Claims, Creditors, and the Bankruptcy Estate
Avoidance and Recovery
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Claims, Creditors, and the Bankruptcy Estate
Avoidance and Recovery
Chapter 11 practice – like so many other professional service specialties – is regrettably jargon-laden. Businesses that need to get their financial affairs in order “enter restructuring.” Those that must re-negotiate their debt obligations attempt to “de-leverage.” And those facing resistance in doing so seek the aid of Bankruptcy Courts in “cramming down” their plans over creditor opposition.
Likewise, the Bankruptcy Code – and, consequently, Bankruptcy Courts – employ what can seem an entirely separate vocabulary for describing the means by which a successful “cram-down” is achieved. One such means involves providing the secured creditor with something which equals the value of its secured claim: If the secured creditor holds a security interest in the debtor’s apple, for example, the debtor may simply give the creditor the apple – or may even attempt to replace the creditor’s interest in the apple with a similar interest in the debtor’s orange (provided, of course, that the orange is worth as much as the original apple).
The concept of replacing something of value belonging to a secured creditor with something else of equivalent value is known in “bankruptcy-ese” as providing the creditor with the “indubitable equivalent” of its claim – and it is a concept employed perhaps most frequently in cases involving real estate assets (though “indubitable equivalence” is not limited to interests in real estate). For this reason, plans employing this concept in the real estate context are sometimes referred to as “dirt for debt” plans.
A recent bankruptcy decision out of Georgia’s Northern District issued earlier this year illustrates the challenges of “dirt for debt” reorganizations based on the concept of “indubitable equivalence.”
Green Hobson Riddle, Jr., a Georgia businessman, farmer, and real estate investor, sought protection in Chapter 11 after economic difficulties left him embroiled in litigation and unable to service his obligations.
Mr. Riddle’s proposed plan of reorganization, initially opposed by a number of his creditors, went through five iterations until only one objecting creditor – Northside Bank – remained. Northside Bank held a first-priority secured claim worth approximately $907,000 secured by approximately 36 acres of real property generally referred to as the “Highway 411/Dodd Blvd Property,” and a second-priority claim secured by a condominium unit generally referred to as the “Heritage Square Property.” It also held a judgment lien recorded against Mr. Riddle in Floyd County, Georgia.
A key feature of Mr. Riddle’s plan involved freeing up the Heritage Square Property in order refinance one of his companies, thereby generating additional payments for his creditors. To do this, Mr. Riddle proposed to give Northside Bank his Highway 411/Dodd Blvd Property as the “indubitable equivalent,” and in satisfaction, of all of Northside’s claims.
Northside Bank objected to this treatment, respectfully disagreeing with Mr. Riddle’s idea of “indubitable equivalence.” Bankruptcy Judge Paul Bonapfel took evidence on the issue and – in a brief, 9-page decision – found that Mr. Riddle had the better end of the argument.
Judge Bonapfel’s decision highlights several key features of “indubitable equivalent” plans:
- The importance of valuation. The real challenge of an “indubitable equivalence” plan is not its vocabulary. It is valuing the property which will be given to the creditor so as to demonstrate that value is “too evident to be doubted.” As anyone familiar with valuation work is aware, this is far more easily said than done. Valuation becomes especially important where the debtor is proposing to give the creditor something less than all of the collateral securing the creditor’s claim, as Mr. Riddle did in his case. In such circumstances, the valuation must be very conservative – a consideration Judge Bonapfel and other courts recognized.
- The importance of evidentiary standards. Closely related to the idea of being “too evident to be doubted” is the question of what evidentiary standards apply to the valuation. Some courts have held that because the property’s value must be “too evident to be doubted,” the evidence of value must be “clear and convincing” (the civil equivalent of “beyond a reasonable doubt”). More recent cases, however, weigh the “preponderance of evidence” (i.e., does the evidence indicate something more than a 50% probability that the property is worth what it’s claimed to be?). As one court (confusingly) put it: “The level of proof to show ‘indubitably’ is not raised merely by the use of the word ‘indubitable.’” Rather than require more or better evidence, many courts seem to focus instead on the conservative nature of the valuation and its assumptions.
