SINGLE ASSET PROPOSALS
The preparation of the discussion sections for these proposals
is the individual work of Senior Adviser Stephen H. Case and
the members of the Small Business Working Group, John
Gose, Jeffery J. Hartley and James I. Shepard, with the staff
assistance of Jennifer Frasier. These proposals were adopted by the Commission based on a five to three vote.
A significant number of Chapter 11 cases involves a partnership or
corporation whose sole significant asset is an office building, apartment complex,
warehouse, or similar real property. In the typical case, the sole significant creditor
is the mortgage holder. When the rental value of the property declines, or the debtor
suffers an increase in vacancies, the debtor is no longer able to pay debt service. The
mortgage goes into default, the debtor and the lender fail to agree upon an out-of-court workout, and the debtor files Chapter 11 to stave off foreclosure.
All persons who appeared before the Commission's working group on single-asset realty ("SARE") matters conceded that some use of Chapter 11 in these cases
was abusive and unjustified. However, these persons differed significantly on
whether the problem was very serious, on the one hand, or trivial, on the other hand.
Two concerns are voiced most frequently by those who contend that abuse is
rampant and must be stamped out(1678). First, the automatic stay enables the debtor to
prevent foreclosure for an extended period of time without filing a plan or making
postpetition payments. This gives the debtor substantial leverage over the secured
lender by imposing the principal costs of delay on that creditor. Second, SARE
debtors sometimes attempt to use the provisions of Chapter 11 to keep
overencumbered property without either paying the mortgage in full or obtaining the
assent of a majority of creditors. These concerns are heightened because, many
contend, SARE cases fulfill few of the recognized goals of Chapter 11.
Reorganization is not generally necessary to preserve jobs and going-concern value
in SARE cases. Whether the debtor keeps the real property or the secured creditor
takes it back, the property will be operated in the same manner, creating the same
jobs and economic activity. Opponents of the status quo contended that too many
SARE cases involved individual equity owners, often functioning through syndicates
such as partnerships, faced as a result of foreclosure large liabilities to pay cash tax
on completion of the sale even though no cash proceeds thereof were paid to the
equity. (This results from the operation of federal and state income tax laws on
certain investments in real estate). Anecdotal examples were cited to the
Commission's working group of extremely drawn out, expensively litigated SARE
cases where tax avoidance/tax postponement strategies were the only conceivable
explanation for the behavior of the debtor. The most extreme types of cases which
were complained about involved efforts by debtors to confirm so-called "lien-stripping, new-value" plans. In these plans, the debtor's pre-bankruptcy owners ask
the court to fix a value for the property which is usually much less than the unpaid
principal amount of the secured debt and then to retain ownership by infusing new
capital into the debtor.
A number of published articles and persons who appeared before the Working
Group defended availability of Chapter 11, as presently constituted, for SARE
cases(1679). These spokespersons contend, as noted above, that there is no greater
incidence of abuse in the SARE area than in other areas and that increasingly wise
and thoughtful case management by bankruptcy judges, U.S. Trustees and
Bankruptcy Administrators was bringing the problems under control without need
for significant statutory reform. These commentators repeatedly asserted that
whatever the problems with SARE cases might or might not be, the SARE debtor did
not deserve more restriction in how it could function in Chapter 11 than any other
debtor.
All individuals expressing views to the Commission shared the belief that in
recent years, the incidence of cases where tax-shelter-preservation motivations
predominated had declined significantly. Also, there seemed to be a consensus that
the courts, the U.S. Trustees and the Bankruptcy Administrators had gotten much
wiser about moving more swiftly against abusive single-asset realty cases.
Nevertheless, in spite of some indication of some favorable trends, problems
alleged to arise from SARE cases continue to demand the careful attention of judges
and makers of public policy. Congress recently addressed the concern that SARE
debtors enjoy the benefit of the automatic stay for too long. In 1994, Congress
enacted section 362(d)(3), which entitles secured creditors relief from stay, unless
within 90 days after the order for relief the SARE debtor: (1) files a confirmable
plan, (2) commences postpetition mortgage payments, or (3) obtains an extension of
the 90-day plan-or-payment deadline. The effect of section 362(d)(3) is limited,
however, by the fact that it does not apply to cases in which the secured debt exceeds
$4 million.
Court decisions have established limitations on when a SARE debtor may
keep overencumbered property without paying a mortgage debt in full. Whether a
SARE debtor can confirm a lien-stripping plan generally turns on whether an
impaired class has accepted the plan, and whether the plan satisfies the new-value
exception to the absolute priority rule. The Courts of Appeals have made it
increasingly difficult for the debtor to create an impaired accepting class, by
restricting the debtor's ability to divide unsecured claims into more than one class. (1680)
The drawback in this approach is that reliance on classification rules does not ensure
that reasonable lien-stripping plans are confirmed and that unreasonable lien-stripping plans are not confirmed.
The Commission's working group on small business, partnership and single-asset real estate, conducted several discussions regarding SARE cases, during which
it received comments from many attorneys, lenders, and judges. A consensus
emerged within the working group from those discussions that the incidence of abuse
in the past and danger of additional abuse in the future from SARE cases was very
significant and requires tightening up in the statute. The Commission rejected the
extreme view, advocated by some, that SARE debtors should be excluded from
Chapter 11 altogether. However, the Commission's Recommendations provide for
additional steps be taken to reduce cost and delay, and for incorporation of clear,
objective standards regarding use of the so-called "new-value exception" in SARE
cases.
RECOMMENDATIONS
2.6.1 Change the Present Statutory Definition of "Single Asset Real Estate" in
two ways.
First, the $4 million debt limit should be eliminated from the
definition of "single asset real estate" debtor subject to section
362(d)(3).
Second, the definition of "single asset real estate" should be more
carefully worded to exclude cases in which the real property is
used by a debtor in an active business.
The definition, as proposed, incorporating both concepts, would read as
follows:
undeveloped real property or other real property constituting a
single property or project other than residential real property
with fewer than 4 residential units on which is located a single
development or project which property or project generates
substantially all of the gross income of a debtor and on which no
substantial business is being conducted by a debtor, or by a
commonly controlled group of entities substantially all of which
are concurrently Chapter 11 debtors, other than the business of
operating the real property and activities incidental thereto.
2.6.2 Amend Code Section 362(d)(3) in Three Particulars
a. Make clear that payments required by section 362(d)(3) may
be made from rents generated from the property.
b. Provide that the interest rate with respect to which payments
are calculated shall be the nondefault contract rate.
c. Amend the statute to provide that the payments must be
commenced or a plan filed on the later of 90 days after the
petition date or 30 days after the court determines the debtor to
be subject to section 362(d)(3).
2.6.3 Require Substantial Equity in order to Confirm a Lien-Stripping Plan
Using the New Value Exception
In cases where the secured creditor has not made the election
under section 1111(b)(1)(a)(i), a plan must satisfy the following
requirements to be confirmed under the new-value exception
following rejection by a class that includes the unsecured portion
of a claim secured by real property: (1) The new value
contribution must pay down the secured portion of the claim on
the effective date of the plan so that, giving effect to the
confirmation of the plan, sufficient cash payments on the secured
portion of the claim shall have been made so that the principal
amount of debt secured by the property is no more than 80
percent of the court-determined fair market value of the property
as of the confirmation date; (2) the payment terms for the secured
portion of the claim must both (i) satisfy all applicable
requirements of section 1129 of the Code, and (ii) satisfy then-prevailing market terms in the same locality regarding maturity
date, amortization, interest rate, fixed-charge coverage and loan
documentation; and (3) the new value contribution must be
treated as an equity interest that is not convertible to or
exchangeable for debt.
DISCUSSION
2.6.1 Change the Present Statutory Definition of "Single Asset Real Estate" in
two ways.
First, the $4 million debt limit should be eliminated from the
definition of "single asset real estate" debtor subject to section
362(d)(3).
Second, the definition of "single asset real estate" should be more
carefully worded to exclude cases in which the real property is
used by a debtor in an active business.
The definition, as proposed, incorporating both concepts, would read as
follows:
undeveloped real property or other real property constituting a
single property or project other than residential real property
with fewer than 4 residential units on which is located a single
development or project which property or project generates
substantially all of the gross income of a debtor and on which no
substantial business is being conducted by a debtor, or by a
commonly controlled group of entities substantially all of which
are concurrently Chapter 11 debtors, other than the business of
operating the real property and activities incidental thereto.
Comments. Under current law, "single asset real estate is defined as:
real property constituting a single property or project, other
than residential real property with fewer than 4 residential
units, which generates substantially all of the gross income of
a debtor and on which no substantial business is being
conducted by a debtor other than the business of operating the
real property and activities incidental thereto having
aggregate, noncontingent, liquidated secured debts in an
amount no more than $4,000,000. (1681)
Four Million Dollar Cap Issues. The most significant aspect of the proposed
amendment is the elimination of the four million dollar cap. The Working Group
determined the cap should be eliminated because the reasons supporting the 90 day
plan-or-payment deadline apply to the typical large SARE case as well as to the
typical small SARE case. (1682)
The time needed to formulate a plan is similar in large
and small SARE cases, because the basic task in each instance is usually financial
restructuring rather than business restructuring. The focus of the plan in SARE
causes of all sizes is typically on a single secured creditor. The harm caused by delay
is also similar in large and small SARE cases. The debtor's failure promptly to file
a plan or commence interest payments imposes the cost and risk of reorganization on
the secured creditor to the same extent in SARE cases of all sizes. Finally,
reorganization provides limited social benefit in SARE cases of all sizes. Unsecured
trade creditors are typically a very small percentage of total debt in large SARE cases
as well as small ones. Although preservation of jobs and going-concern value may
be an issue in some SARE cases, it is not typically an issue in either large or small
SARE cases. In those unusual cases in which enforcement of the ninety-day deadline
would cause injustice, the Bankruptcy Code affords sufficient flexibility to courts to
extend the deadline as appropriate.
The Commission considered and rejected raising the debt limit rather than
eliminating it. Except perhaps in very large cases, (1683) the amount of secured debt is
not a reliable indicator of complexity and the need for more time. Only in a minority
of large SARE cases is the ninety-day deadline too short. Yet the debt limit removes
the wholesome discipline of section 362(d)(3) from all cases with secured debt
exceeding four million dollars on the basis that a few such cases may require
additional time. In other words, the general rule for large SARE cases (no plan or
payment deadline) is derived from the needs of the unusual case.
If the rationale for eliminating the four million dollar cap were to be
expressed in two sentences, they would be these:
(1) The ninety-day plan-or-payment deadline is an appropriate general
rule for SARE cases of all sizes.
(2) Unusual cases should be addressed through the court's power to
extend the deadline, not by creating a lax general rule for all large
cases.
Active-Business Issues. The proposed definition of the SARE debtor is
designed to include real estate investors, and to exclude debtors who use real estate
in an active business, such as a wholly owned subsidiary that holds a building used
as a factory by the parent, or a television broadcast tower held in a separate entity
owned by the FCC licensee, but only when the parent or the licensee was also a
debtor in a bankruptcy case. Whether the debtor uses real property in an active
business should be viewed in terms of economic substance rather than the form of
ownership. Thus, where a debtor conducting an active business holds title to the real
property used in that business through a separate entity, the entity holding the real
property should not be considered a SARE debtor.
In other words, a basic idea embedded in the Proposal is that SARE not
include members of a consolidated group of debtors operating a substantial non-realty business in the real estate. A prime motive in proposing this requirement is
that lenders in workouts will not be motivated to demand that operational companies,
such as manufacturing companies, drop all their factory buildings into single-asset
subsidiaries for the purpose of mandating fast-track treatment of these subsidiaries
as single-asset realty entities if the workout fails and Chapter 11 becomes necessary.
Not only would the transaction costs of this procedure be excessive, but should
Chapter 11 eventuate, the additional stress of fast-track treatment for the so-called
SARE entities in the consolidated group might endanger fulfillment of two of the
prime goals of Chapter 11, namely, preservation of jobs and going-concern values.
It is necessary to define carefully the relationship the real estate debtor must
have to the operating debtor to come within the operating business exception to the
definition of SARE. The Commission has opted in favor of the undefined term
"group of commonly controlled entities of which the debtor is a member" because
the existing definition of "affiliate" in the Code would be too loose. The definition
of "affiliate" in Section 101 uses a 20% ownership threshold, which might sweep out
of the defined concept of SARE too many situations in which the affiliated entity was
not so closely related to the debtor that the relationship, alone, should be sufficient
grounds to exempt the debtor from the definition of SARE. The concept is to
provide special treatment for stand-alone realty entities but not to impose that
treatment on an entity which is only one part of a larger enterprise in bankruptcy. The
following examples illustrate what the Commission has in mind.
1. Debtor is a limited liability company owned by a group of lawyers,
doctors, and dentists which owns an office building held for rental. Debtor is an
SARE. This would be true even if the debtor provides its own cleaning, maintenance,
snow removal, and landscape services, because these are activities incidental to the
operation of the property.
2. Debtor is a wholly owned subsidiary of a Fortune 500 manufacturing
company which owns a manufacturing facility operated by the parent. The debtor and
its parent are both Chapter 11 debtors. The debtor is not an SARE. This is because
the debtor is a member of a commonly controlled group in Chapter 11 which
conducts a substantial business on the debtor's property other than a business
incidental to the operation of the property.
3. Debtor is a limited partnership owned by a group of business
executives which owns a strip shopping center with twenty-three stores, none of
which stores is operated by the debtor. Debtor is an SARE.
4. Debtor is the same limited partnership owned by the same group of
business executives which owns the same strip shopping center with twenty-three
stores. However, in this example, the smallest of the store spaces is operated as a
frozen-yogurt stand by the debtor. Debtor is an SARE, even though it operates a
business other than an activity incidental to real estate because the frozen-yogurt
stand is not "substantial."
