Byline: Paul Arrow, Esq.

Daily Journal, Buchalter Nemer Points & Authorities

A chapter 11 bankruptcy case is often a negotiation more than anything else. But in the bankruptcy world, the normal balance of power between a lender and borrower is altered: the borrower is given a number of bargaining chips that it lacks in the real world. For example, an automatic stay prevents a lender from exercising any rights and remedies notwithstanding a borrower’s defaults. Also, in a process called “cramdown,” a borrower in bankruptcy has the power to restructure a loan, including altering the term, interest rate, and even the amount of the secured obligation. In short, aside from an exception not discussed here, a lender’s secured claim is worth only as much as the value of the collateral. A lender has an unsecured deficiency claim for the amount owed in excess of the collateral value. With the recent steep declines in real estate value, secured lenders are getting a crash course in what it means to be an undersecured creditor in a bankruptcy case.       

While not a good thing, ending up with an unsecured deficiency claim has not been all bad. It often gives a lender the opportunity to block confirmation of a reorganization plan, and in so doing, create bargaining leverage. To confirm a plan over a secured creditor’s objection, the debtor must obtain the consent of at least one impaired class of claims. A class of claims can accept a plan if half in number and two-thirds in dollar amount of the total claims in the class, vote to accept. In a real estate case, the consenting-impaired class that debtors most often try to obtain is the class of general unsecured claims. Also, typically in real estate cases, the class of unsecured creditors is not large, either by number or dollar amount. While aggregate trade claims may total less than $1 million, the secured creditor’s unsecured deficiency claim may be (and often is) many multiples of that. If the deficiency claim is included in the class of general unsecured claims, the secured creditor can swamp the votes of the other unsecured claimants and control the class vote. By ensuring a vote to reject the plan, the secured creditor may deprive the borrower of the necessary consenting impaired class, and prevent confirmation.

To deal with this problem, borrowers have long tried to separately classify large deficiency claims. The problem with this tactic is that case law requires similar claims to be classed together. Most courts have held that absent specific business reasons, unsecured deficiency claims are substantially similar to other general unsecured claims, and must be classed together. Borrowers’ attempts to separately classify deficiency claims to obtain confirmation are derisively dismissed as gerrymandering.

Two recently published opinions by the same Bankruptcy Judge, however, may provide borrowers with a clearer path to separately classify deficiency claims. In In re Loop 76, LLC, a single asset real estate case decided on November 22, 2010, a secured creditor had a total claim against the borrower of $23 million. It also held the secured guarantee of a third party. The property securing the claim was valued at only $17 million. Accordingly, the claim was bifurcated into two: a secured claim for $17 million, and an unsecured deficiency claim for $6 million. The borrower’s plan separately classified the deficiency claim from the general unsecured claims. Had they been classed together, the secured creditor would have controlled the general unsecured class, and may have defeated confirmation of the plan.

The secured creditor objected to the classification, arguing that the deficiency claim was substantially similar to the general unsecured claims, that they must be classed together, and that the borrower was impermissibly gerrymandering the classes to obtain acceptance. The Court disagreed noting that while similar claims may be classed together, the Bankruptcy Code requires that dissimilar claims must not be classed together. The Court went on to hold that because the creditor held a third party guarantee, it had an independent source of payment for its deficiency claim. According to the Court, that difference was sufficient to mandate separate classification of the deficiency claim. The ruling permitted the borrower to obtain an accepting impaired class (the general unsecured class) and confirm the plan over the secured creditor’s objection.

Five months later, on April 14, 2011, the same Judge made a similar ruling in In re Red Mountain Machinery Co. Again, he permitted confirmation of a plan over the primary secured creditor’s objection that the borrower impermissibly separately classified its unsecured deficiency claim. Again, the basis for the ruling was that the creditor had an independent source of payment for its deficiency claim, rendering it dissimilar from other unsecured claims, and mandating separate classification.  

Since many, if not most, commercial lenders obtain third party guarantees or otherwise have recourse to third parties to support loans, the impact of these rulings could be widespread. If permitted to stand, they will alter the playing field by removing a significant strategic bankruptcy bargaining chip traditionally held by a creditor. The Loop 76 order has already been appealed to the Ninth Circuit Bankruptcy Appellate Panel. The secured creditor in Red Mountain also intends to appeal the ruling in that case. If the rulings are upheld on appeal, they may be binding on all bankruptcy courts in the Ninth Circuit, and will provide support for extension to other circuits. Stay tuned for further developments.