Daily Development for Tuesday, January 18, 2005
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

BANKRUPTCY; AUTOMATIC STAY; RELIEF FROM STAY; FORECLOSURE:   When a bankruptcy court grants relief from stay to allow a secured mortgage lender to foreclose, the amount of its claim, for the purpose of a credit bid at the foreclosure sale, is calculated pursuant to applicable state law without regard to Bankruptcy Code limitations. Thus, if a mortgage lender bids the full amount of its state law claim at the foreclosure sale, and the claim is allowed in a lesser amount in the debtor's bankruptcy, there is no foreclosure "surplus" due to the debtor.

In re Home and Hearth Plano Parkway, L.P, 2004 Bankr. LEXIS 2030 (Bankr. N.D. Tex. Dec. 15, 2004).

LaSalle Bank, as trustee in a securitized mortgage lending transaction, made a nonrecourse hotel mortgage loan in 1998 to the debtor, Home and Hearth Plano Parkway, L.P. ("Debtor"), in the amount of $4,600,000.  The deed of trust executed by the Debtor covered the hotel, and included an assignment of leases and rents, as well as all hotel FF&E and cash and deposit accounts.

The Debtor commenced a Chapter 11 bankruptcy proceeding in March 2003. LaSalle filed a proof of claim in the case, asserting a secured claim in the amount of $4,853,047. During the bankruptcy proceeding, LaSalle continuously maintained that the actual value of the hotel was no more than $3,360,000, and that as a result the Debtor had no equity in the hotel property. Subsequently, the bankruptcy court denied confirmation of the Debtor's reorganization plan and granted relief from the automatic stay to LaSalle. The parties stipulated that the fair market value of the real and personal property (as shown in the appraisal submitted as evidence by LaSalle) was $3,360,000.

LaSalle foreclosed on the hotel, in Texas state court, on February 3, 2004. LaSalle was the sole and successful bidder at the "highly publicized and well attended" foreclosure sale, at which LaSalle credit-bid the amount of $4,740,000. After the foreclosure sale, LaSalle filed an amended claim in the Debtor's bankruptcy proceeding, to reflect the result of the foreclosure sale and its credit bid. After crediting the amount it bid at the foreclosure sale, LaSalle claimed it was still owed the amount of $195,682 as an unsecured claim. The parties ultimately agreed that LaSalle's claim against the bankruptcy estate was allowable in the amount of $4,393,941 (i.e., the amount due to LaSalle on the petition date, $4,853,047, less post-petition payments made to LaSalle in the amount of $459,105), and that any claim in excess of that amount would be disallowed.

The Debtor then filed an adversary proceeding with the bankruptcy court, alleging that because LaSalle's foreclosure bid was in excess of the amount of its allowed claim in the Debtor's bankruptcy proceeding, there were surplus proceeds from the foreclosure sale in the amount of $346,058 (i.e., the $4,740,000 bid by LaSalle at the state foreclosure sale less LaSalle's claim in the bankruptcy proceeding of $4,393,941), and that the Debtor therefore was entitled to this "surplus" under the terms of the deed of trust. The Debtor also claimed that the language in the deed of trust limited LaSalle's permissible bid to the amount of its debt, and that LaSalle breached this provision by bidding an amount greater than that contained in the bankruptcy claim order. The Debtor further argued that because of this "improper" bid, it was entitled to damages from LaSalle and the Trustee in the amount of $346,058 (the alleged "surplus" calculated by subtracting $4,393,941 from the credit bid of $

4,740,000). The Debtor further alleged a violation of the Texas Finance Code, resulting in a forfeiture of all principal, interest and other amounts charged by LaSalle; that it was entitled to a penalty of three times the interest LaSalle "improperly" received; that LaSalle had violated its duty of good faith and fair dealing; and that it was entitled to a constructive trust on the claimed surplus.

LaSalle argued, and the bankruptcy court agreed, that once LaSalle was granted relief from the automatic stay, the calculation of the debt owed to it under the mortgage note was no longer subject to the limitations set forth in the Bankruptcy Code and the parties would be returned to their legal relationships as they existed before the stay became operative.  LaSalle argued (successfully) that, therefore, the amount owed to it under its note, calculated in accordance with the loan documents and state law (i.e., $4,989,481) would alone determine whether the foreclosure sale generated any surplus proceeds. LaSalle noted that in fact it had filed a deficiency claim in the pending bankruptcy proceeding, since the hotel had sold for less than its debt as calculated under state law.

