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Priming a Secured Creditors Lien

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In many instances, the ability of a debtor to propose a successful plan of reorganization is dependent upon acquiring a new lender willing to provide operating capital. In most instances, lenders willing to take such a risk rely heavily on the value of the assets pledged to secure the loan. It is usual in these circumstances that the new lender pay off the senior secured lender as part of the plan refinancing. In addition, it is customary that the new "asset-based lender" will require a first priority lien in all of the reorganized debtor’s assets. What happens, then, if there is a secured creditor whose claim will not be paid upon confirmation of the plan, but who instead will receive deferred cash payments, and who refuses to subordinate to the new lender?

To further illustrate the problem, consider the following facts. On the petition date, a debtor had two secured creditors. Secured Creditor One (SC1) was owed $440,000, secured by a mortgage on real estate valued at $1.4 million and certain machinery and equipment valued at $80,000. Secured Creditor Two’s (SC2) debt in the amount of $2.1 million was incurred subsequent to SC1, and was secured by all of the debtor’s assets, including real estate, all machinery and equipment valued at $730,000, inventory valued at $650,000 and account receivables valued at $900,000.1 SC2 and SC1 entered into an intercreditor agreement that partially subordinated SC1’s debt and lien to SC2’s debt and lien and resulted in SC1 having collateral valued at $1.03 million.

The debtor proposed a plan that separately classified each secured creditor. The plan provided that SC2’s secured claim would be paid in full on the effective date of the plan from the new lender’s funds. The plan further provided that SC1’s secured claim would be paid pursuant to its note’s remaining term and existing covenants and conditions. The SC1 claim would continue to be secured by a mortgage on the real estate and a security interest in certain machinery and equipment, together with a interest in all of the debtor’s machinery and equipment, accounts receivable and inventory. SC1’s liens in the reorganized debtor’s assets would, however, be junior and subordinate to the first priority liens of the new lender.

...§1129(b) can provide a powerful and effective tool that can be used to satisfy the first priority lien requirements of a new lender...

The new lender was required to advance $2.1 million to fund the plan. SC1 rejected the plan and objected to con-firmation, arguing that the plan could not be confirmed because it did not provide for the retention of SC1’s lien, nor did the plan provide the realization of the indubitable equivalent of SC1’s allowed claim. Can the debtor obtain confirmation of the plan pursuant to the "cramdown" provisions of §1129(b)(1)?

Section 1129(b)(1) allows a court to confirm a plan despite its rejection by an impaired class of creditors if the proponent of the plan demonstrates that it does not discriminate unfairly and is fair and equitable, with respect to each class of rejecting and impaired claims. This section is known generally as the "cramdown" provision of the Bankruptcy Code. To meet the "fair and equitable" requirement for cramdown with respect to a class of secured claims, the plan must provide for the secured claimant to either (i) retain its lien and be paid the full amount of its claim in deferred cash payments having a present value equal to the claimant’s collateral, (ii) be paid from the sale of its collateral, or (iii) realize the "indubitable equivalent" of its claim. 11 U.S.C. §§1129(b)(2)(A)(i)-(iii); Matter of May,.174 B.R. 832, 835-36 (Bankr. S.D. Ga. 1994). When the secured creditor’s collateral will be retained, plan proponents have attempted to obtain confirmation by using §1129(b)(2)(A)(i) (providing for the retention of liens) or §1129(b)(2)(A)(iii) (providing for the indubitable equivalent).

Can the Debtor Obtain Confirmation under §1129(b)(2)(A)(i)?

In the illustration above, the first issue is whether the debtor’s plan provides for the retention of SC1’s lien, thereby permitting the court to confirm the debtor’s plan under §1129(b)(2)(A)(i). As the court noted in Corestates Bank N.A. v. United Chemical Technologies Inc., 202 B.R. 33, 49-50 (E.D. Pa. 1996), there exists a "paucity of case law either interpreting §1129(b)(2)(A)(i)(I) or fashioning a definition that might assist the court in assessing the retention of liens issue." See, also,.Friedman, What Courts Do to Secured Creditors in a Chapter 11 Cram Down,.14 Cardozo L.Rev. 1495, 1524 (1993). Nevertheless, there are several published cases that shed some light on how courts might assess this issue.

In In re L.B.G. Properties Inc., 72 B.R. 65 (Bankr. S.D. Fla. 1987), the court held that it could not approve the proposed plan under the Code’s cramdown provisions where the plan failed to preserve the creditor’s existing lien. The court found that the effect of the plan’s proposed replacement lien, which was subordinate to a new first mortgage, was to replace the creditor’s present fully collateralized lien with a lien that was unsecured to the extent of approximately $2 million. Id. at 67. In so holding, the court focused on the debtor’s projections, which reflected years of anticipated shortfalls in meeting its obligations under the new note. The court stated, "The sole purpose of collateralization is to protect a lender against the possibility that a borrower’s projections are not realized." Id.

Similarly, in In re Ford Products Corporation,.159 B.R. 693 (Bankr. S.D.N.Y. 1993), the court denied confirmation of a plan that required secured creditors to subordinate the priority of their liens to leasehold tenants. The court applied a hard-line rule that an involuntary subordination of a secured creditor’s lien violates the absolute priority rule, which is implicit in the "fair and equitable" standard. Id. at 694-95. As in the L.B.G., the court found significant that the debtor’s projections revealed a negative cash flow over the first five years of the plan. Id. at 694.

