Ninth Circuit Reverses Course on Measure of Collateral Value in Cramdown Confirmation of Chapter 11 Plan

by Jones Day

Jones Day

In First Southern Nat’l Bank v. Sunnyslope Hous. LP (In re Sunnyslope Hous. LP), 2017 BL 216965 (9th Cir. June 23, 2017), the U.S. Court of Appeals for the Ninth Circuit held en banc that, in determining whether a chapter 11 plan may be confirmed over the objection of a secured creditor, the creditor’s collateral must be valued in accordance with the debtor’s intended use of the property, even if the property would realize more in a foreclosure sale because of the existence of restrictive covenants. According to the Ninth Circuit, this conclusion was mandated by section 506(a)(1) of the Bankruptcy Code and U.S. Supreme Court precedent.

Valuing a Secured Creditor’s Collateral in a Cramdown

Section 1129(b) of the Bankruptcy Code provides that a chapter 11 plan may alter the payment terms of an objecting secured lender’s loan if, among other things, the plan’s treatment of the dissenting secured creditor’s claim is "fair and equitable." In such a "cramdown" confirmation, section 1129(b)(2) provides that "fair and equitable" means that: (i) the dissenting secured creditor retains the lien on its collateral and receives deferred payments totaling at least the allowed amount of its secured claim at an appropriate rate of interest; (ii) the collateral is sold and the creditor’s lien attaches to the sale proceeds; or (iii) the creditor receives the "indubitable equivalent" of its secured claim.

The Bankruptcy Code does not mandate any specific method for valuing collateral. However, section 506(a)(1) provides that the value of collateral must be "determined in light of the purpose of the valuation and of the proposed disposition or use of such property." In Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997), the U.S. Supreme Court held that, to confirm a chapter 13 plan over the objection of a dissenting secured creditor, section 506(a)(1) requires a "replacement value," rather than a "foreclosure value," standard.

Under a replacement value standard, the value of the collateral equals "the cost the debtor would incur to obtain a like asset for the same ‘proposed . . . use.’ " Id. at 965 (quoting section 506(a)(1)). By contrast, under a foreclosure value standard, value is determined on the basis of the amount a creditor would realize upon immediate foreclosure and sale of the property. In nearly all cases, replacement value will exceed foreclosure value.

According to the Supreme Court in Rash, only a replacement value standard takes into account the debtor’s "proposed disposition or use of such property" because the debtor—by virtue of its bankruptcy filing—opted to avoid foreclosure. The Court also emphasized that the replacement value standard protects creditors from the "double risks" they face when a defaulting debtor opts to retain and continue using collateral instead of allowing the creditor to repossess it. If a debtor retains collateral instead of surrendering it to the secured creditor, the creditor risks: (1) another default by the debtor; and (2) a decline in the value of the property because of extended use. Neither risk is present, the Court noted, if a creditor can repossess the property and immediately realize its value.

Sunnyslope Housing presented the Ninth Circuit with an unusual scenario: mortgaged real property owned by the debtor was subject to certain covenants that reduced the value of the property if the debtor retained ownership, but could be shed in a foreclosure sale.

Sunnyslope Housing

Sunnyslope Housing Limited Partnership ("Sunnyslope") owned an apartment complex in Arizona. Capstone Advisors, LLC ("Capstone") provided $8.5 million in construction financing for the complex. The Capstone loan, which had an annual interest rate of 5.35 percent, was secured by a first-priority deed of trust on the complex and guaranteed by the U.S. Department of Housing and Urban Development ("HUD"). In order to obtain the HUD guarantee, Sunnyslope entered into a regulatory agreement mandating that the complex be used for affordable housing. Sunnyslope also entered into other agreements with state and city agencies that required portions of the complex to be reserved for low-income housing. These covenants ran with the land but terminated upon foreclosure.

In 2009, Sunnyslope defaulted on the Capstone loan. HUD acquired the Capstone loan shortly thereafter and later sold it to First Southern National Bank ("First Southern") for $5.05 million. Although HUD terminated its regulatory agreement as part of the sale, the other low-income housing covenants remained in effect.

First Southern initiated foreclosure proceedings, and a state court appointed a receiver for the apartment complex. A proposed sale of the complex for $7.65 million was pending when Sunnyslope’s general partner filed an involuntary chapter 11 petition for Sunnyslope in January 2011 in the District of Arizona.

Sunnyslope proposed a chapter 11 plan under which it would retain the apartment complex and modify the terms of First Southern’s secured loan. First Southern objected to the proposed treatment of its claims.

Sunnyslope and First Southern disputed the value of the apartment complex for purposes of confirmation of a cramdown chapter 11 plan. The bankruptcy court ruled that, even though the restrictive covenants lowered the property’s value, that value should be "the value of the property as it is owned by the Debtor, which means as low-income property." After the bankruptcy court made its valuation determination, First Southern elected to treat the entirety of its claim as fully secured under section 1111(b) of the Bankruptcy Code.

