Paul M. Hilkert
Lane & Nach, P.C.
Paul practices in the areas of bankruptcy law and creditors' rights.
This article seeks to address the general mechanics of the debtor's ability to "cram-down" undersecured liens in a Chapter 11 reorganization, and a creditor's ability to mitigate the effects of such a "cram-down" by electing to have its claim treated under 11 U.S.C. Section 1111(b)(2). Although Chapter 11 of the Bankruptcy Code is oftentimes viewed as the "business reorganization" chapter, this characterization is not accurate as both businesses and individuals reorganize under Chapter 11 and creditors need to maintain vigilance in both business and individual cases.
Under Chapter 11, a debtor generally must prepare a separate disclosure statement and plan of reorganization. 11 U.S.C. Section 1125. Except in the case of small business cases and certain other special situations, confirmation of the disclosure statement and plan of reorganization generally follows a two-step process, with confirmation of the disclosure statement being the first step. 11 U.S.C. Section 1125(b); Fed. R. Bankr. P., Rules 3016 and 3017. The purpose of the disclosure statement is to provide creditors and other interested parties information about the debtor, including, but not limited to, background information about the debtor, factors that led to the filing of the Chapter 11 bankruptcy petition, and factors that will allow the debtor to successfully reorganize under Chapter 11. The purpose of the Chapter 11 plan of reorganization is to set forth the terms and priority of payment to creditors.
Generally, a Chapter 11 plan of reorganization consists of multiple classes into which the creditors are placed. While debtors have a great deal of discretion in both creating and placing creditors into the separate classes, such discretion is limited by the fact that a claim or interest may be placed into "a particular class only if such claim or interest is substantially similar to the other claims or interests of such class." 11 U.S.C. Section 1122(a). Although 11 U.S.C. Section 1122(a) theoretically allows a debtor to place all creditors with liens secured by real property into the same class, since 11 U.S.C. Section 1123(a)(4) requires each claim and interest within a class to receive the same treatment, "unless the holder of a particular claim or interest agrees to a less favorable treatment of such particular claim or interest," most debtors that own multiple pieces of real property elect to place each creditor with a lien secured by real property into separate classes.
Placing each creditor secured by a lien in real property into its own separate class is advantageous to the debtor for two main reasons. First, the debtor has the ability to propose non-identical treatment of each class pursuant to 11 U.S.C. Section 1123(b)(5), which allows the debtor to propose a plan that "modif(ies) the rights of holders of secured claims, other than a claim secured only by a security interest in real property that is the debtor's principal residence, or of holders of unsecured claims, or leave unaffected the rights of holders of any class of claims." Second, each class that is modified under 11 U.S.C. Section 1123(b)(5) is considered an impaired claim under 11 U.S.C. Section 1124. Although beyond the scope of this article, if the plan contains one or more impaired classes, a debtor can only confirm a plan if at least one of the impaired classes votes to accept the plan. By placing creditors into separate classes the debtor increases the likelihood of procuring at least one (or more) votes to accept the plan in an effort to confirm the plan despite opposition from other classes of creditors.
Although simplified for purposes of this article, the confirmation process provides the context necessary to understand the implications of a creditor electing to have its claim treated under 11 U.S.C. Section 1111(b)(2). It is important to note at the outset that the election under 11 U.S.C. Section 1111(b)(2) is not available to all creditors; "wholly unsecured" creditors and creditors with claims of inconsequential value are prohibited from making the election. See In re O'Leary, 183 B.R. 338, 27 Bankr. Ct. Dec. (CRR) 478 (Bankr. D. Mass. 1995). For those creditors eligible to make the election, the effect of 11 U.S.C. Section 1111(b)(2) is to allow an undersecured creditor to have its entire claim, including the secured and unsecured portion, treated as fully secured. For example, assume that a debtor in Chapter 11 has an investment property with one outstanding loan that has an unpaid principal balance in the amount of $500,000 and a fair market value of $300,000. Pursuant to 11 U.S.C. Sections 1123(b)(5) and 1129(a)(7), if the creditor does not elect treatment of its claim under 11 U.S.C. Section 1111(b)(2), the debtor has the ability to propose a plan of reorganization which "crams down" the principal balance to the fair market value of $300,000, to be repaid pursuant to what can best be described as "commercially reasonable" terms, with the remaining $200,000 balance being classified as unsecured and being repaid along with other unsecured claims.
