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Preserving frozen assets.

Here is a useful primer about the bankruptcy process and how lenders can defend the value of their secured and unsecured claims.

The conventional wisdom is that in any bankruptcy proceeding you are better off as a secured lender than as an unsecured lender. True, but not true. Both Chapter 11 and Chapter 13 of the bankruptcy code allow a debtor to modify rights of a secured lender as part of the debt repayment plan, and that could cause the secured lender some insecurity.

In a recent decision, Toibb v. Radloff (111 S.Ct. 2197 [1991]), the United States Supreme Court concluded that an individual without a business is eligible for Chapter 11. With respect to Chapter 13, a bill (S. 1985) was recently introduced in the U.S. Senate that proposes to increase the eligibility limits from the current level of not more than $100,000 of unsecured debt and $350,000 of secured debt to $1 million total. With the clarification of the eligibility of individuals to file for Chapter 11, along with the likelihood of an increase in the eligibility limits in Chapter 13, both chapters become increasingly available to debtors faced with a foreclosure on their real estate holdings.

This article briefly discusses provisions in Chapter 11 and Chapter 13 that allow a debtor to modify the rights of a lender holding a mortgage on real estate. Along the way it discusses some strategies for lenders to pursue in seeking to minimize the modification of their rights. By knowing something about the debtor's rights to modify, and the responses available to secured lenders, some of the mental insecurity can be avoided.

General provisions modifying a secured lender's rights

A discussion of the bankruptcy code and its effect on lenders normally begins with the automatic stay. The automatic stay, among other things, stops most collection and enforcement actions by creditors. Once a bankruptcy is filed, the lender's state law rights to foreclose on its collateral is stayed.

A secured lender can obtain relief from stay under two circumstances. The first exists when the lender is refused "adequate protection." The second instance applies when there is no equity in the property and the property is not necessary for an "effective reorganization."

Adequate protection is intended to protect the value of the lender's secured claim so it does not diminish during the bankruptcy proceeding. Adequate protection can take the form of periodic payments, interest payments, replacement liens on other property or other compensation as necessary to prevent any loss to the lender arising out of its being delayed in the enforcement of its rights.

Another bankruptcy provision that is becoming more familiar to lenders is Section 506. Section 506 provides for the determination of secured status. Under the authority of Section 506(a), a lender's claim can be bifurcated into a secured portion and an unsecured portion. The Supreme Court decided on January 15, 1992, in Dewsnup v. Timm that Section 506(d) does not allow a Chapter 7 debtor to "strip down" a lien to the judicially determined value of the collateral. It is not believed, however, that this decision will limit a debtor's ability to bifurcate claims in Chapter 11 and Chapter 13.

If the value of the collateral exceeds the lender's claim, the lender is fully secured and there will be no bifurcation. On the other hand, if the value of the collateral is less than the amount of the lender's claim, then the lender is considered "undersecured" and its claim can be bifurcated into a secured portion--equal to the value of its interest in the collateral--and an unsecured portion--equal to the deficiency balance.

The bifurcation of a claim can have significant ramifications. First, it affects how the lender will be treated in a plan. Second, if it is determined that the lender is undersecured, the lender will not be entitled to any interest, or other reasonable fees, costs or other charges provided within its loan documents that accrue after the date of the bankruptcy filing.

The interplay between the "automatic stay" and Section 506 creates some important strategy considerations early in a bankruptcy case. Among the forms of adequate protection recognized by bankruptcy courts is an "equity cushion." An "equity cushion" is the difference between the amount of the lender's claim and the value of the real estate.

As long as a lender is "adequately protected" by an "equity cushion," the debtor need make no "adequate protection" payments while the bankruptcy is pending.

If the lender is undersecured or enjoys what it believes to be a relatively small "equity cushion," it would, in almost all instances, want to seek relief from the automatic stay early in the bankruptcy case. It could and should argue that it is entitled to relief from stay unless periodic payments or another satisfactory form of "adequate protection" is provided. In this way, the lender will at least get some protection from any further diminution in the value of its "secured" claim, and if the debtor defaults in the periodic payments, obtain relief from stay. To the extent that the debtor is successful in arguing that there is a sufficient "equity cushion" in the property to protect the lender, because the debtor believes the value is greater than that determined by the lender's appraiser, the debtor may find it difficult, as a practical matter, to argue for a lower value when it becomes time for confirmation of the Chapter 11 or 13 plan.

Avoiding insecurity under Chapter 11

The culmination of the Chapter 11 process is the confirmation of the Chapter 11 Plan of Reorganization. The plan is required to provide adequate means for the plan's implementation. These "means" can include a modification to a lender's right to payment. The modification can take a number of forms.

The plan can provide for a cure of any default and the deceleration of an accelerated loan. It can propose to cure the arrearages over time, or provide for the reamortization of the arrearages along with the principal balance. The plan can also provide for a modification of the interest rate and/or term of the loan. In fact, bankruptcy courts have acknowledged that there is nothing in the code that prohibits, as a matter of law, the imposition of a period of negative amortization on a loan.