5. Debtor is a corporation owning a regional shopping mall. Debtor is
majority owned by an enterprise which also operates a nationwide chain of 147
ladies-apparel stores, one of which is on the debtor's premises. The debtor is not an
SARE, because the business being operated by the debtor's group is "substantial."
Elimination of Other Ambiguities. The present definition contains several
ambiguities. The phrase "which generates substantially all of the gross income of a
debtor" has led at least one court to question whether the definition includes raw
land. (1684)
It is the intention of this Proposal that the SARE definition includes raw
land. It is also unclear whether under the $4 million debt limit refers to the face
amount of the secured claim or to the lesser of the face amount or the value of the
collateral. (1685)
Eliminating the debt limit will moot this question.
2.6.2 Amend Code Section 362(d)(3) in Three Particulars
a. Make clear that payments required by section 362(d)(3) may be made
from rents generated from the property.
b. Provide that the interest rate with respect to which payments are
calculated shall be the nondefault contract rate.
c. Amend the statute to provide that the payments must be commenced
or a plan filed on the later of 90 days after the petition date or 30 days
after the court determines the debtor to be subject to section 362(d)(3).
The Commission suggests that three additional minor amendments be made
to the language of section 362(d)(3). First, the statute should make clear that the
payments required may be made from rents generated from the property. Second, the
statute should be amended to provide that the interest rate from which the payments
are calculated be the nondefault contract rate, rather than the "current fair market
rate" as now specified. This change will provide greater certainty and reduce
litigation. Third, the statute should be amended to provide that the payments must
be commenced or a plan filed on the later of 90 days after the petition date or 30 days
after the court determines that the debtor is subject to section 362(d)(3). If a debtor
does not timely comply with section 362(d)(3) based on its contention that it is not
an SARE debtor, and it is later determined that section 362(d)(3) does apply, relief
from stay must be granted even if the debtor is ready to make payments or file a plan
promptly. This trap would be eliminated by the suggested amendment.
Congress adopted section 362(d)(3) for the express purpose of reducing delay
and potential abuse in SARE cases. (1686) Section 362(d)(3) requires the SARE debtor
within 90 days after the order for relief to: (1) file a confirmable plan; (2) commence
postpetition mortgage payments; or (3) obtain an extension of the 90-day plan-or-payment deadline. If the SARE debtor fails to perform any of these three options,
secured creditors are entitled to relief from the automatic stay. (1687)
Subject to the
provisions of the Commission Small Business Proposal, the Commission believes
that section 362(d)(3) establishes a sound approach to SARE cases. (1688)
Rationale for the Ninety-Day Plan Deadline. SARE cases, both large and
small, typically fit the following fact pattern. The debtor's investment is highly
leveraged, i.e., mortgage debt represents a high percentage of the value of the real
property. Rental income has declined, so that the debtor is no longer able to pay all
operating expenses, taxes, and mortgage debt from the rental income. The decline
in rental income typically results from: (1) a general decline in the relevant rental
market; (2) overbuilding; (3) vacancy caused by loss of a major tenant; or (4)
vacancy and decline in rental value caused by mismanagement, poor maintenance,
or both.
In this typical SARE case, ninety days is generally sufficient time for the
debtor to file a feasible plan of reorganization, regardless of the amount of mortgage
debt involved. First, the plan in a SARE case involves financial restructuring, not
operational restructuring of the business. The debtor whose case usually involves
business restructuring may need to open or close a branch or division. The debtor
may then need to operate the restructured business for some time, to see how
profitable it will be, before the debtor can propose a plan. In contrast, the financial
restructuring involved in SARE cases is generally accomplished by reducing
creditors' claims and/or by infusing new capital to cover the difference between
rental income and the amount needed to pay expenses and debt service. In addition,
the typical SARE debtor has only one significant creditor, the first mortgage holder.
Trade debt is generally de minimis, and paid in full under the plan. Thus, the typical
SARE case is in substance a two-party dispute, the primary focus of which is to
restructure the terms of the debtor's secured debt. In this respect, the typical SARE
case is very different from the typical manufacturing case, in which there may be a
significant number of jobs at stake, and which may involve a significant amount of
trade debt, unsecured bond debt, and numerous secured creditors, each secured by
different collateral.
It should also be noted that filing a plan within the ninety-day period is not
the debtor's only option. The SARE debtor need not file a plan if it either
commences making interest payments to the mortgage holder within ninety days, or
seeks an extension from the ninety-day deadline by showing cause of why more time
is needed to either file a plan or commence payments. Thus, section 362(d)(3)
carefully balances the interest of the secured creditor for speedy resolution of the
Chapter 11 proceeding and the SARE debtor's needs for adequate time to attempt to
reorganize.
Rationale for Requiring Payments if Plan not Filed withing Ninety Days.
Section 362(d)(3) provides that if an SARE debtor does not file a plan within ninety
days or obtain an extension of that deadline, the debtor must commence making
monthly interest payments or the secured creditor is entitled to relief from the
automatic stay. The Commission believes that this requirement is appropriate for the
following reasons. (1689)
If the debtor does not promptly file a plan or commence payments,
continuation of the automatic stay places the primary cost and risk of reorganization
on the secured creditor. In SARE cases in which the secured debt exceeds the value
of the debtor's real property, the debtor and unsecured creditors have no present
economic interest in the property. There is value only for the secured creditor. If the
debtor is permitted to hold the property for an extended period without making
payments and the value of the property declines further, it is the return to the secured
creditor that is diminished. Moreover, the secured creditor is deprived of the use of
property in which only it has a present economic interest without payment for that
use. Judge Lisa Hill Fenning has succinctly described this situation as follows:
[T]he plans proposed in most of these [single-asset] cases
attempt to buy a few years' delay in foreclosure in the hope that the
real estate market will improve, shifting the risk of failure to the
secured creditor, while trying to preserve the upside potential for the
equity holders. (1690)
Imposing the cost and risks of delay on the secured creditor for more than
three months are not justified because SARE cases often serve few recognized goals
of Chapter 11. First, confirmation of a plan provides minimal benefit to unsecured
creditors. Unsecured trade debt is typically paid after the property is foreclosed,
either by the purchaser, who wants to maintain the same services to the property, or
by the general partners of the debtor, who remain liable for partnership debts. (1691) Second, the bankruptcy does not serve the purpose of eliminating the destructive race
among unsecured creditors. There is typically only one significant asset, the real
property, and that is generally fully encumbered by the first mortgage. Third, the
debtor often has no equity in the property to preserve. In such cases, the debtor is not
trying to preserve a present economic interest, but rather is attempting to retain the
property in the hope that its value will increase in the future. Fourth, loss of jobs and
going-concern value are generally not at stake in single-asset real estate cases. In the
usual case, if a debtor loses the property to a new owner, the new owner operates the
property in the same general manner as the debtor, thus preserving the same number
of jobs and economic activity in the community.
Doubts about the social utility of reorganization in SARE cases deepen when
one considers the public interest in proper building maintenance. It is not unusual
for a financially strapped SARE debtor to maintain its property poorly because the
debtor applies available cash flow to debt service, operating expenses, and taxes.
Capital improvements, replacements, and even routine maintenance may therefore
be deferred. (1692)
Inadequately maintained properties may also contribute to the
decline in value of surrounding property and a related decline in the tax base. (1693) Confirmation of a plan does not necessarily remove the impediments to proper
upkeep. After confirmation, the debtor is often left with secured debt equal to the
entire value of the property. (1694) This high debt-to-equity ratio means debt service is high relative to operating income. Moreover, equity holders may not have sufficient
incentive to put new money into the property for maintenance, because they have no
current equity to protect. In this respect, transfer of the property to a new owner after
foreclosure may lead to better maintenance. The new purchaser is likely to have a
more conventional debt-to-equity ratio and, as a result, has both the incentive and the
cash flow to property maintain the property.
It should also be noted that the payments that the debtor is required to make
under section 362(d)(3) are smaller than the payments the debtor would be required
to make pursuant to a plan of reorganization. Section 362(d)(3) requires the debtor
to make payments, if any at all, only on a principal amount not to exceed the value
of the collateral. Under a plan, the debtor will also have to make payments to
unsecured creditors, pay administrative and other priority claims in full, and provide
for the payment of the principal balance of the secured claim. Generally a debtor that
can reorganize should be capable of paying interest on the current value of the
property from rental income.
2.6.3 Require Substantial Equity in order to Confirm a Lien-Stripping Plan
Using the New Value Exception
In cases where the secured creditor has not made the election under
section 1111(b)(1)(a)(i), a plan must satisfy the following requirements
to be confirmed under the new-value exception following rejection by a
class that includes the unsecured portion of a claim secured by real
property: (1) The new value contribution must pay down the secured
portion of the claim on the effective date of the plan so that, giving effect
to the confirmation of the plan, sufficient cash payments on the secured
portion of the claim shall have been made so that the principal amount
of debt secured by the property is no more than 80 percent of the court-determined fair market value of the property as of the confirmation
date; (2) the payment terms for the secured portion of the claim must
both (i) satisfy all applicable requirements of section 1129 of the Code,
and (ii) satisfy then-prevailing market terms in the same locality
regarding maturity date, amortization, interest rate, fixed-charge
coverage and loan documentation; and (3) the new value contribution
must be treated as an equity interest that is not convertible to or
exchangeable for debt.
To further reduce cost and delay in SARE cases, the Commission
recommends that the requirements for confirmation of "new value exception" plans
be clarified.
Under current law, some courts allow pre-petition equity holders to retain
property under a plan of reorganization, over the objection of creditors and even
though creditors are not paid in full, by infusing "new value" into the reorganized
business. This concept is known as the new value exception to the absolute priority
rule. (1695)
The new-value exception is invoked most frequently in SARE cases in
which the mortgage debt exceeds the value of the real property. The new value
exception is used in such cases to enable the debtor to keep the property without
paying the mortgage debt in full.
The principal problem with the new-value exception is that its elements are
not precisely defined. Under current case law, the new-value exception contains five
requirements. The new-value contribution must be: (1) new; (2) in money or
money's worth; (3) substantial; (4) necessary; and (5) reasonably equivalent to the
interest retained. (1696) While court decisions provide reasonably precise definitions for
the "new" and "money or money's worth" requirements, case law does not come
close to providing clear rules for the other three requirements. (1697)
Cases addressing
the "substantial" requirement are split over whether substantiality is to be measured
in absolute terms or relative to unsecured claims. Cases addressing the "necessary"
requirement are split over whether the contribution must be necessary to operations
or whether it may be used to pay preconfirmation creditors. It is also unsettled
whether old equity must be the sole available source of new capital. (1698)
Regarding the
"reasonably equivalent" requirement, it is unclear whether indirect benefits to
equity holders, such as expected future salary and deferral of taxes, must be taken
into account. Courts also differ as to whether the equity interest must be put up for
auction. (1699)
A recent survey concludes that "the courts have offered few insights
regarding the methodology of satisfying this requirement."(1700)
The Commission proposes a clear, objective standard for new-value plans in
SARE cases. The new-value exception would be satisfied if, and only if, the secured
portion of the loan was paid down to 80 percent of the value of the property. This
would permit the debtor to "strip off" liens to the extent that they exceed the current
value of the property, while providing the secured creditors conventional terms on
the remaining portion of the lien. The Proposal improves the balance of equities
between debtors and secured creditors in SARE cases, and reduces litigation over
what constitutes sufficient "new value."
Rationale Supporting a Loan-to-Value Test. The loan-to-value test for new
plans improves upon current law in three ways: It more equitably balances the
interests of debtors and secured creditors; it increases the likelihood of success of the
reorganized debtor; and it reduces litigation.
The loan-to-value standard fairly balances the interests of debtors and
creditors. The debtor would be able to reorganize overencumbered property in
Chapter 11 over the objection of its secured creditor by reducing the mortgage debt
to the current value of the property and retaining the property through a new-value
contribution. This new value contribution would provide the secured creditor with
a conventional layer of equity beneath its mortgage loan. Without this layer of
equity, the secured lender bears all the risks of any future decline in value, while the
debtor enjoys all the benefits of any future appreciation. With a conventional layer
of equity, the debtor enjoys the benefits and bears the burdens of ownership. From
the lender's perspective, it would be as if the property were sold to a creditworthy
purchaser for a price equal to a court-determined value. (1701) The loan-to-value
proposal would not give additional leverage to holders of junior liens that are
completely unsecured. This is so because the protections apply to the treatment of
the secured portion of the debt only.
Requiring the debtor to reduce the principal balance of its secured note by
twenty percent would also leave the debtor with a sound capital structure coming out
of confirmation. A new-value plan in which the secured debt equals 100 percent of
the value of the property is a virtual recipe for future default and poor
maintenance. (1702) In such cases, too much of the debtor's net income must be spent
on mortgage debt service, leaving the debtor too little for maintenance and reserves.
Requiring the debtor to maintain an 80 percent loan-to-value ratio decreases the
amount of net income that must be spent on debt service, greatly increasing the
likelihood that the debtor will properly maintain the property and will fully perform
its obligations under the plan. Requiring the equity holders to make this down
payment will also give those equity holders a greater incentive to put in additional
new money as needed, because they will have a current economic interest in the
property to protect.
Finally, the Proposal should reduce or simplify litigation in several respects.
First, by more precisely defining the requirements of the new-value exception, it
should reduce litigation over whether those requirements have been met in a
particular case. Second, the loan-to-value requirement would relieve courts from
having to determine the market rate of interest on one hundred percent loan-to-value
loans - loans which do not exist in the marketplace. Third, the Proposal should
reduce litigation over classification of claims and artificial impairment of classes in
SARE cases. (1703) Fourth, clarifying the rules for debtors who seek to reorganize
overencumbered real estate in Chapter 11 may increase the number of out-of-court
workouts.
