Valuation Litigation

Since 2005, the debtor owned and developed a mixed use residential subdivision in Lehigh County, PA, planned for 411 units (the Project). A total of 101 units had been constructed and delivered when in January 2009, with the continued
collapse of the residential real estate market and the debtor in default and facing foreclosure, a bankruptcy was filed with the intent to reorganize under Chapter 11, complete the Project, and distribute the net proceeds to creditors. The debtor financed the Project though a bank loan that was secured by a first-priority lien on substantially all of the debtor's assets (the Senior Secured Debt). To raise additional working capital for the Project, in 2008 the debtor entered into prepetition loan agreements with a group of individuals and trusts (the Subordinate Lenders) and granted to each a second lien on substantially all of the debtor's assets.

The debtor initially filed a plan of reorganization that incorporated a “waterfall” for payment to secured and unsecured creditors through net revenues generated from build-out of the Project and sale of the residential housing units. As originally proposed on June 9, 2009, the debtor's plan would first pay the Senior Secured Lenders in full, then pay the Subordinate Lenders in full starting in 2012, and then starting in 2013 pay the unsecured creditors on a pro rata basis the balance of the plan proceeds projected to result in an unsecured dividend of approximately 20% before the build out was to be completed in 2013. The payment waterfall and timing were based upon projections of cash flows produced by the debtor and attached to the plan as an exhibit (the Projections).

On Sept. 4, 2009, the Official Committee of Unsecured Creditors (Committee) filed its motion to determine the value of the secured claims of the Subordinate Lenders pursuant to Bankruptcy Code ' 506(a) and Rule 3012 of the Federal Rules of Bankruptcy Procedure (the Motion). In conjunction with the Motion, the Committee objected to the proposed treatment of the Subordinate Secured Claim under the plan. Citing Bankruptcy Code ” 506(a) and (d), as well as the Motion, the Committee took the position that the Subordinate Debt was wholly unsecured, and that it violated the absolute priority rule for the Subordinate Lenders to have their claims paid before the commencement of payments to other unsecured creditors. The plan was then modified to provide that the treatment for the Subordinate Debt would be determined by the bankruptcy court's decision on the Committee's Motion, which the Committee and the Subordinate Lenders agreed would occur after confirmation of the plan. The Subordinate Lenders did not object, and the plan was confirmed on April 1, 2010.

In connection with the hearing on the Motion, the Committee and the Subordinate Lenders stipulated that based on an appraisal from 2009 (the Appraisal), which was submitted in connection with a contested cash collateral hearing, adjusted to account for the units sold during the period while the debtor was in Chapter 11, the total fair market value of the Project as of the Confirmation Date was $9,362,264.15 (the Confirmation Date Value). The Confirmation Date Value was based on the $15 million fair market value established by the Appraisal, minus the per lot Appraisal values attributed to each Project phase, multiplied by the number of lot sales since the date of the Appraisal to the Confirmation Date.

In the Courts

In bankruptcy court, the Subordinate Lenders argued that in valuing their claim for distribution purposed, the Projections should control over the Confirmation Date Value established by the Appraisal, and that since the Projections showed sufficient cash flow to pay in full the Subordinate Debt with a residual for payment on account of unsecured claims, the Subordinate Lenders should retain the full benefit of their liens on the Project. Rejecting this position, the bankruptcy court concluded that the security interests of the Subordinate Lenders should be limited to the fair market value of the Project as of the effective date of the plan, and that the Appraisal, not the Projections, was the only true determinant of value presented for that that purpose.

As a result of the ruling, the claims of the Subordinate Lenders would be treated as wholly unsecured, included with all other unsecured creditors for purposes of the distribution under the Plan, and paid pro rata with the other unsecured creditors after payment in full of the Senior Secured Debt. The district court affirmed the Order of the bankruptcy court, and the Subordinate Lenders took the case to the court of appeals.

