The Bankruptcy Code separately classifies chapter 11 cases where the debtor’s business consists primarily of the ownership and operation of a single real estate asset, such as an apartment complex, an office building, or a development parcel. The automatic stay in such cases will automatically be lifted unless the debtor begins making adequate protection payments to secured creditor(s), or files a plan and disclosure statement, within 90 days of the commencement of the case.
Real estate values are often contested in chapter 11. Whether the value figure comes in high or low has implications for the handling of the debtor’s case and the payments required in and after bankruptcy.
Secured creditors are entitled to what is known as adequate protection of their liens. If a secured creditor’s collateral value exceeds the creditor’s claim (if the creditor is ‘oversecured’) as of the date the case was filed (the “petition date”), the adequate protection owed to the creditor includes interest on its claim and attorneys’ fees and expenses (both before and after the petition date). If a creditor’s claim exceeds the value of its collateral (i.e., it’s claim is undersecured), it is entitled to interest and attorneys’ fees on its claim before the petition date but not after the petition date through confirmation of a plan.
There are counterbalancing risks and benefits to advancing high collateral values versus low collateral values in chapter 11. A low value determination may mean no interest obligations from the petition date through the date of confirmation, but also an increased risk of relief from the automatic stay because of a lack of equity in the property and the high risk of the lender’s control of the unsecured creditor class for plan voting purposes (see below). Conversely, a high valuation may cost the debtor interest accruals from the petition date through confirmation, but ease the path to a plan providing for an interest rate reduction, extension of the maturity date and the right to partial releases in exchange for partial payments should the property be subdivided in the future.
The quality of management for a debtor’s income-producing property will impact the feasibility determination required to confirm a chapter 11 plan or reorganization for a single asset debtor. Low occupancy rates and/or significant deferred maintenance, historically and during chapter 11, do not bode well for healthy positive cash flow projections projected in a disclosure statement for the post-confirmation period(s).
Often, one or more secured lenders in a single asset real estate case will be undersecured. The undersecured creditor’s claims will be bifurcated by operation of Bankruptcy Code § 506(a) into two kinds of claims: a secured claim in the amount of the value of the secured creditor’s collateral; and an unsecured claim for the rest of the amount owed to the creditor as of the petition date. The unsecured component (from the ‘haircut’ applied through the valuation process) usually dominates and controls the unsecured creditor class for purposes of voting on a chapter 11 plan. This can have fatal consequences for the debtor’s chances at confirmation.
In the absence of a consensual plan, and all other things being equal, the debtor must first obtain the affirmative vote of at least one class of impaired claims. With an accepting impaired class, the debtor may seek cramdown of the plan over the ‘no’ vote and objection of the undersecured creditor under Bankruptcy Code § 1129(b). Subsection 1129(b) requires, inter alia, that the debtor’s proposed treatment of claims that have rejected the plan be “fair and equitable” and that it not “discriminate unfairly”. In other words, secured creditors must retain their liens and receive the present value of their claims (essentially interest on such claims at a rate to be determined by the Bankruptcy Court). Further, unsecured creditors must be paid in full before the debtor or other junior classes of claims and interests receive or retain anything under the plan. This last requirement is a codification of the “absolute priority rule”.
To recap, the absolute priority rule provides that equity (junior classes of claims and ownership interests generally) cannot receive or retain anything of value under a chapter 11 plan (other than in a SBRA case and to a much more limited extent in an individual chapter 11 case) if senior classes of claims are not paid in full. In the typical single asset real estate case, in the absence of an exception to the absolute priority rule, the debtor will not be able to confirm a plan over the objection of the undersecured (mortgage) creditor, wearing its unsecured creditor hat.
The debtor can overcome the undersecured creditor’s objection through use of an exception to the absolute priority rule, known as the “new value” exception. Generally speaking, to accomplish this the debtor’s ownership interest must be valued in some fashion acceptable to the Bankruptcy Court, and the debtor must contribute value equivalent to the value of its ownership interest (equity) from non-estate assets, and such new value infusion must be necessary to the success of the plan. That may include funds obtained from a new loan. To recap, a single-asset real estate debtor dealing with an undersecured creditor with whom a consensual plan cannot be reached will need exit financing of some kind to confirm.
Michael D. Pinsky, P.C. represents clients throughout New York’s Hudson Valley in a full range of bankruptcy matters. Please call 845-394-2616 or contact me online for a free initial consultation at my office in Newburgh.