Dirt for Debt, Valuation Issues and the Indubitable Equivalent

In order to confirm a plan under chapter 11 of the Bankruptcy Code, a debtor must satisfy the requirements of 11 U.S.C. § 1129(a)(8) or show the court that the plan “does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” [1] While there are several options for satisfying the fair and equitable standard as to secured claims, dirt-for-debt cases focus specifically on providing secured creditors with the indubitable equivalent of their claims under 11 U.S.C. § 1129(b)(2)(A)(iii) and typically involve real estate collateral [2].

In a dirt-for-debt plan, a debtor proposes to surrender all or a portion of a secured creditor’s collateral to satisfy all or a portion of the debt owed to the creditor, and must prove, by a preponderance of the evidence, that the value of the surrendered collateral equals or exceeds the value of the secured claim or credit sought [3]. In reality, however, the debtor’s burden is often much greater, as “indubitable” requires that there be no doubt that the creditor will be paid in full [4]. While the statutory language is relatively straightforward, application of the indubitable equivalence standard can be nuanced and fact-intensive, as a court must determine whether a secured creditor’s treatment is “adequate to both compensate the secured creditor for the value of its secured claim, and also ensure the integrity of the creditor's collateral position.” [5]

Traditional Dirt-for-Debt Scenarios

Courts have long held that a transfer of all of the collateral securing a single secured creditor’s claim meets the indubitable-equivalent requirement under § 1129(b)(2)(A)(iii) [6]. After all, receipt of the collateral itself, by definition, provides the creditor with the full value of its secured claim [7].

However, the analysis is not always that simple, particularly when creditors are vastly oversecured [8], when there are competing liens on the underlying collateral [9], and when debtors seek to cherry-pick collateral for surrender in partial dirt-for-debt plans.

Valuation Issues in Partial Dirt-for-Debt Cases

Section 1129(b)(2)(A)(iii) requires a deb tor to provide the indubitable equivalent of a creditor’s secured claim only, and thus, valuation of the underlying collateral under 11 U.S.C. § 506 plays a critical role in dirt-for-debt cases [10].

Section 506(a)(1) states that the “value [of a secured creditor’s collateral] shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.” [11] In other words, there is no fixed valuation approach, and a court must examine the particular facts of each case to determine which valuation method is most appropriate [12]. While a sale is not required to determine value in this context, market factors must be taken into account by the bankruptcy court [13]. Valuation for purposes of § 1129(b)(2)(A)(iii) is determined as of the date of plan confirmation [14].

Whatever the valuation method employed, courts take a conservative approach to valuation under the strict indubitable-equivalent standard, leaving ample margin for error in favor of the secured creditor to account for the increased risk to the secured creditor and to ensure full payment of the secured claim [15]. Under this framework, courts typically apply liquidation or market value analyses, often with modifications for delay or sale costs, taking into account the “highest and best use” of the property (i.e., that use which is reasonably available that will result in the highest realized value) [16].

Generally, a liquidation analysis is applied in circumstances where it is almost certain that surrender of the collateral will result in liquidation of the collateral by the lender. For example, in In re Simons, the purpose of the disposition was to return undeveloped rural land parcels, best used for recreation or ranching, to the creditor as an adjacent landowner who would need to liquidate the property to be compensated for his claim [17]. The court applied a liquidation value analysis, adding a 10% deduction in the property’s liquidation value to account for costs of sale [18].

Likewise, in In re Invs. Lending Grp. LLC, the court held that “[i]f a proposal before the Court is to surrender property in whole or in part, then a foreclosure or liquidation type value is the proper standard,” and denied confirmation where the determined liquidation value did not provide a sufficient equity cushion to the secured creditor after an 8% reduction for costs of sale [19]. In the chapter 12 case of In re Holland, the court found it inappropriate to use a fair market value for cramdown purposes where the debtor proposed to surrender ranch acreage and buildings to its bank creditor in satisfaction of secured debt, as the bank was not in the ranching business, and “the possibility of forced liquidation would be assumed and a deduction for selling costs would be logical” under such circumstances [20].

