Important new bankruptcy case you need to read

28 Jul

From: Charles Cox [mailto:charles@bayliving.com]
Sent: Tuesday, May 01, 2012 3:45 PM
To: Charles Cox
Subject: Important new bankruptcy case you need to read

Charles W. Trainor

Attorney at Law

Trainor Fairbrook

916-929-7000

Begin forwarded message:

Subject: Important new case you need to read

The summary below highlights an important (and disturbing, from a lender’s viewpoint) new court ruling out of the 9th Circuit BAP (which is composed of bankruptcy judges and not the regular, notoriously liberal 9th Circuit judges). I commend it to your reading and encourage you to ask me questions if you don’t understand it. It’s a major game-changer for under-water, single asset real estate cases where the borrower is a single-asset LLC and there’s a separate guarantor. Everyone, whether you’re a transactional attorney or a litigator, needs to understand the implications of this case.

With the issuance of this decision, instead of borrowers just letting the property get foreclosed on and facing the need to defend the inevitable lawsuit on the guaranty, many owners are going to choose to file a chapter 11 and try to keep the property, successfully confirming a plan that bifurcates the lender’s claim into a secured and unsecured portion (the latter of which is now classified separately from the other general unsecured creditors), and then cramming down the plan over the lender’s objections, paying only pennies on the dollar on that unsecured portion. Previously, separate classification was not permitted, and because the deficiency claim of a lender was usually so high that it could control the voting of the unsecured class, it would also veto any plan that didn’t pay out 100 cents on the dollar to the unsecured class, invoking the absolute priority rule. Now, with separate classification permitted, the lender’s leverage is eliminated and it will no longer be able to preclude plan confirmation. Of course, the lender still retains its rights against the guarantor and can immediately demand payment of the unrealized portion of the unsecured claim from the guarantor, and sue if payment thereof isn’t received. But the leverage that the borrower/owner has by threatening a cram-down through a bankruptcy will be a major negotiating point on the enforcement of those guarantees.

And yes, Chuck, I’ll be writing a client bulletin about it right away.

From: Gall, Travis
To: Sections: Bus Law Insolvency Constituency List
Subject: Update from the State Bar Business Law Section’s INSOLVENCY LAW COMMITTEE

Insolvency Law Committee – Business Law Section of the State Bar of California
Bankruptcy e-Bulletin
Robert G. Harris
Co-Chair
Binder & Malter LLP
2775 Park Avenue
Santa Clara, CA 95050
408-295-1700
rob

Elissa D. Miller
Co-Chair
Sulmeyer Kupetz
333 S. Hope Street, 35th Fl.
Los Angeles, CA 90071
213-626-2311
emiller

Thomas R. Phinney
Co-Vice Chair
Parkinson Phinney
400 Capitol Mall, Suite 2560
Sacramento, CA 95814
916-449-1444
tom

James P. Hill
Co-Vice Chair
Sullivan Hill Lewin Rez & Engel
550 West C Street, 15th Floor
San Diego, CA 92101
619-233-4100
hill

March 6, 2012

Dear constituency list members of the Insolvency Law Committee, the following is a recent case update:

The United States Bankruptcy Appellate Panel of the Ninth Circuit recently affirmed the separate classification of a lender’s deficiency claim based on the existence of a third-party source of payment for the subject deficiency claim. Wells Fargo Bank, N.A. v. Loop 76, LLC (In re Loop 76, LLC), ___ B.R. ___ (9th Cir. BAP February 23, 2012). To read the decision, click: HERE.

FACTS:

The facts are straightforward. In 2005, Wells Fargo Bank provided a construction loan in the approximate amount of $23 million to Loop 76, LLC, repayment of which was secured by an office/retail complex in Scottsdale, Arizona. Loop 76 was unable to secure replacement financing before the construction loan’s maturity date, and, Wells Fargo ultimately sued Loop 76 in state court seeking appointment of a receiver. Loop 76 responded by filing its single asset Chapter 11 case. Wells Fargo countered by filing a separate lawsuit in state court against the non-debtor guarantors of the construction loan.