- The importance of a legitimate reorganization purpose. Again, where a creditor is receiving something less than the entirety of its collateral as the “indubitable equivalent” of its claim, it is up to the debtor to show that such treatment is for the good of all the creditors – and not merely to disadvantage the creditor in question. Judge Bonapfel put this issue front and center when he noted, in Mr. Riddle’s case:
In re Riddle, 444 B.R. 681, 686 (Bankr. N.D. Ga. 2011).
One of the most effective vehicles for the rescue and revitalization of troubled business and real estate to emerge in recent years of Chapter 11 practice has been the “363 sale.”
Named for the Bankruptcy Code section where it is found, the “363 sale” essentially provides for the sale to a proposed purchaser, free and clear of any liens, claims, and other interests, of distressed assets and land.
The section has been used widely in bankruptcy courts in several jurisdictions to authorize property sales for “fair market value” . . . even when that value is below the “face value” of the liens encumbering the property.
In the Ninth Circuit, however, such sales are not permitted – unless (pursuant to Section 363(f)(5)) the lien holder “could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”
A recent decision issued early this year by the Ninth Circuit Bankruptcy Panel and available here) provides a glimpse of how California bankruptcy court are employing this statutory exception to approve “363 sales.”
East Airport Development (EAD) was a residential development project in San Luis Obispo which, due to the downturn of the housing market, never came completely to fruition.
Originally financed with a $9.7 million construction and development loan in 2006, EAD’s obligation was refinanced at $10.6 million in mid-2009. By February 2010, the project found itself in Chapter 11 in order to stave off foreclosure.
A mere two weeks after its Chapter 11 filing, EAD’s management requested court authorization to sell 2 of the 26 lots in the project free and clear of the bank’s lien, then to use the excess proceeds of the sale as cash collateral.
In support of this request, EAD claimed the parties had previously negotiated a pre-petition release price agreement. EAD argued the release price agreement was a “binding agreement that may be enforced by non-bankruptcy law, which would compel [the bank] to accept a money satisfaction,” and also that the bank had consented to the sale of the lots. A spreadsheet setting forth the release prices was appended to the motion. The motion stated EAD’s intention to use the proceeds of sale to pay the bank the release prices and use any surplus funds to pay other costs of the case (including, inter alia, completion of a sewer system).
The bank objected strenuously to the sale. It argued there was no such agreement – and EAD’s attachment of spreadsheets and e-mails from bank personnel referencing such release prices ought to be excluded on various evidentiary grounds.
The bankruptcy court approved the sale and cash collateral use over these objections. The bank appealed.
On review, the Ninth Circuit Bankruptcy Appellant Panel found, first, that the bankruptcy court was within the purview of its discretion to find that, in fact, a release price agreement did exist – and second, that such agreement was fully enforceable in California:
The Ninth Circuit Bankruptcy Appellate Panel‘s East Airport decision provides an example of how bankruptcy courts in the Ninth Circuit are creatively finding ways around legal hurdles to getting “363 sales” approved in a very difficult California real estate market. It likewise demonstrates the level of care which lenders’ counsel must exercise in negotiating the work-out of troubled real estate projects.
Practitioners and business people who have toiled in and around US-based restructuring work are well-acquainted with one of the great strengths (and primary threats) of Chapter 11: The ability of a debtor to restructure its secured obligations over the objection of a lender through the use of the “cram-down” procedures of Section 1129(b).
For those who may be less familiar, the concept of “cram-down” is not as difficult than the colorful term might suggest. Essentially, a debtor may confirm a Chapter 11 plan and restructure its debts over the objection of secured creditors so long as the debtor’s plan offers those creditors the present value of their allowed secured claims, such that they receive an appropriate rate of interest which accurately maintains the present value of their concern.
Fighting over “cram-down,” therefore, really boils down to fighting over which interest rate ought to apply to the lender’s restructured loan.
In an era where real estate and other collateralized capital assets are under significant duress (and “risk-free” rates of interest are near all-time lows), the issue of “cram-down” is once again a matter of immediate relevance – and its resolution can often spell the difference between restructuring or foreclosure.
Because the notion of “cram-down” has been part of US insolvency jurisprudence for decades, US Courts have accumulated considerable collective sophistication in addressing the financially-oriented evidence and arguments that surround “cram-down fights.”
But sophistication does not mean consistency.