When a creditor makes the election for claim treatment under 11 U.S.C. Section 1111(b)(2), the debtor loses the ability to bifurcate the creditors claim into secured and unsecured claims. Instead, as to the electing creditor's claim, the debtor must comply with 11 U.S.C. Section 1129(b)(2)(A), which requires that the entire allowed claim in be paid in full and that the plan provide for payments equal to or greater than the present value of the collateral. Said another way, by making the election under 11 U.S.C. Section 1111(b)(2), the creditor will have one fully secured claim equal to the combined amount of its secured and unsecured claims, instead of one secured and one unsecured claim, and the plan must set forth payment terms which will pay to the creditor the full amount of its secured claim.
The decision regarding the election under 11 U.S.C. Section 1111(b)(2) is more involved than simply comparing the outstanding principal balance to the value of the property and involves an good understanding of the current lending environment as well as bankruptcy law. For those creditors with the option to make the election under 11 U.S.C. Section 1111(b)(2), one of the first steps is to look to the plan proposed by the debtor, and to determine whether the election under 11 U.S.C. Section 1111(b)(2) will be beneficial to the creditor. This determination will require an analysis of several factors including, but not limited to, present value, interest rates, length of repayment, the nature of the subject property, and the economic environment. As well, a creditor must understand that while courts look to the lending community for guidance regarding fair treatment of a claim, the final determination as to the repayment terms contained within a plan are likely going to be guided more by legal precedent than by commercially reasonable terms a similarly situated party would receive outside of the bankruptcy context. For example, in determining the appropriate rate of interest to be paid on a claim, courts apply the "prime-plus" approach first established in the Supreme Court's decision Till v. SCS Credit Corp., 541 U.S. 465, 479 (2004). Under the "prime-plus" approach, the interest rate to be applied to secured claims is the prime rate of interest, plus an adjustment for risk. Although simple in theory, determining a fair interest rate under the "prime-plus" formula has generated a significant amount of litigation. Additionally, the length and dynamics of the plan payment terms, as discussed below, are not well defined within the law, which means that counsel will likely need to be consulted in order to fully understand the impact of making an election under 11 U.S.C. Section 1111(b)(2).
Using the example set forth above, the effect of making the election under 11 U.S.C. Section 1111(b)(2) would allow the creditor to receive total payments of $500,000 over the life of a proposed repayment plan. However, once the election is made under 11 U.S.C. Section 1111(b)(2), the debtor, subject to court approval, controls the repayment schedule. What this means is that although the debtor may have initially proposed a plan which would pay off the entire "crammed down" value in 10 years, once the election is made under 11 U.S.C. Section 1111(b)(2), the debtor may theoretically propose a much longer repayment plan instead. Accordingly, creditors must be aware of time value of money considerations in making the election under 11 U.S.C. Section 1111(b)(2) weighed against the present day inflation or deflation of the subject real property value and the potential, or lack thereof, secondary market for the loan.
Additionally, by making the election under 11 U.S.C. Section 1111(b)(2), a creditor foregoes the right to an unsecured claim. In certain circumstances, a creditor that has a large enough unsecured claim to control the vote of the unsecured class, may have the ability to control whether a debtor can confirm a plan. This ability to control the reorganization process is, in many instances, more valuable than the election provided under 11 U.S.C. Sectino 1111(b)(2), and can provide such a creditor the ability to obtain even better terms than if it had elected to have its claim treated under 11 U.S.C. Section 1111(b)(2).
A secured creditor must be vigilant in protecting its rights whenever the borrower files Chapter 11 bankruptcy. If the secured creditor fails to take the time necessary to review the plan and disclosure statement, and to timely make an election under 11 U.S.C. Section 1111(b)(2), the secured creditor may be foregoing a powerful, and financially beneficial, right.
This article should not be considered or construed as legal advice on any fact or circumstance. You should consult your own attorney regarding your own personal situation or any legal question you may have.