The bankruptcy court noted that "the Order Denying Confirmation expressly authorized LaSalle to proceed under the terms of the Loan Documents and Texas law, both of which permit LaSalle to credit bid the amount of its debt, as calculated under the Loan Documents." Id. at *17. The  bankruptcy court stated that, "Contractually, therefore, the Debtor has no interest in the proceeds of a foreclosure sale until LaSalle is paid all sums owed to it under the Loan Documents, and LaSalle may bid for the property at such a sale by crediting against the purchase price all sums owed to it under the Loan Documents." Id. at *21. Further, according to the court, "the Debtor is overlooking the effect of the distinction between the debt owed to a mortgagee under its note, and the amount of that debt which the mortgagee may recover in a bankruptcy case from estate assets by filing a proof of claim."  Id. at *23-24. The court noted that if a mortgage lender obtains relief from the automatic stay and

 then completes a foreclosure in state court, it can then make a claim in the debtor's bankruptcy proceeding for any deficiency, but when it does so the bankruptcy law can affect and limit the amount of this claim. In this case, the court found, since there was no surplus over the debt owed to LaSalle under the loan documents, there was no property of the estate in which the Debtor retained any interest. The court also found that, having stipulated just two months before the foreclosure sale that there was no equity in the property, the Debtor was estopped from asserting that any surplus proceeds were generated from the foreclosure sale.

The court then discussed the relevance to its decision of Sec. 1111(b) of the Bankruptcy Code, which, according to the court, provided support for its holding that LaSalle was entitled to bid the full amount of its claim at the foreclosure sale, calculated in accordance with the loan documents and applicable state law. The court noted that Sec. 1111(b) provides that a nonrecourse loan is nonetheless to be treated as a recourse loan in bankruptcy (unless the lender specifically elects otherwise), so that the lienholder may either receive payment in full (or at least a claim against the estate for the full amount of the debt and the ability to vote on the plan to the extent of its claim) or the right to bid on the property at a foreclosure sale. The court noted further that Sec. 1111(b) excepts from recourse treatment a lender whose collateral is sold under Sec. 363 or is otherwise to be sold under a plan, or is to be sold by the nonrecourse lender through a foreclosure proceeding.

The court stated that, in such a case, "The lender has the opportunity to become the highest bidder and take title to the property, preserving future appreciation for itself if it feels that the sale price is too low . . . and the lender no longer needs the protection of Sec. 1111(b) recourse treatment."  Id. at *31. The court found that such was the case in this matter, where LaSalle became the owner of the hotel, preserving the future appreciation for itself but remaining a nonrecourse creditor.

The bankruptcy court also rejected the Debtor's claim that LaSalle had violated the duty of good faith and fair dealing, stating that "under Texas law, there is no implied covenant of good faith and fair dealing in the lender-borrower relationship, and the Debtor has not pointed to any contractual language expressly creating one." Id. at *33.

The court then turned to LaSalle's counterclaim alleging that it was entitled to prepaid rents and other sums diverted by the Debtor and not applied to the ordinary and necessary expenses of the property. The Debtor contended that LaSalle was not entitled to these sums because its claim had been paid in full as the result of the foreclosure sale of the hotel, i.e., because its bid of $4,740,000 exceeded the amount owed to it pursuant to its allowed bankruptcy claim, LaSalle had been paid in full and its claim for any additional proceeds failed as a matter of law. The bankruptcy court agreed with the Debtor on this issue, rejecting LaSalle's argument that even after the foreclosure sale it continued to be owed at least $249,481 because its credit bid was less than the full amount of the debt as calculated under the loan documents.

LaSalle argued that it was still entitled to collect its remaining "personal property" collateral (i.e., the Debtor's remaining cash) when the stay was lifted. But the court ruled that based on the undisputed facts of the case, as a matter of law LaSalle had been paid all that it was entitled to receive from the Debtor's bankruptcy estate. The court reasoned that because LaSalle was a nonrecourse creditor, it could not assert an unsecured deficiency claim against the bankruptcy estate after its foreclosure of the hotel property, i.e., as a nonrecourse creditor who foreclosed on its collateral it was not entitled to a recourse secured claim under Sec. 1111(b).