Upon different facts, the court in Corestates Bank N.A..denied confirmation of a plan requiring the secured creditor to release its liens on the debtor’s machinery and equipment where the debtor proposed to pay its secured creditor the full amount due on the machinery and equipment loans on the effective date of the plan. Id. at 49-50. The court found dispositive that the debtor’s entire debt to its secured creditor was secured by a cross-collateralization of all of the debtor’s assets, and therefore, by requiring the secured creditor to release its lien, the secured creditor "effectively lost security designed to protect the entire debt, not just the lien used to secure the machinery and equipment loans." Id. at 50. The court applied the standard definition of retain, i.e.."to continue to hold, have, use, recognize, etc., and to keep." Id. (citation omitted).

By contrast, the court in In re Sherwood Square Assocs.,.107 B.R. 872 (Bankr. D. Md. 1989), did not strictly construe §1129(b)(2)(A)(i) when it confirmed a plan requiring a limited subordination of the secured creditor’s lien, finding that "the conditions for the subordination do not detract from the value of [the] [sic] lien as security for the allowed amount of [the creditor’s] secured claim." Id. at 880. The court specifically found that the lien was preserved where the integrity of the lien remained in tact and the modifications affected only the amount of the claim and the interest rate to be paid. Id. at 880-81.

Turning back to our illustration, to confirm the debtor’s plan under §1129(b)(2)(A)(i), the court, at the very least, must be satisfied that the "integrity" of SC1’s liens remain intact. The case law shows that the debtor must demonstrate that SC1 retains all of the liens it bargained for to secure the debt, and that SC1’s claim will be fully paid. If the court focuses only on the subordination of SC1’s existing liens on real estate and certain equipment and the resulting impact on SC1’s collateral position with respect to those assets, the debtor in the illustration will likely fail to obtain confirmation under this section.

Can the Debtor Obtain Confirmation under §1129(b)(2)(A)(iii)?

The next issue is whether the debtor can demonstrate that SC1 is realizing the indubitable equivalent of its claim. Because the three requirements articulated in §1129(b)(2)(A) are disjunctive and non-exclusive, failure to satisfy subsection (A)(i) (requiring retention of liens) will not defeat a plan so long as the plan satisfies subsection (A)(iii) (requiring the indubitable equiv-alent). Corestates Bank, N.A.,.202 B.R. at 51. Something is "dubitable" if it is open to doubt or question and, conversely, is "indubitable," for the purposes of giving a creditor the indubitable equivalent of its claim in a cramdown, if it is not open to any doubt. In re Freymiller Trucking Inc., 190 B.R. 913, 915 (Bankr. W.D. Okla. 1996). "In other words, the issue is whether there is any real doubt but that, as a matter of fact, the [creditor] will be paid in full." Id. at 916.

In the context of §1129(b)(2)(A)(iii), the majority of the published decisions focus on the sufficiency of the substitute collateral proposed to be granted by a plan proponent to a secured creditor. Viewing the subordination or priming of liens as substitute collateral in assessing whether a secured creditor will be paid, courts are primarily concerned (a) that the creditor’s risk of exposure not be increased as a result of the substitute collateral, In re Keller,.157 B.R. 680, 683-84 (Bankr. E.D. Wash. 1993) and In re Sparks,.171 B.R. 860, 866 (Bankr. N.D. Ill. 1994), and (b) that the secured creditor obtains an equal or greater equity cushion in the substitute collateral to guard against any depreciation that might realistically occur. In re San Felipe @ Voss Ltd.,.115 B.R. 526, 531 (S.D. Tex. 1990).

Judge Posner of the Seventh Circuit Court of Appeals in In re James Wilson Assocs.,.965 F.2d 160 (7th Cir. 1992), notes that the adage that liens pass through bankruptcy unaffected cannot be taken at face value. Id. at 171. In that case, the court upheld the bankruptcy court’s confirmation of the plan because the court found that the plan provided the secured creditor with the indubitable equivalent of its secured interest despite the subordination of its lien on rents to pay attorneys’ fees and to protect junior creditors. The court found dispositive that the secured creditor’s lien on the debtor’s building was considerably oversecured. Id. at 172. In so holding, the court made the following observation concerning secured creditors’ security interests and liens:

So liens are affected by bank-ruptcy. But is it permissible to bite into them in order to pay attorney’s [sic] fees and to protect the interest of another, but junior, secured creditor? We think so, given the oversecured character of the [secured creditor’s] claim. A security interest is a security interest. It is not a fee simple. [The secured creditor] does not own a $6 million building or the rents that that building throws off month after month, year after year. It is just a creditor with a claim currently worth about $3.2 million that it has secured with liens against the building, and against the rents, to assure payment. It has no right to fence off the entire collateral in which it has an interest so that no other creditor can get at it. Its only entitlement is to the adequate protection of its interest...The first lienor is entitled to the preservation of so much of his security interest as is necessary generously to secure his claim, but to no more. Id. (citations omitted).

The case law requires, therefore, that there be no doubt a secured creditor will be paid in order to confirm a plan that purports to provide a secured creditor with the indubitable equivalent of its claim. In the illustrated case, the debtor’s plan actually increased the collateral value of SC1’s secured position notwithstanding its junior position to the new lender, leaving little doubt that it would be paid. When faced with the illustrated fact situation, the bankruptcy court for the Southern District of Indiana in the unreported opinion of In re Eagle Industries Inc., (Case No. 97-00100-LV- 11), confirmed such a plan over the objection of the secured claimant.

For bankruptcy practitioners, §1129(b) can provide a powerful and effective tool that can be used to satisfy the first priority lien requirements of a new lender without having to satisfy and obtain the release of liens from existing secured claimants.


1The total value of all of the debtor’s assets on the confirmation date equaled $3.68 million. Return to text.
Journal Date: 
Wednesday, July 1, 1998

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