Third Circuit Clarifies How Secured Claims Are Valued Under Section 506 of the Bankruptcy Code


The Business Advisor

February 21, 2013

The long-standing bankruptcy principle of priority in distribution requires that a secured creditor receive the entire amount of its secured claim before any unsecured claims are paid. Courts have traditionally struggled with which party should bear the burden of proving the value of the secured claim and which valuation method should be used to quantify the amount of a secured claim.

In In re Heritage Highgate, Inc., 679 F.3d 132 (3d Cir. 2012), the Third Circuit Court of Appeals held that a secured creditor’s collateral should be valued at its fair market value at the time of plan confirmation rather than based on any future disposition or use of the collateral. The Court also clarified the burden of proof to value secured claims under section 506(a) of the Bankruptcy Code, adopting a burden-shifting approach under which the party challenging the secured claim bears the initial burden to overcome “the presumed validity of the secured creditors’ claim” while the ultimate burden of persuasion remains with the secured creditor to prove by a preponderance of the evidence the extent of its claim and the value of the underlying collateral.

The collateral at issue in the Heritage Highgate case was the development of a residential subdivision to build townhouses and single-family detached homes (the “Property”). The Debtors needed financing in connection with this project and entered into a series of construction loan agreements with certain bank lenders (the “Bank Lenders”). As security for the loans, the Bank Lenders retained a lien in “substantially all of the Debtors’ assets.” 679 F.3d at 136. The Debtors subsequently borrowed more funds and granted liens of equal priority on “substantially all of the Debtors’ assets” to a group of investors known as the Cornerstone Investors. Id. The Cornerstone Investors agreed to subordinate their secured claims to the claims of the Bank Lenders. Id. In connection with the cash collateral hearing, a real estate appraisal was submitted indicating that the value of the Property was greater than the aggregate claims of the Bank Lenders and the Cornerstone Investors and therefore, both secured creditors would be paid in full. Id. at 136-37.

Eight months later, the Official Committee of Unsecured Creditors (the “Committee”) filed a motion to value the Cornerstone Investors’ secured claim pursuant to section 506(a) of the Bankruptcy Code and Bankruptcy Rule 3012. Id. at 137. In its motion, the Committee argued that the Cornerstone Investors did not have a secured claim because the fair market value of the Property was not sufficient to pay the Bank Lenders’ lien in full. Id. The Cornerstone Investors responded that the Property should not be valued based on the fair market value but rather, should be estimated based on the revenue the Debtors would derive from the Property, an amount estimated in the plan budget. Id. The Bankruptcy Court agreed with the Committee and applied the fair market valuation method as of the plan’s confirmation date. Applying this method, the value of the Property was not sufficient to pay the Bank Lenders in full, rendering the Cornerstone Investors unsecured. Id. at 138. The District Court affirmed. Id.

The Third Circuit applied a burden shifting analysis to determine the question of value, which placed the initial burden on the Committee “to overcome the presumed validity and amount of” the Cornerstone Investors’ claim, leaving the ultimate burden of persuasion on the Cornerstone Investors “to demonstrate by a preponderance of the evidence both the extent of its lien and the value of the collateral securing its claim.” Id. at 140. The Court rejected the approaches applied by other courts, where the burden rests with either the secured creditor or the challenging party. Id. The Court reasoned that a properly filed claim should be given “prima facie effect” and therefore, the initial burden should lie with the contesting party. Id.

The Court then addressed the proper method of determining value under section 506(a). Rejecting the wait-and-see approach to valuation proposed by the Cornerstone Investors, the Court opined that the appropriate measure for valuing property retained by the Debtors is the fair market value approach, which reflects “the price a willing buyer in the debtor’s trade, business, or situation would pay a willing seller to obtain property of like age and condition.” Id. at 142. The Court reasoned that under “ordinary circumstances the present value of the income stream would be equal to the collateral’s fair market value.” Id. at 142 (quoting In re Winthrop Old Farm Nurseries, Inc., 50 F.3d 72, 75 (1st Cir. 1995)). Where a debtor’s plan of reorganization provides for the debtor to retain and use collateral to generate income with which to make payments to creditors, “[t]he proper measure [of value] under §506(a) must … be the collateral’s fair market value because it is most respectful of the property’s anticipated use.” In re Heritage Highgate, Inc. 679 F.3d at 142. The approach encouraged by the Cornerstone Investors is speculative and could lead to an inequitable result if the reorganization is not carried out as anticipated. The valuation approach adopted by the Court ensures that the secured creditors receive the market value of collateral in its current condition, regardless of the plan’s success or failure. Id. at 142. Any appreciation in collateral would be contingent upon the Debtors’ post-confirmation efforts, which is not appropriately allocated to the secured creditor.

Additionally, the Court concluded that the timing of the valuation should be left to the Bankruptcy Court’s discretion in light of the facts presented. Id. at 142 (noting that the wait-and-see approach deprives the Bankruptcy Court of its obligation to value claims during reorganization and before the plan’s success or failure is clear). Here, the Court approved the lower courts’ decision to value the Property as of the confirmation date, due to the fact that the hearing on the Committee’s motion was post-confirmation, finding that it would be improper to credit the secured creditor for value earned based on the Debtors’ post confirmation efforts. Id. at 143. Thus, the Cornerstone Investors’ claim was rendered unsecured.

The “take away” for secured creditors is two fold. First, timing matters – from the time of the cash collateral hearing until the Committee filed its motion, the Debtors were permitted to sell portions of the Property that generated approximately $5.45 million in proceeds, which funded the Debtors’ operations and was paid to the Bank Lenders in partial satisfaction of their senior secured claims. The sales reduced the fair market value of the Property and exposed the junior lien holders to the risk that they would be rendered unsecured creditors upon a valuation of their collateral (as occurred here). Second, secured creditors should obtain their own independent appraisal and not just accept valuations provided by the Committee.