The proposed loan-to-value test is not a departure from the present new-value
exception, but rather applies the five elements of the existing new-value exception
to the unique circumstances of SARE cases:
1. "New" and "money or money's worth." The Proposal requires the
contribution to be in cash paid on the effective date of the plan from a source other
than the property of the estate. In this respect it is identical to the present new-value
exception.
2. "Necessary." The payment required under the Proposal is "necessary"
in that it is precisely calculated to further the likelihood of success of the reorganized
SARE debtor. As explained above, the required equity cushion is designed to leave
the reorganized debtor with a capital structure that will enhance its ability to maintain
the property and fully perform its obligations under the plan.
3. "Substantial" and "reasonably equivalent to the interest retained." The
primary concern raised by lien-stripping plans is that the secured creditor bears all
risk of future decline in the value of the property, while the debtor enjoys the benefits
of all future appreciation. Thus, although the equity interest in the reorganized
debtor may have no value in an accounting sense, it has a substantial practical value,
because it affords the debtor's equity holders an opportunity to recover future profits
without putting their assets at risk, and because foreclosure often has substantial
adverse tax consequences for equity holders. The size of the new-value contribution
required under the Proposal is calculated to allocate more equitably the benefits and
risks of reorganization. The debtor's equity holders, who reap the entire benefit of
any future appreciation, are required to bear an appropriate share of the risk of any
future decline in value by supplying the same equity cushion an outside purchaser
would have to put up.
The new-value exception is never easy to satisfy, because it requires equity
holders to make a "substantial" contribution of capital. Undoubtedly, the equity
holders in many cases would not be able, or willing, to contribute sufficient new cash
to pay down the secured debt as required under the Proposal. It is doubtful, however,
that cases in which equity holders propose a smaller contribution would be confirmed
under current law either. (1704) The big difference between current law and the proposed
loan-to-value test is that the Proposal creates an objective test that will lead to faster,
less expensive resolution of SARE cases.
There must be some restriction on how the debtor treats the new-value
contribution. It would completely undermine the logic of the Proposal, for instance,
to permit the debtor to treat the new contribution as a senior lien on the real property.
A more realistic danger is that the contribution might be treated as equity convertible
to debt on a par with unsecured claims to be paid under the plan. In that instance the
new-value contribution might not have the hoped-for effect of enhancing the capital
structure of the debtor and the feasibility of the plan. The Proposal provides that the
contribution be equity that is not convertible to debt without consent of the secured
lender.
The loan-to-value requirements would not apply when the secured creditor
makes the section 1111(b) election. When a creditor makes the election, its entire
claim is treated as secured. The absolute priority rule and the new-value exception
apply only to unsecured claims.
Annex A, attached hereto, presents accounting entries illustrating how the
loan-to-value test for the new-value exception would work in various hypothetical
cases.
Credit-Bid Approach to New-Value Exception.The Commission received
many comments stating that the real property should be put up for auction, and the
secured creditor permitted to credit bid its note, when an SARE debtor proposes to
confirm a plan under the new-value exception. (1705)
The Commission considered this
approach carefully, but declined to adopt it, out of concern that it might prevent a
debtor from ever confirming a new-value plan over the objection of a secured
creditor. At the same time, however, the Commission acknowledges that the credit-bid approach has advantages, and suggests that Congress give this approach serious
review. Attached as Annex B is a copy of a memorandum received by the
Commission that explains the credit-bid approach in detail. (1706)
Professor Kenneth N. Klee of the University of California at Los Angeles
School of Law submitted the Alternative Proposals set forth below after the
Commission voted on the previous Single Asset Real Estate Proposals. The
Commission did not have the opportunity to vote on Professor Klee's Proposals.
The Small Business Working Group did consider a number of the concepts
embodied in the proposals but rejected them.
While there has been no Commission vote on the Alternative Proposals
discussed below, they have the support of five Commissioners who were not
members of the Small Business Working Group. They view it as a well-reasoned alternative and hope that it will receive careful consideration by
Congress.
ALTERNATIVE SINGLE ASSET PROPOSALS
A significant number of Chapter 11 cases involve a partnership or
corporation whose sole significant asset is an office building, apartment complex,
warehouse, or similar real property. In the typical case, the sole significant creditor
is the mortgage holder. When the rental value of the property declines, or the debtor
suffers an increase in vacancies, the debtor is no longer able to pay debt service. The
mortgage goes into default, the debtor and the lender fail to agree upon an out-of-court workout, and the debtor files Chapter 11 to stave off foreclosure.
Although use of Chapter 11 in some of these cases is abusive and unjustified,
in other cases, access to Chapter 11 serves legitimate reorganization objectives.
Moreover, as Judge Samuel Bufford testified before the working group, there is
something to be learned from the depression when ownership of United States real
estate was concentrated in the hands of American banks. Therefore, the
Commission's objective should be to fine-tune Chapter 11 to weed out the abusive
cases without precluding reorganization of the non-abusive cases.
Two concerns are voiced most frequently by those who contend that abuse is
rampant and must be stamped out(1707). First, the automatic stay enables the debtor to
prevent foreclosure for an extended period of time without filing a plan or making
postpetition payments. This gives the debtor substantial leverage over the secured
lender by imposing the principal costs of delay on that creditor. Second, SARE
debtors sometimes attempt to use the provisions of Chapter 11 to keep
overencumbered property without either paying the mortgage in full or obtaining the
assent of a majority of creditors. These concerns are heightened because, some
contend, SARE cases fulfill few of the recognized goals of Chapter 11. They
contend that reorganization is not generally necessary to preserve jobs and going-concern value in SARE cases. Whether the debtor keeps the real property or the
secured creditor takes it back, they believe that the property will be operated in the
same manner, creating the same jobs and economic activity. Opponents of this view
contend that lenders do not always operate properties after foreclosure. Anecdotal
evidence of foreclosing banks boarding-up buildings in Texas during the 1980's
supports this view. Jobs can be lost.
Several published articles and persons who appeared before the Working
Group defended availability of Chapter 11, as presently constituted, for SARE
cases(1708). These spokespersons contend, as noted above, that there is no greater
incidence of abuse in the SARE area than in other areas and that increasingly wise
and thoughtful case management by bankruptcy judges, U.S. Trustees and
Bankruptcy Administrators was bringing the problems under control without need
for significant statutory reform. These commentators repeatedly asserted that
whatever the problems with SARE cases might or might not be, the SARE debtor did
not deserve more restriction in how it could function in Chapter 11 than any other
debtor.
All individuals expressing views to the Commission shared the belief that in
recent years, the incidence of cases where tax-shelter-preservation motivations
predominated had declined significantly. Also, there seemed to be a consensus that
the courts, the U.S. Trustees and the Bankruptcy Administrators had gotten much
wiser about moving more swiftly against abusive single-asset realty cases.
Nevertheless, in spite of some indication of some favorable trends, problems
alleged to arise from SARE cases continue to demand the careful attention of judges
and makers of public policy. Congress recently addressed the concern that SARE
debtors enjoy the benefit of the automatic stay for too long. In 1994, Congress
enacted section 362(d)(3), which entitles secured creditors relief from stay, unless
within 90 days after the order for relief the SARE debtor: (1) files a confirmable
plan, (2) commences postpetition mortgage payments, or (3) obtains an extension of
the 90-day plan-or-payment deadline. The effect of section 362(d)(3) is limited,
however, by the fact that it does not apply to cases in which the secured debt exceeds
$4 million. During the 105th Congress, as noted below, the House Committee on the
Judiciary reported out H.R. 764 which would increase the $4 million limit to $15
million. Congress will determine whether $4 million, $15 million, or something in
between is an appropriate cap for these cases.
Court decisions have established limitations on when an SARE debtor may
keep overencumbered property without paying a mortgage debt in full. Whether an
SARE debtor can confirm a lien-stripping plan generally turns on whether an
impaired class has accepted the plan, and whether the plan satisfies the new-value
exception to the absolute priority rule. The Courts of Appeals have made it
increasingly difficult for the debtor to create an impaired accepting class, by
restricting the debtor's ability to divide unsecured claims into more than one class. (1709)
The drawback in this approach is that reliance on classification rules does not ensure
that reasonable lien-stripping plans are confirmed and that unreasonable lien-stripping plans are not confirmed.
The Commission's working group on small business, partnership and single-asset real estate, conducted several discussions regarding SARE cases, during which
it received comments from many attorneys, lenders, and judges. A consensus
emerged within the working group from those discussions that the incidence of abuse
in the past and danger of additional abuse in the future from SARE cases was very
significant and requires tightening up in the statute. The Commission rejected the
extreme view, advocated by some, that SARE debtors should be excluded from
Chapter 11 altogether. However, the Working Group's Recommendations provide
for additional steps be taken to reduce cost and delay, and for incorporation of clear,
objective standards regarding use of the so-called "new-value exception" in SARE
cases.
Set forth below are Alternative Proposals that should be considered by
Congress as a variation on the Single Asset Real Estate proposals made by The Small
Business Working Group. The proposal is a conservative approach in light of the lack
of empirical data in this important area. The Alternative Proposals make different
recommendations to reduce cost and delay by providing a streamlined definition of
SARE cases and leaving the development of the "new-value exception" to court
decisions.
The Alternative Proposals are designed to embrace the consensus of the
Working Group "that SARE debtors should not be excluded from chapter 11, but that
additional steps be taken to reduce cost and delay." The proposals do not use the
Working Group approach of employing objective standards into the single asset real
estate cases, either in the definition or in the confirmation standards. While clear
standards are generally to be applauded, they work well only when people generally
agree that they are appropriate, both as a matter of principle and as an empirical
matter. In SARE cases, there is no such consensus, which means that any
recommendation incorporating objective standards is bound to be controversial. A
controversial proposal will offer little guidance to Congress, setting up another round
of contentious hearings that to little to forward the debate in the absence of empirical
data.
The kind of rigid standard recommended by the Working Group for
incorporation into the new-value exception to the fair and equitable rule--requiring
a 20% cash equity infusion--may make sense in some cases, but may wreak havoc in
others, forcing businesses to close only because a technical financial rule, that
seemed sensible in the abstract, makes no sense in a specific case. Moreover,
tinkering with the fair and equitable rule in the absence of concrete data could have
detrimental spill-over effects in non-SARE cases as well as in countless out of court
workout agreements.
Similarly, the Working Group's definition for SARE cases would permit
sophisticated lenders to condition all significant real estate loans by requiring
borrowers to drop real estate collateral down into a single-purpose subsidiary which
would qualify for SARE treatment in the event of default. This would enable lenders
to opt into section 362(d)(3) even though in essence the loan is made to a viable
business, and, in some cases, it would prevent the operating company from
reorganizing.
RECOMMENDATIONS
2.6.1A Change the Present Statutory Definition of "Single Asset Real Estate" in
two ways.
First, the $4 million debt limit should be raised to $15 million in
the definition of "single asset real estate" debtor subject to section
362(d)(3).
Second, the definition of "single asset real estate" should be more
carefully worded to exclude cases in which the real property is
used by a debtor or related company in an active business.
The definition, as proposed, incorporating both concepts, would read as
follows:
undeveloped real property or other real property constituting a
single property or project, other than residential real property
with fewer than 4 residential units, on which is located a single
development or project which property or project generates
substantially all of the gross income of a debtor and on which no
substantial business is being conducted by a debtor, or by a
member of a commonly controlled group of companies of which
the debtor is a member, other than the business of operating the
real property and activities incidental thereto having aggregate,
noncontingent, liquidated secured debts in an amount no more
than $15,000,000.
2.6.1B Congress should fund a study to compare results in SARE cases with those in single asset real estate cases in which the secured debt exceeds $15 million
2.6.2A Amend Code Section 362(d)(3) in Three Particulars
a. Make clear that payments required by section 362(d)(3) may
be made from rents generated from the property.
b. Provide that the interest rate with respect to which payments
are calculated shall be the nondefault contract rate.
c. Amend the statute to provide that the payments must be
commenced or a plan filed on the later of 90 days after the
petition date or 30 days after the court determines the debtor to
be subject to section 362(d)(3).
2.6.3A An SARE debtor should be able to confirm a lien-stripping under the new- value exception to the absolute priority rule
Codification of the new-value exception should apply in all
Chapter 11 cases, including SARE cases. The Commission's
proposal to terminate plan exclusivity when the plan proponent
seeks to confirm a new-value plan under section 1129(b)(2)(B)(ii)
should also apply in SARE cases.
DISCUSSION
2.6.1A Change the Present Statutory Definition of "Single Asset Real Estate" in
two ways
First, the $4 million debt limit should be raised to $15 million in
the definition of "single asset real estate" debtor subject to section
362(d)(3).
Second, the definition of "single asset real estate" should be more
carefully worded to exclude cases in which the real property is
used by a debtor or related company in an active business.
The definition, as proposed, incorporating both concepts, would read as
follows:
undeveloped real property or other real property constituting a
single property or project, other than residential real property
with fewer than 4 residential units, on which is located a single
development or project which property or project generates
substantially all of the gross income of a debtor and on which no
substantial business is being conducted by a debtor, or by a
member of a commonly controlled group of companies of which
the debtor is a member, other than the business of operating the
real property and activities incidental thereto having aggregate,
noncontingent, liquidated secured debts in an amount no more
than $15,000,000.
2.6.1B Congress should fund a study to compare results in SARE cases with those in single asset real estate cases in which the secured debt exceeds $15 million
Comments. Under current law, "single asset real estate" is defined as:
real property constituting a single property or project, other
than residential real property with fewer than 4 residential
units, which generates substantially all of the gross income of
a debtor and on which no substantial business is being
conducted by a debtor other than the business of operating the
real property and activities incidental thereto having
aggregate, noncontingent, liquidated secured debts in an
amount no more than $4,000,000. (1710)
Four Million Dollar Cap Issues.
