Reversing the three-judge panel, Ninth Circuit sat en banc and held that a secured creditor in a cramdown is only entitled to the replacement value of the collateral, not the price that would be realized after foreclosure in those rare cases where foreclosure value is higher than replacement value.
The majority in the three-judge panel opinion from April 2016 believed that valuation, governed by Section 506(a), is not measured by the income an owner could generate by operating the property as affordable housing. In the 2/1 decision a year ago, the majority believed that the bankruptcy court could not shortchange a secured creditor if foreclosure would generate a higher value by freeing the property from the strictures of affordable housing.
Reversing en banc, the 8/3 majority in the Ninth Circuit’s May 26 opinion decided that Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997) requires using the “replacement value standard” rather than the value from a foreclosure sale that will not take place.
Valuation of an Affordable Housing Project
Valuation in the context of a chapter 11 cramdown was complicated because the debtor owned an affordable housing complex. The property had an $8.5 million, government-guaranteed first mortgage and two subordinate mortgages. After 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 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 when the three-judge panel issued its opinion last year.
The 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. The lender had exercised a Section 1111(b) election. As confirmed, the plan gave the lender a new secured note for $3.9 million, with interest at 4.4% and a balloon payment when the loan matured in 40 years.
The new investor agreed to continue operating the property as an affordable housing project. The project’s expert testified that it would be worth $7 million if affordable housing restrictions did not apply. The affordable housing restrictions would terminate on foreclosure.
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 last year written by Circuit Judge Richard R. Clifton. Dissenting last year, Circuit Judge Richard A. Paez said that the majority had misread Rash by basing valuation on the creditor’s perspective. Judge Paez also pointed out that the majority’s approach to valuation under Section 506(a) was at odds with the Collier bankruptcy treatise.
The Ninth Circuit granted the debtor’s petition for rehearing en banc. The 8/3 majority opinion on May 26 was written by Circuit Judge Andrew D. Hurwitz.
Rash and Cramdown Valuation
Because the lender objected to the plan, the debtor was required to employ cramdown under Sections 1129(a)(7)(B) and 1111(b)(2). In turn, those sections invoke the provision in Section 506(a)(1) that the lender’s debt is deemed secured “to the extent of the value of such debtor’s interest in” the collateral.
Since foreclosure would shed the requirement that the property be used as affordable housing, the lender argued that the proper value should be the higher value realized after foreclosure. The debtor contended that the value must represent the price the project would fetch as an affordable housing project, the use contemplated by the plan. Judge Hurwitz agreed with the debtor.
Judge Hurwitz said that Rash requires using the “replacement value standard,” not foreclosure value, even in an “atypical case” where foreclosure value would be higher. He said that the “essential inquiry” was to determine the price the debtor “would pay to obtain an asset like the collateral for the particular use proposed in the plan.” He said that Rash adopted replacement value even though the Supreme Court “implicitly acknowledged” that foreclosure on occasion might yield a higher value.
Judge Hurwitz said that “Rash did not adopt a rule requiring that the bankruptcy court value the collateral at the higher of its foreclosure value or replacement value.”
Because the lender did not contest the $3.9 million valuation as an affordable housing complex, Judge Hurwitz turned to other issues, such as the proper interest rate on cramdown.
The Proper Interest Rate on Cramdown
The lender argued that the plan was not “fair and equitable” under Section 1129(b) because the 4.4% interest rate on the new note was too low.
Judge Hurwitz began with Till v. SCS Credit Corp., 541 U.S. 465, 469 (2004), where the Supreme Court adopted a “formula approach” that adjusts the prime rate up or down according to risk.
The lender complained that 4.4% was lower than the rate on the original loan.
With a prime rate of 3.25% at confirmation, the bankruptcy court adjusted the rate up to account for risk. The bankruptcy court also had evidence that 4.18% would be the market rate for a loan on similar property.
Judge Hurwitz said that interest rates had declined “significantly” since the loan was originally made. In addition, there was more risk at the outset because the project had not been built.
Therefore, Judge Hurwitz said the bankruptcy court “did not clearly err” in fixing the rate on the new loan at 4.4%.
No Second 1111(b) Election
During the confirmation process, the lender attempted to vacate the so-called 1111(b) election it had made. Most likely, the lender wanted to have both a secured and unsecured claim, believing that its unsecured claim would vote down the plan by that class too. The bankruptcy judge did not permit the lender to revoke its election.
Judge Hurwitz said that the bankruptcy court did not commit error by refusing to amend “its scheduling order to allow the creditor a second bite at the apple.” Without deciding, he assumed that a court should allow a change in the election if there were a material modification to the plan.
The only change was an increase in the value of the collateral. Judge Hurwitz said that was “not material to the election decision.”
When the 1111(b) “gambit failed,” Judge Hurwitz said the “bankruptcy court did not err when it rejected [the lender’s] attempt to turn back the clock and torpedo the plan of reorganization.”
The Dissent
Three judges dissented in an opinion written by former Chief Circuit Judge Alex Kozinski, who was in the majority in the panel opinion last year. He said the majority engaged in “cramped formalism” that produced a “strange result.” He believes that Rash is “more flexible” and agreed with the rationale by the majority in the panel opinion last year. To read ABI’s discussion of last year’s opinion published before the court corrected citations to the wrong section of the Bankruptcy Code, click here.
Practical and Curious Aspects of the Opinions
The opinion last year would have made reorganization virtually impossible for owners of affordable housing in the Ninth Circuit where the lender is bent on taking title. The result from the panel opinion would have taken affordable housing units out of the inventory in populous states like California.
Last year, the majority repeatedly and erroneously cited Section 1325 as the governing cramdown statute, when the appeals court should have been referring to Section 1129. Although the court corrected its mistake 13 days later, the question remains whether the court and its clerks had adequately researched cramdown cases in chapter 11. The mistake presumably resulted from the fact that Rash was a chapter 13 case citing Section 1325.
The en banc majority opinion made the same mistake by saying in one instance that the debtor was invoking cramdown under Section 1325(a)(5)(B).
One wonders whether the lender’s decision to buy the defaulted loan for more than value related to affordable housing was based on an opinion of counsel guessing how the Ninth Circuit might rule.
A petition for certiorari to the Supreme Court won’t be a surprise.