Mathew 5:29 – And if thy right eye offend thee, pluck it out, and cast it from thee: for it is profitable for thee that one of thy members should perish, and not that thy whole body should be cast into hell.
In a previous article about cram downs, in which a debtor can take steps to confirm a Chapter 11 plan despite rejection from creditors, I referred briefly to an undersecured, secured creditor’s countermeasure: the section 1111(b)(2) election. By making this election, a secured creditor chooses to do without (i.e., “plucks out”) its unsecured deficiency claim, but preserves greater value for itself by requiring any plan to pay to the secured creditor the full amount of the allowed secured claim, regardless of the value of the collateral at the time of plan confirmation. The section 1111(b)(2) election empowers a secured creditor both to command a higher payout from the debtor’s plan— perhaps rendering the plan unfeasible—and also to take from the debtor any anticipated rise in the collateral’s value (and deny the debtor his “due”).
Under section 506(a) of the Bankruptcy Code, the secured creditor’s claim is secured only to the extent of the collateral’s court-determined value. The balance of the debtor’s obligation to the secured creditor is an unsecured deficiency claim. In that scenario, the court might undervalue the collateral, thus diminishing the secured portion of the secured creditor’s claim. The debtor could keep the property in a plan by paying the secured creditor class (which probably contains only that secured creditor) according to that low valuation, while paying the unsecured deficiency claim at a very low percentage of its face value (and then, presumably cramming down the plan over the dissent of that class). The debtor would derive greater liquidity to purchase the cooperation of other classes or to make the plan otherwise feasible, and the debtor could sell the property later (or borrow on its rising value) and keep all upside.
The undersecured creditor may resist the extent of damnation. Enter section 1111(b) of the Bankruptcy Code, which empowers undersecured creditors to protect themselves from undervaluation risk. Section 1111(b)(2) presents an undersecured creditor with an alternative to accepting the section 506(a) claim bifurcation (with the secured portion subject to court determination). By the section 1111(b)(2) election, the secured creditor can waive its unsecured deficiency claim and have the total allowed amount of its claim treated as though it were fully secured by the collateral. If the debtor wishes to retain the collateral and confirm its plan, the secured creditor’s section 1111(b) election will force the plan to provide that the secured creditor receive the present value of the entire claim. A debtor may be denied confirmation if the plan becomes infeasible, whether due to the greater payout required by the secured creditor’s election otherwise. Faced with a section 1111(b) election, the debtor may be pushed to redraw its plan or to surrender the collateral to the secured creditor.
The enactment of section 1111(b) as part of the Bankruptcy Reform Act of 1978 redressed an inequity suffered by creditors holding nonrecourse claims secured by a lien on property of a debtor’s estate. In re Pine Gate Associates, Ltd. illustrates that inequity.1 In Pine Gate, the debtor’s only asset was an apartment complex, which was financed by mortgages that secured non recourse loans. The debtor’s plan proposed to “cash out” the creditors who held the nonrecourse loans by paying them the court-appraised value of the property, which was substantially less than the amount owed on the loans. The debtor would thus use the bankruptcy process to sever the undersecured creditors’ interest in the property when its value was at a low point.
The creditors rejected the plan, arguing that the debtor should be required to either pay the amount of the loans or relinquish the property to them. The court disagreed and confirmed the plan, finding that the plan’s proposed payment of the appraised value of the property sufficed to satisfy the creditor’s claim. The Pine Gate decision was criticized for allocating the risks of undervaluation to the creditors and allowing the debtor the exclusive right to benefit from future appreciation in the collateral’s value, as well as for making it easier for a debtor to cram down a plan on a lienholder by limiting its participation in the reorganization to the market value of the lien.2 As one court summarized the Pine Gate approach: “If the property is valued by the bankruptcy court and effectively ‘sold’ to the debtor outright at the valuation price, the value of the undersecured lien is reduced to the current market value of the property, and, unlike the situation where he can be a successful bidder [in a public sale of the property], the lienholder is unable to benefit from any unanticipated post-valuation appreciation.”3
Section 1111(b) is designed to protect the undersecured creditor from a Pine Gate result under a plan in which the debtor keeps the collateral. As stated above, under section 1111(b), a creditor may acquiesce to the bifurcation of its claim under section 506(a) (whether the claim is recourse or non-recourse under the loan and security documents) into a secured claim to the value of the collateral and an unsecured claim as to the remaining indebtedness; or the secured creditor may, under section 1111(b)(2), affirmatively forego its unsecured claim and elect to have the entire claim treated as secured by the collateral.
