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Third Circuit Upholds Bankruptcy Court’s Use of Real Estate Appraisal of Fair Market Value Under §506(a) And Clarifies Burden of Proof in Such Cases

July 25, 2012


In In re Heritage Highgate, Inc., 679 F.3d 132 (3d Cir. 2012), the Third Circuit held that the bankruptcy court properly concluded that the fair market value of a project as of the confirmation date controlled whether the claims at issue were secured or unsecured under §506(a). The Court also clarified that a shifting burden of proof was appropriate with respect to such valuations in the §506(a) context.  Finally, the Court found that denying the secured party future proceeds of lot sales did not amount to impermissible lien stripping under Dewsnup v. Timm, 502 U.S. 410 (1992) as Dewsnup only applied in chapter 7 liquidations and not in chapter 11 cases where the debtor is retaining the property for use in rehabilitating its business.

In Heritage, a group of creditors known as the Cornerstone Investors (“Cornerstone”), held a lien on a certain residential subdivision in Lehigh County, Pennsylvania (the “Project”) owned by homebuilders Heritage Highgate, Inc. and Heritage-Twin Ponds II, L.P. (the “Debtors”). The lien held by Cornerstone was subordinated to the lien held by a group of banks led by Wachovia Bank (the “Bank Lenders”).  After building and selling a quarter of the lots at the Project, the Debtors filed petitions under chapter 11 and proposed a plan that provided for completion of the Project and distributions to creditors based upon certain projections.  The projections provided for (i) payment in full of the secured claim of the Bank Lenders, (ii) payment in full of the secured claim of Cornerstone, and (iii) payment of all unsecured claims at a rate of approximately 20% each from funds earned through the sale of lots.

In connection with a contested cash collateral hearing earlier in the case, the Debtors offered a 140 page appraisal of the Project setting forth in detail the appraiser’s estimation of the fair market value of the Project pursuant to two well-accepted appraisal methodologies:  the sales comparison approach and the income capitalization approach.  Both methodologies yielded virtually identical estimates, but the appraiser favored the latter approach as it more accurately considered the time and expenses related to a real estate development like the Project.  The Bankruptcy Court accepted the appraiser’s valuation of $15 million, which at the time was sufficient to cover the entirety of the secured debt.

Later in the case, the Official Committee of Unsecured Creditors (the “Committee”) filed a motion to value the secured claims of Cornerstone at $0 because the collateral securing the liens of Cornerstone was less than the Bank Lenders’ senior secured claim.  As proof of the collateral’s worth, the Committee offered the appraisal previously accepted by the Bankruptcy Court at the contested cash collateral hearing and argued that when reduced by interim sales, the fair market value was approximately $9.54 million, which was insufficient to pay the Bank Lenders’ claim in full, and rendering the secured claims of Cornerstone valueless.  In response, Cornerstone argued that its secured claims should be deemed wholly secured because the plan projections demonstrated that the Debtors would derive revenue from the Project sufficient to pay its claim in full, as well as make a distribution to unsecured creditors.  To find otherwise, Cornerstone argued, would be impermissible lien stripping.  Based upon the projections, the Bankruptcy Court specifically found that the plan was feasible and confirmed it.   The plan also provided that Cornerstone’s claim would be valued in connection with the Committee’s motion.

In considering the motion to value the collateral, the parties stipulated that the Bank Lenders were owed $12 million while Cornerstone was owed $1.4 million and that the appraised value of the Project should be reduced due to the Debtors’ sale of lots since the appraisal was completed months earlier leaving the total fair market value based on the appraisal at $9.5 million. Cornerstone argued that the appraisal did not control because §506(a) requires that the value of property “be determined in light of its proposed disposition or use” and the plan projections demonstrated that under the Debtors’ proposed use, there would be more than sufficient funds to pay the secured claims in full.   The Bankruptcy Court, however, agreed with the Committee that the proper method for valuing the collateral was the fair market value of the Project as of the confirmation date.  Since Cornerstone did not dispute the accuracy of the appraisal and chose instead to rely on the projections in the plan, its claim would be treated as unsecured.

On appeal, the District Court affirmed, and relying upon the decision in Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997), found the fair market value controlling and the appraisal to have accurately measured that value; the plan projections merely demonstrated plan feasibility and not the Project’s present value.

On appeal, the Third Circuit upheld the decision.  As a preliminary matter, the Court clarified that a burden-shifting approach was the proper framework for evaluating §506(a) claims.  Because a proof of claim is prima facie evidence as to the validity and amount of a properly filed claim under §502(a) and Bankruptcy Rule 3001(f), it is only fair that the party seeking to negate a presumptively valid amount of a secured claim bear the initial burden.  If sufficient evidence is provided of the secured claim’s value, the burden shifts to the claimant to refute that evidence by a preponderance of the evidence as to the extent of the lien and the value of the collateral.  Here, Cornerstone did not dispute the validity of the appraisal; it just relied on the plan projections and therefore did not meet its shifting burden.

Further, the Court agreed that the proper method for valuing collateral for §506(a) purposes based on Rash depends on what is to be done with the property – whether it is to be liquidated, surrendered, or retained by the debtor.  In Rash, the court considered the proper valuation under §506(a) in a cramdown context and found that if the debtor elects to use the collateral to generate an income stream, as in cramdown, a foreclosure sale analysis would be improper; rather the value derived from the collateral is equal to its replacement value, i.e., the cost the debtor would incur to obtain a like property for the same proposed use which is consistent with fair market value which reflects what price a willing buyer in the debtor’s business would pay a willing seller to obtain a similar property.  Here, Cornerstone urged a wait and see approach to a valuation of the Project dependent on the sale of lots and the income generated therefrom. The Court was unaware of any court following this approach to valuation and found such an approach at odds with the intent of §506(a) to value collateral into secured and unsecured portions during the reorganization and before the plan’s success or failure is determined.  The budget relied on by Cornerstone was merely a set of projections offered by the Debtors to determine the plan’s feasibility and was not intended to function as anything more.  Indeed, even the plan contemplated that the secured claim of Cornerstone would be determined by the Court pursuant to the Committee’s motion.

The Court also rejected Cornerstone’s argument that to deny it proceeds from the future sale of lots that exceeded the Project’s judicially determined value at confirmation would be impermissible lien stripping under Dewsnup.  However, the Court, analyzing Dewsnup’s holding and its progeny, found that the holding of Dewsnup was limited to liquidations in chapter 7 cases and should not be applied in rehabilitative chapter 11 cases where the liened property is retained and used by the debtor post-confirmation.