As the loan exceeded the stipulated value of Wells Fargo’s real estate collateral, Loop 76’s plan bifurcated Wells Fargo’s $23 million claim into two separate claims: (i) a secured claim for $17 million; and (ii) an unsecured deficiency claim for the $6 million balance. The plan also classified Wells Fargo’s deficiency claim separate from Loop 76’s other general unsecured claims. This separate classification is significant because Wells Fargo’s deficiency claim was substantially greater in amount than the approximate $181,000 of other general unsecured claims; as such, if the deficiency claim had been classified together with the other unsecured claims, Wells Fargo would have been able control the vote of the general unsecured claims, thereby jeopardizing confirmation of the plan overall.

Wells Fargo objected to the plan and argued, among other things, that Loop 76’s separate classification of its deficiency claim violated Bankruptcy Code section 1122(a), because the debtor classified Wells Fargo’s unsecured deficiency claim “solely to gerrymander an affirmative vote on the plan.” Rejecting Wells Fargo’s contention, the bankruptcy court ultimately held that the existence of a third-party source of payment – the guarantors for the construction loan – rendered Wells Fargo’s deficiency claim dissimilar to the unsecured trade claims. As a result, the bankruptcy court determined that 11 U.S.C. § 1122(a) mandated that Wells Fargo’s deficiency claim be separately classified.

HOLDING:

On appeal, the BAP affirmed the ruling of the bankruptcy court on the claims classification issue, and concluded that a third party source for recovery on a creditor’s unsecured claim is a factor which the bankruptcy court may consider when determining whether claims are substantially similar under section 1122(a).

Significantly, Wells Fargo alleged that the law in the Ninth Circuit requires classification “to be based on the nature of the claim as it relates to the assets of the debtor” as stated in pre-Code case law, including the case of In re Los Angeles Land & Invs., Ltd., 282 F.Supp. 448 (D. Haw. 1968), aff’d, 447 F.2d 1366 ( 9th Cir. 1971) (“Los Angeles Land”).

The BAP disagreed with Wells Fargo’s contention in that regard. According to the BAP, the Ninth Circuit’s more flexible approach to claim classification is demonstrated in the more recently published opinion of Steelcase Inc. v. Johnston (In re Johnston), 21 F.3d 323 (9th Cir. 1994), which allowed separate classification of an unsecured claim based on factors not related to the debtor’s assets, including that: (i) the claim was partially secured; (ii) the debtor and the creditor were embroiled in litigation and the debtor’s claim against the creditor might offset or exceed the creditor’s claim against the debtor; and (iii) if the creditor was successful in its litigation, it could be paid in full before other unsecured creditors. As a result, the BAP determined , Johnston (which looked beyond the assets of the debtor and considered third party sources of recovery for the creditor’s unsecured claim as a basis for dissimilarity) did not expressly overrule Los Angeles Land, but did reject Los Angeles Land’s narrow consideration of the “nature” of a creditor’s claim in any section 1122(a) analysis.

Alternatively, Wells Fargo argued that the bankruptcy court’s holding was inconsistent with Ninth Circuit precedent as stated in Johnston and Barakat v. Life Ins. Co. of Va. (In re Barakat), 99 F.3d 1520, 1526 ( 9th Cir. 1996) because neither of those cases expressly held that a third-party source of payment made the claim at issue dissimilar to the other unsecured claims. Distinguishing Johnson and Barakat, the BAP made short shrift of this argument, by pointing out that the third-party source of recovery in Johnston was collateral, not cash, while there was no third party source of recovery in Barakat.

