Third Circuit Rejects Wait-and-See Valuation Approach and Accepts Lien Stripping in Section 506(a)

American Bankruptcy Institute Law Review Staff

 

 

In In re Heritage Highgate, Inc.,[1] the Third Circuit held that the fair market value of property as of the confirmation date controls whether or not a lien is fully secured.[2]  Additionally, the court held that lien stripping is permissible in a chapter 11 reorganization.[3] The debtors, Heritage Highgate and Heritage-Twin Ponds II, were real-estate developers working on a project that was financed by a group of banks (the “Bank Lenders”) and other entities collectively known as Cornerstone Investors (“Cornerstone”).[4]  Both the Bank Lenders and Cornerstone secured their investments with liens on substantially all of the debtors’ assets but Cornerstone’s claims were contractually subordinated to the Bank Lenders’.[5] After selling a quarter of the project’s planned units, the debtors filed a chapter 11 petition.  The debtors’ joint proposed plan of reorganization proposed paying secured claims in full and paying 20% of the unsecured claims with funds obtained through the sale of the project’s remaining units.[6]  These estimated recoveries were based on the debtors’ appraisal, which valued the project at $15 million.[7] During the course of the case, the debtors continued to build and sell units and, with the consent of its secured lenders, used the sale proceeds to fund ongoing operating losses.[8] As a result, the fair market value of the project was reduced to approximately $9.54 million as of the time of plan confirmation, which was less than the Bank Lender’s $12 million secured claim.[9] Cornerstone argued their $1.4 million claim should still be fully secured and to hold otherwise would constitute impermissible lien stripping.[10] The bankruptcy court disagreed and determined that the proper method of valuing Cornerstone’s secured claim was the fair market value of the project as of the time of plan confirmation.[11]  Therefore, Cornerstone’s claim was unsecured.[12]

 

The Third Circuit rejected Cornerstone’s suggestion that the court should take a “wait and see” approach and determine a claim’s secured status based on actual, future sales of project units.[13] The Third Circuit reasoned that using the wait-and-see approach would eliminate the obligation to determine the value of a lien under section 506(a) of the Bankruptcy Code,[14] which provides that that the value of a secured claim is to be determined based upon “the proposed disposition or use of such property.”[15] Therefore, the proper valuation method was the fair market value as of the confirmation date and as a result Cornerstone’s claim was unsecured.[16]

 

Cornerstone’s second argument was that by denying them secured status, the debtor would effectively strip off their lien, in contravention of Dewsnup v. Timm.[17] Cornerstone argued that by determining the value of the collateral at the confirmation date, any increase of revenue from sales would accrue to the debtors. In Dewsnup v. Timm,[18] the Supreme Court held that in a chapter 7 case, “[a]ny increase over the judicially determined valuation during bankruptcy rightly accrues to the benefit of the creditor.”[19] Here, however, the Third Circuit refused to extend Dewsnup to chapter 11 proceedings because pre-code practice allowed lien-stripping and nothing in the legislative history suggested Congress intended to change that.[20] As such, the Third Circuit held there was no impermissible lien stripping.[21]

 

Courts have consistently stressed the importance of valuing liens based upon the proposed disposition and use of the collateral.[22] Courts have consistently rejected attempts by debtors to value secured creditors’ collateral based on the amount received at a foreclosure sale,[23] as not according with section 506(a).[24] One reason they have rejected such attempts is because of the need for predictability and security when determining the value of collateral.[25]  Here, the Third Circuit focused on the need for stability and predictability when it rejected Cornerstone’s proposed wait-and-see approach to valuation.[26]

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