Daily Development for
Monday, March 17, 1997

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

The reporter for this case is Jim Stillman of Murphy, Weir & Butler in its San Franciso office.

BANKRUPTCY; PLAN OF REORGANIZATION; SEPARATE CLASSIFICATION OF MORTGAGE DEFICIENCY CLAIM; SECURITY DEPOSIT CLAIMS: A chapter 11 debtor may not classify separately the unsecured claim of an undersecured mortgage lender from general unsecured claims, where the only justification relied on for distinguishing the deficiency claim is the creditor's right to make the section 1111(b) election and where, without separate classification, no impaired class of creditors would vote for the plan. It might be possible to classify separately the claims of tenants for security deposits if the tenant's leases have been rejected.

In re Barakat, 99 F.3d 1520 (9th Cir. 1996).

The creditor's 1111(b)election right permits it to treat its entire claim as secured, thereby foregoing any deficiency claim in the bankruptcy. The creditor sometimes will do this in order to prevent the debtor from "cashing out" the secured claim at an amount the creditor deems unreasonable. It sometimes is said that the creditor may also make the 1111(b) election for a completely secured claim in order to get potential "upside" improvement in value during the bankruptcy, but waiving any deficiency. Bankruptcy law authority Ray Warner, at UMKC, argues that this is a somewhat illusory benefit. It only permits the creditor to "ride" the improvement in the property if the debtor later defaults in the payout plan set forth in the plan. Otherwise, the debtor is required to pay back to the debtor no more than the present value of the current value of the land, even if in actual dollars this may result in a payback of the total secured claim. Thus, where the debtor's plan does not propose to cash out the secured creditor, a wise secured creditor typically will not elect for treatment as fully= secured.

If the debtor does not elect for treatment as fully secured, the creditor will get a secured claim for the present value of the property and a deficiency claim for the rest of the debt.

The secured creditor did not make the 1111(b) election in this case, apparently to so that it could participate in the unsecured creditors' voting on the plan. Apparently, if the secured creditor could have been classified separately, then it might have been more possible for the debtor to craft a plan that was acceptable to at least one class of unsecured creditors. This, of course, would have given it it considerable leverage in securing adoption of the plan. But here the court concluded that the attempt for separate classification was unlawful gerrymandering.

The debtor argued that the separate classification should not be viewed as prohibited gerrymandering because there was a legitimate basis for treating deficiency claims resulting from an 1111(b) election. The creditor will get recognition of its deficiency claim in such cases *even if the debt contractually is non recourse.* This special feature of the 1111(b) election has led one court (apparently) to conclude that bankruptcy courts *must* treat the 1111(b) deficiency claim as a separate class of claims, since it arises totally as a result of special bankrtupcy statute language. In re Woodbrook Assoc., 19 F.3d 312 (7th Cir. 1994). Actually, it is possible to read Woodbrook as holding simply that *any* 1111(b) election whether or not relating to a mortgage subject to non-recourse or antideficiency restrictions, is a special form of statutory claim and thus must be classified separately.

The Ninth Circuit here specifically rejects the reasoning of Woodbrook, even in the case of mortgage claims that would be non-recourse absent the 1111(b) benefit.

The debtor also argued that the claim of tenants for security deposits could be separately classified from the claims of general unsecured creditors, because the security deposit claims were "legally different,...contingent and unliquidated" and were associated with special state law remedies. (p. 1527.) But, insofar as the tenant leases had not been rejected, the tenants were not creditors with "provable" claims against the estate (p. 1528), and could not participate in the reorganization. The stay was lifted.

Reporter's Comment: If a plan cannot be confirmed "but for" the separate classification of the mortgage deficiency claim (see 11 U.S.C. 1129(a)(10)), the classification will surely be found impermissible without regard to the intent of the debtor, according to the emerging, strong majority view among Circuit Courts of Appeals including, now, the Ninth Circuit. On the other hand, where other, bona fide assenting impaired classes exist in addition to general unsecureds so that confirmation is possible notwithstanding the vote of the lender, then any sensible modicum of business justification will suffice for separately classifying the deficiency claim, in this Reporter's experience. The real issue is, "that prohibiting the debtor form separately classifying deficiency claims will effectively bar [underwater] single asset debtors from utilizing the Bankruptcy Code's cramdown provisions." (p. 1526; emphasis added.) That is probably as it should be.

Editor's Comment: The only issue that the editor would take with the reporter is with the statement that "any sensible modicum of business justification" is necessary to support a classification that cannot be construed as gerrymandering. The courts in both the instant case and Woodbrook appear to acknowledge that the debtor has virtual complete autonomy in classifying debts under the plan *except* when the classification is done to control the voting.

But the editor only reads the cases, while the reporter argues them in the courts. Who you gonna' believe?

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