Section 362(d)(3) establishes a sound approach to small SARE cases where
non payment of taxes and neglect of the property is highly likely. The $4 million cap
should be raised to include other SARE cases in which the level of cash flow is likely
to lead to deferred maintenance and non-payment of property taxes. But the cap
should not be eliminated or raised to a level where projects that can be rehabilitated
will be liquidated in foreclosure sales and jobs will be lost. The recommendation of
the Working Group to repeal the $4 million cap is rejected, however, as too radical
in light of the dearth of empirical data. The only available experiences suggest that
most projects with large debt levels have ample cash flow to maintain tax and
maintenance payments. These large projects are not subject to the same policy
constraints or "abuses" as the smaller projects. Moreover, many of these projects
involve jobs that will be lost if the reorganization process is forced down a fast track.
Furthermore, large projects are more likely to have complex debt structures that
would preclude application of the fast track of section 362(d)(3). More resources are
devoted to developing cash flow models and appraisals than in the smaller cases.
The implications of rigid refinance rules and fast-track negotiations would have
other, unanticipated effects. For example, the possibility of claims trading to enhance
liquidity in large projects and to increase both the leverage and return for the
creditors would be all but eliminated. Rather than increase litigation in these cases
by forcing the debtor to file motions to extend the section 362(d)(3) period, the
proposal leaves large projects in the regular chapter 11 track where the debtor and
creditors can focus their efforts on plan negotiation.
To say that a line is difficult to draw is not to say that a line should not be
drawn. In order to enable further study, the proposal raises the cap to $15 million as
a measured first step. In fact, such a study should be made even if Congress decides
to retain the $4 million cap or raise it to an amount less than $15 million. Proposal
2.6.1 B asks Congress to gather data in SARE cases under $15 million and to compare
the results with single asset real estate cases over $15 million that will not be subject
to section 362(d)(3).After the data are analyzed, further refinements may be made.
Active-Business Issues. The Alternative proposed definition of the SARE
debtor is designed to include real estate investors, and to exclude debtors who use
real estate in an active business, such as a wholly owned subsidiary that holds a
building used as a factory by the parent, or a television broadcast tower held in a
separate entity owned by the FCC licensee, whether or not the parent or the
licensee is also a debtor in a bankruptcy case. Whether the debtor uses real
property in an active business should be viewed in terms of economic substance
rather than the form of ownership. Thus, where a debtor conducting an active
business holds title to the real property used in that business through a separate
entity, the entity holding the real property should not be considered an SARE
debtor. In other words, a basic idea embedded in the Alternative Proposals is that
SARE not include members of a consolidated group of debtors operating a
substantial non-realty business in the real estate.
It is necessary to define carefully the relationship the real estate debtor
must have to the operating debtor to come within the operating business exception
to the definition of SARE. The Commission has opted in favor of the undefined
term "group of commonly controlled entities of which the debtor is a member"
because the existing definition of "affiliate" in the Code would be too loose. The
definition of "affiliate" in Section 101 uses a 20% ownership threshold, which
might sweep out of the defined concept of SARE too many situations in which the
affiliated entity was not so closely related to the debtor that the relationship,
alone, should be a sufficient basis to exempt the debtor from the definition of
SARE. The Alternative Proposals embrace these concepts, but reject the Working
Group's requirement that substantially all members of the commonly controlled
group be Chapter 11 debtors.
The Alternative Proposals amend the definition of SARE to include real
estate investors, but to exclude debtors who use real estate in an active business,
such as a hotel or casino. Moreover, the definition is expanded to exclude groups
where one member owns the real estate and another operates a business on the
real estate. There is no requirement that the member operating the business be a
title 11 debtor as long as the owner or lessee of the property is a chapter 11 debtor.
The concept of a commonly controlled group is broader than the definition of
"affiliate" in section 101(2) of the Bankruptcy Code.
By focusing on the commonly controlled group, the Alternative Proposals
remove incentives for lenders to require real estate borrowers to form single
purpose subsidiaries into which real property must be dropped down as a
condition to financing. By contrast, the Working Group's proposals probably
would encourage single purpose subsidiary financing by excluding such a
subsidiary from the definition of SARE only if substantially all other members of
the commonly controlled group were chapter 11 debtors. Financially sound
commonly controlled companies operating on the real property would not file
chapter 11 petitions. Only the real estate subsidiary would be a debtor. As a
result, under the Working Group proposals, the real estate subsidiary would be on
the SARE fast track even though a viable business was being operated on the
property. If the lender forecloses in the SARE case, the loss of the real estate
could threaten the viability of the remaining business. This is a huge realignment
of power toward the lender in single asset real estate cases that has not been
justified either by principle or empirical necessity.
The following examples illustrate what the Alternative Proposals have in
mind. The result in Example 2 differs from that proposed by the Working Group.
1. Debtor is a limited liability company owned by a group of lawyers,
doctors, and dentists which owns an office building held for rental. Debtor is an
SARE. This would be true even if the debtor provides its own cleaning,
maintenance, snow removal, and landscape services, because these are activities
incidental to the operation of the property.
2. Debtor is a wholly owned subsidiary of a Fortune 500
manufacturing company which owns a manufacturing facility operated by the
parent. The debtor is a Chapter 11 debtor. The debtor is not an SARE whether or
not the parent is also a Chapter 11 debtor. This is because the debtor is a member
of a commonly controlled group which conducts a substantial business on the
debtor's property other than a business incidental to the operation of the property.
3. Debtor is a limited partnership owned by a group of business
executives which owns a strip shopping center with twenty-three stores, none of
which stores is operated by the debtor. Debtor is an SARE.
4. Debtor is the same limited partnership owned by the same group of
business executives which owns the same strip shopping center with twenty-three
stores. However, in this example, the smallest of the store spaces is operated as a
frozen-yogurt stand by the debtor. Debtor is an SARE, even though it operates a
business other than an activity incidental to real estate because the frozen-yogurt
stand is not "substantial."
5. Debtor is a corporation owning a regional shopping mall. Debtor is
majority owned by an enterprise which also operates a nationwide chain of 147
ladies-apparel stores, one of which is on the debtor's premises. The debtor is not
an SARE, because the business being operated by the debtor's group is
"substantial."
Elimination of Other Ambiguities. The current definition contains several
ambiguities. The phrase "which generates substantially all of the gross income of
a debtor" has led at least one court to question whether the definition includes raw
land. (1711)
It is the intention of this Proposal that the SARE definition includes raw
land. It is also unclear whether under the $4 million debt limit refers to the face
amount of the secured claim or to the lesser of the face amount or the value of the
collateral. (1712) Congress should clarify that in raising the debt limit, it is the face
amount of the debt and not the value of the property that is controlling. This
should eliminate or reduce litigation.
2.6.2 A Amend Code Section 362(d)(3) in Three Particulars
a. Make clear that payments required by section 362(d)(3)
may be made from rents generated from the property.
b. Provide that the interest rate with respect to which
payments are calculated shall be the nondefault contract rate.
c. Amend the statute to provide that the payments must be
commenced or a plan filed on the later of 90 days after the
petition date or 30 days after the court determines the debtor
to be subject to section 362(d)(3).
The Alternative Proposals adopt the suggestions of the Working Group in
proposal 2.6.2 . It adopts the Commission's suggestion that three additional minor
amendments be made to the language of section 362(d)(3). First, the statute
should make clear that the payments required may be made from rents generated
from the property. Second, the statute should be amended to provide that the
interest rate from which the payments are calculated be the nondefault contract
rate, rather than the "current fair market rate" as now specified. This change will
provide greater certainty and reduce litigation. Third, the statute should be
amended to provide that the payments must be commenced or a plan filed on the
later of 90 days after the petition date or 30 days after the court determines that
the debtor is subject to section 362(d)(3). If a debtor does not timely comply with
section 362(d)(3) based on its contention that it is not an SARE debtor, and it is
later determined that section 362(d)(3) does apply, relief from stay must be
granted even if the debtor is ready to make payments or file a plan promptly. This
trap would be eliminated by the suggested amendment.
Congress adopted section 362(d)(3) for the express purpose of reducing
delay and potential abuse in SARE cases. (1713) Section 362(d)(3) requires the
SARE debtor within 90 days after the order for relief to: (1) file a confirmable
plan; (2) commence postpetition mortgage payments; or (3) obtain an extension of
the 90-day plan-or-payment deadline. If the SARE debtor fails to perform any of
these three options, secured creditors are entitled to relief from the automatic
stay. (1714)
Subject to the provisions of the Commission Small Business Proposal,
the Commission believes that section 362(d)(3) establishes a sound approach to
SARE cases. (1715)
Rationale for the Ninety-Day Plan Deadline. Small SARE cases typically
fit the following fact pattern. The debtor's investment is highly leveraged, i.e.,
mortgage debt represents a high percentage of the value of the real property.
Rental income has declined, so that the debtor is no longer able to pay all
operating expenses, taxes, and mortgage debt from the rental income. The decline
in rental income typically results from: (1) a general decline in the relevant rental
market; (2) overbuilding; (3) vacancy caused by loss of a major tenant; or (4)
vacancy and decline in rental value caused by mismanagement, poor maintenance,
or both.
In this typical SARE case, ninety days is generally sufficient time for the
debtor to file a feasible plan of reorganization. First, the plan in an SARE case
involves financial restructuring, not operational restructuring of the business. The
debtor whose case usually involves business restructuring may need to open or
close a branch or division. The debtor may then need to operate the restructured
business for some time, to see how profitable it will be, before the debtor can
propose a plan. In contrast, the financial restructuring involved in SARE cases is
generally accomplished by reducing creditors' claims and/or by infusing new
capital to cover the difference between rental income and the amount needed to
pay expenses and debt service. In addition, the typical SARE debtor has only one
significant creditor, the first mortgage holder. Trade debt is generally de minimis,
and paid in full under the plan. Thus, the typical SARE case is in substance a
two-party dispute, the primary focus of which is to restructure the terms of the
debtor's secured debt. In this respect, the typical SARE case is very different
from the typical manufacturing case, in which there may be a significant number
of jobs at stake, and which may involve a significant amount of trade debt,
unsecured bond debt, and numerous secured creditors, each secured by different
collateral.
By contrast, in larger real estate cases where the mortgage debt exceeds
$15 million, debtors are better equipped to keep current on tax and maintenance
payments. At the same time, the debt structure in large cases is likely to be more
complex. For example, the debtor and a third party lender might be parties to an
interest rate swap, a device not likely to be used in smaller cases. Moreover,
based on the dollar amounts at stake, all parties will require more time to perform
a financial analysis of the project than in smaller cases. The $15 million cap will
give Congress the opportunity to gather data to determine whether the cap should
be adjusted up or down or eliminated.
2.6.3 A An SARE debtor should be able to confirm a lien-stripping under the new- value exception to the absolute priority rule
Codification of the new-value exception should apply in all
Chapter 11 cases, including SARE cases. The Commission's
proposal to terminate plan exclusivity when the plan proponent
seeks to confirm a new-value plan under section 1129(b)(2)(B)(ii)
should also apply in SARE cases.
Under current law, some courts allow prepetition equity holders to retain
property under a plan of reorganization, over the objection of creditors and even
though creditors are not paid in full, by infusing "new value" into the reorganized
business. This concept is known as the new value exception to the absolute priority
rule. (1716)
The new-value exception is invoked most frequently in SARE cases in
which the mortgage debt exceeds the value of the real property. The new value
exception is used in such cases to enable the debtor to keep the property without
paying the mortgage debt in full.
The principal problem with the new-value exception is that its elements are
not precisely defined. Under current case law, the new-value exception contains five
requirements. The new-value contribution must be: (1) new; (2) in money or
money's worth; (3) substantial; (4) necessary; and (5) reasonably equivalent to the
interest retained. (1717) While court decisions provide reasonably precise definitions for
the "new" and "money or money's worth" requirements, case law is only beginning
to provide clear guidelines for the other three requirements. (1718)
Cases addressing the
"substantial" requirement are split over whether substantiality is to be determined
on a common sense basis or measured in absolute terms or relative to unsecured
claims. Cases addressing the "necessary" requirement are split over whether the
contribution must be necessary to operations or whether it may be used to pay
preconfirmation creditors. It is also unsettled whether old equity must be the sole
available source of new capital. (1719)
Regarding the "reasonably equivalent"
requirement, it is unclear whether indirect benefits to equity holders, such as
expected future salary and deferral of taxes, must be taken into account. Courts also
differ whether the equity interest must be put up for auction. (1720)
A recent survey
concludes that "the courts have offered few insights regarding the methodology of
satisfying this requirement."(1721)
The Commission has adopted the recommendations of the Chapter 11
Working Group to codify the new-value exception or principle but to terminate plan
exclusivity when the debtor seeks to confirm a new-value plan under section
1129(b)(2)(B)(ii) of the Bankruptcy Code. At this time, the Alternative Proposals
embrace these recommendations in the context of SARE cases. The Alternative
Proposals urge Congress to study the new-value exception to see if codification of
all or part of the principle is appropriate. Currently, in other chapter 11 cases, the
Commission recommends the conservative approach to allow the courts to further
develop the new-value principle. Applications of the principle in different cases
should provide Congress with rich data from which to determine whether
codification of all or part of the elements of the exception is necessary or desirable.
The consensus of the Working Group to codify a loan-to-value test to
measure "substantiality" is not included in the Alternative Proposals. The loan-to-value test would preclude out-of-court workout agreements in which lenders often
take less than an 80% restructured first mortgage. Moreover, the loan-to-value test
would discourage lenders from taking fractional equity positions in workouts, as they
often currently do, because they could hold out for 20% cash or ownership of all of
the equity in a chapter 11 plan. As a practical matter, the Working Group proposals
would make most SARE cases impossible to confirm. Since the Commission has
resolved to give SARE debtors access to chapter 11, it is only fitting that they have
some reasonable opportunity to negotiate a consensual plan. The debtor's threat to
confirm a non-consensual plan, even though tempered by the loss of exclusivity,
gives the debtor reasonable leverage to reach a consensually negotiated plan.