The court noted, however, that if LaSalle had proceeded first to liquidate the personal property of the Debtor (including the cash on hand from rents that the bankruptcy case retained an interest in) instead of foreclosing the hotel property (which foreclosure did not generate any surplus proceeds in which the bankruptcy estate had an interest), "it could have liquidated both without running afoul of either the Claim Order or applicable state law." Id. at *42 n.11.  Thus, the court reasoned, "By proceeding first against the Hotel . . . LaSalle put itself in the position where its allowed claim in the Case was fully satisfied by virtue of its bid at the Hotel foreclosure sale, leaving no claim to be paid from the remaining Personal Property which is property of the estate." Id. at *42. The court noted that while there may theoretically be a deficiency amount still owing to LaSalle (because of the difference of approximately $249,000 between its state law claim and the sale price of

 $4,740,000) LaSalle had no right to assert a further claim against the Debtor because the loan documents provided that the loan was nonrecourse.

Comment 1: This was a lengthy, well reasoned (and correct) decision by the bankruptcy court. (There is very little case law on this issue.) The court appeared particularly bothered by the fact that the Debtor was apparently attempting to reap a "windfall" by changing its position (after previously stipulating that it had no equity in the property) by asking the court to not only turn over the claimed surplus but also require LaSalle to forfeit all of the principal and interest due under the loan documents and pay treble damages. As the court stated, "This result would be inconsistent with bankruptcy's equitable pedigree." Id. at *32.  The bankruptcy court also cited with approval (and quoted from) a 1995 New York bankruptcy decision, In re Five Boroughs Mortgage Co., 176 B.R. 708 (Bankr. E.D.N.Y. 1995), which noted that there is a legally significant distinction between a debt owed under the loan documents (which is governed by the parties' contract and applicable state law), and

the allowable claim that may be asserted in the debtor's bankruptcy case (which amount may be alterable as provided under federal law, i.e., the Bankruptcy Code).

Comment 2: The bankruptcy process treats unsecured creditors differently from secured creditors.  It is important to note that an undersecured creditor (a creditor whose debt exceeds the value of the collateral) has two claims against the debtor's estate by reason of the Bankruptcy Code:  (1) a secured claim in an amount equal to the value of the collateral, and (2) an unsecured recourse claim for the remainder of the debt. See Bankruptcy Code Sec. 506(b).  As the court in In re Home and Hearth Plano Parkway noted, this is true under the Bankruptcy Code even if the loan is nonrecourse. See Bankruptcy Code Sec.1111(b). The valuation of the collateral determines the relative size of these two claims and is often disputed by the debtor, who may take different positions on value throughout the case.  Early in the case the debtor has a minor interest in having a high value on the collateral in order to stop relief-from-stay motions (arguing that the secured creditor is adequately prote

cted).  Later in the case, the debtor has a major interest in having a low value for purposes of the Chapter 11 plan and payment of the secured claim (arguing that the debt must be "crammed down").

Valuation of the collateral is also essential to the secured mortgage lender. Assessing the value of the collateral is the key to virtually all strategies and tactics employed by the lender. If, as in the In re Home and Hearth Plano Parkway case, the creditor is undersecured (with a secured claim for the value of the property and an unsecured claim for the balance), it will need valuation information and testimony in order to prove that it is not adequately protected from diminution in value, so as to receive monthly payments to adequately protect the secured portion of its claim, or to obtain relief from the automatic stay because there is no equity in the property and the property is not necessary for an effective reorganization.

The secured lender has the burden of proving that the debtor has no equity in the property.  This can be done (as in the In re Home and Hearth Plano Parkway case)  with an appraisal and/or testimony of an appraiser, or by introducing the debtor's own financial information from the filing of claims and liabilities.  The court considers not only the debt of the individual secured creditor, but all secured claims against the collateral as of the date of the bankruptcy case.