First, the Third Circuit determined that the fair market value of collateral is the appropriate standard where a Chapter 11 plan of reorganization provides for a debtor to retain such collateral in order to generate income and make payments to creditors. The court rejected the contention of the Subordinate Lenders that a market based on a “wait-and-see” approach to valuation of the Project should be utilized using the plan projections presented by the debtor to establish feasibility. The court then clearly indicated that the time for valuation under ' 506(a) is at the time of confirmation of a Chapter 11 plan of reorganization. The court held that the bankruptcy court correctly concluded that the Subordinate Debt was wholly unsecured because: 1) the plan called for retention of ownership of the Project; 2) the discounted fair market value of the Project as of the plan confirmation date best approximated how secure the claims of the Bank Lenders and the Subordinate Lenders were; and 3) the stipulated Appraisal accurately calculated the fair market value of the Project.

In its ruling, the court also “clarified” the burden of proof with respect to collateral valuations in the ' 506(a) context. Observing that neither the Bankruptcy Code nor the Federal Rules of Bankruptcy Procedure allocates the burden of proof in such proceedings and acknowledging that as a result “courts have arrived at divergent formulations,” the Third Circuit adopted a burden-shifting framework. Under the Third Circuit's ruling, the filing of the Secured Claim is prima facie evidence of its validity. The initial burden then is on the challenger of the secured claim to first establish with “sufficient evidence” that the value of the collateral is insufficient. Once the initial burden is met, the burden shifts to the secured creditor asserting the claim to “demonstrate by a preponderance of the evidence both the extent of its lien and the value of the collateral securing its claim.”

Lessons Learned

As noted above, the Third Circuit took the occasion in Heritage Highgate to request supplemental briefing and then write on an issue that was not addressed by the bankruptcy court or district court ' the burden of proof in valuation disputes under Section 506(a). The shifting burden approach adopted by the court has provided clarity to the bar; however, it also raises strategic questions that need to be addressed with the client as early as possible in the litigation.

The most significant strategic decision that needs to be addressed is whether and when to obtain a valuation expert. While the obvious answer might seem to be that both sides should obtain experts as soon as possible, financial constraints might play a role in the decision. For example, the secured creditor's burden is initially met simply by filing a proof of claim in the amount of the secured claim; thus it need not obtain an expert opinion at the beginning of the case.

The burden then shifts to the challenger to produce “sufficient evidence” to challenge the value of the collateral. While the court did not indicate what is meant by the words “sufficient evidence,” it would appear that anything less than an expert opinion on value would fall short of meeting this burden.

Once the challenger produces such sufficient evidence (presumably, through the submission of an expert opinion), the burden shifts back to the secured creditor to prove by a preponderance of evidence that the value of the collateral exceeds the debt. The creditor must then decide whether to obtain a rebuttal expert opinion in order to meet its ultimate burden of proof.

While, here again, the obvious choice would be to obtain a rebuttal opinion, cost might be a factor to your client. In the absence of obtaining a rebuttal report, then, is all lost for the challenger? Maybe not, depending upon the strength of the secured creditor's expert opinion.

For example, ' 506(a) provides that the “proposed disposition and use of the collateral is of paramount importance to the valuation question.” 11 U.S.C. ' 506(a). Thus, an initial inquiry should be made as to whether the challenger's expert opinion addressed the proposed disposition and use of the collateral. In Associates Commercial Corp. v. Rash, 117 S.Ct. 1879 (1997), the Supreme Court rejected a foreclosure valuation where the Chapter 13 debtor intended to use the collateral to generate an income stream, noting that the foreclosure valuation standard in that instance did not take into consideration the proposed “disposition and use” of the collateral.

Thus, if a challenger's expert opinion on the collateral value fails to take into consideration the proposed disposition and use of the collateral, the secured creditor might be able to avoid submitting a competing opinion, attack the expert opinion on cross examination at trial and then argue that the challenger failed to meet its initial burden under ' 506(a). While this might be a viable and cost-effective strategy, it is extremely risky and, indeed, proved ultimately fatal to the Subordinate Lenders in Heritage Highgate, who employed such a strategy.