Last week, Ray Clark of Orange County-headquartered VALCOR Consulting, LLC released a succinct overview of some of the more notable case law surrounding “cram down” developed in the years since the US Supreme Court decided Till v. SCS Credit Corp., 541 U.S. 465, 124 S.Ct. 1951 (2004).
Tracing several key cases issued by Circuit Courts of Appeal since Till, Ray – who has previously appeared on this blog as a guest – offers a very concise, readable summation of what it takes to win (or defeat) a “cram down” effort in Chapter 11.
One of Ray’s strengths is his ability to make the often unfamiliar and complex financial underpinnings of restructuring work accessible to the average, intelligent business person. His summary is available here – and is well worth a read.
With both the global and regional Southern California economies showing early signs of life – but still lacking the broad-based demand for goods and services required for robust growth – opportunities abound for strong industry players to make strategic acquisitions of troubled competitors or their distressed assets.
Ray Clark, CFA, ASA and Senior Managing Director of VALCOR Consulting, LLC, is no stranger to middle-market deals. His advisory firm provides middle market restructuring, transactional and valuation services throughout the Southwestern United States from offices in Orange County, San Francisco, and Phoenix.
As most readers are likely aware, distressed mergers and acquisitions can be handled through a variety of deal structures. Last week, Ray dropped by South Bay Law Firm to offer his thoughts on a process commonly known in bankruptcy parlance as a “Section 363 sale.”
In particular, Ray covers the “pros and cons” of this approach.
The floor is yours, Ray.
Meanwhile, happy hunting.
This quote from a story in March 15′s Charlotte Observer opens an extensive and intriguing study assembled by Sarah P. Woo, entitled “A Blighted Land: An Empirical Study of Residential Developer Bankruptcies in the United States – 2007-2008.” Woo is an independent risk management consultant and doctoral scholar at Stanford University with prior experience as a research manager at Moody’s KMV London and a background in corporate finance at White & Case LLP. She offers a simple premise as the basis for her 194-page work, which also serves as her dissertation:
Woo is not alone in her assessment of the persistent weakness of the US residential housing sector. A Deutsche Bank study released in early August and briefly summarized in a CNN-Money article last Wednesday indicates that home prices may fall another 14% before hitting a bottom, leaving as many as 48% of mortgage holders “underwater” by 2011.
Among Woo’s findings on developers who have filed Chapter 11 cases over the last 2 years:
- Only 5.3% were able to successfully reorganize. In fact, the majority of cases were actually dismissed or converted to Chapter 7 – leaving real estate to be foreclosed or liquidated in forced sales.
- 72% of the cases sampled involved at least one request by a secured lender to lift the stay for purposes of foreclosure. In such instances, relief was granted approximately 90% of the time. However, foreclosure may not always have been the best outcome for the bank. According to Ms. Woo, “[i]n one case, the bank which repossessed the property not only had trouble with the remaining development process but also found itself in a position where it could not necessarily sell the property as a going concern . . . . In [another] case, the bank which repossessed the property was seized by regulators 2 months later for being insufficiently capitalized, raising the issue of the extent to which a bank’s own financial problems might have contributed to its preference for liquidation during bankruptcy proceedings.”
- Where properties were disposed of through “363 sales,” Woo “uncovered a pattern of winning credit bids where secured lenders acquired the properties . . . at low prices.”
- Access to DIP financing appears to have been severely impaired for developers (as it has been for many Chapter 11 debtors this cycle, regardless of industry). Even where DIP financing has been available, such financing often occurred in cases where the debtor was ultimately liquidated or packaged for sale (again, a common scenario this cycle regardless of the debtor’s industry).
Is the near-certain prospect of liquidation or sale facing struggling residential home developers a good one for the sector?
On the one hand, Woo’s study appears to suggest that the control available to lenders through mechanisms such as DIP financing and stay relief litigation, employed by highly regulated and troubled US banks desperate to raise capital by seizing and liquidating collateral, puts housing developers who might reorganize in Chapter 11 on a very slippery slope with little prospect of survival. On the other, it suggests that the industry may be ridding itself of weak performers very quickly, leaving only the strongest to survive as the residential housing sector struggles back to prior levels.
Where real estate development and the residential housing sector are concerned, is the shortest way up . . . straight down?