Understating the Value of Collateral – A Potential Trap for the Unwary Lender
 
March 21, 2005
 

Borrowers facing foreclosure frequently resort to bankruptcy to protect their assets. The most popular counter-strategy of secured lenders is a motion to lift the automatic stay of section 362 of the Bankruptcy Code[1] to enable the lender to foreclose its collateral under state law. This strategy is frequently successful, especially when the amount of the claim exceeds the value of the collateral. Once a “lift stay” motion has been granted, the secured creditor is free to pursue foreclosure without having to be concerned about the bankruptcy case. Or is he? As a recent case from a Texas bankruptcy court demonstrates, the issue may not be so simple.

The case of In re Home and Hearth Plano Parkway, L.P., 320 B.R. 596 (Bankr. N.D. Tex. 2004) was, at first glance, a straightforward example of a case in which the claim of a mortgage lender exceeded the value of the collateral. Home and Hearth Plano Parkway, L.P. (Debtor) owned a hotel in Plano, Texas, (the Hotel) which served as collateral for a non-recourse note in the principal amount of $4.6 million payable to a bank, as trustee for various holders (collectively, Lender). In addition to the Hotel, the loan was secured by the Debtor’s personal property, receivables, cash and deposit accounts.

Shortly after the Debtor filed a chapter 11 petition in March 2003, Lender filed a proof of claim in excess of $4.85 million. Subsequently, the Debtor filed a plan of reorganization and Lender filed a motion for relief from the automatic stay. In December 2003, the court held a hearing on the two competing filings. At the hearing, the parties stipulated that the value of Lender’s collateral was $3.36 million. Although there was some dispute regarding the amount of Lender’s claim, there was no dispute that the amount of the claim exceeded the stipulated value of the collateral.

Based in large part on the parties’ stipulation, the bankruptcy court denied confirmation of Debtor’s plan and granted the motion to for relief from the automatic stay. The order granting the relief from stay motion was broad, granting Lender the right to pursue all state court remedies to collect on all of Lender’s collateral, specifically including the Hotel as well as the personal property collateral.

Lender foreclosed on the Hotel in February 2004. For reasons that are not completely clear, although Lender was the sole bidder at the foreclosure sale, Lender credit bid $4.74 million an amount that was far more than the value that the parties had stipulated the Hotel was worth approximately two months earlier.

As described below, this disparity between the stipulated value of the Hotel and the amount of Lender’s credit bid at foreclosure led to further litigation in the bankruptcy court.

After the foreclosure, Lender filed an amended proof claim asserting that after crediting the amount of the foreclosure sale, Lender was still owed $195,682.92. The Debtor objected to this claim on the primary ground that the claim consisted of post-petition interest, which, under section 502(b)(2), is not allowable, except to the extent provided for under section 506(b).[2] At the hearing on the claim objection, the parties stipulated that the amount of Lender’s claim prior to crediting the foreclosure sale proceeds was $4,393,941.55, which was the amount owed to Lender as of the petition date, less payments made to Lender thereafter. Thus, Lender apparently conceded that its claim was not oversecured and, consequently, that Lender was not entitled to any post petition interest under section 506(b). Additionally, because the stipulated claim amount was less than Lender’s credit bid at the foreclosure sale, Lender was also conceding that Lender had no further claim against Debtor’s bankruptcy estate. This stipulation, of course, was consistent with the parties’ earlier stipulation as to the value of the collateral but, as discussed below, was not consistent with the amount of Lender’s credit bid at the foreclosure sale.

Lender, one presumes, anticipated that following Lender’s concession that it had no further claim in the bankruptcy case, the bankruptcy would be over as far as Lender was concerned. However, just a few days after the entry of the order resolving Lender’s amended claim, Debtor filed a complaint in the bankruptcy court asserting that the difference between the $4.74 million credit bid at the foreclosure sale and the stipulated claim amount ($4,393.941.55) constituted surplus proceeds from the foreclosure sale to which the Debtor was entitled.

In response, Lender asserted that as a result of the order granting Lender relief from the automatic stay, the calculation of Lender’s claim should be made in accordance with the loan documents and state law and not subject to any limitation contained in the Bankruptcy Code. Accordingly, Lender argued that even after the foreclosure sale, Lender continued to be owed the difference between the credit bid and the amount due when calculated in accordance with the loan documents, which amount Lender was entitled to collect as a secured claim from Lender’s remaining collateral, consisting of the Debtor’s remaining cash.

In consideration of the parties’ cross motions for summary judgment, the bankruptcy court first concluded that, notwithstanding the stipulation between the parties, due to Lender obtaining relief from the automatic stay, Lender was entitled to calculate the amount owed in accordance with the loan documents and applicable state law. The bankruptcy court correctly observed that “there is a legally significant distinction between the debt owed … under the Loan Documents and the allowable claim … in the bankruptcy case.” Home and Hearth Plano Parkway, L.P., 320 B.R. at 607 . In other words, the Bankruptcy Code determines that portion of the debt which may be satisfied from the debtor’s “estate” but does not affect the amount of the debt under the applicable loan documents and state law. But, the Debtor contended, even though the stay was lifted, the Hotel did remain “property of the estate” until the foreclosure sale took place. Therefore, argued the Debtor, Lender was satisfying its claim from “property of the estate.” The bankruptcy court responded as follows:

While the Hotel was property of the estate, once the stay was lifted to allow [Lender] to exercise its state law rights – i.e., foreclosure on the Hotel, the Debtor’s remaining interest in the Hotel is determined by reference to state law and the Loan Documents. Both contractually and under the Loan Documents and in accordance with Texas law, the Debtor has no interest in the proceeds of a foreclosure sale unless and until there is a surplus over [Lender’s] contractual, state law calculated debt. Since there was no surplus over the debt owed to [Lender] under the Loan Documents, there is no property of the estate in which the Debtor had an interest.

