Restructuring

To confirm a chapter 11 plan, a debtor must satisfy the requirements of section 1129(a) of the Bankruptcy Code.  To confirm a plan — or “cram down” — a plan that is rejected by one or more classes of impaired creditors, the plan must also meet the requirements of section 1129(b) of the Bankruptcy Code, which requires that a plan be fair and equitable and not discriminate unfairly against those objecting classes.  If a secured creditor rejects the plan, cramdown can be accomplished by three methods set forth in section 1129(b)(2)(A), including the “realization of the indubitable equivalent” of the secured creditor’s claim.
Judge Learned Hand coined the phrase “indubitable equivalence” in his seminal decision, Met. Life Ins. Co. v. Murel Holding Corp. (In re Murel Corp.), which holding Congress adopted and codified in section 1129(b)(2)(A)(iii) of the Bankruptcy Code.  The legislative history of section 1129(b)(2) provides examples of what Congress thought would and would not satisfy the indubitable equivalence standard:  abandonment of collateral to the secured creditor would constitute the indubitable equivalent of a secured claim, but making cash payments having a present value less than the secured claim or issuing unsecured notes or equity securities to the secured creditor would not.
Conveying all of a secured creditor’s collateral back to the creditor gives the creditor the indubitable equivalent of its secured claim because, as the Fifth Circuit Court of Appeals has stated, “property is the indubitable equivalence of itself.”  The secured creditor is able to realize the collateral in the same way that it bargained for when it extended the loan.  But what if the debtor seeks to confirm a partial “dirt for debt” plan that proposes to convey less than 100% of the secured creditor’s collateral in full satisfaction of the creditor’s claim, with the debtor retaining the remaining collateral free of the creditor’s lien?
The Bankruptcy Court for the Eastern District of North Carolina recently addressed that question in In re SUD Properties, Inc., Case No. 11-03833-8-RDD (Bankr. E.D.N.C. Aug. 23, 2011).  The case serves as a reminder that courts carefully consider whether partial “dirt for debt” proposals are fair and equitable to secured creditors, as valuation issues can be heavily debated, and that the debtor often carries a stiff burden of proof to demonstrate that the value of the property offered will yield enough cash to reach the level of the indubitable equivalent of the secured creditor’s claim.
Background
In SUD, the debtor was engaged in the business of owning and developing real estate.  The debtor’s sole project was development of a subdivision of 88 lots in North Carolina.  The decline in the real estate market made it difficult for the debtor to sell lots — it had not sold a lot since April 2009 and, at the time of its chapter 11 filing, owned 70 lots.  In addition, the subdivision lacked amenities, such as a pool and clubhouse, that were present in other subdivisions within close proximity.
First Bank held two promissory notes executed by the debtor and secured by first and second deeds of trust on the property.  When the debtor defaulted on its obligations to First Bank, the bank initiated foreclosure proceedings on the property, which the debtor’s first chapter 11 petition stayed.  The debtor’s first chapter 11 plan proposed to sell lots in the subdivision to a national homebuilder in order to satisfy First Bank’s claims.  The homebuilder, however, ultimately did not close on the transaction.  Thus, the debtor was unable to consummate the lot sales in accordance with the plan, and the bankruptcy court dismissed its chapter 11 case.  As a result, First Bank again sought to foreclose on the property, prompting the debtor to file a second chapter 11 petition.  First Bank filed a proof of claim in the second case in the amount of approximately $1.35 million.  The debtor valued the property at $2.7 million.
The debtor’s second chapter 11 plan proposed to surrender to First Bank approximately half of the lots in full satisfaction of First Bank’s claims.  First Bank objected to the plan, arguing, among other things, that the plan was not fair and equitable because First Bank would not receive the indubitable equivalent of its secured claim.
Analysis
To determine whether the debtor’s plan could be crammed down over First Bank’s objection, the bankruptcy court first looked at the plain meaning of “indubitable equivalent.”  The court noted the dictionary definition of “indubitable” was “too evident to be doubted:  unquestionable,” and “equivalent” means “equal in force or amount” or “equal in value.”  The bankruptcy court cited to the Third Circuit’s decision in In re Philadelphia Newspapers, LLC, which considered the plain meaning, and concluded that section 1129(b)(2)(A)(iii) referred to the “unquestionable value of a lender’s secured interest in the collateral.”
