Section 506(a): Why “Wait-and-See” Won’t Work to Value Secured-Creditor Claims
Section 506(a) of the Bankruptcy Code contemplates bifurcation of a debtor's obligation to a secured creditor into secured and unsecured claims, depending on the value of the collateral securing the debt. The term "value," however, is not defined in the Bankruptcy Code, and bankruptcy courts vary in their approaches to the meaning of the term. In In re Heritage Highgate, Inc., 679 F.3d 132 (3d Cir. 2012), the Court of Appeals for the Third Circuit ruled that, in a chapter 11 reorganization, the term "value," as applied to section 506(a), should mean the fair market value of collateral as of plan confirmation. In so ruling, the court of appeals rejected the market-based, or "wait-and-see," approach recommended by a group of secured creditors, whose subordinated claims would be rendered unsecured unless the court included projected revenues from the debtor's chapter 11 plan in the valuation analysis. Applying the fair-market-value approach to calculate the amount of a creditor's secured claim, the Third Circuit held, does not constitute impermissible lien stripping. In addition, the court of appeals adopted a burden-shifting approach to the question of who bears the burden of demonstrating value.
Valuation of Collateral Under Section 506
The Bankruptcy Code classifies a debtor's obligations in terms of "claims" rather than "debts." This means that a creditor who is owed money on the basis of a prebankruptcy transaction is generally treated under the statute as the holder of either an unsecured prepetition claim or a secured prepetition claim.
Whether a claim is secured or unsecured is determined in accordance with section 506(a) of the Bankruptcy Code. Section 506(a)(1) provides that a secured creditor's claim is "a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property . . . and is an unsecured claim to the extent that the value of such creditor's interest . . . is less than the amount of such allowed claim." The provision goes on to mandate that "[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property."
The extent to which a claim is secured, therefore, turns on the valuation of the collateral. Section 506(a) is silent, however, as to the valuation method that a court should employ. As noted by the Third Circuit in Heritage Highgate, the legislative history of section 506(a) suggests that Congress's silence on this point was intentional, to enable bankruptcy courts to "choose the standard that best fits the circumstances of a particular case." Even so, the court wrote, the valuation method should be employed in light of the proposed disposition or use of the collateral, language that is "of paramount importance to the valuation question."
Neither section 506(a) nor the Federal Rules of Bankruptcy Procedure allocate the burden of proof as to the value of secured claims. In the absence of any express direction, courts have developed divergent approaches to the issue.
Heritage Highgate, Inc., and Heritage Twin-Ponds II, L.P. (jointly, "Heritage"), are the developers of a residential real estate project (the "Project") in Pennsylvania. To fund the Project, Heritage obtained financing from a group of banks (the "Banks") and later a group of private individuals and entities known as Cornerstone Investors ("Cornerstone"). Loans from both the Banks and Cornerstone were secured with liens on nearly all of Heritage's assets, initially at equal priority, although Cornerstone later agreed to subordinate its claims in a series of intercreditor agreements.
Heritage sought chapter 11 protection in Pennsylvania on January 20, 2009. Shortly afterward, Heritage filed a proposed chapter 11 plan providing that it would complete the Project and make payments to creditors with the resulting revenue, based on a set of projections.
A dispute arose during the chapter 11 case regarding Heritage's use of cash collateral generated by the Project. At a contested hearing on the matter, Heritage provided an appraisal of the Project's fair market value. The bankruptcy court accepted the appraisal, conducted by an independent company in February 2009, which valued the Project at $15 million, an amount exceeding the total amount of debt secured by the property ($12 million owed to the Banks and $1.2 million owed to Cornerstone).
In September 2009, Heritage's official committee of unsecured creditors (the "Committee") challenged the Project's value in a motion to value and determine the extent of Cornerstone's secured claims. The Committee argued that, because Heritage sold certain lots attached to the Project after the appraisal had been performed, the value of the Project should be reduced to approximately $9.54 million, a value less than the amount of the Banks' secured claim. On the basis of this lower valuation, the Committee maintained, Cornerstone's claims against Heritage were wholly unsecured and its secured claims should be valued at zero.
Cornerstone countered that its claims were secured because, in assigning a value to the Project, the court should factor in the revenue from the Project's completion anticipated in Heritage's chapter 11 plan. According to Cornerstone, if the property, when sold, would generate sufficient dollars to pay its secured claims in full, its claims should reflect that value. Because Heritage would continue to develop and sell lots during the plan's life, Cornerstone argued, the extent to which its claims are secured should similarly be calculated over time. This market-based, or "wait-and-see," approach, Cornerstone maintained, would fulfill the plain language of section 506(a), which directs the court to value property "in light of . . . [its] proposed disposition or use." Cornerstone also argued that excluding the expected revenue from the Project's completion in valuing the property would constitute impermissible "lien stripping."
The bankruptcy court confirmed Heritage's chapter 11 plan in March 2010. The following month, the court ruled in favor of the Committee on the motion to value Cornerstone's secured claims at zero. The district court affirmed on appeal, concluding that, in the context before it, fair market value was the appropriate collateral-valuation standard to apply pursuant to section 506(a). Both the bankruptcy and district courts reasoned that the Project's revenue projections were intended as a kind of budget to prove the feasibility of the reorganization plan but were not relevant to the analysis of collateral value for purposes of determining the amount of Cornerstone's secured claim under section 506(a). Moreover, the district court declined to extend to a chapter 11 reorganization case the U.S. Supreme Court's holding in Dewsnup v. Timm, 502 U.S. 410 (1992), which prohibits lien stripping in a chapter 7 liquidation case by depriving a secured creditor of its right to "[a]ny increase over the judicially determined valuation during bankruptcy." Cornerstone appealed.
