Can a Chapter 11 debtor confirm a plan that gives a hostile secured creditor a lien on an orange as a substitute, in essence, for the secured creditor’s lien on an apple that the debtor wants to keep and use?1 Yes, a motion to substitute collateral is valid if the value of the new lien meets the “indubitable equivalent” test with the value of the original lien.
Assume that the land-rich but cash-poor Chapter 11 Debtor has one secured creditor, the Lender, which holds a mortgage on certain commercial real property owned by Debtor, called Apple Acre. The Debtor wants to confirm a Chapter 11 plan under which it will keep Apple Acre, but the Debtor lacks the funds to make the Lender whole. The Lender is hostile and will vote against any plan. The Lender is the Debtor’s only secured creditor, and it will have its own class under any plan. Because that class is impaired and will dissent from confirmation, the Debtor will not be able to confirm its plan on a consensual basis under section 1129(a) of the Bankruptcy Code. The Debtor may try to cram down on the Lender’s class and confirm the plan under section 1129(b) of the Bankruptcy Code.
What are the contours of a cramdown (i.e., when a creditor must accept a bankruptcy plan as ordered by the court despite objection to unfavorable terms)? One requirement is that the plan be “fair and equitable” to the dissenting impaired class. Section 1129(b)(2)(A) provides two ways in which the Debtor’s plan can be fair and equitable to the Lender while keeping Apple Acre.2 First, the plan can provide that reorganized Debtor will make deferred cash payments to the Lender’s class that, taken together, equal or exceed the present value of the class’s claim.3 The Debtor is cash-poor, so that is a non-starter.
Alternatively, the plan can provide the class with the “indubitable equivalent” of its claims.4 This is the Debtor’s chance. The Debtor can provide the indubitable equivalence of Lender’s security in Apple Acre by conveying Apple Acre to Lender, which would be an example of a “dirt for debt” plan in real estate reorganizations. To keep Apple Acre, though, Debtor will have to replace Lender’s interest in Apple Acre with a similar interest on otherwise unencumbered property of the Debtor, such as perhaps Orange Acre (it need not be real property). The Debtor can make a motion to substitute collateral, provided that Orange Acre is worth as much or more than Apple Acre and is at least as liquid and no more volatile in terms of changes in asset value.
The term “indubitable equivalence” was created by Judge Learned Hand,5 as he considered that the property interest of the secured creditor is protected by the Fifth Amendment of the Constitution. Hand was setting an extremely high bar for confirming plans of reorganization over the objections of impaired secured creditors. Application of the concept has varied from court to court. In other words, indubitable equivalence is in the eye of the beholder. Courts differ in the strictness with which they determine whether a plan grants a secured creditor the indubitable equivalent of its claim and in the standard of proof they require. The Debtor would be wise to file its Chapter 11 case in an available venue where judges apply the less strict standards.
A particular plan meets the indubitable equivalent requirement if the plan (1) provides the creditor with the present value of its claim, and (2) if the plan ensures the safety of the secured creditor’s principal.6 A court must examine both whether the substituted security is completely compensatory and the likelihood that the secured creditor will be paid.
The value of the substitute collateral and the degree of risk it imposes on the secured creditor (also conceived of as price volatility relative to other market assets), determine whether the new collateral is sufficiently “safe” and “completely compensatory.” New collateral with a current value less than the value of the original collateral cannot be “completely compensatory.” New collateral with a current value estimated to be equal or higher than that of the original collateral is not “completely compensatory” if the new collateral is materially riskier (i.e., its value is subject to unpredictable shifts—volatility) or materially less liquid than the original collateral. The presence of either of these conditions would mean that there is a substantially greater likelihood that the secured creditor will not be paid.
Indubitable equivalence is raised commonly (but not exclusively) in real estate reorganizations, like that of the hypothetical Debtor of this article, and courts split on the scrutiny they apply to partial “dirt for debt” plans. For example, some jurisdictions refuse to confirm a plan unless it is abundantly clear that the property to be conveyed is worth as much as the secured claim, plus an ample “equity cushion” to spare. These courts have emphasized the inherent risk for error in collateral valuation and potential unfairness in placing the burden of this risk solely on the creditor.
Unfavorable market conditions have also played a key role in the decisions by these courts. Other jurisdictions have confirmed partial dirt-for-debt plans while accepting a small margin of error between the amount of the secured claim and the value of the proffered substitute collateral. Valuations are often contentious matters, with the court deciding among those offered or setting a valuation independently.
Further, courts differ in the standard of proof they apply to the indubitable equivalent test. Some courts require proof of value by “clear and convincing evidence,” while other jurisdictions require the less strict “preponderance of the evidence” standard. In a given set of circumstances, the standard of proof applied can decide the outcome in a motion to substitute collateral.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: The Nuts & Bolts of a Chapter 11 Plan and Cash Collateral and DIP Loan Contests. This is an updated version of an article originally published on May 28, 2014.]
1. The author is Lindsey Young Distinguished Professor of Law and Director of the James L. Clayton Center for Entrepreneurial Law, The University of Tennessee College of Law. The author thanks Koi Lomas, University of Tennessee College of Law class of 2015, for substantial assistance with research for and cite checking of this article.
2. We omit discussion of subsection (b)(2)(A)(ii), which provides for the sale of the collateral.
3. 11 U.S.C.§ 1129(b)(2)(A)(i)(II).
4. 11 U.S.C.§ 1129(b)(2)(A)(iii).
5. Hand, a judge on the Second Circuit Court of Appeals, coined the term 43 years before “indubitable equivalent” was enacted into law in the Bankruptcy Code. SeeIn Re Murel. Holding Corp., 75 F.2d 941 (2d Cir. 1935).
6. In re Sparks, 171 B.R. 860 (Bankr. N.D. Ill. 1994).
©All Rights Reserved. June, 2020. DailyDACTM, LLC
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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