taking title. The majority admit that the precedent will result in fewer affordable housing units.
The dissent, by Circuit Judge Richard A. Paez, argues that the majority misread the Supreme Court’s 1997 decision in Rash by basing valuation on the creditor’s perspective. Judge Paez also points out that the majority’s approach to valuation under Section 506(a) is at odds with the Collier bankruptcy treatise.
All three judges agreed that the appeal was not moot, making the Ninth Circuit an even more dangerous forum for purchasers or investors in bankrupt properties.
“The opinion should alert judges that their clerks ought to have taken bankruptcy if they are going to write published opinions on the subject,” Prof. Bruce A. Markell of Northwestern Univ. Pritzker School of Law said in an e-mailed statement reflecting on the miscitation of Section 1325. Prof. Markell was a bankruptcy judge in Nevada and a member of the Ninth Circuit Bankruptcy Appellate Panel before he returned to teaching in 2013.
The project had an $8.5 million, government-guaranteed first mortgage and two subordinate mortgages. Following default on the first mortgage, the government paid off the first lien lender and sold the mortgage to a third party for about $5 million. The new owner of the mortgage had arranged to sell the property after foreclosure for about $7.7 million. To halt foreclosure, the owner of the project filed a chapter 11 petition.
The three mortgages and agreements related to affordable housing all provided that the restrictions related to affordable housing would terminate in the event of foreclosure. The project had not been foreclosed by the time the circuit court issued its opinion on April 8.
The project’s owner financed the reorganization with $1.2 million in new equity provided by a new investor who in substance took over ownership when the plan was confirmed and consummated. As confirmed by the bankruptcy court, the plan valued the first lien at $3.9 million. Although not mentioned in the opinion, the lender exercised the Section 1111(b) election. Consequently, the plan gave the lender a new note, with interest, where the full amount of the debt would be paid on maturity of the loan in 40 years.
The new investor agreed to continue operating the property as an affordable housing project. The project’s expert conceded that it would be worth $7 million if affordable housing restrictions did not apply.
The lender appealed and was denied stays in the bankruptcy and district courts. The district court later upheld the confirmation order, leading to a reversal in the majority opinion written by Circuit Judge Richard R. Clifton.
The governing Supreme Court authority, of course, is Rash, a chapter 13 case involving valuation of a truck under Sections 1325 and 506(a). In the first paragraph of the opinion and later, Judge Clifton cited Section 1325 as containing the relevant cramdown standard, not Section 1129, which should have been applicable because the case entailed an appeal arising from a chapter 11 reorganization.
Judge Clifton said that valuation, governed by Section 506(a), is not measured by the income an owner could generate by operating the property as affordable housing. He said that nothing under Section 1325(a)(5) authorizes “shortchanging the creditor with regard to its current secured value.” He said that Rash does not authorize reducing the value simply because bankruptcy prohibits the lender from foreclosing, when affordable housing restrictions would end as a matter of contract.
Judge Clifton admitted there will be a “negative effect” by eliminating use of the project as affordable housing. Although that result would be “unfortunate” in “an immediate sense,” he said that the lower courts’ decisions “would drastically reduce” what the government could gain from selling defaulted mortgages. He added that the government could have designed financing so the property would remain affordable housing even after foreclosure.
Dissenting, Judge Paez said that the “majority errs in several major respects, all relating to its misapplication” of Rash. Saying that Rash “rejected starting the valuation from the creditor’s perspective,” he cited Collier’s statement that the amount paid to a secured creditor under Section 506(a) “turns on the value of the debtor’s proposed use of the relevant property under the plan, not the value achievable in a foreclosure scenario that is not proposed.”
Citing the Ninth Circuit’s Transwest decision from 2015, Judge Paez agreed with the majority in finding that the appeal was not equitably moot.
Conversely, the debtor contended that the appeal was equitably moot because reversal would be unfair to the third party that already had invested $1.2 million and would incur tax penalties were the transaction unraveled. The appeals court said that the new investor “is not the kind of innocent third party the doctrine of equitable mootness is intended to protect.” The investor, according to Judge Clifton, knew there were “potential tax risks if something went wrong.”
The appeals court also dispensed with the previously imposed requirement that an appellant must pursue a stay pending appeal in the circuit court to avoid equitable mootness. Because the appeals court rarely grants stays in these circumstances, the circuit said that a third futile stay motion was not required.
Transwest, also a 2-1 opinion, held that a buyer who actively participates in reorganization is not protected by equitable mootness. Transwest, combined with the new opinion, implies that investors or owners should think long and hard before consummating sales or plans if there is an outstanding appeal in the Ninth Circuit. The opinion gives more ammunition to lawyers advising their clients not to file chapter 11 petitions in the Ninth Circuit.
Unless an existing owner can somehow escape the restrictions associated with affordable housing projects, a lender intent on taking ownership should always be able to defeat a reorganization plan in the Ninth Circuit, taking low-cost units out of the housing market in the process.