In contrast, a fair market value has been used in cases where commercial markets exist for a brokered sale and marketing of the collateral, usually with a reduction in value based on the projected costs of the sale. In In re Stockbridge Properties I, the court found that a fair market value appraisal was more probative of the value of undeveloped commercial lots than the fair value appraisal (or duress appraisal), which provided and modified the fair market value appraisal to reflect a projected delay in sale and costs associated with the same [21]. The court made a similar finding in In re Pioneer Inv. Servs. Co., holding that the lower court “did not err in selecting fair market value (as opposed to liquidation value) as the appropriate measure of value” where the lender stated that the collateral real estate could be sold in a commercially reasonable manner, without the need for foreclosure [22]. In In re Bate Land & Timber LLC, the Fourth Circuit affirmed the bankruptcy court’s findings after it considered testimony from appraisers, loggers, bankers, soil analysts and other creditors over 10 hearings, including testimony relating to topography, average days on the market of property in the area, the economic climate of the location of the properties, and the economic history of the particular tracts, to determine the highest and best use of the land and fair market valuation based on the same [23].

Despite having multiple methodologies available for valuation, wide variances in proposed valuations of the parties may result in a lack of certainty such that a court is unable to find indubitable equivalence, sending the parties back to the drawing board. For example, in In re Arnold & Baker Farms, the Ninth Circuit held that because the per-acre valuations presented to the bankruptcy court were so far apart, the court could not determine, without a doubt, that the secured creditor would realize the indubitable equivalent of its secured claim upon disposition of the collateral surrendered [24].

Additionally, the Central District of California’s recent opinion in In re Fleming reopened a court’s determination of value after sale, finding that equitable mootness did not apply under the facts of the case [25]. In In re Fleming, the bankruptcy court issued a determination of value in connection with 46 unfinished lots in a real estate development, finding that selling the lots individually would be the commercially reasonable method of disposition, and that transfer of the lots to the objecting secured creditor met the indubitable-equivalence standard using a present-day value methodology as of April 2019 [26].

The Ninth Circuit BAP subsequently vacated the confirmation order and remanded the case to the bankruptcy court, but only after the subject collateral was transferred to the secured lender [27]. The debtor ultimately proposed a new plan approximately two years later that sought to offset the secured creditor’s claim using the court’s April 2019 value of the surrendered collateral, and such plan was again confirmed over the secured creditor’s objection [28]. The secured creditor appealed the bankruptcy court’s order confirming the later plan, arguing that the April 2019 valuation did not account for the holding and sale costs that were incurred by the lender and did not provide the indubitable equivalent of the secured creditor’s claim [29].

The district court held that the later plan was not fair and equitable, as its use of the April 2019 value to reduce the secured creditor’s remaining claim failed to account for holding costs, discounted cash flow, or associated risk incurred by the secured creditor and could not support a dollar-for-dollar reduction of the secured claim [30]. In finding the same, the court noted that because the secured creditor chose to sell the lots in a bulk sale, and not individually, the secured creditor was not entitled to the cash equivalent of its shortfall, but rather some other lesser amount to be determined by the bankruptcy court [31].

Key Takeaways

Dirt-for-debt cases demonstrate the broad risk to secured creditors associated with a return of collateral in cramdown scenarios and highlight the value of trusted experts in determining value in light of all possible uses of the collateral, both in lending and in defending claims in the context of a dirt-for-debt plan. Additionally, secured creditors must consider projected costs and methods of disposition in their valuation analyses to effectively protect their interests. Likewise, because the indubitable-equivalent standard is so high, debtors’ counsel should consider the same factors in fashioning relief under 11 U.S.C. § 1129(b)(2)(A)(iii) to increase the likelihood of plan confirmation in dirt-for-debt cases.