In re Sunnyslope Housing L.P.: Ninth Circuit Uses Foreclosure Valuation in Cramdown Where Debtor Retains Affordable Housing Apartment Complex

Section 506(a) of the Bankruptcy Code provides that a claim is secured “to the extent of the value of such creditor’s interest in the estate’s interest in such property,” and that for purposes of determining a secured claim, the value of collateral “shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property.” However, with a few exceptions, § 506 does not specify a valuation methodology.

In the context of a cramdown, where the debtor retains the collateral, in Associates Commercial Corp. v. Rash[1] the Supreme Court determined that the proper methodology is a debtor’s hypothetical purchase of the same collateral, adopting the replacement value of property of the same age and condition, and rejecting the foreclosure value. The debtor’s actual proposed disposition or use was prioritized under Rash. The foreclosure-value standard is inapplicable because it is a hypothetical; only the replacement-value standard focuses on the debtor’s actual use of the property. The rule announced was that value “is the cost the debtor would incur to obtain a like asset for the same proposed use.”[2]

Rash dealt with valuation of a tractor used by a chapter 13 debtor in a trucking business.  The Court was confronted with the normal situation where a foreclosure by a creditor will result in a lower valuation than a replacement value. What happens when the foreclosure value is higher than the replacement value?

In In re Sunnyslope Housing L.P.,[3] the Ninth Circuit recently decided that issue in favor of the secured creditor, holding that when a debtor’s proposed use, based on restrictions that burdened only the debtor’s use of the property, results in a lower value than in a foreclosure not subject to those restrictions, the secured creditor is entitled to the higher valuation.

In Sunnyslope, the debtor developed and operated an apartment complex, financed by HUD-guaranteed and other affordable housing program loans. The debtor and its successors were restricted in the use of the property by the restrictive provisions running with the land. However, each of the secured creditors had provisions in their security documents stating that, in the event of foreclosure, the affordable housing restrictions would automatically terminate.[4]

Shortly after completion of the development, the debtor defaulted on the senior mortgages, so HUD took over the loan and sold it to a third party, releasing the regulatory restrictions as part of the sale. After the successor creditor moved to foreclose, the debtor filed a chapter 11 and sought to restructure the claims under a plan. The debtor’s appraiser valued the property at $7 million without the affordable housing restrictions, and $2.6 million with the restrictions.[5] Identifying the restrictions as the driver of differing value, the bankruptcy court concluded that the property should be valued subject to the restrictions and confirmed a plan. After a remand and later affirmance by the district court, the case made its way up to the Ninth Circuit.

The Ninth Circuit concluded that the affordable housing restrictive provisions should not limit the amount of the creditor’s secured claim. While the debtor argued that Rash rejected a foreclosure valuation in favor of a replacement valuation in a cramdown context, the Ninth Circuit stated that replacement value is not limited to the way in which the debtor intends to use the property. In a footnote rebutting the dissent, the majority stated that it was in fact using a replacement, not a foreclosure, valuation, but that the replacement should not include the restrictive covenants.[6] Additionally, the majority rejected the debtor’s policy arguments that the decision would negatively impact the affordable housing market because it would limit cramdown restructuring opportunities for those projects. The majority instead focused more broadly on the lender’s reliance on its mortgage position not being subject to the restrictions, and being willing to extend loans on that basis, and held that its ruling preserved that aspect of the housing finance market.[7]

Facially, as pointed out in the dissent in Sunnyslope, the majority decision appears directly contrary to Rash: The court used a hypothetical foreclosure method valuation rather than a replacement cost method in a cramdown where the debtor retained the collateral.[8] However, the decision could be read in a number of ways. One reading is that “replacement cost” should not include any restrictions that the debtor voluntarily places on the property – i.e., using it for less than its highest and best use.[9] Stated in the language of the Rash rule, in Sunnyslope a “like asset for the same proposed use” was an apartment complex, but not one that was subject to any use restrictions – such as the cost of the debtor to build or acquire a complex without any affordable housing restrictions.[10] The issue is really what the like asset is that the debtor is replacing: Is it an apartment complex, or an affordable housing apartment complex?

Examined another way and viewed from a senior creditors’ perspective, the creditor’s interest in the property, or the use or disposition of the property, is hindered only by interests senior or equal to the secured creditor’s position.[11] In Sunnyslope, the lender could take title to the property free of the affordable housing restrictions, so the value of the creditor’s interest should not be limited by those restrictions. The contrary would be true, for example, if there were regulatory use or zoning restrictions applicable to any owner – not just the debtor or its successors – that would limit value.

Alternatively, Rash directs bankruptcy courts to consider value in light of the debtor’s choice. The Sunnyslope decision could be read to hold that a creditor should receive the benefit of the higher valuation given the burden of being crammed down and facing the “double risks” of subsequent default and diminished value from extended use.[12]

The decision in Sunnyslope allows for creativity in appraising real property in a cramdown context to the extent that value can be influenced by the debtor’s use of the property. In the narrow context of restructuring affordable housing complexes, if the limited rental income combined with any tax credits is insufficient to service debt at unrestricted values, it would severely restrict restructuring opportunities.