Confirmation of consensual plans will reduce litigation.
The Alternative Proposals reject the notion that in all SARE new-value cases
the property should instead be put up to auction for the lender to credit bid its note.
When the property is worth less than the debt, the lender's credit bid does not
accurately determine the value of the property; it deliberately deviates from the
market value of the property and permits a bankruptcy-endorsed foreclosure. The
typical SARE case has few assets other than the real property. Therefore, the lender
can afford to ignore its unsecured deficiency claim and can bid its entire debt to get
the property. Indeed, if the debt is nonrecourse, the lender would have no other
option in an auction. The Alternative Proposals rely instead on the market place to
determine the value of the property. The competing plan process can be expected to
produce a superior result by encouraging consensual workouts and providing
opportunities to save businesses, and hence save jobs, for operating companies. The
competing plan offers conservative changes to the current Bankruptcy Code and does
not run the risk of sharply unbalancing established business relationships.
CONCLUSION
The Alternative Proposals offer a balanced, measured approach to single asset
real estate reorganization cases. Congress should give serious consideration to the
more conservative amendments embraced in the Alternative Proposals. After
empirical data are gathered and evaluated, perhaps the time will be ripe to adopt the
sweeping suggestions made by the Working Group. On the other hand, perhaps the
data will yield conclusions that show the Working Group's proposals to be
undesirable, and the Alternative Proposals, or some variations, to be closer to the
norms that should be adopted in single asset real estate cases.
Annex A
Example of Operation of Single-Asset Real Estate
Proposal As It Applies to New Value Plans
The Working Group's single-asset proposal, in so far as it applies to new-value
plans, is designed to implement the requirements of Case v. Los Angeles Lumber
Products, Inc., 308 U.S. 106 (1939) (new value must meet certain tests, including
that it be "substantial") by requiring that the terms of debt issued to secured creditors
in the plan meet two minimum requirements with two statutory "floors", namely
(1) that the post-confirmation loan-to-value ratio must be no more than 80% and (2)
that the "cram-down" requirements of Section 1129(b) be met with respect to classes
which do not accept the plan.
As explained more fully below, the proposal is designed to work whether or not
the secured creditor makes the election provided for in Section 1111(b)(2) of the
Bankruptcy Code. However, the proposal does not apply when the creditor makes
such election. The example of the operation of the plan when the election is made
is set forth under Heading II below solely to compare and contrast the situation where
it is made with the situation where it is not. A particular purpose of this comparison
is to reveal the Working Group's analysis about which entity captures future
appreciation in the collateral, depending on whether the election is made.
The operation of the proposal in a simplified, hypothetical real-estate situation,
where no Section 1111(b) election is made, is as follows:
I. Creditor Does Not Make Section 1111(b)(2) Election;
Proposal Applies and Would Change Present Law
A. Pre-petition Balance Sheet
Debtor, a single-asset real estate entity as defined by the Working Group's
proposal, owns Blackacre, which, immediately prior to the filing of its voluntary
petition, is on its books for $12,000,000. The property has depreciated in value.
Debtor contends the current fair-market value is $6,000,000. The mortgage holder
contends the value is $8,000,000. Inability to resolve the issue defeats a pre-petition
workout effort. Debtor thereupon files for chapter 11. Debtor's balance sheet,
immediately prior to the filing, is as follows. The bookkeeping entries for each
account in this balance sheet and all subsequent balance sheets showing the
implementation of the plan appear on Exhibit 1. Each number on each balance sheet
(with one or two exceptions) ties to a line item in one of the accounts. The balance
sheet entries and the line items can be connected to Exhibit 1 (or 2, as the case may
be) by using the number appearing under the symbol "#".
Assets |
Liabilities and Equity |
|
Category |
Amount |
# |
Category |
Amount |
# |
|
Cash |
$ 100,000 |
1 |
Payables |
$ 100,000 |
20 |
Realty |
12,000,000 |
7 |
Mortgage |
9,000,000 |
24 |
Tractor |
65,000 |
10 |
Tractor Loan |
40,788 |
34 |
|
|
-- |
Total Liabilities |
9,140,788 |
14 |
|
|
-- |
Equity |
3,024,212 |
16 |
Total Assets |
$ 12,165,000 |
12 |
Total Liabilities and equity |
$ 12,165,000 |
18 |
Note that, based on pre-petition book value, the financial structure is
conservative: the loan-to-value ratio is 75%.
B. Interim Balance Sheet After Marking Realty to Market
Expert testimony and findings of fact by the court in the Chapter 11 process
establish conclusively that the realty asset has a current fair value of $6,000,000.
Under Bankruptcy Code Section 506, this (assuming no Section 1111(b) election)
makes the balance sheet look like this (on an interim basis):
Assets |
Liabilities and Equity |
|
Category |
Amount |
# |
Category |
Amount |
# |
|
Cash |
$ 100,000 |
1 |
Payables |
$ 100,000 |
20 |
Realty |
6,000,000 |
9 |
Mortgage |
9,000,000 |
24 |
Tractor |
65,000 |
10 |
Tractor Loan |
40,788 |
34 |
|
|
-- |
Total Liabilities |
9,140,788 |
14 |
|
|
|
Equity |
(2,975,588) |
16 |
Total Assets |
$ 6,165,000 |
12 |
Total Liabilities and equity |
$ 6,165,000 |
18 |
C. Debtor Confirms Chapter 11 Plan with High Level of New Value
Debtor then develops the following chapter 11 plan. In summary, the plan
distributes a total of $1,500,000 in cash plus a new secured note with a principal
amount of $4,500,000. The plan cancels $3,100,000 of debt. (The plan contains
alternative treatment in case the mortgage holder makes the Section 1111(b)(2)
election.) The following chart summarizes the plan treatment when no
Section 1111(b)(2) election is made. This plan treatment is explained more fully in
the ensuing text (the alternative treatment for the Section 1111(b)(2) election being
described under Heading II below):
Claimant |
Total Claim |
Treatment
|
|
|
Percentage |
Cash |
Notes |
Total Distribution |
|
Payables |
$ 100,000 |
-- |
-- |
-- |
-- |
Deficiency |
3,000,000 |
-- |
-- |
-- |
-- |
Tractor loan |
40,788 |
100% |
-- |
$ 40,788 |
$ 40,788 |
Secured Claim |
$ 6,000,000 |
100% |
$ 1,500,000 |
$ 4,500,000 |
$ 6,000,000 |
1. Unsecured creditors: There is no value for this class, and they receive
nothing in the plan. Members of the class include both the creditors to whom the
payables are owed and the unsecured deficiency claim of the secured lender.
2. Secured claims: The mortgage lender receives a new note with a
principal amount of $4,500,000 and indisputable local-market levels for the interest
rate (say, 8.5%) and maturity (say, 10 years), with appropriate amortization this new
note represents a 75% loan-to-value ratio on the restated, lower, marked-to-market
value of the realty) plus cash of $1,500,000. (The new note amount was designed to
be more conservative than the required 80% to give a "cushion" against adverse fact
findings at the confirmation hearing.) This means that, according to the plan
proponent, the secured creditor will receive on account of the $6 million secured
claim, property with a value equal to the $6 million value of the collateral. This debt
paper meets both (a) the requirements of the Working Group proposal, in that it has
rate, maturity and loan-to-value characteristics which meet a current market test and
(b) the cramdown standards of Section 1129 because it pays the secured creditor at
least the amount of the allowed secured claim (i.e., $6,000,000) in cash ($1,500,000)
and market-rate, short maturity notes ($4,500,000) which have a value (i.e., fair
market value of the $4.5 million note) equal to the remaining value of the
mortgagee's interest in the collateral, after giving effect to the up-front payment.
The high level of cash new value is required because the Working Group's
proposal that the new loan meet local-market requirements, i.e., on a building worth
$6,000,000, the loan cannot exceed 80% of the value. The loan-to-value ratio used in this numerical equation is a more conservative one than which is proposed by the Working Group. This calls for a $1,500,000 cash payment to the secured creditor.
3. Tractor Loan. The prepetition tractor loan amount due is unchanged.
The holder of this loan accepts a five-year extension of maturity and step up in the
interest rate of one per cent over the prepetition rate. The holder of this loan is the
impaired class which accepts the plan under Code Section 1129(a)(10).
4. Infuse New Value. Inasmuch as cash of $1,500,000 is required for
distribution under the plan, the proponent determines to infuse $2,000,000. The
amount of cash exceeds the paydown requirements, because capital and cash will be
needed to attract new tenants and finance tenant improvements. Also, the large
amount of cash infused helps the debtor meet the feasibility requirements for
confirmation of a chapter 11 plan.
D. Debtor Confirms Plan
Here is what the balance sheet of the reorganized debtor looks like, pro forma for
the confirmation of the plan:
Assets |
Liabilities and Equity |
|
Category |
Amount |
# |
Category |
Amount |
# |
|
Cash |
$ 600,000 |
6 |
Mortgage |
4,500,000 |
27 |
Realty |
6,000,000 |
9 |
Tractor Loan |
40,788 |
34 |
Tractor |
65,000 |
11 |
Total Liabilities |
4,540,788 |
15 |
|
|
|
Equity |
2,124,212 |
17 |
Total Assets |
$ 6,665,000 |
13 |
Total Liabilities and equity |
$ 6,665,000 |
19 |
E. Subsequent Sale
Two years after confirmation, the market improves and the debtor sells the
property for $8,000,000. The use of proceeds is:
To Secured Creditor: |
|
$ 4,500,000 |
To Equity: |
|
$ 3,500,000 |
II. Secured Creditor Makes Section 1111(b) Election; No Change From Existing Law; Presented Solely for Comparison As To Difference in Capture of Future Appreciation
This scenario initially involves the same two balance sheets as those shown under
A and B in Heading I above.
However, the treatment of the creditors changes when the secured creditor makes
valid, timely Section 1111(b)(2) election. Under the proposal, no 80% ceiling on the
loan-to-value ratio is required when the election is made. This example is presented
for purposes of contrasting the capture of future appreciation by the equity when the
election is not made with its capture by the debt when the election is made. The
treatment provided for in the plan for this situation is that the electing mortgage
holder must receive a payment stream with a value at least equal to the allowed
secured claim (in this case $6,000,000). This is met by delivery of a non-interest
bearing note for $9,144,500, payable in ten equal installments of $914,450. Using
an 8.5% discount rate, this note has a present value equal to the value of the
collateral, namely, $6,000,000.
Obviously, this loan does not meet the standard of 80% loan-to-value as
described under Heading I above. This is because that standard does not apply when
the secured creditor exercises its right to make the Section 1111(b)(2) election. The
reasoning is that when the creditor opts for the protections of Section 1111(b), as
provided to creditors in 1978, there is no need for the new protection proposed by the
Working Group.
The following chart summarizes the treatment:
|
|
|
|
Notes
|
|
Claimant |
Total Claim |
Treatment |
Cash |
At Face |
Present Value at 8.5% Discount Rate |
Total Distribution at Face |
|
Payables |
$ 100,000 |
-- |
-- |
-- |
-- |
-- |
Deficiency |
-- |
-- |
-- |
-- |
-- |
-- |
Tractor Loan |
40,788 |
100% |
-- |
$ 40,788 |
$ 40,788 |
$ 40,788 |
Secured Claim |
$ 9,000,000 |
100% |
-- |
$9,144,500 |
$ 6,000,000 |
$ 9,144,500 |
Under Section 1129(b), the secured creditor being crammed down must receive
at least (i) deferred payments equal to the allowed amount of the secured claim (in
this case, due to Section 1111(b)(2), $9,000,000) and (ii) with a value as at the
effective date of the plan of at least as much as the value of the collateral (in this
case, $6,000,000). These requirements are met, as shown above.
Here is the debtor's balance sheet, pro forma for the confirmation of the plan:
Assets |
Liabilities and Equity |
|
Category |
Amount |
# |
Category |
At Face |
# |
At Present Value |
# |
|
Cash |
$ 2,100,000 |
6 |
Mortgage Debt |
$ 9,144,500 |
24 |
$ 6,000,000 |
|
Realty |
6,000,000 |
9 |
Tractor Loan |
40,788 |
31 |
40,788 |
31 |
Tractor |
65,000 |
-- |
Total Liabilities |
9,185,288 |
-- |
6,040,788 |
-- |
|
|
|
Equity |
(1,020,288) |
15 |
2,124,212 |
37 |
Total Assets |
$ 8,165,000 |
|
Total Liabilities and equity |
$ 8,165,000 |
|
$ 8,165,000 |
-- |
In the above example, the $2 million cash contriubtion is still shown, even though it was not legally required, since the secured creditor made the election. This was done primarily for simplicity of computation and comparison of the two examples. In the "real world," this contribution would not be made, and both sides of the balance sheet would deplete by $2 million. Obviously, if the plan debt is shown at face, debtor is technically insolvent, in the
balance sheet sense. Presumably, this is irrelevant to feasibility, inasmuch as the
feasibility showing at the confirmation hearing presumably showed enough regular
cash flow to assure that the liabilities of the enterprise will be met on a current basis.
Future earnings will work the debtor over time out of the insolvency "hole" into a
positive net worth. Assuming that the accounting rules (using concepts like those of
"fresh start" accounting) would permit the debt to be shown at its present value
amount, the debtor could also report the debt at its present value at the confirmation
date and thus avoid having to address the credit markets with a balance sheet
showing a negative net worth. (The Working Group has not consulted accounting
professional to determine whether this mode of presenting financial condition would
be permitted under present accounting rules.) If the debt could be shown at present
value, the debtor would then be required to charge earnings to accrete the carrying
amount upward every year by $314,500, an annual amount which will permit the debt
amount to grow over the life of the debt to the full principal amount. These
accretions would be offset by the annual payments so that, at year ten, the whole
liability would be amortized to zero.
