Reaffirming Rash – Replacement Value Applies to Cram Down Valuations

Cram down reorganization, a fundamental concept in bankruptcy law, allows a debtor to retain possession and use of collateral while reducing the principal value of the secured debt to the present value of the collateral.  Inherent in creating this repayment plan is the need to determine the value of the secured collateral at the time the court approves the bankruptcy plan.  Decades ago, the United States Supreme Court held that for purposes of a cram down, valuation of the collateral depends not upon the foreclosure value of the collateral but rather on the amount that a similarly situated debtor would pay to obtain an asset similar to the collateral, i.e., its “replacement value.”  (Associates Commercial Corp. v. Rash (1997) 520 U.S. 953 [“Rash”].)  Because the replacement-value approach ordinarily results in a higher valuation than an amount derived from a hypothetical foreclosure sale, creditors seeking to value collateral in a cram down have rarely challenged the Supreme Court’s decision in Rash

Recently, however, the Ninth Circuit Court of Appeals found itself confronted with an atypical situation where the foreclosure value exceeded the replacement value of the collateral. (In re Sunnyslope Housing Limited Partnership, No. 12-17241 (9th Cir. May 26, 2017) [“Sunnyslope”].)  In rejecting the creditor’s attempt to use the higher valuation, the Ninth Circuit held that even if the replacement value results in a lower valuation of the collateral, for purposes of a cram down, the value of the collateral must equal an amount that takes into account the intended use of the property at the time of bankruptcy.  

In Sunnyslope, the debtor had obtained a number of secured loans in order to develop an apartment complex.  As a condition to receiving each loan, the debtor simultaneously agreed to a restrictive covenant requiring that the entire complex be devoted to low-income housing.  Significantly, only a foreclosure sale could terminate the existence of the restrictive covenant. 

After the debtor filed Chapter 11 bankruptcy, opting for a cram down approach, the bankruptcy court in creating the reorganization plan, found that the value of the collateral was the present value of the complex with the restrictive covenants.  Notably, this valuation was several million dollars less than the amount derived from a foreclosure-sale approach, which would have valued the property without the affordable housing limitations.  On appeal, the creditor argued that the foreclosure sale approach applied because the purpose of a cram down plan is to obtain the highest and best value for the creditor. 

In declining to adopt the creditor’s reasoning, the Sunnyslope Court noted that Rash explicitly rejected use of the foreclosure-value approach when it held in a cram down, property must be valued in light of the debtor’s continued use of the property.  Using the foreclosure-value of the property without the covenant would render the debtor’s choice of a cram down inconsequential because such a valuation would be higher than the amount the debtor could obtain on the sale of the property with the covenant.  Because neither the debtor nor a subsequent purchaser could use the apartment complex for anything other than affordable housing, valuation of the property, the Court held, must account for presence of the restrictive covenant. 

Although Sunnyslope represents a unique situation, its decision is nonetheless important for secured creditors because it rejects the notion that a cram down is intended to result in the highest valuation of the collateral for the creditor’s benefit.  To the extent that creditors use covenants like the ones in Sunnyslope, it may be fruitful to consider whether the covenants are necessary to protect the secured collateral.  Or alternatively, whether by use of contractual provisions, the creditor can unilaterally vitiate the covenant upon the debtor’s default in order to prevent a situation where the foreclosure value exceeds the replacement value of the property upon use of a cram down.