As indicated, a debtor can also bifurcate an undersecured lender's claim into secured and unsecured portions. Only the secured portion would be amortized in accordance with the modified interest rate and/or term. The unsecured portion would be thrown in with other unsecured claims and treated accordingly.

Notwithstanding the power to modify secured lenders' rights as a means to implement a repayment plan, there are limits. Those limits arise out of a lender's ability to reject a plan that modifies its rights, and the conditions that must be satisfied before a plan can be "crammed down" against a rejecting class.

"Cramdown" sounds painful, and it is. It is the word used to describe the confirmation of a plan notwithstanding the rejection of that plan by a class of lenders. This includes secured lenders who, generally, should each have their own class, at least with respect to their "secured" claim. While a "cramdown" is viewed as favoring debtors by allowing them to achieve confirmation over a lender's objection, the conditions that must be satisfied for a "cramdown" set the limits of what a debtor can do to modify a lender's right.

In order for a plan to be crammed down against a dissenting secured lender class, the plan must be "fair and equitable." The code provides that, with respect to a "secured" class, the standard of fair and equitable includes the retention of liens and, further, to the extent that the debtor proposes a new payment schedule, that the present value of the deferred cash payments equal the amount of the "secured" claim. The present-value requirement sets the floor for the interest rate modification. Some courts determine the rate by using the rate on government securities plus some premium for "risk." Other courts use a rate of interest determined by the "market rate," which is defined as the "prevailing market rate for a loan of a term equal to the payment period, with due consideration of the quality of the security and the risk of subsequent default." Whichever formula is used, the lender can always argue that the rate proposed by the debtor fails to properly reflect risk and/or the market rate.

The concept of "fair and equitable" goes beyond a simple calculation of present value, however, and includes an examination of the fairness of any other proposed modifications to a secured lender's rights. For example, courts have rejected plans that have extended the term of the loan beyond that of the normal term for loans of that type. Courts have also rejected plans that have provided for negative amortization, or balloon payments, where there was little or no equity cushion to reduce the risk of that treatment. Courts have also rejected plans that sought to limit a lender's rights to foreclose if a debtor defaulted in the plan payments.

If there is a central theme to the "fair and equitable" test, it is probably one of commercial reasonableness. Courts will not force a debtor to pay interest rates in excess of 20 percent under the "market rate" formula just because lenders will generally not lend to debtors in bankruptcy.

By the same token, courts will not force lenders to accept commercially unreasonable modifications just because the debtor is in bankruptcy.

In order to take advantage of the "fair and equitable" limitation on a modification, it is necessary for a lender to make sure that its secured claim has been separately classified, that it votes against the plan and that it objects to plan confirmation. To the extent that a proposed modification is commercially unreasonable under the circumstances, that should be argued in the objection.

A side benefit could potentially result from opposition to the plan. While debtors may use the threat of a "cramdown" in negotiating a workout with a lender, they are generally no more anxious to litigate a "cramdown" than is a lender. The threat of a lender's objection to the plan, or the actual objection itself, may be sufficient to convince a debtor to lessen the impact of any proposed modification.

Valuing the secured portion

The focus, thus far, has been on the modification of the "secured" claim as bifurcated from the unsecured portion for the undersecured lender. Certainly, any attempt to bifurcate the loan should be disputed if it will result in the lender receiving a lower "secured" claim than it would recover if it were permitted to liquidate its collateral. Methods of valuation used by the debtor and his or her experts must be closely examined.

To the extent the claim is bifurcated, the unsecured portion will be thrown in with other general unsecured claims. General unsecured creditors are generally only paid a small portion of their claims. A class of unsecured creditors is deemed to have accepted a plan if more than one-half in number, and more than two-thirds in amount of allowed claims of creditors voting, vote in favor of the plan. Because not all creditors vote, those who do vote control the fate of those who don't. A plan can be confirmed over the rejection of a class of unsecured creditors receiving less than 100 percent only if no subordinate class (like the interest holder) is to receive anything under the plan.

Most debtors (or interest holders) wish to retain their interests. That is why they file for Chapter 11 instead of Chapter 7. A large unsecured claim resulting from a Section 506 bifurcation could, because of its size, exercise voting control over the class of unsecured lenders. A threat to vote a bifurcated unsecured claim against the plan, or actually voting it against the plan, could provide the lender with some negotiating leverage or at least potentially prevent confirmation.

Avoiding insecurity under Chapter 13

Chapter 13 is similar to Chapter 11 in that it generally allows a secured lender's rights to be modified in a plan. Chapter 13 is different, however, in a number of significant ways.

First, and perhaps most significantly from the perspective of a mortgage lender, the rights of a lender secured only by the debtor's principal residence cannot be modified. This includes modification of term and interest. However, a debtor can decelerate a mortgage in default and can, over the life of the Chapter 13 plan, cure any existing arrearages.