Lastly, on the hypothetical of the subsequent sale of the property for $8,000,000
after two years, the secured creditor would have received one payment of $914,450,
reducing the outstanding debt (at face) during year two to $8,230,050. If there were
a closing, then, the use of proceeds would be as follows:
To Secured Creditor: |
|
$ 8,000,000 |
To Equity: |
|
$ 0 |
In other words, because of the making of the Section 1111(b) election, all
proceeds would go to the lender. The equity would get nothing. For this reason, the
equity would probably not sell the property at this point, waiting until later when the
debt had been amortized to an amount less than the net proceeds of the selling price.
EXHIBIT 1 TO ANNEX A (Page 1) BOOKKEEPING ENTRIES
NO 1111(b) ELECTION
Transaction |
Amount |
D/C |
# |
|
Transaction |
Amount |
D/C |
# |
Account: Cash |
|
|
|
|
Account: Payables |
|
|
Opening balance |
100,000 |
dr |
1 |
|
Opening balance |
100,000 |
cr |
20 |
Infuse new value |
2,000,000 |
dr |
2 |
|
Pay at consumm. |
-- |
dr |
21 |
Pay sec. clm at conf |
(1,500,000) |
cr |
3 |
|
Cancel at discharge |
(100,000) |
dr |
22 |
Pay uns df at conf |
-- |
cr |
4 |
|
Closing balance |
-- |
cr |
23 |
Pay uns clm at conf |
-- |
cr |
5 |
|
|
|
|
|
Closing balance |
600,000 |
dr |
6 |
|
|
|
|
|
|
Account: Real Esatate |
|
|
|
Account: Mortgage Debt |
|
Opening balance |
12,000,000 |
dr |
7 |
|
Opening balance |
9,000,000 |
cr |
24 |
Write asset to mkt |
(6,000,000) |
cr |
8 |
|
Create unsec. defic. |
(3,000,000) |
dr |
25 |
Closing balance |
6,000,000 |
dr |
9 |
|
Pay cash at conf. |
(1,500,000) |
dr |
26 |
|
|
|
|
|
Closing balance |
4,500,000 |
cr |
27 |
|
Account: Tractor |
|
|
|
Account: Unsecured Portion of Mortgage |
|
Opening balance |
65,000 |
dr |
10 |
|
Opening balance |
3,000,000 |
cr |
28 |
Closing balance |
65,000 |
dr |
11 |
|
Pay at consumm. |
-- |
dr |
29 |
|
|
|
|
|
Cancel at disch. |
(3,000,000) |
dr |
30 |
Opening total assets |
12,165,000 |
dr |
12 |
|
Closing balance |
-- |
cr |
31 |
Closing total assets |
6,665,000 |
dr |
13 |
|
|
|
|
|
Opening total liabs. |
9,140,788 |
cr |
14 |
|
Account: Tractor Loan |
Closing total liabs. |
4,540,788 |
cr |
15 |
|
Opening balance |
39,000 |
cr |
32 |
|
|
|
|
|
Perpet. acc. int. |
1,788 |
cr |
33 |
Opening equity |
3,024,212 |
cr |
16 |
|
Total |
40,788 |
cr |
34 |
Closing equity |
2,124,212 |
cr |
17 |
|
|
|
|
|
Opening liab. plus equity |
12,165,000 |
cr |
18 |
|
Account: Equity |
Closing liab plus equity |
6,665,000 |
cr |
19 |
|
Opening balance |
3,024,212 |
cr |
35 |
|
|
|
|
|
Write down realty |
(6,000,000) |
dr |
36 |
|
|
|
|
|
Infuse new value |
2,000,000 |
cr |
37 |
|
|
|
|
|
Cancel p'ables at consumm. |
100,000 |
cr |
38 |
|
|
|
|
|
Cancel unsec. portion |
3,000,000 |
cr |
39 |
|
|
|
|
|
Closing balance |
2,124,212 |
cr |
40 |
EXHIBIT 1 TO ANNEX A (Page 2) BOOKKEEPING ENTRIES
Assets |
Liabilities and Equity |
|
Category |
Amount |
# |
Category |
Amount |
# |
|
Cash |
$ 100,000 |
1 |
Payables |
$ 100,000 |
20 |
Realty |
12,000,000 |
7 |
Mortgage |
9,000,000 |
24 |
Tractor |
65,000 |
10 |
Tractor Loan |
40,788 |
34 |
|
|
-- |
Total Liabilities |
9,140,788 |
14 |
|
|
-- |
Equity |
3,024,212 |
16 |
Total Assets |
$ 12,165,000 |
12 |
Total lia. & eq. |
$ 12,165,000 |
18 |
Assets |
Liabilities and Equity |
|
Category |
Amount |
# |
Category |
Amount |
# |
|
Cash |
$100,000 |
1 |
Payables |
$100,000 |
20 |
Realty |
6,000,000 |
9 |
Mortgage |
9,000,000 |
24 |
Tractor |
65,000 |
10 |
Tractor Loan |
40,788 |
34 |
|
|
-- |
Total Liabilities |
9,140,788 |
14 |
|
|
|
Equity |
(2,975,788) |
-- |
Total Assets |
$ 6,165,000 |
-- |
Total lia. & eq. |
$ 6,165,000 |
|
Claimant |
Total Claim |
Treatment |
Cash |
Notes |
Total Dist. |
|
Payables |
-- |
0% |
-- |
-- |
-- |
Deficiency |
-- |
0% |
-- |
-- |
-- |
Tractor Loan |
40,788 |
100% |
-- |
40,788 |
40,788 |
Secured Claim |
6,000,000 |
100% |
1,500,000 |
4,500,000 |
6,000,000 |
Assets |
Liabilities and Equity |
|
Category |
Amount |
# |
Category |
Amount |
# |
|
Cash |
$600,000 |
6 |
Mortgage |
$4,500,000 |
27 |
Realty |
6,000,000 |
9 |
Tractor Loan |
40,788 |
34 |
Tractor |
65,000 |
11 |
Total Liabilities |
4,540,788 |
15 |
|
|
|
Equity |
2,124,212 |
17 |
Total Assets |
$ 6,665,000 |
13 |
Total lia. & eq. |
$ 6,665,000 |
19 |
EXHIBIT 2 TO ANNEX A (Page 1) BOOKKEEPING ENTRIES
NO 1111(b) ELECTION MADE BY CREDITOR
Transaction |
Amount |
D/C |
# |
|
Transaction |
Amount |
D/C |
# |
Account: Cash |
|
|
|
|
Account: Payables |
|
|
Opening balance |
100,000 |
dr |
1 |
|
Opening balance |
100,000 |
cr |
16 |
Infuse new value |
2,000,000 |
dr |
2 |
|
Pay 0 at consumm. |
-- |
dr |
17 |
Pay sec. clm at conf |
-- |
cr |
3 |
|
Cancel 100% dis |
(100,000) |
dr |
18 |
Pay uns df at conf |
-- |
cr |
4 |
|
Closing balance |
-- |
cr |
19 |
Pay uns clm at conf |
|
cr |
5 |
|
|
|
|
|
Closing balance |
2,100,000 |
dr |
6 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Account: Real Estate |
|
Account: Mortgage Debt (face) |
Opening balance |
12,000,000 |
dr |
7 |
|
Opening balance |
9,000,000 |
cr |
20 |
Write asset to mkt |
(6,000,000) |
cr |
8 |
|
Add Increment |
144,500 |
dr |
21 |
Closing balance |
6,000,000 |
dr |
9 |
|
Secured claim |
9,144,500 |
cr |
22 |
|
|
|
|
|
Pay cash at conf. |
-- |
dr |
23 |
|
|
|
|
|
Closing balance (face) |
9,144,500 |
cr |
24 |
|
|
|
|
|
|
|
|
|
|
|
Account: Unsecured Portion of Mortgage |
|
|
|
|
|
Opening balance |
-- |
cr |
25 |
|
|
|
|
|
Pay at conf. |
-- |
dr |
26 |
|
|
|
|
|
Cancel at conf. |
-- |
dr |
27 |
|
|
|
|
|
Closing balance |
-- |
cr |
28 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Account: Tractor Loan |
|
|
|
|
|
Opening balance |
39,000 |
cr |
29 |
|
|
|
|
|
Prepet. acc. int. |
1,788 |
cr |
30 |
|
|
|
|
|
Total |
40,788 |
cr |
31 |
|
|
|
|
|
|
|
|
|
Account: Equity (At Face) |
|
|
|
Account: Equity (At Present Value) |
Opening balance |
3,024,212 |
cr |
10 |
|
Opening balance |
3,024,212 |
cr |
32 |
Write down realty |
6,000,000 |
dr |
11 |
|
Write down realt |
6,000,000 |
dr |
33 |
Infuse new value |
2,000,000 |
cr |
12 |
|
Infuse new value |
2,000,000 |
cr |
34 |
Cancel p'ables at consumm. |
100,000 |
cr |
13 |
|
Cancel p'ables at consumm. |
100,000 |
cr |
35 |
Add $144,500 debt |
144,500 |
dr |
14 |
|
Cancel $3 million |
3,000,000 |
cr |
36 |
Closing balance |
(1,044,500) |
cr |
15 |
|
Closing balance |
2,124,212 |
cr |
37 |
EXHIBIT 2 TO ANNEX A (Page 2) BOOKKEEPING ENTRIES
NO 1111(b) ELECTION MADE BY CREDITOR
|
|
|
|
Ten-Year Note
|
|
Claimant |
Total Claim |
Treatment |
Cash |
At Face |
At Present Value 8.5% Disc. Rate |
Total Dist. (Face) |
|
Payables |
100,000 |
0% |
-- |
-- |
|
-- |
Deficiency |
-- |
-- |
-- |
|
|
-- |
Tractor loan |
40,788 |
100% |
|
40,788 |
40,788 |
40,788 |
Secured Claim |
9,000,000 |
100% |
-- |
9,144,500 |
6,000,000 |
9,144,500 |
Assets |
Liabilities and Equity |
|
Category |
Amount |
# |
Category |
Face Amount |
# |
PV Amount |
# |
|
Cash |
2,100,000 |
6 |
Mortgage debt |
9,144,500 |
24 |
6,000,000 |
|
Tractor |
65,000 |
|
Tractor loan |
40,788 |
31 |
40,788 |
31 |
Realty |
6,000,000 |
9 |
Equity |
(1,020,288) |
15 |
2,124,212 |
37 |
Total assets |
8,165,000 |
|
Tot. liab. & equity |
8,165,000 |
|
8,165,000 |
|
ANNEX B
TO: Small Business Working Group Bankruptcy Commission
FROM: Dain C. Donelson and Judge Robert D. Martin
DATE: September 9, 1997
RE: Proposed New Value Exception - Single Asset Real Estate Entities Alternative Proposal/Additional Analysis
I. Introduction
This follow-up to the memorandum of September 5, 1997 analyzes the proposed modification to the new value exception ("NVE") as it applies to single asset real estate ("SARE") entities. Putting aside questions of whether the NVE can exist under/with the absolute priority rule and whether § 362 and the rest of the Code already provide a sufficient structure for this type of case, this memo addresses an alternative to the proposed 20% rule. In so doing, it addresses concerns about the 20% rule as articulated in the previous memorandum, discusses how this proposal deals with these issues, and attempts to address drawbacks to this new proposal.
In order to assess what system is appropriate for the NVE, it is helpful to examine what is actually happening in a NVE situation. To utilize the NVE, the estate must be insolvent or become insolvent during the bankruptcy. Otherwise, all creditors could be paid in full and the absolute priority rule would not be an issue. However, creditors in a NVE case are not paid in full. Therefore, applying the absolute priority rule, the debtor has no equity and can retain nothing on account of the prior equity interest. The debtor's only rights are those in the Code.
The question therefore becomes: What is happening in the NVE plan? It seems that the equityholders are "purchasing" an interest in a reorganized entity which essentially consists of a single piece of real estate. This is reasonable under the traditional elements of the NVE as it requires that any interest received must be reasonably equivalent to the equityholders' contribution, and that the contribution must be both new and in money or moneys' worth.
In a NVE SARE case, therefore, it seems the debtor is actually re-purchasing the property it formerly held. The key point is that the old equity position is valueless. Therefore, any attempt to take an interest in the post-reorganization property by the former equityholders is quite similar to what occurs in a sale of property outside the ordinary course of business under § 363(b). Any sale of property under § 363(b) is subject to § 363(k), which provides that the secured creditor may bid on the property. Courts have held that this requires the allowance of credit bids.
While this analogy may seem simplistic, the key points are difficult to dispute. First, there is no equity in the property. If there were, the NVE could not be utilized. Second, the debtor is contributing money or money's worth. Third, the debtor is receiving an interest that is reasonably equivalent to the contribution in exchange for the contribution. Therefore, any attempt to utilize the NVE in a SARE case is essentially similar to a sale of property of the estate. The issue is what the best method to handle this simulated sale is in the context of a SARE chapter 11 case.
II. Proposal: Credit Bidding
A. Credit Bidding as a Viable Alternative?
One possible alternative to the 20% proposal is to use a limited "auction" system allowing the secured creditor to "bid" on the property against the debtor. Other possible alternatives include reducing or eliminating the exclusivity period in a SARE NVE case or simply leaving the Code in its current form, relying on creditors to take advantage of the opportunity to get exclusivity terminated or have the stay lifted based on the facts of the specific case.