As noted above, the Subordinate Lenders in Heritage Highgate decided against submitting a competing expert valuation opinion at trial. Instead, they challenged the Appraisal submitted by the Committee as based on a methodology that, they argued, did not take into consideration the proposed disposition and use of the collateral. The Subordinate Lenders advanced the novel theory that, because the residential subdivision was to be completed over the next several years, the valuation as of the Plan confirmation date did not take into consideration the proposed disposition and use and, instead, the valuation should be predicated on a “wait-and-see” approach based on projections as to future sales. The Third Circuit rejected the theory and concluded that the challenger's appraisal was based on a proper valuation standard. Accordingly, because the Subordinate Lenders' attack on the Committee's expert opinion methodology failed, they were left with no way to meet their burden of proof as to the value of the collateral secured by its lien.

Conclusion

Ultimately, the Heritage Highgate decision may serve as a reminder to bankruptcy litigators to begin thinking about burdens of proof early and often during the course of a valuation dispute, or anticipated valuation dispute, under ' 506(a) as well as other sections of the Bankruptcy Code. Strategic decisions will need to be made and discussions held with cost-sensitive clients with those burdens of proof in mind.

Samuel H. Israel is a partner in the Litigation Department of Fox Rothschild LLP in Philadelphia, where he has represented trustees, corporate debtors and creditors in a variety of bankruptcy disputes. Joshua T. Klein is a partner and Brian R. Isen is an associate in the Financial Restructuring and Bankruptcy Department. They may be reached at [email protected], [email protected] and [email protected], respectively. The authors and Fox Rothschild LLP represented the Committee in the Heritage Chapter 11 proceedings, as well as in the litigation and appeals that are the subject of this article.

On May 14, 2012, the United States Court of Appeals for the Third Circuit issued its opinion in the case of In re Heritage Highgate, Inc., 679 F.3d 132 (3d Cir. 2012), concerning the lien of a junior secured creditor and the creditor's treatment under the debtor's Chapter 11 plan of reorganization. The Third Circuit addressed the use of lien stripping under a plan of reorganization and the relevant time and standards for valuation of the creditor's collateral.

While this decision is a must read for bankruptcy practitioners dealing with multiple levels of secured debt in formulating Plans of Reorganization, it provides equally important lessons to bankruptcy litigators addressing the shifting burdens of proof required in valuation litigation under Section 506(a) of the Bankruptcy Code. This article addresses those lessons and pitfalls to avoid in trying these types of disputes in bankruptcy court.

Case Background

Since 2005, the debtor owned and developed a mixed use residential subdivision in Lehigh County, PA, planned for 411 units (the Project). A total of 101 units had been constructed and delivered when in January 2009, with the continued
collapse of the residential real estate market and the debtor in default and facing foreclosure, a bankruptcy was filed with the intent to reorganize under Chapter 11, complete the Project, and distribute the net proceeds to creditors. The debtor financed the Project though a bank loan that was secured by a first-priority lien on substantially all of the debtor's assets (the Senior Secured Debt). To raise additional working capital for the Project, in 2008 the debtor entered into prepetition loan agreements with a group of individuals and trusts (the Subordinate Lenders) and granted to each a second lien on substantially all of the debtor's assets.

The debtor initially filed a plan of reorganization that incorporated a “waterfall” for payment to secured and unsecured creditors through net revenues generated from build-out of the Project and sale of the residential housing units. As originally proposed on June 9, 2009, the debtor's plan would first pay the Senior Secured Lenders in full, then pay the Subordinate Lenders in full starting in 2012, and then starting in 2013 pay the unsecured creditors on a pro rata basis the balance of the plan proceeds projected to result in an unsecured dividend of approximately 20% before the build out was to be completed in 2013. The payment waterfall and timing were based upon projections of cash flows produced by the debtor and attached to the plan as an exhibit (the Projections).