We pause here to note that recourse treatment of the secured claim is terminated if the creditor’s claim is nonrecourse and the property is not kept by the debtor but is rather sold under a plan or outside of a plan pursuant to section 363 of the Bankruptcy Code. In a sale, the non recourse secured creditor gets only the net proceeds and faces the risk that the collateral will not be sold for a fair price (or will be sold at a low point in its market value). The undersecured creditor (recourse or nonrecourse) is protected, however, by section 363(k) of the Bankruptcy Code, which requires that the secured creditor be given the opportunity to credit bid at the sale. Thus the creditor may help bid up the sale price or acquire the collateral if it prefers to hold the collateral itself.
Recourse treatment is also necessarily denied if the creditor makes the § 1111(b)(2) election—that is what waiving the deficiency claim means. There is a cost: making the election deprives the undersecured creditor of any benefit from a distribution to unsecured creditors of the class into which the debtor would put the claim in its plan. Further, if the deficiency claim is large, it could control whatever class into which it is placed, and a rejection of the plan by that impaired class would make confirmation hinge upon the debtor’s ability to meet the higher standards of cram down.
In exchange, the creditor that made the section 1111(b)(2) election is thus assured that the plan will not be able to cash out its interest without paying the secured claim in full. Should the secured creditor then dissent from confirmation of the plan, confirmation will depend upon whether it provides for either the indubitable equivalent of the creditor’s claim, the sale of the collateral securing the claim with a right to credit bid, or that the creditor retain its lien on the collateral (kept by the debtor) and that the debtor make deferred cash payments to that allowed amount with a present value equal to the secured claim.4
But section 1111(b)(2) cannot save all undersecured creditors from perdition. A creditor cannot make the election if the creditor’s interest in the collateral is of inconsequential value. Courts measure the inconsequentiality of collateral value either by reference to (a) the amount of the creditor’s total claim or to (b) the value of the collateral itself.
As to measure (a), the court in In re Wandler5 found that property valued at 4% of the creditor’s claim was of inconsequential value with respect to the claim (hence no section 111(b) election could be made) while the court in In re Baxley held that property valued at 8% of the creditor’s claim was not of inconsequential value.6 As to measure (b), where the claims of a creditor are secured by a junior lien on collateral that is of insufficient value to secure the claim of the secured creditor with a senior lien on the same collateral, the junior lienholder’s interest in the collateral is considered to be of inconsequential value, and the junior lienholder cannot make a section 1111(b) election.7
Secured lenders facing undervaluation of their collateral and receiving too little under a plan may initially resist salvation in the form of waiving what can be a substantial chunk of their total claim. However, understanding the collateral’s true value, and understanding the mechanics and meaning of the section 1111(b) election, can preserve substantial value. The election can crush a weak debtor’s reorganization plan that depends upon an undervaluation of the collateral and bifurcation of the secured lender’s claim. As a result, the lender may get relief from the automatic stay and foreclose upon the collateral.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinar: A Distressed Company and Its Secured Lender. This is an updated version of an article originally published on April 14, 2014.]
1. In re Pine Gate Associates, Ltd. 2 Bankr. Ct. Dec. (CRR) 1478 (Bankr. N.D. Ga. 1976).
2. See, e.g., In re South Village, Inc., 25 B.R. 987 (Bankr. D. Utah 1982).
3. In re 680 Fifth Ave. Associates, 29 F.3d 95 (2d Cir. 1994).
4. 11 U.S.C. § 1129(b)(2)(A)
5. In re Wandler, 77 B.R. 728 (Bankr. D.N.D. 1987).
6. In re Baxley, 72 B.R. 195 (Bankr. D.S.C. 1986).
7. In re Union Meeting Partners, 160 B.R. 757 (Bankr. E.D. Pa. 1993).
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Prior to joining the faculty in 2000, Professor Kuney was a partner in the San Diego office of Allen Matkins Leck Gamble & Mallory LLP where he concentrated his practice on insolvency and reorganization matters nationwide. Before that he received his legal training with the Howard, Rice and Morrison & Foerster firms in his hometown…
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