The reason we focus on credit bidding is that it provides more protection to creditors than the current Code, but does not take away the debtor's right to formulate a plan. In addition, by not lifting exclusivity in every NVE case, it will not be necessary for both the debtor and creditor to formulate a plan. As the key provisions of the plan will deal with financial restructuring, primarily concerned with valuation and loan terms, full-scale competing plans would seem unnecessary. Thus, in a SARE NVE case, allowing the creditor to bid if it does not accept the plan should provide sufficient protection to the creditor with the least burden.
Credit bidding would address concerns regarding valuation. The creditor could not complain about unfair valuation if given an opportunity to bid. While the allowance of credit bidding at NVE "auctions" has been argued against by some, the primary concern with such a rule is whether this would tip the scales too far in the creditor's favor. To determine whether the creditor is unduly favored, the motivations and likely behavior of the creditor must be analyzed.
B. Assumptions: Creditor Behavior
First, we assume that the creditor is not in the business of real estate investment. If it were, the creditor would not be lending to other entities but would be using its capital to purchase properties. Second, as a result of the first assumption, the creditor will not want or may not be allowed to hold the real estate for a significant period of time. Therefore, if a loan goes bad and the real estate is worth less than it was at the time the loan was made, the lender will have an incentive to limit its loss on the loan. Conversely, the creditor will have an incentive to avoid taking ownership for a significant period of time, particularly if there is no benefit in doing so.
C. The Application
The Annex A reorganization will be used as an example. The property was originally valued at $12,000,000, subject to a mortgage of $9,000,000. The property declined in value. The debtor claimed the property was worth $6,000,000 and the creditor claimed $8,000,000.
In the example, the court valued the property at $6,000,000 and the debtor crammed down a plan. Under an alternative credit bidding system, the creditor would seem to have an incentive to bid at least the $8,000,000 it believed the property was worth, if not the full $9,000,000 of its debt. However, this is questionable if the situation is realistically evaluated.
While the creditor undoubtedly has some expertise in the valuation of properties so that it may make intelligent lending decisions, a decision to bid will not be undertaken lightly. If the creditor bids over $6,000,000 and is wrong, it will suffer a loss as it will receive less on a subsequent sale than it would have under the plan. The creditor should bid the debt (or a portion of the debt) only when it legitimately believes that the debtor's bid is low. However, this forces creditors to make a more critical analysis of a property than if they were merely contesting the debtor's valuation. If the lender is willing to actually bid $8,000,000 for the property the debtor values at only $6,000,000, then it is difficult for the debtor to claim a value of only $6,000,000.
Another question then arises in credit bidding situations, which is whether the creditor is really bidding. This is because the creditor will offset the loan balance with the bid price, meaning that there is no balance sheet cost until the creditor bids more than the debt. One benefit of this system is that it does not require creditor liquidity to bid. Conversely, it might be argued that the creditor would always bid as there is no "real cost" to doing so.
Again, however, it is useful to look at the creditor's motivations. If the creditor "overbids", the creditor will eventually suffer a loss on the subsequent sale. As the creditor will not be holding the property indefinitely, it must look at relatively short term sale value in making its assessment. This may give the debtor another advantage as the debtor can look at the long term possibility of appreciation. If the debtor is only looking at short term sale value, as it appears in Annex A, there is no real justification for giving the property to the debtor without exposing it to the limited market produced by letting the creditor bid on the property as well. The 20% proposal, conversely, gives the debtor the opportunity to take the property at a low value--with loan forgiveness thrown in--by convincing the court that its valuation is reasonable.
III. Benefits of the Credit Bidding Proposal
A. Valuation Issues
One of the main objections to the 20% proposal involves the necessity of court valuation in every case. Our proposal reduces the problems inherent in the speculative valuation of property by a court. The creditor can protect itself from inaccurate valuations by acting on its own valuation proposal if it is dissatisfied. By giving the creditor a limited veto power, a lowball valuation attempt by a debtor is preempted. See also section IV. C. for reasons why any creditor bid would have to be reasonable. Conversely, this also prevents posturing by a creditor in order to "drive up" a court's valuation as the creditor will have to take the property at any proposed "high" valuation. This may lead to more fruitful negotiation between the parties and may reduce court involvement. Therefore, this proposal acts as a check on possible problems in valuation.
B. § 1111(b) Issues
This proposal also seems to alleviate the questions raised regarding the § 1111(b) election. As discussed in the previous memorandum, it seems that the primary reason for a creditor to take the election in a NVE case is to guard against a low valuation by the court. The ability to credit bid takes care of this problem. Therefore, strategic use of the § 1111(b) election as a check on valuation should not be necessary if this proposal is used instead of or in conjunction with the 20% proposal. While the presence of the § 1111(b) election may protect creditors under the 20% proposal, thereby encouraging negotiation, the potential to cramdown on the creditor at a valuation with which the creditor disagrees is too large a risk to take (and is totally unnecessary).
C. "Market Terms" Issue
A portion of the 20% proposal indicates that the portion of the new value (the 80% that is not paid at the time of confirmation) must be in the form of a loan at market terms. The credit bidding proposal would also help alleviate problems with this issue, which would lead to large amounts of litigation in order to determine what "market terms" are in any given situation.
The credit bid option would give the creditor veto power over any offensive loan terms. This gives the creditor some control over its own destiny and requires that any proposal made must be reasonable. The balance here is in the creditor's favor, but the debtor should have an incentive to push for terms that are actually in line with the current market as otherwise the debtor would be unable or unwilling to get the plan confirmed. While the 20% proposal would obviously require court validation of the loan terms in a cramdown, the credit bidding proposal would give the secured creditor the ability to avoid these litigation costs.
IV. Potential Drawbacks
Questions may be raised regarding this proposal. Primarily, these questions would likely deal with possible creditor misbehavior during the bidding process, the possible unique value that property may have in the hands of the original equityholders, the potential that a secured creditor would bid the full amount of the debt in every NVE case and no NVE plan would ever be confirmed, and whether too much power is given to creditors under this proposal.
A. Creditor Misbehavior
An unreasonable or antagonistic creditor could bid the full amount of the debt and take the property simply to spite the debtor. It would appear that no unsecured creditors would be paid as the amount of the secured claim is exactly equal to the value of the estate. The unsecured creditors are no worse off, however, than they would be in a cramdown situation (see Annex A example). The problem with this argument is that in addition to antagonism it assumes irrationality on the part of the creditor. The creditor must do something with the property. If the creditor sells the property for less than the NVE plan was proposing, the creditor has shot itself in the foot. Therefore, it does not seem likely that creditors will act out of spite in most situations.
B. Potential "Unique Value" to the Original Equityholder
Given that unique tax advantages (or other unique ownership value) may exist which may only be realized by leaving the property in the hands of the original equityholders, the secured creditor may get the highest price for its interest in the property by a "sale" to the old equityholders. The equityholders should be willing to pay something to retain such benefits.
To illustrate, assume that the property in Annex A held tax advantages of $500,000 in the debtor's hands. Assume further that the secured creditor values the property at $6,000,000 on the open market to a third party (the $8,000,000 figure is a bargaining posture) but thinks that the debtor should be willing to pay for the tax advantages. Therefore, the creditor determines that the property is worth $6,500,000 to the debtor. However, the debtor will not want to pay for tax breaks that no other party can use. While the debtor will not be willing to pay over $6,500,000, the creditor will not accept under $6,000,000. This provides a range of possible negotiated solutions, any of which would be reasonable. The exact outcome will depend on the bargaining strengths of the parties, as intended and currently implemented in chapter 11.
C. No Confirmed NVE Plans
It might be argued that no NVE plan would ever be confirmed under the credit bidding proposal. This does not seem to be a legitimate concern. No rational creditor would bid its debt in every NVE case. As discussed earlier, creditors are generally not in the real estate business and must do something with any property they acquire. Assuming a creditor acts rationally and in its economic self interest, the creditor will only bid the full amount of the debt if it actually believes that the debtor is underbidding. If this is not the case, then there is no reason for the creditor not to accept the debtor's proposal.
In addition, it is helpful to remember here that the creditor will undergo some transaction costs in reselling the property. Besides any carrying costs, the property will have to be marketed and sold, involving legal and other fees. Therefore, there would need to be a substantial disparity in valuation in order for it to be worthwhile for a creditor to bid (i.e., a $50,000 difference in valuation would be insufficient to undergo the bidding and resale process).
It might also be argued that a cramdown will not be possible if this limited veto power is given to creditors. This is not necessarily true, however, and this proposal does not guarantee that courts will not have to assess the propriety of NVE plans in certain circumstances. For instance, the debtor and creditor may agree on valuation (or may be close enough that the creditor does not contest it), but may not be able to reach agreement on credit terms. While the credit bidding proposal should encourage negotiation, and the creditor would have limited veto power in any event, disputes may still exist where the creditor simply does not want to take possession of the property. Therefore, in these and other circumstances, cramdowns may still be utilized.
D. Creditor Power Under this Proposal
In reality, this proposal should do nothing but protect creditors and their legitimate interests. As discussed above, this proposal acts as a check on low valuation by the debtor and/or court, but also prevents the creditor from pushing for valuation at a price higher than it reasonably believes or is willing to take the property for itself. Additionally, a rational creditor will not simply bid the full amount of debt in each case and reasonable NVE plans will still be confirmable.
This proposal will merely serve to ensure that the values espoused by the 20% proposal and the NVE's traditional five requirements are actually met in each individual case. It would also take some of the burden off the court in NVE cases by giving power to the creditor. This should result in less court involvement, and whatever court involvement is necessary should only need to focus on genuine issues.
V. Conclusion
The most important point to consider in assessing which NVE implementation is "the best" is that none actually improve the current Code if it is properly implemented by a court. While it could be credibly argued that the credit bidding proposal allows unilateral action by creditors through a veto power on any proposed plan, the 20% proposal gives just such unilateral power to debtors through the use of cramdowns if the initial valuation obstacle is met. Such unilateral action, whether on the part of debtor or creditor, is not the point of the reorganization process. The parties should be encouraged to negotiate and settle their own disputes.
The primary advantage of the credit bidding proposal is that it provides a check on valuation and prevents "unfair" cramdowns. Under the 20% proposal, the creditor has an incentive to push for the highest valuation possible, yet assumes little or no risk by taking such a position. The debtor, meanwhile, has every incentive to push for the lowest valuation possible, as a finding of low value would allow the debtor to cramdown a NVE plan, thereby keeping its property and achieving significant loan forgiveness.
In comparison, the creditor's ability to push for a high valuation is tempered in a credit bidding scenario. The risk of taking the property ensures that creditor valuation proposals are reasonable. It could be argued that the creditor's incentives do not change significantly as compared to the 20% proposal because a high valuation in such a case would require the creditor to take the property because the debtor would be unable to confirm a plan. However, it seems more likely that a creditor under the 20% proposal would argue for a higher valuation than it legitimately felt justified in order to counter the debtor's low proposal.
Whatever system (if any) is adopted, it should encourage realistic valuation proposals by the parties and serious negotiations between the parties. The 20% proposal does not provide these incentives. It provides the debtor with the incentive to gamble on a low valuation by the court whenever a property begins to lose value, which encourages a strategic response by the creditor. The credit bidding proposal is designed to provide checks on each of the parties during the valuation and reorganization process in order to ensure that valuation is reasonable and to hopefully minimize unnecessary court involvement.
Notes:
1678 Some even question whether SARE debtors should be excluded from Chapter 11. See, e.g., Robert M. Zinman, No Chapter 11 For Single Asset Real Estate, No "New Value" for Single
Asset Real Estate, Am. Bankr. Inst. Winter Leadership Conf. (Dec. 5-7, 1996)(unpublished article
on file with the American Bankruptcy Institute and the National Bankruptcy Review Commission);
Alan Robin & James Lipscomb, Real Estate Bankruptcies and the Bankruptcy Process, REAL PROP.
PROB. & TR. J (Spring 1997).
Return to text
1679 See, e.g., L.E. Creel, III & Weldon L. Moore, III, Unjustified Criticism of Single Asset
Real Estate Cases in Bankruptcy, Am. Bankr. Inst. Winter Leadership Conf. (Dec. 5-7,
1996)(unpublished article on file with the American Bankruptcy Institute and the National
Bankruptcy Review Commission
Return to text
1680 See, e.g., In re Barakat, 99 F.3d 1520, 1526 (9th Cir. 1996), cert. denied, 117 S. Ct. 1312,
reh'g denied, 117 S. Ct. 1725 (1997); In re Lumber Exch. Bldg. Ltd. Partnership, 968 F.2d 647, 649
(8th Cir. 1992); In re Bryson Properties, XVIII, 961 F.2d 496, 502 (4th Cir.), cert. denied, 506 U.S.
866 (1992); In re Greystone III Joint Venture, 995 F.2d 1274, 1281 (5th Cir. 1991), cert denied, 506
U.S. 821 (1992);In re Boston Post Road Ltd. Partnership, 21 F.3d 477, 483 (2d Cir. 1994) cert.
denied, 513 U.S. 1109 (1995).
Return to text
1681 A bill which is currently pending before the House of Representatives would increase the cap
to $15 million dollars. See H.R. 764, § 2 (2)(B), 105th Cong., 1st Sess. (1997). Section 2(2)(B) of
H.R. 764 is based on H.R. 73, the "Single Asset Bankruptcy Reform Act," introduced by Rep.
Knollenberg on January 7, 1997.
Return to text
1682 PROPOSED AMENDMENTS TO THE UNITED STATES BANKRUPTCY CODE:
HEARINGS BEFORE THE SUBCOMM. ON COMM. AND ADMIN. LAW, 105th CONG., 1st
Sess. (April 30, 1997) (testimony of Donald R. Ennis, noting that the average commercial loan at risk
in the single asset context is ten million dollars).