On Sept. 4, 2009, the Official Committee of Unsecured Creditors (Committee) filed its motion to determine the value of the secured claims of the Subordinate Lenders pursuant to Bankruptcy Code ' 506(a) and Rule 3012 of the Federal Rules of Bankruptcy Procedure (the Motion). In conjunction with the Motion, the Committee objected to the proposed treatment of the Subordinate Secured Claim under the plan. Citing Bankruptcy Code ” 506(a) and (d), as well as the Motion, the Committee took the position that the Subordinate Debt was wholly unsecured, and that it violated the absolute priority rule for the Subordinate Lenders to have their claims paid before the commencement of payments to other unsecured creditors. The plan was then modified to provide that the treatment for the Subordinate Debt would be determined by the bankruptcy court's decision on the Committee's Motion, which the Committee and the Subordinate Lenders agreed would occur after confirmation of the plan. The Subordinate Lenders did not object, and the plan was confirmed on April 1, 2010.

In connection with the hearing on the Motion, the Committee and the Subordinate Lenders stipulated that based on an appraisal from 2009 (the Appraisal), which was submitted in connection with a contested cash collateral hearing, adjusted to account for the units sold during the period while the debtor was in Chapter 11, the total fair market value of the Project as of the Confirmation Date was $9,362,264.15 (the Confirmation Date Value). The Confirmation Date Value was based on the $15 million fair market value established by the Appraisal, minus the per lot Appraisal values attributed to each Project phase, multiplied by the number of lot sales since the date of the Appraisal to the Confirmation Date.

In the Courts

In bankruptcy court, the Subordinate Lenders argued that in valuing their claim for distribution purposed, the Projections should control over the Confirmation Date Value established by the Appraisal, and that since the Projections showed sufficient cash flow to pay in full the Subordinate Debt with a residual for payment on account of unsecured claims, the Subordinate Lenders should retain the full benefit of their liens on the Project. Rejecting this position, the bankruptcy court concluded that the security interests of the Subordinate Lenders should be limited to the fair market value of the Project as of the effective date of the plan, and that the Appraisal, not the Projections, was the only true determinant of value presented for that that purpose.

As a result of the ruling, the claims of the Subordinate Lenders would be treated as wholly unsecured, included with all other unsecured creditors for purposes of the distribution under the Plan, and paid pro rata with the other unsecured creditors after payment in full of the Senior Secured Debt. The district court affirmed the Order of the bankruptcy court, and the Subordinate Lenders took the case to the court of appeals.

First, the Third Circuit determined that the fair market value of collateral is the appropriate standard where a Chapter 11 plan of reorganization provides for a debtor to retain such collateral in order to generate income and make payments to creditors. The court rejected the contention of the Subordinate Lenders that a market based on a “wait-and-see” approach to valuation of the Project should be utilized using the plan projections presented by the debtor to establish feasibility. The court then clearly indicated that the time for valuation under ' 506(a) is at the time of confirmation of a Chapter 11 plan of reorganization. The court held that the bankruptcy court correctly concluded that the Subordinate Debt was wholly unsecured because: 1) the plan called for retention of ownership of the Project; 2) the discounted fair market value of the Project as of the plan confirmation date best approximated how secure the claims of the Bank Lenders and the Subordinate Lenders were; and 3) the stipulated Appraisal accurately calculated the fair market value of the Project.

In its ruling, the court also “clarified” the burden of proof with respect to collateral valuations in the ' 506(a) context. Observing that neither the Bankruptcy Code nor the Federal Rules of Bankruptcy Procedure allocates the burden of proof in such proceedings and acknowledging that as a result “courts have arrived at divergent formulations,” the Third Circuit adopted a burden-shifting framework. Under the Third Circuit's ruling, the filing of the Secured Claim is prima facie evidence of its validity. The initial burden then is on the challenger of the secured claim to first establish with “sufficient evidence” that the value of the collateral is insufficient. Once the initial burden is met, the burden shifts to the secured creditor asserting the claim to “demonstrate by a preponderance of the evidence both the extent of its lien and the value of the collateral securing its claim.”

Lessons Learned

As noted above, the Third Circuit took the occasion in Heritage Highgate to request supplemental briefing and then write on an issue that was not addressed by the bankruptcy court or district court ' the burden of proof in valuation disputes under Section 506(a). The shifting burden approach adopted by the court has provided clarity to the bar; however, it also raises strategic questions that need to be addressed with the client as early as possible in the litigation.