Finally, Wells Fargo argued that the bankruptcy court’s ruling was inconsistent with Barakat’s express holding, in that deficiency claims are so “substantially similar” to other unsecured claims that they cannot be classified separately from other unsecured claims absent a business or economic justification. Rejecting this argument, the BAP pointed out that in the Loop 76 case, Wells Fargo did in fact have a “special circumstance” which did not apply to any other unsecured creditors:– Wells Fargo had a third party source of recovery for its deficiency claim in the form of the nondebtor guarantors. Therefore, the BAP opined, even if the debtor were able to pay its proposed pro rata distribution to Wells Fargo under the plan, Wells Fargo still had the right to collect its entire debt from the guarantors, unlike any other of the debtor’s unsecured creditors. Discussing Johnson in detail, the BAP also clarified that the same analysis applies if the third party source of recovery is collateral rather than cash.

Accordingly, the BAP affirmed the bankruptcy court and held that, “at minimum, a bankruptcy court may consider sources outside of the debtor’s assets, such as the potential for recovery from a non-debtor or nonestate source” when determining whether unsecured claims are substantially similar under section 1122(a).

AUTHORS’ NOTE:

This case is significant in that it enables a Chapter 11 debtor to reduce and/or eliminate a significant point of leverage for most commercial lenders, especially in single asset Chapter 11 cases – the ability to use an unsecured deficiency claim to control the vote of the class of unsecured non-priority claims. Indeed, a commercial lender in single asset Chapter 11 cases often has its loan bifurcated into two separate claims: (i) a secured claim to the extent of the value of the real property collateral; and (ii) an unsecured deficiency claim for the balance of the loan amount. If the unsecured deficiency claim is classified together with other general unsecured claims, the unsecured deficiency claim will usually be greater than one-third of the total unsecured non-priority claims, thereby giving the lender veto power over the treatment of unsecured non-priority claims. See 11 U.S.C. § 1126(c), which provides that a class of claims has accepted a plan if at least two-thirds in amount and more than one-half in number of the allowed claims in such class have voted to accept the plan.

This veto power can be devastating to a Chapter 11 debtor in a single asset case with only one class of impaired unsecured claims. While the debtor may be in a position to “cram down” the lender’s secured claim over the lender’s objection, the debtor will be unable to confirm a plan making less than 100% distributions on unsecured claims if because the lender votes its deficiency claim to block the plan and therefore causes the sole impaired class of unsecured claims to reject the plan.

The Loop 76 case reduces the partially secured creditor’s power to veto a Chapter 11 plan. This is because a commercial lender with an undersecured claim in a single asset real estate Chapter 11 case usually finds itself in the unique position of having recourse to third parties via personal guaranties – a characteristic that other unsecured non-priority claims do not typically share. The Loop 76 case confirms that the Chapter 11 debtor may use that unique characteristic to separately classify the lender’s unsecured deficiency claim without violating section 1122(a), thereby providing the debtor with a stronger opportunity to “cram down” its plan over the secured creditor’s objection.

These materials were prepared by Martin A. Eliopulos of Higgs Fletcher & Mack, LLP, San Diego, California, with editorial contributions from Monique Jewett-Brewster, of MacConaghy & Barnier, PLC, Sonoma, California. Mr. Eliopulos is a member of the Insolvency Law Committee.

Thank you for your continued support of the Committee.

Best regards,

Insolvency Law Committee

The Insolvency Law Committee of the Business Law Section of the California State Bar provides a forum for interested bankruptcy practitioners to act for the benefit of all lawyers in the areas of legislation, education and promoting efficiency of practice. For more information about the Business Law Standing Committees, please see the standing committees web page.

These periodic e-mails are being sent to you because you expressed interest in receiving updates from the Insolvency Law Committee of the State Bar of California’s Business Law Section. As a Section member, if you would also like to sign up to receive e-bulletins from other standing committees, simply click HERE and follow the instructions for updating your e-bulletin subscriptions in My State Bar Profile. If you have any difficulty or need assistance, please feel free to contact Travis Gall. If you are not a member, or know of friends or colleagues who might wish to join the Section to receive e-bulletins such as this, please click HERE to join online.

To keep up-to-date on the latest news, case and legislative updates, as well as events from the Business Law Section and other Sections of the State Bar of California as well as the California Young Lawyers Association (CYLA), you can follow them on Facebook or add their Twitter feed.

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