Further, a debtor can bifurcate the lender's claim in most jurisdictions into secured and unsecured portions if the lender is undersecured. The Senate bill referred to earlier, S. 1985, proposing to raise the eligibility limits, also proposes the elimination of a debtor's right to bifurcate the claim of a lender with a primary lien on the debtor's principal residence.

In the event that the claim of a lender with a lien only on the debtor's principal residence is bifurcated, the secured portion will still be subject to the prohibition against modification. Courts seem to generally require the debtor to continue to make the same payments as provided in the original loan documents with the result of an earlier payoff.

A second significant difference between Chapter 11 and Chapter 13 is the length of the plan. There is no statutory limit to the duration of a Chapter 11 plan. Chapter 13 plans can be no more than three years unless the court, for cause, approves a longer period. In no event can the plan be longer than five years.

The limitation on the duration of a plan prevents a debtor from extending the term of a debt that comes due before the end of the plan, beyond the life of the plan. For example, a debtor faced with a balloon payment could, theoretically, file for bankruptcy just before the balloon payment comes due and then provide for the amortization of that balloon payment in a plan. In Chapter 11, there is no statutory limit to term. In Chapter 13, provided the loan could be modified, the limit would be the allowed life of the plan.

A third significant difference is the plan process. A Chapter 11 debtor has no statutory deadline for filing a plan and the plan process can drag out for some time. A Chapter 13 debtor must, by Bankruptcy Rule, file his or her plan within 15 days of the bankruptcy. This significantly reduces the debtor's opportunity to delay his or her lenders, but it also limits a lender's time to react.

There is no voting on Chapter 13 plans. Instead, a secured lender must object to the plan if it believes that its claim has been improperly modified. Similar to Chapter 11, a Chapter 13 debtor can "cram" the plan down against an objecting secured lender, provided that the lender's liens are retained and the present value of the deferred payments is not less than the lender's secured claim.

A lender is bound by the plan if it is confirmed, whether or not it has accepted the plan, and whether or not the plan meets the conditions for "cramdown." In a recent Third Circuit decision, it was expressly held that a Chapter 13 plan that provided for no interest to the secured lender, but was not objected to prior to confirmation by the lender, could not be challenged later. Thus, the creditor was bound by treatment that could not have been "crammed down" against it had it raised a timely objection.

Like Chapter 11, if the lender's claim is bifurcated, the unsecured portion will be thrown into the unsecured creditors' class. And similar to Chapter 11, the rules for "cramdown" on unsecured creditors are different than that for secured lenders. A plan can be "crammed down" over the objection of an unsecured creditor in Chapter 13, as long as the court is satisfied that all income received by the debtor in excess of that reasonably necessary for the maintenance or support of the debtor and dependents, and the operation of a debtor's business if he or she has one, is applied to the plan. It is not necessary that these payments go to unsecured creditors. Often the payments will be used primarily for priority taxes or to cure arrearages on secured claims. Plans have been "crammed down" under this standard that have paid only a nominal distribution to unsecured lenders.

To the extent the lender is secured only by the debtor's principal residence, the lender would want to object to any modification on the basis that it is prohibited by statutory language. To the extent that the jurisdiction allows bifurcation of mortgages on the debtor's principal residence, the lender would want to make sure that the secured claim that it is ultimately allowed, correctly reflects the value of the property. Because the debtor will be keeping the property, the lender should argue that hypothetical selling costs should not be deducted in determining its secured claim.

Just like in Chapter 11 situations, the lender should object to any proposed modification that it believes is commercially unreasonable and thereby force the debtor to satisfy the cramdown conditions. To the extent that the lender has had part of its claim relegated to unsecured status, it should object to confirmation on behalf of that unsecured claim. This way the debtor will be forced to establish that all "disposable income" is being used to fund the plan. If the distribution to unsecured creditors is nominal, the court might be persuaded to deny confirmation on that basis.

Bankruptcy goals

Bankruptcy courts are typically debtor-oriented. Two of the goals of the Bankruptcy Code are, after all, "fresh start" and "reorganization," which are both directly related to the debtor. This notwithstanding, courts will not force secured lenders to accept commercially unreasonable modifications or ones that are clearly inconsistent with the code. However, it is necessary for lenders to protect their rights. Courts will not do it for them.

Lenders can prevent commercially unreasonable modifications and unauthorized modifications by actively participating in the plan process and objecting to plan confirmation. Such active involvement may also occasionally result in negotiated resolutions that are more favorable to the lender than those originally proposed. In any event, the key is knowing what to object to and when to do it, in order to accomplish your goal. This knowledge will not always avoid bifurcation and an unsecured debt, but it should help to avoid the insecurity that arises from not understanding the process.

Owen Katz is a partner in the law firm of Bernstein and Bernstein, P.C. in Pittsburg, Pennsylvania. The firm specializes in business, commercial and bankruptcy law.
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Title Annotation:defense of lender's claims in bankruptcy cases
Author:Katz, Owen
Publication:Mortgage Banking
Date:Feb 1, 1992
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