Restructuring

Last month, the United States Bankruptcy Court for the Northern District of Iowa in In re Civic Partners Sioux City, LLC denied confirmation of a chapter 11 debtor’s plan of reorganization, in part, because the bankruptcy court rejected the debtor’s valuation and, therefore, found that the plan was not feasible.  An examination of the bankruptcy court’s order denying confirmation provides insight into the evidence courts consider when choosing between competing valuations and how courts apply postpetition rental payments made to undersecured creditors.

Events Leading to Chapter 11
More than a decade ago, the City of Sioux City, Iowa selected Civic Partners Sioux City, LLC to develop a retail and movie theater complex.  Civic received the bulk of its construction financing from First National Bank, for which it granted the bank a first mortgage on the property and an assignment of rents.  Civic also received financing from the City, for which it granted the City a second mortgage on the property.  The City’s lien was expressly subordinate to the bank’s lien.  Civic soon completed construction of the movie theater space, and even though construction continued on the rest of the property, it leased that space to Main Street Theatres.
Over the next several years, Civic fell behind on its debt obligations.  In 2009, Civic, Main Street, the bank, and the City agreed to attend mediation in the hope that the parties would consensually restructure their interrelated obligations.  The parties eventually reached a tentative agreement to reduce Main Street’s annual rent in exchange for an upfront one-time payment and to modify Civic’s obligations to the City and the bank.  The City, however, was unable to attend the final mediation session.  While the City considered whether to ratify the agreement, the other parties executed their deal documents (including an amended lease between Civic and Main Street) with the expectation that the City would subsequently ratify the agreement.
The City ultimately decided not to ratify the agreement.  The bank then cancelled its agreement with Civic and commenced foreclosure proceedings on the property.  Thereafter, Civic filed a petition under chapter 11 with the United States Bankruptcy Court for the Northern District of Iowa.
The Civic Plan and Objections Thereto
Shortly before filing for bankruptcy, Civic attempted to cancel the amended lease and reinstate the original lease.  That action, however, required approval from the bank, which Civic did not obtain.  Additionally, after executing the amended lease, Civic and Main Street operated under its terms:  Main Street made its upfront payment, and Civic accepted rental payments at the lower rate.  Despite its attempt to cancel the amended lease and reinstate the original lease, however, Civic never sought to reverse actions taken under the amended lease (e.g., return the upfront payment to Main Street).  Given the circumstances, the parties disagreed over which lease was in effect at the time Civic commenced its bankruptcy case.
Civic ultimately filed a plan of reorganization in which (a) the original lease with Main Street would be reinstated, including significant back rents, (b) the claims of the bank and the City would be equitably subordinated, for their alleged conspiracy with Main Street to trap Civic into an unfairly low rental payment under the amended lease, and (c) Civic would contribute new value in the form of a relatively modest cash payment.
The bankruptcy court agreed to resolve the lease dispute before it held a hearing on confirmation of the Civic plan and, after a separate hearing on that dispute, ruled that the amended lease was in place at filing and would govern.  Main Street, therefore, only opposed confirmation of the Civic plan to the extent that the plan was contrary to the bankruptcy court’s ruling on the amended lease.  The bank and the City, however, maintained more robust objections to confirmation of the plan.  Their main argument was that the plan failed to satisfy the feasibility requirement under section 1129(a)(11) of the Bankruptcy Code because Civic incorrectly valued the bank’s secured claim and, when valued properly, Civic would be unable to make the required payments on that claim.
Valuation – Competing Testimony
Both Civic and the City relied on a discounted cash flow methodology to support their valuation of the property.  Valuation, however, is often more art than science:  Civic and the City differed significantly in their assumptions and, therefore, their conclusions.  The City used the rental rate under the amended lease to forecast cash flows for seven years, the remaining term of the amended lease, and then added the projected value to be realized at sale after seven years.  Like the City, Civic used the rental rate under the amended lease to forecast cash flows for seven years.  Unlike the City, however, Civic continued to forecast cash flows for another three years, during which it projected a steep drop in rental payments.  Civic then added the projected value to be realized at sale after ten years.  The assumptions regarding rental payments accounted for a difference between the competing valuations of approximately $2 million.
Civic’s valuation depended on the assumption, supported by testimony from its expert witness, that rents under the amended lease were “above-market.”  After hearing “lengthy and very specific testimony” on this issue, the bankruptcy court found that assumption to be lacking in credibility and adopted the City’s valuation, subject to minor adjustments.  In reaching its conclusion on credibility, the bankruptcy court observed that Civic’s position was “hard to square” with the fact that Civic had consistently argued that the bank, the City, and Main Street had conspired to trap Civic into an unfairly low rental payment under the amended lease and that their actions in this regard were so egregious that the claims of the bank and the City should be equitably subordinated.
