December 02, 2005
Part One of this Article explored some of the possible bankruptcy implications of a real estate slowdown. It began with the premise that a slowdown would be triggered, among other things, by increasing interest rates and would be characterized by lagging sales and declining prices. Part One examined how a slowdown will impact the pace of real estate bankruptcies, recovery of interest, fees and costs in bankruptcy and disputes over adequate protections of collateral and relief from the automatic stay. Part Two concentrates on the culminating event in every bankruptcy reorganization, the reorganization plan, and how a real estate slowdown will impact plan content and strategy.
Subject to certain statutory requirements, the Bankruptcy Code (“Code”) permits rather extensive restructuring of secured debt pursuant to a reorganization plan. For one thing, Code § 506(a), provides that secured debt can be written down to the current value of the real estate collateral, even if it happens to be less than the outstanding debt, in what commonly is referred to as a "strip down". The remainder of a creditor's claim is not treated as secured but rather as a general, unsecured claim. Thus, in the case of a $1 million claim secured by real estate of a value of $800,000, a plan could "strip down" the secured claim to $800,000 with the remaining $200,000 treated as unsecured. A potential creditor response to threatened "strip down" is included in Code § 1111(b). In the previous example that section would allow a secured creditor to choose to retain its $1 million secured claim and forego any unsecured claim. However, under § 1111(b) the $1 million secured claim could be satisfied with payments which, when discounted, had a present value of only $800,000. What this means is that the plan payments would (1) be deferred and (2) bear interest at a below market rate. In most cases, the § 1111(b) election will not be an attractive choice for the secured creditor.
"Strip down" is not the only contractual change to which a real estate secured claim may be susceptible pursuant to a plan. Section 1123(a)(5)(H) permits a plan both to extend the term of repayment and to adjust the applicable interest rate. Subject to specified conditions, a plan also may provide for a sale of real estate collateral free and clear of liens. Code § 1123(a)(5)(D). A plan may even reverse a prior debt acceleration and eliminate accrued penalty interest by including provision for prompt cure at non-default rates. Code § 1124. See In re Entz-White Lumber & Supply, Inc., 850 F.2d 1338 (9th Cir. 1988).
Although the preference is that any plan-related contractual alterations be acceptable to a secured creditor, the Code permits changes to be imposed on an unwilling secured lender utilizing the so-called "cram down" powers under Code § 1129(b). With respect to real estate secured claims, that section requires that the creditor retain its lien and receive "deferred cash payments totaling at least the allowed amount of such (secured) claim, of a value, as of the effective date of the plan, of at least the value of such holder's interest in the estate's interest in such property." This necessitates a collateral valuation and assurance that a plan provides a payment stream which, when discounted to present value, equals the current value of the collateral. Thus, in the example cited above, ($1 million debt secured by $800,000 property), a plan potentially could be “crammed down” if it offered a payment stream with a discounted present value of $800,000.
A real estate market which is characterized by rising interest rates and declining values can impact virtually every aspect of a plan to reorganize real estate secured debt. As real estate values drop, there will be a temptation for debtors to attempt to “strip down” the secured claim to the reduced value of the collateral. On the negative side, in a declining market, equity is eroding. This will make it more difficult for a debtor to satisfy the requirements for a sale free and clear of heirs under Code § 363(f).
Increased interest rates will have an entirely negative effect on a debtor’s plan-related attempt to reorganize real estate secured debt. For example,
· Post-filing interest accrues on fully secured debt. Code § 506(b). Current rates can impact a court’s determination of the appropriate rate of post-filing interest.
· As interest rates climb, the cost to cure a pre-bankruptcy default with new borrowed money pursuant to Code § 1124 increases.
· As market rates increase, any plan-related downward adjustment of contract interest rates becomes an impossibility.
· Because current market rates are taken into account in the present value calculation, increased interest rates will be reflected in the plan so that the present value calculation satisfied the “cram down” requirement of § 1129(b)(2).
In general a down real estate market, marked by slowing sales and rising interest rates, will make it increasingly more difficult for debtors successfully to reorganize real estate secured debt in bankruptcy.