Client Alert:
Date: December 21, 2011.

TO: All SLG Clients and Affiliates

Subject: An Antidote to Real Estate “ Lien Strips” in Chapter 11.

The Scheer Law Group (“SLG”) recently prevailed for a client in a Chapter 11 Confirmation Trial in bankruptcy proceedings, in the case of In re Sroa, 2011 Bankr. LEXIS 4552 (Bankr. N.D. Cal. Nov. 16, 2011). The case is noteworthy because it is one of the first cases in the 9th Circuit in many years to define the parameters and use of an 1111b election to combat an attempted strip off of a lien in a Chapter 11 case. Lenders should be aware of the issues and use this tool in appropriate cases.

Background: Given the dramatic drop in real estate prices, many borrowers file bankruptcy and try and confirm plans that reduce the value of an under secured lender’s claim to the actual value of the underlying property (cram down), which is often much less than what is owing on the loan.

When there is no equity to support the loan, the creditors lien can be “stripped off” the property or removed, in reorganization proceedings. Lien strips and cram downs are prohibited on loans secured solely by the Debtor’s residence (See 11 USC § 1322 (b) and 11 USC § 1123(b), but are used frequently to rearrange creditor rights and liens on rental properties, commercial loans or when the loan is cross collateralized.

The ‘cram down” and lien strip is also an unfair practice in many instances because the Debtor can “freeze” the creditor’s rights at a low point in the economy and get the benefit of any future appreciation in the collateral, down the road.

The 1111b Election: In response and in some instances (Chapter 11) a creditor can use what is called an “ 1111b election” (using the provisions of 11 USC § 1111b), to keep the full amount of its secured loan on the property, even if some or most of the loan would be unsecured because of the decline in equity.

Since 11 USC § 1111b also allows non-recourse creditors to accept payment as an unsecured creditor under a proposed Chapter 11 plan, (which would not be allowed under state law unless there was personal liability on the loan), the creditor has to make a choice (election):

  • Either lose its secured status and take the distribution to be paid under a Chapter 11 plan to unsecured creditors (often “pennies on the dollar”) or;
  • Elect to remain fully secured (if it can meet the requirements of the statute) and retain its lien on the Property, with no payment to be made on the unsecured portion of the debt.

 

An 1111b election must be made by the conclusion of the hearing on the Debtor’s Disclosure Statement, or at a later date fixed by the Court (BK Rule 3014).

The Sroa case goes over the parameters of how to apply the analysis of when a creditor can make the election and how it works.

Holding:

In the Sroa case the court found that in order for a creditor to avoid a lien strip and make the 1111b election, there had to be an equity cushion supporting the creditor’s lien that was not “inconsequential”. In making such a determination, the Court found that you do not include costs of sale Id. at page 2.

This is how the 1111b election worked in the Sroa case. Marin Mortgage Bankers (“MMB”), the creditor making the election had a million dollar loan. The senior liens to MMB totaled $765,000.00. The property subject to the creditors’ claims was valued differently by three appraisers, and the Court found the value to be $800,000. This left an equity cushion of $35,000.00.

The Court found that this slim equity cushion was not “inconsequential” , so that MMB could elect to be fully secured. Note: Some courts require more equity. See e.g. In re Wandler 77 B.R. 728 (Bankr D.N.D. (1987) holding that where secured portion of claim was 4%, that this was inconsequential and could not support an 1111b election).

Having made the election to be fully secured, the result was the following: MMB would be paid as a secured creditor to the extent of $35,000.00, with interest, through the Chapter 11 Plan. MMB would not be able to retain its rights to be paid as an unsecured creditor (pennies on the dollar). MMB would be able to retain the full balance of its lien on the Property and it would not be stripped off. Accordingly, it would be subject to payment upon sale or refinance.

Conclusion: It should be noted that the election can be a game of “chicken” between the creditor and debtor. While the 1111b election can avoid unfair results where the Debtor unfairly “freezes” property values and strips off liens in an economic downturn, making the election can also cause a debtor to “abandon ship” leaving the electing creditor to deal with the senior liens.

However, in cases where a creditor believes it would do much better owning the collateral, or where the “leverage” gained because of making the election forces the debtor to propose a fair and equitalbe plan (including sharing appreciation in the value of the property in the future), the 1111b election is a powerfull and neglected tool that can protect secured creditor’s rights.

Every creditor subject to a Chapter 11 plan (or sale free and clear of liens) on a commercial or non-owner occupied, or cross collateralized loan, should examine its rights to determine if the 1111b election should be made.

If you have any questions, please contact Spencer Scheer.

 

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