Comment 3: One of the first issues facing a debtor is how to continue in operation after the bankruptcy filing.  Businesses that plan to continue operations through a Chapter 11 reorganization require cash -- it is the key to a successful reorganization.  Cash is required by creditors, employees, trade suppliers, the tax authorities, and a myriad of other parties whose cooperation is essential to continued operations.  Also, the administrative expenses of a Chapter 11 for attorneys' and accountants' fees are extensive.  It is well established that cash collateral may appropriately be used to pay administrative expenses only if the interest of the creditor secured by the collateral is adequately protected or such expenditures are necessary to preserve or maintain the lender's collateral.

One of the tests that the debtor must meet under Chapter 11 is to prove to the court that all obligations incurred after the Chapter 11 filing can be paid promptly -- meaning in cash. The court recognizes the importance of continued support from suppliers, employees, and other groups and grants them a priority, unsecured status for their post-petition claims. The cash needed by the business during reorganization can be generated internally or borrowed.  Only in rare circumstances does a company considering bankruptcy have a sufficient "war chest" to fund the costs of filing and still have the necessary cash reserves to continue in operation after the filing. For example, one significant expense for the debtor is the large, up-front retainer required by his or her (or its) bankruptcy counsel.  In most cases, the debtor who has not been able to hoard pre-petition cash will either need to borrow this cash or arrange for the use of cash collateral. A pre-petition debtor holding unencu

mbered property is in the enviable position of being able to declare a unilateral moratorium on the payment of its debt and, through the collection of receivables and/or the sale of property, hoard cash for use during an attempted out-of-court restructuring or ensuing Chapter 11 case. This explains the actions taken by the Debtor in the In re Home and Hearth Plano Parkway case to preserve its right to the pre-petition rents (upon which issue it prevailed), even though its reorganization plan was ultimately rejected and the automatic stay lifted to allow LaSalle to proceed with foreclosure of the hotel.

Comment 4: As noted above, the claim of an undersecured creditor is divided into two claims: (1) a secured claim equal to the value of its collateral, and (2) an unsecured deficiency claim for the balance. This is true even though, as in the In re Home and Hearth Plano Parkway case, the loan is nonrecourse. Under section 1111(b)(2) of the Bankruptcy Code, an undersecured creditor has the right to elect to have its entire claim treated as fully secured.  By making this election, the undersecured creditor loses its unsecured claim and its right to vote such claim.  Under Section 1111(b)(2), the creditor will never get less than the full mortgage amount but also never get more than the net present value of the collateral on the plan date.  (On the other hand, a "cramdown plan" could provide a market rate return on the collateral value plus potential upside in the form of a share in excess cash flow or a scheduled payment on the unsecured portion of the claim.)

By making the Section 1111(b)(2) election, the creditor becomes fully secured and therefore loses its vote in the unsecured class, or in other words, loses one opportunity to vote against the debtor's Chapter 11 reorganization plan. By foregoing its unsecured claim, the undersecured creditor also foregoes the opportunity to assert classification, unfair-discrimination and fair-and-equitable objections, which could prove fatal to the confirmation of the debtor's plan.  Thus, the undersecured creditor could be relinquishing major litigation advantages by making the Section 1111(b)(2) election. (The right to make the Section 1111(b)(2) election belongs solely to the secured creditor, it cannot be made by the debtor on behalf of the secured creditor.)


However, Section 1111(b)(2) is worth considering by the secured creditor  when the deficiency claim  is small and unlikely to dominate voting in its class.  In this instance, losing a vote as a consequence of making the Section 1111(b)(2) election may not be a factor. Also, as pointed out by the court in the In re Home and Hearth Plano Parkway case, Sec. 1111(b) expressly excepts a nonrecourse mortgage lender's claim from recourse treatment where the collateral is sold under Sec. 363 of the Bankruptcy Code or is otherwise to be sold under the plan (see Sec. 1111(b)(1)(b)(2)), or is sold (as determined by applicable bankruptcy case law cited by the court) through foreclosure outside of bankruptcy. As the court also noted, the lender may bid less than the amount of its entire debt as calculated under applicable state law in order to capture anticipated appreciation in the value of the property for itself; but in such event it remains a nonrecourse creditor and cannot obtain any clai

med deficiency amount from the debtor's bankruptcy estate.

The Reporter for this item was Jack Murray of First American Title Insurance, Chicago office.

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