Despite Lack of Value, Seventh Circuit Permits Nonrecourse Secured Lender to Assert Deficiency Claim

Contributed by Andrea Saavedra
In an issue of first impression before it, the Seventh Circuit Court of Appeals held in In re B.R. Brookfield Commons No. 1, LLC that the plain language of section 1111(b) of the Bankruptcy Code permits election by a nonrecourse undersecured lender of the deficiency portion of its claim as recourse against the debtors.  Further, even though the collateral property at issue had no value, the court held that the claim could not be disallowed.  In issuing its decision, the Seventh Circuit distinguished previous precedent of other bankruptcy courts as improperly decided.
The facts of Brookfield Commons are not unusual to those familiar with single asset real estate bankruptcies.  Prior to its bankruptcy, the debtor placed two mortgages on its principal asset, a commercial shopping center.  The second mortgage was nonrecourse, which simply meant that, outside bankruptcy, the second mortgagee’s recovery in a foreclosure or sale scenario would be limited solely to the proceeds of the pledged collateral.  In other words, if any debt were left outstanding after disposition of the collateral, the lender would be barred from pursuing a deficiency claim against the debtor for such amounts.
As part of its chapter 11 plan of reorganization, the debtor proposed to retain ownership of the shopping center.  The judicial valuation of the property established that its appraisal value would be less than the amount of the first mortgage.  Accordingly, the second mortgagee’s claim was “totally unsecured by any equity” in the real property.  The debtor argued that because the claim was unsecured by any value in the real property, it should be disallowed.  The second mortgagee’s assignee, however, argued that section 1111(b)(1)(A) of the Bankruptcy Code permitted it to treat its nonrecourse claim as if it had recourse, requiring allowance of an unsecured deficiency claim for the full amount of the debt.
The court began its analysis with the language of section 1111(b)(1)(A), which provides, in relevant part, that a claim “secured by a lien on property of the estate” shall be allowed or disallowed “as if the holder of such claim had recourse against the debtor on account of such claim, whether or not such holder has such recourse.”  The court found that the “only precondition to the statute’s application” is that the claim at issue be secured by a lien on property of the estate.  Because the statute does not state that the claim must be secured by property of any value (or that the creditor has to have an allowed secured claim as determined by section 506(a) of the Bankruptcy Code), the Seventh Circuit determined that the “value of the collateral” was “immaterial”, and the second mortgagee could assert its deficiency claim.
While the court found the statutory language to be clear, because there were some differing interpretations of its provisions by lower courts, the Seventh Circuit also looked to the legislative history on section 1111(b).  While the legislative history did not provide definitive guidance on the issue, the court reasoned that it supported the conclusion that permitting nonrecourse secured lenders a right of recourse in bankruptcy, particularly where the debtor intends to retain its property as part of its reorganization plan, struck an appropriate balance between “debtor protections and equitable treatment of creditors.”  Indeed, the court noted that, prior to the adoption of section 1111(b), a debtor could have enjoyed a “windfall” at the undersecured creditor’s expense because it could retain the property, but leave the creditor without full payment of the loan or the right to foreclose.  Lastly, the court made clear that any prior precedent on the issue contrary to its Brookfield Commons holding was neither persuasive nor controlling.
Accordingly, through Brookfield Commons, the Seventh Circuit has made clear that the plain meaning of section 1111(b) permits recourse election for nonrecourse undersecured creditors in bankruptcy, regardless of the value of their secured claim under section 506(a).  Bad news for debtors, but good news for secured lenders.