“For You, Today”: Valuation as Impacted by Proposed Use

Bankruptcy Code § 363(e) requires that when property is sold free and clear of an interest in property, the court shall prohibit or condition such sale as is necessary to provide adequate protection of such interest. Parties sometimes concentrate on whether property can be sold free and clear of an interest, and overlook the need to request and demonstrate the value of the interest that is subject to the requirement of providing adequate protection.

In In re November 2005 Land Investors, LLC,[1] the Ninth Circuit considered the rights of a party holding a contingent interest following a § 363 sale. The debtor was part of a residential master planned community involving several homebuilders. When the first builder started development of infrastructure, agreements were negotiated to provide some assurance that the other builders would shoulder their share of the project’s infrastructure costs. BOH Park Highlands NV, L.P (BOH) was the successor to the rights of the first builder. Because BOH funded more than $4.9 million of the infrastructure costs up front, its future contributions were to be reduced. A Conditional Repayment and Funding Agreement (CRFA) provided that if the lender exercised remedies that resulted in a transfer of title “whether by foreclosure, deed-in-lieu of foreclosure, or otherwise,” then the acquirer was required to elect either to assume the agreement or to make a “buyout payment” of $3.2 million.[2] A purchaser could also post a letter of credit in the amount of the buyout payment to release the property from the CRFA. Separately, the CRFA would terminate if the amount of the excess funding ($4.9 million) were paid.

In November 2005, Land Investors, LLC filed for bankruptcy and moved for sale of the property via a § 363 sale.[3] Ultimately the sale to a third party was approved, and the parties stipulated that any interests of BOH would attach to the proceeds. BOH argued that it was entitled to $4.9 million pursuant to the CRFA. The bankruptcy court, district court and Ninth Circuit Court of Appeals all disagreed. The Ninth Circuit reasoned that BOH was entitled to payment under the CRFA only if the lender exercised remedies resulting in a change in title and the purchaser did not assume the CRFA. Because the loan no longer existed, these events could never occur. “Thus, once the bankruptcy court sold the property pursuant to § 363(f), Section 1 could no longer be triggered and the CRFA no longer had any legal effect. As a contingent interest that expired upon the sale of the property, the CRFA has no value to BOH.”

The Ninth Circuit also noted that BOH had failed to present any evidence from which a valuation of its “contingent interest” as of the sale date could be made. Since BOH had the burden of proof pursuant to § 363(p)(2), that failure was fatal to its claim.

In In re Metroplex on the Atl. LLC,[4] the court considered the ability to sell real property free and clear of an easement granting beach access. Pre-petition, the debtor had sued to quiet the title to the real property, asserting that the easement had terminated decades before. The debtor abandoned that litigation, and a default was entered on a counterclaim, which included findings that there was a valid easement and that the debtor had intentionally and willfully violated the easement. A default judgment was entered against the debtor in the amount of $650,400, comprised of $115,000 in damages for diminution of value to the defendant’s property, $35,400 in damages to that property, and $500,000 in punitive damages.[5] The court concluded that under New York state law, the holder of an easement could be compelled to accept a monetary satisfaction, based on the fact that applicable law vested a court with discretion to award damages rather than requiring demolition where a completed building violated an easement. Further, the court found that the easement was largely inaccessible and that residents had adequate access via other routes, concluding that the value of the easement was “de minimus, at best.” The bankruptcy court concluded that the state court decision did not rule on the same issue, measuring damages to the defendant’s property rather than the value of the easement over the debtor’s property. Since the plan set aside $25,000 to be shared by those asserting claims on account of the easement, the court held that adequate protection had been afforded.

Other cases find that the use of the property may inform the determination of its value. In In re Flyboy Aviation Properties LLC,[6] adjacent landowners objected to a sale free and clear of land based on their claim of an easement to utilize runways and taxiways. However, the easement itself was “not perpetual but … limited by its terms to the period in which the Airport is used as an airport.” The debtor concluded that maintaining an airport on the property was not economically feasible and sought to sell the property to a homebuilder. The court held that the property could be sold free and clear of the purported easement, since the easement did not survive the use of the property for other purposes than that of an airport.

A recent case involving valuation for purposes of determining the required cramdown payment under § 1129(b)(2)(i)(II) took a different approach, holding that the value of the secured claim was not limited by the actual and proposed use of the property. In re Sunnyslope Hous. Ltd. P'ship[7] involved property that was subject to restrictive covenants governing its use as affordable housing; however, such covenants would automatically be terminated in the event of foreclosure. While the estimate value of the property as an affordable housing project (the debtor’s actual use) was estimated at approximately $2.8 million, “[i]f there were a foreclosure sale, there is no doubt that the restrictive provisions would be swept away, giving [the lender’s] interest a value of at least $7 million.” Both parties cited to the seminal Supreme Court decision Associates Commercial Corp. v. Rash[8] for the proposition that “value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property.”[9] The Ninth Circuit rejected the debtor’s argument that its proposed use required a finding of the lower value. First, the court held that Rash referred to “use” only as an alternative to “disposition,” and the replacement value required to be paid where the debtor retains property did not mean property devalued by virtue of restrictions that would not apply in a foreclosure. Second, the court noted that the purpose of utilizing replacement value where property is maintained is to give the secured creditor the additional value normally associated with such a valuation, since the creditor is exposed to additional risks when it is prevented from foreclosing. “Applying the replacement value standard — establishing a value higher than the foreclosure value — was deemed by the court to be more appropriate in light of the double risks that must be borne by the creditor.”[10] However, the debtor’s proposal would not compensate the secured creditor for the additional risks associated with the debtor’s continued use of the property. “To the contrary, it imposes them on the creditor at the same time that it provides the creditor with a value about one-third of what the creditor could obtain if the property were surrendered.”[11]

These cases serve as a reminder of the importance of providing persuasive evidence of value. Further, failure to object to a § 363 sale and request an adequate protection determination may impair the ultimate recovery. Sales that involve a combination of real property, fixtures, personalty, intangibles and contracts afford the opportunity for each creditor to demonstrate the value of its specific collateral or claim and demand full payment in order for the sale to proceed. However, once the property is sold, an effort to apportion the proceeds may advantage the real property lender to the detriment of other creditors.