Valuation – Application of Postpetition Rental Payments
The court next turned to the postpetition rental payments.  After commencing its chapter 11 case, Civic had paid a portion of the postpetition rents it received from the property to the bank.  Although Civic did not specifically designate its case as a single asset real estate case, the property was Civic’s only major asset, and its postpetition payments to the bank were ostensibly intended to keep the automatic stay in place pursuant to section 362(d)(3) of the Bankruptcy Code.
At confirmation, no party disputed that the bank held a security interest in postpetition rents under section 552(b) of the Bankruptcy Code.  The parties disagreed, however, on whether the postpetition payments Civic had made should be applied to reduce the bank’s secured claim or its unsecured deficiency claim.
On the one hand, Civic argued that its postpetition payments to the bank should reduce the bank’s secured claim.  In support of its position, Civic cited a line of cases following In re Kalian, which hold that an assignment of rents does not constitute a separate source of collateral that would accrue postpetition, thereby fixing the value of the secured claim at the petition date, and that postpetition payments from rent should be applied to reduce the secured portion of the claim.  On the other hand, the bank urged the bankruptcy court to apply a contrary line of cases, as represented by In re South Side House, LLC, which hold that an assignment of rents is an independent source of collateral that allows postpetition rents to accrue as additional collateral, thereby increasing the value of the secured claim over time.  Postpetition payments from rent, therefore, only reduce a secured claim to the same extent such rents also added to that claim.  Thus, the secured claim remains the same even though the undersecured creditor’s overall claim is reduced, which effectively reduces any deficiency claim.
The bankruptcy court noted that the split in authority derives from varying interpretations of the following statement, made in dicta, from United Savings Association of Texas v. Timbers of Inwood Forest Associates, Ltd.:  “Section 552(b) therefore makes possession of a perfected security interest in postpetition rents or profits from collateral a condition of having them applied to satisfying the claim of the secured creditor ahead of the claims of unsecured creditors.”  A majority of courts read the phrase “claim of the secured creditor” to mean the entire claim (i.e., both secured and unsecured portions) and have adopted the “addition” approach advocated by the bank.  A minority of courts, however, read the phrase “claim of the secured creditor” to mean only the secured portion of the claim, as fixed on the petition date, and have adopted the “subtraction” approach advocated by Civic.
The bankruptcy court adopted the majority approach.  In doing so, it found that “a much more natural reading of the Supreme Court’s dicta in Timbers is that if the creditor has a valid security interest in post-petition proceeds under § 552(b)(1), the value of its secured claim includes those proceeds.”  The bankruptcy court also noted that Timbers involved an undersecured creditor seeking postpetition interest as “use value” under section 362(d)(1).  In Timbers, the Supreme Court held, among other things, that the undersecured creditor was not entitled to postpetition interest payments, in part, because it was “unfair to allow an undersecured creditor to recover interest from the estate’s unencumbered assets before unsecured creditors had recovered any principal.”  Thus, the bankruptcy court concluded that Timbers distinguished between an undersecured creditor seeking postpetition interest under section 362(d) and an undersecured creditor with a perfected security interest in postpetition rents.  Further, the bankruptcy court found the notion that a secured claim should be fixed as of the petition date to be dubious given that a secured claim is based on the value of collateral, which can change during the pendency of a bankruptcy case.  Accordingly, the bankruptcy court found that the bank’s secured claim should not be reduced by Civic’s postpetition payments, but, in fact, should be increased insofar as Civic failed to make full rental payments.
Lessons Learned
The bankruptcy court’s decision has two significant take-aways.  First, the ruling serves as a reminder that bankruptcy judges often determine whether or not to confirm a plan after considering all evidence in the case and not just the evidence offered at the confirmation hearing.  Consistency and credibility, therefore, are key.  Second, the majority approach adopted by the bankruptcy court applies postpetition rental payments to an undersecured creditor’s deficiency claim ahead of other unsecured claims, which allows an undersecured creditor to capture value from the estate at the expense of unsecured creditors.
To make optimal decisions within a restructuring, it is critical that parties understand how the bankruptcy court reaches conclusions with respect to value.  The decision in In re Civic Partners Sioux City, LLC is important because it offers insight on this point.