Id. at 608.

With respect to Lender’s claim that it was entitled to foreclose on its additional collateral as a result of obtaining relief from the automatic stay, the bankruptcy court noted that Lender had failed to take any action to realize on the balance of its collateral (the cash on hand) prior to the foreclosure on the Hotel and, accordingly, drew a line distinguishing between Lender’s rights as to the Hotel and to the cash collateral:

[U]nlike the foreclosure proceeds, the estate continues to have an interest in the cash on hand. That cash remains in the Debtor’s possession and the case remains pending.

Id. at 613.

But in what way was the cash on hand different from the Hotel prior to the foreclosure sale? After all, up to the time of sale, the Hotel was also in the Debtor’s possession.

In a footnote, the bankruptcy court tried to explain the inconsistency:

By proceeding first, against the Hotel, however, [Lender] put itself in a position where its allowed claim in the Case was fully satisfied by virtue of its bid at the Hotel foreclosure sale, leaving no claim to be paid from the remaining … collateral which is property of the estate.

Id. at 613 n.11 (emphasis added).[3]

Consideration of the bankruptcy court’s analysis begs the question whether Lender could have avoided the additional litigation had it acted differently with respect to the foreclosure proceeding. While it is true that Lender might have been able to credit bid a lower amount, one wonders what would have been the result had the foreclosure auction been won by a bidder who paid cash. In that case, would the bankruptcy court have reached the same conclusion regarding surplus proceeds? Another difficulty with the bankruptcy court’s decision is that it does not deal with a possible sale under the Bankruptcy Code. Suppose for a moment that the Hotel had been auctioned pursuant to a bankruptcy plan or a sale under section 363.[4] In such circumstances, the question arises as to whether Lender would have been bound by its prior stipulation as to the value of its collateral.

With respect to the initial stipulation, Lender apparently assumed that the stipulated value of its collateral was fixed for the purpose of the bankruptcy case, notwithstanding the Lender’s credit bid at the subsequent foreclosure sale. But was it? The decision does not quote the language of the stipulation. However, unless the stipulation explicitly provided that it was immutable, it would not be unusual for the value to be subject to change to reflect the actual price achieved at the foreclosure sale. If the stipulation had not ruled out such an adjustment based on subsequent facts, Lender would have been entitled to post-petition interest under section 506(b) to the extent that the foreclosure sale price exceeded Lender’s pre-petition claim. If the parties had not stipulated as to the value of the collateral and the bankruptcy court had determined the value of the collateral, that value would not necessarily have been binding on the parties in all future proceedings. Certainly, if subsequent events demonstrate that the collateral had appreciated in value, that issue can be revisited. See, e.g., In the Matter of T-H New Orleans Limited Partnership, 116 F.3d 790 (5^th Cir. 1997); In re R&S Vinyl Products Group, L.L.C., 291 B.R. 685 (Bankr. W.D. Pa. 2003). Moreover, the cases indicate that if a secured creditor’s collateral was sold during a bankruptcy case for an amount greater than the amount of the secured claim the creditor is entitled to post-petition interest. See, e.g., In re Monclova Care Center, Inc., 254 B.R. 167 (Bankr. N.D. Ohio 2000).

The issue addressed in Home and Hearth could arise any time collateral is sold in a bankruptcy case for more than the value previously determined by the bankruptcy court or by stipulation. The only unusual twist here, is that the collateral was not sold for cash, but for a credit bid.

Seemingly, Lender erred when it entered into the second stipulation following the foreclosure sale when Lender agreed that its claim did not include any post-petition interest since, based on the foreclosure sale, Lender would have been entitled to such interest. In determining, however, that Lender was not liable for “surplus proceeds” resulting from the foreclosure of the Hotel, the bankruptcy court essentially rescued Lender from its own miscalculation. Similarly, the court’s refusal to allow Lender any recovery on Lender’s additional collateral may well reflect the court’s view that while it would have been inequitable to require Lender to pay cash into the bankruptcy estate, when, after all, Lender did not receive any cash in the foreclosure sale, it was not inequitable to hold Lender to its agreement embodied by the second stipulation when Lender sought a payment from the estate.

This case well illustrates some of the pitfalls that a secured creditor faces in a bankruptcy case. Although obtaining a low valuation may be in the lender’s interest when the lender is trying to lift the automatic stay, that low valuation could come back to haunt the lender later. Also, this case serves as a reminder that stipulations must be carefully considered. In retrospect, one can question why Lender agreed to stipulate that its claim had been satisfied by the foreclosure sale, thereby giving up all remaining leverage to pursue its remaining collateral, without also obtaining a release from the bankruptcy estate.

For more information, e-mail David J. Mark at david.mark@hklaw.com or call toll free, 1-888-688-8500.

1. Unless otherwise stated, section references are to the United States Bankruptcy Code, 11 U.S.C. § 101, et seq.

2. Under section 506(b), an oversecured lender is entitled to include in its claim postpetition interest, fees and costs provided for in the loan documents to the extent of the value of the collateral securing the claim.

3. This footnote is clearly inconsistent with the bankruptcy court’s prior statement that in a foreclosure proceeding Lender’s claim was not to be measured by what was allowable under the Bankruptcy Code but by the amount of its claim under state law. If state law is to determine the amount of Lender’s claim, it is not clear why Lender could not have foreclosed its additional collateral under state law. This question was not squarely addressed by the bankruptcy court.

4. Section 363 specifically preserves the right of a secured creditor to credit bid its claim on a sale of the property securing the secured creditor’s claim.