9th Circuit BAP Decision Gives Debtors Greater Leverage in Single Asset Real Estate Cases

June 5, 2012

Bankruptcy Law Watch

A recent decision in a single asset real estate case has real estate lenders watching the outcome of its appeal. The issue addressed by the Ninth Circuit Bankruptcy Appellate Panel (the “BAP”) is important in cases where a single asset real estate debtor seeks to confirm its reorganization plan over an undersecured lender’s objection.  In In re Loop 76, LLC v. Wells Fargo Bank, N.A., 465 B.R. 525 (9th Cir. B.A.P. 2012), the court permitted the debtor to separately classify the real estate lender’s deficiency claim from other general unsecured claims where the lender also had a third party credit worthy guarantor as a recovery source. The BAP held that the bankruptcy court may consider the existence of a third-party source for payment, including a guarantor, when determining whether unsecured claims are substantially similar for classification purposes under Section 1122(a).   This separate classification and the accepting votes of the other general unsecured creditor class gave the debtor the requisite votes to have its plan confirmed over the objection of the real estate lender.

In single asset real estate transactions, lenders may hold deficiency claims in excess of one-third of the total dollar amount of general unsecured claims, so a plan would not be confirmable over a lender’s objection where the lender’s deficiency claim is placed in the same class as the other general unsecured creditors.  If allowed to separately classify unsecured claims, debtors have greater leverage in confirming a reorganization plan over an undersecured lender’s objection.

Loop 76, the debtor, was a commercial real estate developer in Scottsdale Arizona who obtained a $23,125,000 construction loan from Wells Fargo Bank, N.A. ("Wells Fargo").  The loan was secured by an office/retail complex referred to as the "Airmark Property" in addition to personal guarantees from the principals of Loop 76.  As a result of the real estate market crash and tightening credit markets, when the Wells Fargo loan matured, Loop 76 was unable to procure permanent financing and defaulted on its obligations to Wells Fargo.  Loop 76 filed a chapter 11 petition, and separately, Wells Fargo brought an action in state court against the guarantors of the loan. 

During the bankruptcy proceeding, the parties stipulated to a value of $17,000,000 for the Airmark Property, leaving Wells Fargo undersecured in excess of $6,000,000.  Loop 76's proposed plan sought to separately classify Wells Fargo's deficiency claim from the general class of unsecured creditors.

Wells Fargo sought to have its deficiency claim placed in the class of general unsecured claims ("Wells Fargo's Classification Motion"), arguing that separate classification of its deficiency claim was improper "gerrymandering" and that its deficiency claim was substantially similar to the other general unsecured claims.   

The bankruptcy court denied Wells Fargo's Classification Motion, holding that based on the structure and purpose of Section 1122(a), the history of the former Bankruptcy Act, Ninth Circuit case law, and the legislative intent behind Section 1129(a)(10), a claimant who has a third party repayment source is dissimilar from  a claimant who lacks an alternative source of repayment. The court noted that the parties were free to introduce evidence to show that the guaranty was not a significant factor affecting the creditors’ votes, or that Wells Fargo was no longer pursuing the guaranty, or that the guarantors were insolvent, to support a finding that the existence of the guaranty was not a distinguishing characteristic which would render the claims dissimilar.  No such evidence was forthcoming and the bankruptcy court ultimately confirmed the plan and Wells Fargo appealed. 

The BAP affirmed the lower court’s decision, concluding that separate classification of Wells Fargo's unsecured claim was proper because Wells Fargo had a loan guarantee, which constituted a third-party source of repayment for its deficiency claim.  The court noted that the personal guarantees were a "special circumstance" that did not apply to any other unsecured creditors, which warranted a different treatment of Wells Fargo's claim.  The court found no legal distinction between a claimant's ability to recover against collateral held by a third party and a claimants ability to recover against a third party guarantor in determining the similarity of claims. The court explained that Ninth Circuit precedent allows the bankruptcy court to consider third party sources for payment, including a guarantor, when determining whether unsecured claims are substantially similar for purposes Section 1122(a). 

Wells Fargo, having a deficiency claim over one-third of the total dollar amount owed to the general unsecured class, would have controlled the class and been able to veto the proposed plan. Had Wells Fargo’s claim been included in the class of general unsecured claims, Loop 76 may not have been able to confirm its plan over Wells Fargo’s objection.  By allowing Loop 76 to separately classify Wells Fargo’s deficiency claim, the court significantly reduced Wells Fargo’s bargaining power in the plan confirmation process.  The decision is on appeal to the Ninth Circuit.  If affirmed, in certain instances, debtors may be able to more readily confirm single asset real estate plans over the objection of their secured lender.  Consequently, the real estate industry is watching the outcome of this case.   

Reprinted with permission from Bankruptcy Law Watch © 2012. For more information, visit www.BankruptcyLawWatch.com.