Third Circuit in Heritage Clarifies Burden of Proof For Valuation And Allowance of Secured Claims Under Bankruptcy Code Section 506(a)

On May 14, 2012, the Third Circuit Court of Appeals in In re Heritage Highgate, Inc., et al., No. 11-1889 (3d Cir. May 14, 2012) clarified the burden of proof with respect to the valuation and ultimate allowance of alleged secured claims under Bankruptcy Code section 506(a). In clarifying this burden, the Third Circuit held that a burden-shifting approach applies under Section 506(a), requiring the debtor to first overcome the presumed validity and amount of the creditor’s secured claim, with the creditor bearing the ultimate burden of persuasion to demonstrate, by a preponderance of the evidence, both the scope of its lien and the value of the collateral securing its claim. In addition, the Third Circuit held that the value of collateral is based on the fair market value of the collateral at the time of confirmation, and not based on any proposed future disposition or use of the collateral.

In Heritage, the underlying debtors owned and developed residential subdivision in Lehigh County, Pennsylvania (the “Property”). Based on a real estate appraisal of the Property presented to the bankruptcy court in conjunction with cash collateral hearings, the value of the Property was initially greater than the aggregate claims of its senior secured lenders (the “Bank Lenders”) and its junior secured lenders (a group of individuals identified as the “Cornerstone Investors”). (It should be noted that the Third Circuit, in a footnote, gave credence to the use of both the sales comparison approach and income capitalization approach in deriving the fair market value of property.)

Thereafter, however, the appraised value of the Property declined as a result of the sale of certain parcels of land. Nevertheless, the debtors proposed a Chapter 11 plan under which they would pay both the Bank Lenders and the Cornerstone Investors one hundred percent of their secured claims from the proceeds of the sale of Property over time. The Official Committee of Unsecured Creditors (the “Committee”) filed a motion to value the Cornerstone Investors’ alleged secured claims at zero pursuant to Section 506(a) and Fed.R.Bankr.P. 3012. The Committee claimed that the market value of the Property at the time of confirmation should control for purposes of determining whether the Cornerstone Investors held fully-secured claims under Section 506(a). As a result of the sale of certain Property lots, the appraised value of the Property was below the aggregate amount of the Bank Lenders and Cornerstone Investors’ claims at confirmation of the debtors’ Chapter 11 Plan. In opposition, the Cornerstone Investors argued that their claims were fully-secured because “the value of property [was to] ‘be determined in light of [its] proposed disposition or use’ and the plan budget demonstrated that the Debtors would be able to pay their claims in full over time as more homes were sold.”

The bankruptcy court, and the district court on appeal, agreed with the Committee. The bankruptcy court found that “the proper method of valuing the Cornerstone Investors secured claims was the fair market value of the Project as of the plan confirmation date.” Because the Bank Lender’s secured claim exceeded the fair market value of the Property, the claims were unsecured, and the debtors’ plan would treat the Cornerstone Investors as unsecured creditors.

On appeal, the Third Circuit first focused on the burden of proof in establishing a secured claim under Section 506(a) - an issue not addressed by the lower courts. The Third Circuit adopted a burden-shifting analysis, with the initial burden resting with the challenging party because of the prima facie effect of a properly filed proof of claim. However, “[i]f the movant establishes with sufficient evidence that the proof of claim overvalues a creditors secured claim because the collateral is of insufficient value, the burden shifts.” Once the burden shifts, the creditor bears the burden of proof to establish its security interest and the value of its collateral.

After addressing the burden of proof, the Third Circuit went on to consider the proper timing for valuing collateral under Bankruptcy Code section 506(a), largely relying on in Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997). In that case, the U.S. Supreme Court decided the proper valuation standard under Section 506(a) in the Chapter 13 context, holding that the “replacement-value” standard (i.e., “what the debtor would have to pay for comparable property”) controlled. The Third Circuit applied this “replacement-value” standard to value the Property. The Third Circuit rejected the Cornerstone Investors’ “wait-and-see approach” (i.e., analyzing value based on proposed development and sale of lots over time) in valuing the Property, stating that this approach was at odds with Section 506(a)’s requirement “for the division of allowed claims supported by liens into secured and unsecured portions during the reorganization, before the plans success or failure is clear.” Further addressing the Cornerstone Investors’ arguments, the Third Circuit also agreed with the lower court’s characterization of the debtor’s plan-budget as a set of projections supporting plan feasibility rather than a valuation tool.

The Third Circuit also addressed the Cornerstone Investors’ argument that the disallowance of their secured claims would constitute lien-stripping violative of the U.S. Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992). In that case, the U.S. Supreme Court concluded that any increase in value of collateral during the pendency of a Chapter 7 case accrues to the benefit of a secured creditor, and not the Chapter 7 debtor. The Third Circuit, however, distinguished Dewsnup, finding that its holding only applied to Chapter 7 liquidation cases, and not Chapter 11 reorganization cases. In addition, the Third Circuit also addressed the Cornerstone Investors’ late argument that the debtors’ real estate appraiser utilized a flawed methodology. Because the Cornerstone Investors did not contest the appraisal before the bankruptcy court, the Third Circuit refused to consider this argument.

The Heritage decision provides several practice points for commercial real estate and commercial/industrial chapter 11 cases. It clarifies the burden-shifting analysis for allowing secured claims under Section 506(a) in the Third Circuit. In addition, the Heritage decision confirms the benefits of active participation in a Chapter 11 case, including the filing of a claim of a proof of claim, due to the presumption of a valid proof of claim under the Bankruptcy Code and the resulting burden shifting analysis applied by the Third Circuit.

The Heritage decision also highlights the need to commission one’s own appraiser, particularly in conjunction with contested proceedings. With respect to cash collateral, the Cornerstone Investors did not challenge the debtors’ initial appraisal because it presumably sufficed for adequate protection purposes. Cornerstone Investors also relied on the appraisal commissioned by the debtors for purposes of valuing the Property at plan confirmation. Had they engaged their own appraiser, Cornerstone Investors may have obtained a higher valuation for the Property and created a question of fact as to its value. A secured creditor must be careful to rely on its own analysis and experts for valuation purposes, particularly if it bears the burden of proof.

Furthermore, the Heritage decision emphasizes the difficult choices that a secured creditor may face in a Chapter 11 proceeding. A secured creditor must be vigilant in guarding its rights and preserving all options as a case proceeds. For example, the outcome of this case for the Cornerstone Investors might have changed had they made a Section 1111(b) election to have its entire claim treated as secured. Couple with their own appraisal, the treatment of the Cornerstone Investors claim could have been substantially different had they made this election.

Finally, the Heritage decision demonstrates how valuation can be particularly important and have different uses depending on the procedural posture of the case. For example, a lower property valuation may be important in conjunction with a secured creditor’s opposition to the use of cash collateral or its request for relief from the automatic stay. At confirmation, however, a creditor may desire a higher valuation to preserve its treatment as a secured creditor under a Chapter 11 plan, or could desire a lower valuation to allow it to control two different classes of claims (i.e., based on the bifurcation of a lender’s secured/unsecured claims under Section 506(a)). Consequently, a secured creditor must be cautious in consenting to relief - which could be interpreted as a consent to valuation - and should preserve its strategic options and remedies, many of which flow from collateral valuation.