In First S. Nat’l Bank v. Sunnyslope Hous. Ltd. P’ship (In re Sunnyslope Hous. Ltd. P’ship), 2017 U.S. App. LEXIS 9198 (9th Cir., 5/27/2017), the Ninth Circuit Court of Appeals, because of restrictive covenants in junior position deeds of trust, permitted a bankruptcy debtor to cram down a first-position deed of trust to an artificially low value.
The decision in late May of 2017 effectively ruled that despite the underlying collateral having a value of $7 million and the loan’s balance in excess of this amount, a first position lender’s claim was only secured to the extent of $3.9 million. The Court of Appeals also ruled that the Debtor’s intended use of a piece of property in a Chapter 11 plan of reorganization determines its valuation, rather than the property’s highest and best use; and that a valuation finding is a factual finding, subject to reversal on appeal only in the event of clear error.
The first position loan on the property was made an $8.5 million loan at a 5.35% rate secured by a first-position deed of trust and guaranteed by the United States Department of Housing and Urban Development. An agreement was made that required using 40 percent of the units for low‑income housing, with such restrictions to be terminated in the event of a foreclosure.
The City of Phoenix held a second-position deed of trust and the State of Arizona held a third-position deed of trust. The City of Phoenix required that 23 units be set aside for low‑income families. Further, a 40‑year agreement with the State of Arizona was made to set aside five units for low‑income residents. However, in this case, the borrower agreed to use the entire complex as low‑income housing to receive federal tax credits.
In 2009 the borrower defaulted on a first position loan. The loan’s guarantor, HUD sold it to First Southern National Bank (“First Southern”) for $5.05 million. In the Loan Sale Agreement (“LSA”), HUD released its Regulatory Agreement, but the LSA dictated that the property remained subject to other covenants, conditions, and restrictions.
First Southern began foreclosure proceedings, but a bankruptcy case was filed before a sale of the property for $7.65 million was completed. The borrower’s Chapter 11 plan of reorganization crammed down the property pursuant to the Bankruptcy Code. However, the borrower and First Southern disagreed as to how the property should be valued. While the borrower contended that the complex should be valued as low‑income housing, its intended use for the property, First Southern disagreed and countered that the complex should be valued without considering any low‑income housing restrictions.
The borrower’s expert valued the property at $7 million or $2.6 million based on whether the low‑income housing restrictions were applied to the Bankruptcy Court valuing the property at $2.6 million. First Southern made an election under § 1111(b) of the Bankruptcy Code that allowed it to retain the entire secured portion of its claim.
First Southern appealed to the District Court, which affirmed the Bankruptcy Court’s valuation but held that a $1.3 million tax credit should have been considered in determining the value of First Southern’s secured claim, and thus the matter was remanded to the Ninth Circuit Court of Appeals. The matter was initially decided in favor of First Southern Bank, but in an 8 to 3 en banc decision, the Ninth Circuit Court of Appeals reversed itself and last month held that the revised plan as confirmed was valid.
Citing In Re Rash, the Ninth Circuit noted that the instruction in § 506(a) of Title 11 is “to value the collateral based on its proposed disposition or use in the plan of reorganization.” The court also noted that, based on Rash, any judicial determination of replacement value is a factual finding subject to reversal only in the event of clear error.
“The essential inquiry under Rash is to determine the price that a debtor in Sunnyslope’s position would pay to obtain an asset like the collateral for the particular use proposed in the plan of reorganization.” In rejecting First Southern’s argument that the property should be valued at its highest and best use without any low‑income restrictions, and because the other covenants were contained in junior position deeds of trust, the Ninth Circuit stated that although such deeds of trust were subordinate, the covenants ‘run with the land’ and therefore were properly considered in determining the value of the collateral.
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