The court then noted that courts are split over the level of scrutiny to apply to partial “dirt for debt” plans.  Some courts require “clear and convincing evidence” — or near certainty— that the property to be conveyed under the plan is equal in value to the secured claim.  Other courts will confirm a plan under a lesser “preponderance of the evidence” standard, which requires a debtor to show the rough equivalence of the property being conveyed to the secured creditor to the full value of the secured claim.
The bankruptcy court in SUD adhered to the more conservative “clear and convincing” approach.  The court explained that the debtor must first demonstrate by a preponderance of evidence the key considerations of value and risk and then demonstrate by clear and convincing evidence that the secured creditor will receive the full value of its claim.  The first step is a fact-intensive inquiry that generally requires the court to determine if the expert testimony on values and risk supports the debtor’s outcome.  The SUD court used a three-step process for valuation in “dirt for debt” cases:  (1) determine the fair market value of the property; (2) reduce the fair market value by 10% to reflect the likely costs to the secured creditor in liquidating the properties; and (3) apply a discount rate to the net value of the property to account for the time the property will remain unsold.
The bankruptcy court heard testimony from three different real estate appraisers that testified to varying valuations for the property.  All three experts agreed that the lots were sufficiently similar so that they could ascribe equal value to each lot.  The experts each relied on the income approach and sales comparison approaches to valuation and took into account various factors, including the real estate market decline; the surplus of real estate inventory, including vacant lots, in the county; and the subdivision’s lack of amenities that were present in other subdivisions within close proximity (which the debtor’s expert assumed would be constructed as planned and in a timely manner).  In addition, two of the three appraisers applied an “entrepreneurial profit discount” to reflect the monetary incentive needed to attract a buyer for a large number of lots where the amenities had not been completed.  The appraisal testimony varied significantly, from a low of $1.4 million to a high of $3.37 million.
After hearing the extensive testimony and reviewing the appraisals, the bankruptcy court found that the entrepreneurial profit discount should be considered because of the bleak real estate market, large quantity of lots to be transferred under the plan, the absence of amenities in the subdivision, and the funds that either First Bank or another investor inevitably would expend on marketing and maintaining the property.  In addition, First Bank had indicated its intent to liquidate the collateral at a bulk sale rather than slowly through the retail marketing and sales process.  Applying the three-step valuation process, the court found that the plan only would convey property having a value of $875,000 to First Bank.
Next, the court considered whether there was any doubt that First Bank would realize the full value of its claim.  The court found that the values suggested by two of the appraisers would not even pay off First Bank’s claim.  Furthermore, given that many courts have required substantial equity cushions in order to satisfy the indubitable equivalent standard in a partial “dirt for debt” plan, the approximately $50,000 cushion under the debtor’s appraisal was insufficient to insure the safety of, or prevent jeopardy to, the principal.  Therefore, the debtor did not satisfy the clear and convincing burden of proof required to cram down the plan over First Bank’s objection because, in light of all the applicable variables and risks, it was not beyond dispute that First Bank would have the same likelihood of payment in full on its secured claim with just a portion of the collateral as it would have if the debtor surrendered all the collateral to First Bank.
The bankruptcy court went on to speculate as to whether any number of lots less than the full parcel of property, if surrendered to First Bank, would equal the indubitable equivalence of its secured claim.  The bankruptcy court answered in the negative.  Because of the large disparity in the values presented at the hearing, the bankruptcy court concluded that the value of the property was far from certain.  In addition, the court expressed doubt that the lots could be absorbed at the rates projected by the appraisers given the “recessionary state of the American economy, the inability of buyers and builders to obtain financing without significant down payments, and the state of the market for residential subdivision lots in [the county].”  Simply put, “[t]oo much variation in values and too much uncertainty in the market equals no indubitable equivalent.”  Thus, the bankruptcy court denied confirmation of the debtor’s plan.
The Take-Away
The surrender of real property in an uncertain, down market poses challenges to valuation.  Depending on the jurisdiction, proponents of partial “dirt for debt” plans (and secured creditors) should take into account the clear and convincing burden of proof debtors may face in persuading a court that, despite the relative values and risks attendant to such a plan, a secured creditor will realize the unquestionable value of its interest in collateral.  Notably, the bankruptcy court in SUD cited not just the faltering real estate market, but also the recessionary American economy as casting too much uncertainty on the valuation of the property to meet the indubitable equivalence standard’s evidentiary burden.