The Third Circuit's Ruling
A three-judge panel of the Third Circuit affirmed, ruling that the proper valuation standard to apply in this context pursuant to section 506(a) was fair market value as of the confirmation date of the chapter 11 plan, rather than the wait-and-see approach proffered by Cornerstone. In addition, the court held permissible any "lien stripping" resulting from a determination that the value of the Project was insufficient to render Cornerstone's claim secured, declining to extend the holding in Dewsnup to the chapter 11 reorganization context. Finally, the Third Circuit established a burden-shifting framework to govern valuation claims pursuant to section 506(a).
The Meaning of "Value"
Acknowledging the importance of valuing collateral in light of its "proposed disposition or use," the Third Circuit viewed the requirement differently than Cornerstone. The court drew an analogy to Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997), in which the U.S. Supreme Court held that valuation in a chapter 13 cramdown scenario should be based on the collateral's replacement value, defined as "the cost the debtor would incur to obtain a like asset for the same ‘proposed use,' " rather than a "hypothetical foreclosure sale." Similarly, in a chapter 11 reorganization, the Third Circuit explained, the collateral's proposed use is intended to generate income with which to pay off creditors. Thus, the court concluded, the collateral's fair market value, which is "consistent with" the meaning of "replacement value" in Rash, is "most respectful of the property's anticipated use."
The Third Circuit ruled that the lower courts properly concluded that the fair market value of the Project as of the confirmation date controlled whether Cornerstone's claims were secured or not. Because the confirmed plan of reorganization called for Heritage to retain ownership of the Project in order to complete its development, the court wrote, "[t]he discounted fair market value of the property as of the confirmation date . . . best approximated just how secure the liens held by creditors—namely, the [Banks and Cornerstone]—were at the relevant point in [Heritage's] bankruptcy."
The Third Circuit emphasized that Cornerstone's proposed wait-and-see valuation model has never been used, and for good reason:
A wait-and-see approach would in effect do away with bankruptcy courts' obligation to determine value under § 506(a). . . . That result is at odds with the Bankruptcy Code. In § 506(a), Congress expressly provided for the division of allowed claims supported by liens into secured and unsecured portions during the reorganization, before the plan's success or failure is clear. The fact that its "proposed disposition or use" should be factored into the valuation does not mean that the time as of which property is valued is to be postponed or altered.
Heritage's projections, the Third Circuit explained, were offered as support for the feasibility of its chapter 11 plan, not to determine the extent of secured claims. Moreover, in order to be realized, the projections would entail the expenditure of Heritage's time and resources, which, the court noted, "should not be credited to the secured creditor at confirmation." According to the Third Circuit, valuations should be "based upon realistic measures of present worth," not on speculative projections.
Lien Stripping and Chapter 11
The Third Circuit declined to extend Dewsnup's lien-stripping prohibition to chapter 11 cases. In Dewsnup, the court of appeals explained, the U.S. Supreme Court held that when the value of a chapter 7 debtor's property increases from the time of judicial valuation to the time of the foreclosure sale, "the creditor's lien stays with the real property until the foreclosure." Following a majority of courts, the Third Circuit acknowledged that, although this rationale makes sense in a chapter 7 case, where the encumbered property will be liquidated, a chapter 11 reorganization is different. Reorganizations, the court noted, necessarily involve the continued and productive use of the retained property, which can and should entail future profits.
According to the Third Circuit, to prohibit lien stripping in the chapter 11 context would render many of the reorganization provisions in the Bankruptcy Code meaningless or nonsensical. After Dewsnup, the court explained, Congress amended the Bankruptcy Code to expressly allow for the modification of most rights of secured creditors in what the court perceived as "explicit approval of lien stripping in Chapter 11 bankruptcies."
Clarifying the "divergent formulations" that have developed for valuing collateral under section 506(a), the Third Circuit adopted a burden-shifting framework for parties challenging the valuation of a secured claim. That is, the party filing the motion to determine the value and extent of a secured claim bears the initial burden of production and must present enough evidence to overcome the presumed validity of the secured creditor's claim.
In the case before it, the Third Circuit ruled, the Committee provided sufficient evidence that "the Project's fair market value, together with the value of other collateral held by [Heritage], was less than the [Banks'] secured claim." Furthermore, the court concluded, the submission of an appraisal of the collateral's fair market value that was completed "in light of the property's ‘proposed disposition or use' " and also accepted by Cornerstone, was sufficient to meet the Committee's burden.
However, the Third Circuit determined that the ultimate burden of persuasion rested with Cornerstone, as the allegedly secured creditor. The court held that Cornerstone failed to meet that burden, having declined to retain its own appraiser and instead opting, as part of its wait-and-see approach, to rely on the appraisal proffered as part of Heritage's plan-feasibility projections.
The need to value collateral arises in many different contexts during a bankruptcy case, and valuation methodologies can vary widely, depending upon, among other things, the nature of the case (e.g., a chapter 11 reorganization or a liquidation under chapter 7 or chapter 11) and the purpose of the valuation. In addition, the timing of any valuation is critical, and collateral may be valued differently at different times during the course of a bankruptcy case. In Heritage Highgate, the Third Circuit clarified that, in the context of chapter 11 reorganization, collateral must be assigned its fair market value as of the confirmation date in determining the amount of a creditor's secured claim under section 506(a). The Third Circuit's burden-shifting approach to establishing value under section 506(a) is instructive, although it remains to be seen whether other courts will adopt it. Finally, the Third Circuit's refusal to extend Dewsnup's lien-stripping prohibition to chapter 11 cases is consistent with the majority view on this issue.