The bankruptcy court later confirmed Sunnyslope’s chapter 11 plan. Under the plan, First Southern’s secured claim, valued at $2.6 million (the value of the complex as a low-income housing project), would be paid over 40 years at a 4.4 percent annual rate of interest. Any remaining balance on the claim would be paid through a balloon payment at the end of the 40-year period. The court found the plan to be fair and equitable because First Southern retained its lien, would receive market-rate interest, and maintained the right to foreclose on the property in the event of default.

On appeal, the district court affirmed the bankruptcy court’s valuation of the complex. According to the district court, Rash established that "value is based on what a willing buyer in the debtor’s trade, business, or situation would pay to obtain like property from a willing seller." Since a willing buyer would be able to operate the complex as affordable housing only while the restrictive covenants were in place, the district court reasoned, the bankruptcy court correctly found that the property’s foreclosure value (albeit higher than the replacement value) was irrelevant to the valuation analysis under section 506(a)(1).

The district court ruled, however, that the bankruptcy court erred in omitting certain tax credits from its valuation. On remand, the bankruptcy court adjusted the value of the collateral (with the tax credits applied) to $3.9 million. First Southern then sought to modify its section 1111(b) election so that a portion of its claim would be unsecured. The court denied this request, finding the change to be immaterial and ruling that First Southern was not entitled to a "second bite at the apple" and a new opportunity to reject the plan and unwind the reorganization.

A divided three-judge panel of the Ninth Circuit reversed the bankruptcy court’s confirmation order. See In re Sunnyslope Hous. Ltd. P’ship, 818 F.3d 937 (9th Cir.), vacated, 838 F.3d 975 (9th Cir. 2016). The majority ruled that: (i) Rash requires the court to use replacement value in determining the value of collateral; (ii) in accordance with section 506(a)(1), replacement cost "is a measure of what it would cost to produce or acquire an equivalent" parcel of property; and (iii) "the replacement value of a 150-unit apartment complex does not take into account the fact that there is a restriction on the use of the complex." Rash cannot be interpreted, the majority explained, to impose the double risks (debtor default and property deterioration resulting from extended use) on creditors while providing them with "about one-third of what the creditor could obtain if the property were surrendered." By contrast, the dissenting opinion argued that "a straightforward application" of Rash "compels valuing First Southern’s collateral . . . in light of Sunnyslope’s proposed use of the property in its plan of reorganization as affordable housing."

The Ninth Circuit later agreed to reconsider the panel’s decision en banc and vacated the ruling.

The Ninth Circuit’s En Banc Ruling

After a rehearing en banc, an 8-3 majority of the Ninth Circuit reversed course and affirmed the lower court rulings. At the outset, the majority recognized that the case was unusual, since the foreclosure value of the apartment complex exceeded the replacement value.

Writing for the majority, circuit judge Andrew Hurwitz stated that the "essential inquiry under Rash is to determine the price that a debtor in Sunnyslope’s position would pay to obtain an asset like the collateral for the particular use proposed in the plan of reorganization." Under Rash, Judge Hurwitz concluded, the property must be valued at the debtor’s "proposed disposition or use" even if the property could achieve a higher value if used differently.

He cautioned against using a "hypothetical" foreclosure value, because the debtor opted to retain the property in the reorganization: "We cannot depart from [the replacement value] standard without doing precisely what Rash instructed bankruptcy courts to avoid—assuming a foreclosure that the Chapter 11 petition prevented." In this instance, Judge Hurwitz explained, the valuation must take into account the restrictive covenants because the property could be used for no other purpose absent foreclosure.

Judge Hurwitz also responded to various policy arguments by noting that the primary purpose of chapter 11 is to maximize the value of the debtor’s estate, not protect creditor interests. He rejected the argument that "valuing the collateral with the low-income restrictions in place would discourage future lending on like projections." According to the judge, First Southern was aware of the restrictions when it purchased the loan at a discount, and thus, the bankruptcy court’s valuation subjected First Southern to "no more risk than it consciously undertook."

The majority ultimately held that Sunnyslope’s chapter 11 plan was fair and equitable because First Southern would receive payments equal to the present value of its secured claim. It also ruled that the bankruptcy court committed no error by denying First Southern’s request to modify its section 1111(b) election on remand because the amended plan adjusted the valuation of the collateral but did not alter First Southern’s treatment.

The Dissent

Three judges dissented. According to the dissent, the majority "adopted a test that is not dictated by the letter of Rash and is contradicted by its reasoning." The dissent would instead base the valuation on the "market price of the building without restrictive covenants." Although Rash adopted a replacement value standard, the dissent explained, the Court intended that standard to be flexible and dependent on the "type of debtor and the nature of the property." Otherwise, the debtor’s unique preferences could, in some instances, drastically undervalue the property to the detriment of the creditor.


The scope and significance of Sunnyslope Housing are uncertain. It remains to be seen whether other circuits will interpret Rash as mandating that replacement value be used in valuing collateral for purposes of nonconsensual confirmation of a chapter 11 plan, even where replacement value is demonstrably less than foreclosure value. Courts not bound by the Ninth Circuit’s ruling may distinguish Sunnyslope Housing because of its unusual facts. However, secured creditors should be aware of the prospect that debtors may rely on the ruling to argue that collateral must be valued on the basis of its proposed use under a plan, even if that valuation is less than foreclosure value.

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