The most significant strategic decision that needs to be addressed is whether and when to obtain a valuation expert. While the obvious answer might seem to be that both sides should obtain experts as soon as possible, financial constraints might play a role in the decision. For example, the secured creditor's burden is initially met simply by filing a proof of claim in the amount of the secured claim; thus it need not obtain an expert opinion at the beginning of the case.

The burden then shifts to the challenger to produce “sufficient evidence” to challenge the value of the collateral. While the court did not indicate what is meant by the words “sufficient evidence,” it would appear that anything less than an expert opinion on value would fall short of meeting this burden.

Once the challenger produces such sufficient evidence (presumably, through the submission of an expert opinion), the burden shifts back to the secured creditor to prove by a preponderance of evidence that the value of the collateral exceeds the debt. The creditor must then decide whether to obtain a rebuttal expert opinion in order to meet its ultimate burden of proof.

While, here again, the obvious choice would be to obtain a rebuttal opinion, cost might be a factor to your client. In the absence of obtaining a rebuttal report, then, is all lost for the challenger? Maybe not, depending upon the strength of the secured creditor's expert opinion.

For example, ' 506(a) provides that the “proposed disposition and use of the collateral is of paramount importance to the valuation question.” 11 U.S.C. ' 506(a). Thus, an initial inquiry should be made as to whether the challenger's expert opinion addressed the proposed disposition and use of the collateral. In Associates Commercial Corp. v. Rash , 117 S.Ct. 1879 (1997), the Supreme Court rejected a foreclosure valuation where the Chapter 13 debtor intended to use the collateral to generate an income stream, noting that the foreclosure valuation standard in that instance did not take into consideration the proposed “disposition and use” of the collateral.

Thus, if a challenger's expert opinion on the collateral value fails to take into consideration the proposed disposition and use of the collateral, the secured creditor might be able to avoid submitting a competing opinion, attack the expert opinion on cross examination at trial and then argue that the challenger failed to meet its initial burden under ' 506(a). While this might be a viable and cost-effective strategy, it is extremely risky and, indeed, proved ultimately fatal to the Subordinate Lenders in Heritage Highgate, who employed such a strategy.

As noted above, the Subordinate Lenders in Heritage Highgate decided against submitting a competing expert valuation opinion at trial. Instead, they challenged the Appraisal submitted by the Committee as based on a methodology that, they argued, did not take into consideration the proposed disposition and use of the collateral. The Subordinate Lenders advanced the novel theory that, because the residential subdivision was to be completed over the next several years, the valuation as of the Plan confirmation date did not take into consideration the proposed disposition and use and, instead, the valuation should be predicated on a “wait-and-see” approach based on projections as to future sales. The Third Circuit rejected the theory and concluded that the challenger's appraisal was based on a proper valuation standard. Accordingly, because the Subordinate Lenders' attack on the Committee's expert opinion methodology failed, they were left with no way to meet their burden of proof as to the value of the collateral secured by its lien.

Conclusion

Ultimately, the Heritage Highgate decision may serve as a reminder to bankruptcy litigators to begin thinking about burdens of proof early and often during the course of a valuation dispute, or anticipated valuation dispute, under ' 506(a) as well as other sections of the Bankruptcy Code. Strategic decisions will need to be made and discussions held with cost-sensitive clients with those burdens of proof in mind.

Samuel H. Israel is a partner in the Litigation Department of Fox Rothschild LLP in Philadelphia, where he has represented trustees, corporate debtors and creditors in a variety of bankruptcy disputes. Joshua T. Klein is a partner and Brian R. Isen is an associate in the Financial Restructuring and Bankruptcy Department. They may be reached at [email protected], [email protected] and [email protected], respectively. The authors and Fox Rothschild LLP represented the Committee in the Heritage Chapter 11 proceedings, as well as in the litigation and appeals that are the subject of this article.