An opinion by Bankruptcy Judge Robert J. Faris explains why the valuation of a debtor’s assets in a chapter 11 cramdown can be lower than “fair market value” in an ordinary appraisal, because a hypothetical chapter 7 trustee is typically compelled to sell expeditiously without the luxury of operating the business.
Sitting in Honolulu, Judge Faris composed a template for someone writing a cramdown opinion where the focus is valuation. Judge Faris also sits on the Ninth Circuit Bankruptcy Appellate Panel.
The Decrepit Dairy Farm
The corporate debtor in Subchapter V of chapter 11 operated a dairy farm with a herd of 1,100 dairy cattle. The business operated on land leased from the State of Hawaii under a seven-year lease where several years had already burned off.
In his October 24 opinion, Judge Faris said that the “facilities and equipment are outdated and in dilapidated condition” and that the cattle were mostly “in poor to fair condition” with “less genetic diversity than is desirable.”
Three years before bankruptcy, the debtor contracted to sell the business for $700,000, but the buyer never closed. Also before bankruptcy, a third party purchased most of the debtor’s stock for $600,000 and provided another $450,000 in financial support.
In chapter 11, the new owner supplied $200,000 in so-called DIP financing approved by Judge Faris. The debtor was losing about $90,000 a month in chapter 11, the judge said.
The debtor proposed a chapter 11 plan with nothing for unsecured creditors. Judge Faris explained that secured and priority claims totaled more than $1.4 million, with administrative claims adding another $800,000.
Before unsecured creditors would be entitled to a distribution in the plan, Judge Faris said that “all secured, administrative, and priority claims would have to be paid in full,” a total of some $2.2 million.
Receiving nothing under the plan, unsecured creditors were deemed to have rejected the plan. For a so-called cramdown under Sections 1191 and 1129, Judge Faris said that all of the requirements had been met aside from the “best interests” test, as defined in Section 1129(a)(7)(A)(i). To confirm over a dissenting class, the section requires the debtor to prove that unsecured creditors will receive “not less than the amount that [unsecured creditors] would so receive or retain if the debtor were liquidated under chapter 7 of this title.”
The Hypothetical Sale
Before valuing the debtor’s assets, Judge Faris pointed out the implications of a hypothetical sale by a chapter 7 trustee.
Quoting Bankruptcy Judge Christopher M. Klein, Judge Faris said that a “hypothetical liquidation ‘entails a considerable degree of speculation about a situation that will not occur unless the case is actually converted to chapter 7.’” In re Sierra-Cal, 210 B.R. 168, 172 (Bankr. E.D. Cal. 1997). Next quoting a district judge from New York, he said that a hypothetical chapter 7 sale price is “inherently speculative.”
Paraphrasing the Collier treatise, Judge Faris said that “chapter 7 trustees often must sell property for less than the amount that a private, solvent seller could realize.” He proceeded to explain why a chapter 7 sale won’t bring the best price.
First, a trustee must sell quickly, “although not necessarily at ‘fire sale’ prices.” If a sale is “impossible or disadvantageous,” the trustee must abandon the property.
If the property were in the hands of a private party, the owner could continue operating while searching for a better offer. On the other hand, Judge Faris said that a chapter 7 trustee “rarely” seeks and obtains court approval to operate the business and would probably need financing, another factor requiring court approval.
In short, a chapter 7 trustee is under pressure to sell.
The Facts Applied to the Law
Alluding to the $700,000 sale that never closed, Judge Faris decided that $700,000 was the best price that a trustee could obtain for all of the assets, including the dairy cattle and the lease. He said it was “nearly inconceivable” that the value had risen in the last three years.
Judge Faris rejected the idea of selling the cattle on the mainland, because transportation costs of $560,000 needed to be paid up front, but the trustee had less than $70,000 in cash.
The creditor’s expert claimed that the lease alone was worth $1.15 million. Judge Faris disagreed, for several reasons.
Primarily, Judge Faris said that the expert’s valuation of the lease, based on projected cash flow, “represents the appraiser’s opinion of the ‘market value’ of the leasehold, ‘assuming that neither [the buyer nor the seller] is under undue duress.’”
“As I have explained above,” Judge Faris said, “the law basically forces a chapter 7 trustee to sell quickly. A definition of market value that assumes no ‘undue duress’ is not a good fit.”
The unsecured creditors’ expert believed that the lease was worth $1 million just to grow hay for someone else.
First, the lease only allowed growing hay for use on the ranch itself. Second, the terrain was “too rough” for harvest. Consequently, Judge Faris concluded that “the grass on the ranch is probably valuable only to the lessee under the lease.”
The Numbers Don’t Work for Unsecured Creditors
A chapter 7 trustee must sell the assets for more than $2.2 million before unsecured creditors would be entitled to a distribution.
Even if the lease itself were worth $1 million and a trustee could sell other assets for $700,000, Judge Faris said that “unsecured creditors would still receive nothing.”
Judge Faris overruled the objection to confirmation and directed the debtor’s counsel to submit a confirmation order.
An opinion by Bankruptcy Judge Robert J. Faris explains why the valuation of a debtor’s assets in a chapter 11 cramdown can be lower than “fair market value” in an ordinary appraisal, because a hypothetical chapter 7 trustee is typically compelled to sell expeditiously without the luxury of operating the business.
Sitting in Honolulu, Judge Faris composed a template for someone writing a cramdown opinion where the focus is valuation. Judge Faris also sits on the Ninth Circuit Bankruptcy Appellate Panel.