Return to text
1683 E.g., where the secured debt exceeds fifty million dollars.
Return to text
1684 In re Oceanside Mission Associates, 192 B.R. 232, 234 (Bankr. S.D. Cal. 1996). Return to text
1685 Compare In re Pensignorkay, Inc., 204 B.R. 676 (Bankr. E.D. Pa. 1997) (holding that the cap should be calculated by reference to the value of the collateral) with In re Oceanside Mission Associates, 192 B.R. 232 (Bankr. S.D. Ca. 1996) (holding that the four-million-dollar cap should be
calculated by reference to the total value of the secured creditor's nonbankruptcy claim).
Return to text
1686 3 LAWRENCE P. KING, COLLIER ON BANKRUPTCY ¶ 362.07[5][b] (1996) (citing S. REP. NO. 168, 103d Cong., 1st Sess. (1993) ("This amendment will ensure that the automatic stay
provision is not abused, while giving the debtor an opportunity to create a workable plan of
reorganization."); 140 CONG. REC. 10, 764 (daily ed. October 4, 1994), reprinted in App. Pt. 9(b)
(statements of Rep. Brooks, chairperson of the House Judiciary Committee):
Without bankruptcy reform, companies, creditors, and debtors alike will
continue to be place on endless hold until their rights and obligations are
adjudicated under the present system--and that slows down ventures, new
extensions of credit and new investments.
Return to text
1687 Section 362(d)(3) provides that the court shall grant relief from the automatic stay:
(3) with respect to a stay of an act against single asset real estate under subsection
(a), by a creditor whose claim is secured by an interest in such real estate, unless, not later than the
date that is 90 days after the entry of the order for relief (or such later date as the court may determine
for cause by order entered within that 90-day period)--
(A) the debtor has filed a plan of reorganization that has a reasonable
possibility of being confirmed within a reasonable time; or
(B) the debtor has commenced monthly payments to each creditor
whose claim is secured by such real estate (other than a claim secured by
a judgment lien or by an unmatured statutory lien), which payments are
in an amount equal to interest at a current fair market rate on the value of
the creditor's interest in the real estate. Return to text
1688 The Small Business Proposal, adopted by the Commission in May 1977, defines "small
business" to include all single-asset realty debtors. As a consequence, the 150-day-confirmation,
financial reporting, U.S.-Trustee-supervision and other provisions of the Proposal would apply in
SARE cases. To coordinate section 362(d)(3) with the Small Business Proposal, it would be
necessary to amend section 362(d)(3) to provide that extensions of the ninety-day period thereunder
would have to be obtained pursuant to the section which sets forth burden-of-proof standards
proposed for extensions of small business debtors.
Return to text
1689 This requirement would not apply to small-business debtors which are not SARE debtors.
Return to text
1690 The Honorable Lisa H. Fenning, The Future of Chapter 11: One View From the Bench, Advanced Bankruptcy Workshop 1993 (650 PLI/COM. L. AND PRAC. COURSE HANDBOOK SERIES 317
at 331).
Return to text
1691 J. Ayer, Bankruptcy as an Essentially Contested Concept: The Case of the One-Asset Case, 44 S.C.L. REV. 863, 868-70 (1993).
Return to text
1692 E.g., Shannon C. Bogle, Bonner Mall and Single-Asset Real Estate Cases in Chapter 11:
Are the 1994 Amendments Enough?, 69 S. CAL. L. REV. 2163 (1996); Alan Robin & James
Lipscomb, Real Estate Bankruptcies and the Bankruptcy, REAL PROP. PROB. & TR. J (Spring 1997).
Return to text
1693 See id.
Return to text
1694 But see infra pp 624-79. As described below, the Commission proposes to condition confirmation of a new value plans proposed by SARE debtors on the debtors' infusion of sufficient
cash to yield a market-rate loan-to-value ratio.
Return to text
1695 It is an open question whether the new-value exception exists under the 1978 Code. The
Supreme Court granted certiorari in a case in which the Ninth Circuit held that the new-value
exception does exist, even though there was no conflict among the circuits. The court later dismissed
the appeal as moot when the parties settled the appeal. In re Bonner Mall Partnership, 2 F.3d 899,
908 (9th Cir. 1993), cert. granted, 510 U.S. 1039, 114 S. Ct. 681, case dismissed as moot, 513 U.S.
118, 115 S. Ct. 386 (1994). On September 19, 1996, the Commission adopted a Proposal to codify
the new value exception. See Recommendation 2.4.15: Absolute Priority and
Exclusivity.
Return to text
1696 In re Bonner Mall Partnership. 2 F.3d 899, 908 (9th Cir. 1993), cert. granted, 510 U.S. 1030. 114 S.Ct. 681, case dismissed as moot, 513 U.S. 118, 115 S. Ct. 386 (1994).
Return to text
1697 The lack of clarity in the case law regarding the other three requirements is set forth in J. Ronald Trost, et al., Survey of the New Value Exception to the Absolute Priority Rule and the
Preliminary Problem of Classification, (1996).
Return to text
1698 Id. at 1336-37.
Return to text
1699 Id. at 1346-47.
Return to text
1700 Id. at 1348.
Return to text
1701 The restructured loan could also likely be classified as a performing loan, reducing regulatory problems for the lender.
Return to text
1702 As explained on pages 673-74, in the text the main concern of the public in SARE cases is that the affected apartment building or other real property be property maintained.
Return to text
1703 The Commission believes that none of the existing restrictions on confirmation of lien-stripping plans should be modified in SARE cases unless the loan-to-value test for new-value plans
is adopted. These existing limitations include the impaired accepting class requirement of Section
1129(a)(10), case law precluding separate classification of the mortgage holder's unsecured
deficiency claim and case law regarding artificial impairment of claims. The Commission also
believes that the new-value exemption should not be recognized in SARE cases without the loan-to-value test.
Return to text
1704 See The Honorable Thomas E. Carlson, Memorandum to the Small Business Working Group Regarding the Loan-to-Value Approach to the New Value Exception (June 5, 1997) (noting
that courts confirm new-value plans in only eleven percent of reported cases).
Return to text
1705 Joel B. Zweibel, O'Melveny & Meyers LLP, Letter to the Small Business Working
Group Regarding Single Asset Real Estate Proposal Numbers 10-12 (Sept. 8, 1997); John D.
Cleavenger, The Principal Financial Group, Letter to the National Bankruptcy Review Commission
Regarding Single Asset Real Estate (Aug. 9, 1997); Dean A. Rogeness, MassMutual Ins. Co., Letter
to the National Bankruptcy Review Commission Regarding Single Asset Real Estate (Sept. 9, 1997);
Dain C. Donelson & The Honorable Robert D. Martin, Memorandum to the Small Business Working
Group Regarding Proposed New-Value Exception--Single Asset Real Estate Entities Alternative
Proposal/Additional Analysis (Sept. 9, 1997).
In addition, three commentators who supported to loan-to-value approach stated they would
also support a credit-bid approach. J.S. Hollyfield, sole practitioner, Letter to the National
Bankruptcy Review Commission; Alan J. Robin, Metropolitan Life Ins. Co., Letter to John Gose, Esq.
(Sept. 5, 1997); Prof. Robert M. Zinman, Memorandum to the National Bankruptcy Review
Commission, Small Business Working Group Regarding Single Asset Real Estate (Sept. 9, 1997).
Return to text
1706 Dain C. Donelson & The Honorable Robert D. Martin, Memorandum to the Small Business Working Group Regarding Proposed New-Value Exception--Single Asset Real Estate
Entities Alternative Proposal/Additional Analysis (Sept. 9, 1997)
Return to text
1707 Some even question whether SARE debtors should be excluded from Chapter 11. E.g.,
Robert M. Zinman, No Chapter 11 For Single Asset Real Estate, No "New Value" for Single Asset
Real Estate, AM. BANKR. INST. WINTER LEADERSHIP CONF. (Dec. 5-7, 1996)(unpublished article on
file with the American Bankruptcy Institute and the National Bankruptcy Review Commission); Alan
Robin & James Lipscomb, Real Estate Bankruptcies and the Bankruptcy Process, REAL PROP.
PROB. & TR. J (Spring 1997).
Return to text
1708 See, e.g., L.E. Creel, III & Weldon L. Moore, III, Unjustified Criticism of Single Asset
Real Estate Cases in Bankruptcy, AM. BANKR. INST. WINTER LEADERSHIP CONF. (Dec. 5-7,
1996)(unpublished article).
Return to text
1709 See, e.g., In re Barakat, 99 F.3d 1520, 1526 (9th Cir. 1996). cert. denied, 117 S. Ct.
1312, 137 L. Ed. 2d 475, reh'g denied, 117 S. Ct. 1725 (1997); In re Lumber Exch. Bldg. Ltd.
Partnership, 968 F.2d 647, 649 (8th Cir. 1992); In re Bryson Properties, XVIII, 961 F.2d 496, 502
(4th Cir.) cert denied, 506 U.S. 866, 11 S.Ct. 191, 121 L.Ed.2d 134 (1992);In re Greystone III Joint
Venture, 995 F.2d 1274, 1281 (5th Cir. 1991), cert denied, 506 U.S. 821, 113 S. Ct. 72, 121 L. Ed.
2d 37 (1992). In re Boston Post Road Ltd. Partnership, 21 F.3d 477, 483 (2d Cir. 1994) cert. denied,
513 U.S. 1109, 115 S. Ct. 897, 130 L. Ed. 2d 782 (1995).
Return to text
1710 A bill which is currently pending before the House of Representatives would increase the cap
to $15 million dollars. See H.R. 764, § 2 (2)(B), 105th Cong., 1st Sess. (1997). Section 2(2)(B) of
H.R. 764 is based on H.R. 73, the "Single Asset Bankruptcy Reform Act," introduced by Rep.
Knollenberg on January 7, 1997. The bill was ordered reported, as amended, by the House Judiciary
Committee on July 16, 1997. The amended bill imposes a $15 million cap on the definition of
"single asset real estate" in section 101(51B) of title 11.
Return to text
1711 In re Oceanside Mission Assocs., 192 B.R. 232, 234 (Bankr. S.D. Cal. 1996). Return to text
1712 Compare In re Pensignorkay, Inc., 204 B.R. 676 (Bankr. E.D. Pa. 1997) (holding that
the cap should be calculated by reference to the value of the collateral)with In re Oceanside Mission
Assocs., 192 B.R. 232 (Bankr. S.D. Cal. 1996) (holding that the four-million-dollar cap should be
calculated by reference to the total value of the secured creditor's nonbankruptcy claim).
Return to text
1713 3 LAWRENCE P. KING, COLLIER ON BANKRUPTCY ¶ 362.07[5][b] (1996) (citing S. REP. NO. 168, 103d Cong., 1st Sess. (1993) ("This amendment will ensure that the automatic stay provision is not abused, while giving the debtor an opportunity to create a workable plan of reorganization.");
140 Cong. Rec. 10, 764 (daily ed. October 4, 1994), reprinted in App. Pt. 9(b) (statements of Rep.
Brooks, chairperson of the House Judiciary Committee):
Without bankruptcy reform, companies, creditors, and debtors alike will
continue to be place on endless hold until their rights and obligations are
adjudicated under the present system--and that slows down ventures, new
extensions of credit and new investments. Return to text
1714 Section 362(d)(3) provides that the court shall grant relief from the automatic stay:
(3) with respect to a stay of an act against single asset real estate under subsection
(a), by a creditor whose claim is secured by an interest in such real estate, unless, not later than the
date that is 90 days after the entry of the order for relief (or such later date as the court may determine
for cause by order entered within that 90-day period)--
(A) the debtor has filed a plan of reorganization that has a reasonable
possibility of being confirmed within a reasonable time; or
(B) the debtor has commenced monthly payments to each creditor
whose claim is secured by such real estate (other than a claim secured by
a judgment lien or by an unmatured statutory lien), which payments are
in an amount equal to interest at a current fair market rate on the value of
the creditor's interest in the real estate. Return to text
1715 The Small Business Proposal, adopted by the Commission in June 1997, defines "small
business" to include all single-asset realty debtors. As a consequence, the 150-day-confirmation,
financial reporting, U.S.-Trustee-supervision and other provisions of the Proposal would apply in
SARE cases. To coordinate section 362(d)(3) with the Small Business Proposal, it would be
necessary to amend section 362(d)(3) to provide that extensions of the ninety-day period thereunder
would have to be obtained pursuant to the section which sets forth burden-of-proof standards
proposed for extensions of small business debtors.
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1716 Both courts of appeals to decide the issue have squarely held that the new-value
exception exists under the 1978 Code. In re 203 N. LaSalle St. Partnership, _F.3d_, 1997 U.S. App.
Lexis 27008 (7th Cir. Sept. 29, 1997); In re Bonner Mall Partnership, 2 F.3d 899, 908 (9th Cir.
1993), cert. granted, 510 U.S. 1039, 114 S. Ct. 681, case dismissed as moot, 513 U.S. 118, 115 S.
Ct. 386 (1994). On September 19, 1996, the Commission adopted a Proposal to codify the new value
exception. See, Chapter 11 Working Group Proposal #1: Absolute Priority and Exclusivity.
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1717 In re Bonner Mall Partnership, 2 F.3d 899, 908 (9th Cir. 1993), cert. granted, 510 U.S. 1030, 114 S.Ct. 681, case dismissed as moot, 513 U.S. 118, 115 S. Ct. 386 (1994).
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1718 The lack of clarity in the case law regarding the other three requirements is set forth in J. Ronald Trost, et al., Survey of the New Value Exception to the Absolute Priority Rule and the
Preliminary Problem of Classification, (1996). But as the courts of appeals refine these concepts,
clear guidelines will emerge. For example in 203 N. LaSalle St. Partnership, note 10 supra, the Court
of Appeals for the Seventh Circuit adopted a common sense approach in evaluating these
requirements as opposed to a mathematical formula.
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1719 Id. at 1336-37.
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1720 Id. at 1346-47.
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1721 Id. at 1348.
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