Bankruptcy Developments: (1) Supreme Court Gets Active in Bankruptcy Law, and (2) Chapter 11 Reform is Under Way

While overall bankruptcy filings continue a decline that started in 2010, the U.S. Supreme Court is unusually active in bankruptcy issues this term, having accepted six cases with bankruptcy issues (by comparison, it accepted only three such cases in 2013, and only one in 2012). In this article, we discuss one of the issues the Supreme Court is considering: whether a debtor can strip a lien off of real estate in a Chapter 7 case. Another important development in the bankruptcy world is the growing momentum for a major overhaul of chapter 11. A significant milestone on that front was reached in December 2014, with the issuance of the Final Report and Recommendations of the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11. Secured lenders are a major target of that report, and we discuss in this article some of the recommendations of that report that are relevant to lenders.

1. The Supreme Court takes up Chapter 7 Lien Strip Offs.

By way of brief review, a lien strip off is a complete removal of a lien, such as a mortgage lien, from real estate based upon the absence of equity in the real estate to secure the underlying debt. A common strip-off scenario involves a second mortgage that is completely “underwater” because the payoff on the first mortgage exceeds the value of the real estate.

In our August article we noted that strip off is not possible in Chapter 7 bankruptcy in Virginia. The Supreme Court, however, has now decided to take up the issue - in November 2014 it accepted two cases from the Eleventh Circuit Court of Appeals in which the Chapter 7 debtor was allowed to strip off a second mortgage.

What seems to be a clear prohibition against strip offs in Chapter 7 bankruptcy originates with the Supreme Court’s decision in 1992, in Dewsnup v. Timm, that a Chapter 7 debtor could not “strip down” the first lien on his real estate. The debtor in Dewsnup, whose real estate was worth far less than the payoff on the single deed-of-trust lien that encumbered it, argued that he should be allowed to reduce the amount of the lien (i.e., strip it down) to the value of the real estate. He argued that the plain language of the Bankruptcy Code states that a lien is void to the extent it is underwater.[1] The Supreme Court rejected the argument, primarily on the grounds that (a) the traditional rule is that “liens pass through bankruptcy unaffected,” and (b) the debtor’s argument could result in him receiving a windfall if the real estate appreciated in value after the bankruptcy filing.

So, if adherence to traditional bankruptcy law and aversion to debtors receiving windfalls as a result of upswings in the real-estate market preclude lien strip downs in Chapter 7, why would they not also preclude strip offs in Chapter 7? Indeed, the Fourth Circuit Court of Appeals, which covers Virginia, and the Sixth Circuit have ruled that the strip off is not allowed in Chapter 7.[2]

Nevertheless, the Eleventh Circuit has allowed Chapter 7 strip offs based on one of its own pre-Dewsnup cases. In that earlier case, the Eleventh Circuit was persuaded by the “plain-language-of-the-Bankruptcy-Code” argument that was rejected in Dewsnup, and it also commented that “[t]he whole point of bankruptcy is to provide a debtor with a fresh start” and that the Bankruptcy Code “does not give a debtor its property back as some sort of windfall.”

So, it seems that the Eleventh Circuit’s view of strip off is simply contrary to theSupreme Court’s, and we therefore expect that in these new cases the Supreme Court will reaffirm Dewsnup and rule that strip off is not allowed in Chapter 7. However, we can’t completely discount the possibility that, in these troubled economic times, the Supreme Court will find a way around Dewsnupand give Chapter 7 debtors a powerful new tool to fix their mortgage problems.

2. The American Bankruptcy Institute issues its report on reforming Chapter 11.

“[A]necdotal evidence suggests that chapter 11 has become too expensive … and is no longer capable of achieving certain policy objectives such as stimulating economic growth, preserving jobs and tax bases … or helping to rehabilitate viable companies that cannot afford a chapter 11 reorganization.” So says the Final Report and Recommendations (the “Report”) of the Commission to Study the Reform of Chapter 11 created by the American Bankruptcy Institute, which bills itself as “the largest multi-disciplinary, non-partisan organization dedicated to research and education on matters related to insolvency.” The Report, issued December 8, 2014, is the product of three years of study by a host of prominent bankruptcy judges, lawyers, and other professionals. The Report notes that the law of business reorganizations has been overhauled in the U.S. about every 40 years since 1898 (the last one having occurred in 1978) and states that “the general consensus among restructuring professionals is that the time has come once again to evaluate U.S. business reorganization laws.”

A comprehensive survey of the Report, which is over 300 pages and contains dozens of recommendations, is beyond the scope of this article. Nonetheless, the Report is notable because of

(a) the likelihood that it represents a significant step toward a major reform of chapter 11, and

(b) the target of a number of its proposed reforms - secured lenders. For example, the Report proposes that at the outset of a chapter 11 case, when the Debtor is often negotiating with its lender about how to provide the necessary “adequate protection” for the lender’s collateral, the standard for valuing the collateral should be “foreclosure value,” instead of the higher “going-concern value” or even “liquidation value.” This proposal, if made into law, would shift the playing field to help debtors survive in chapter 11, potentially at the expense of lenders’ ultimate recoveries. Other recommendations aimed at secured lenders include that - (a) pre-petition lenders should no longer be allowed to provide a post-petition loan that effectively pays off their pre-petition loan and thereby turns it into a post-petition loan that, accordingly, (i) has administrative-priority status, and (ii) protects the lender from the kinds of loan modifications - i.e., reduced interest rates, and reduced loan balances based on new collateral valuations - that chapter 11 has traditionally subjected them to; (b) lenders should no longer be allowed to require debtors and bankruptcy trustees to waive their right to “surcharge” the lender’s collateral for costs incurred relating to preserving the collateral;

(c) lenders should no longer be allowed to require debtors and bankruptcy trustees to waive their right to try to limit, alter, or terminate the extension of the lender’s pre-bankruptcy lien to proceeds or rents that accrue after the bankruptcy filing;

(d) lenders should no longer be allowed to receive liens on debtors’ “claw-back” actions, such as lawsuits to recover preference payments; and

(e) lenders should no longer be allowed to require debtors to take certain actions, such as completing a sale of assets or filing a chapter 11 plan, within 60 days after filing a chapter 11 case;

(f) lenders should no longer be allowed to include representations regarding the validity or extent of their liens in an interim order relating to bankruptcy financing; and

(g) in large business bankruptcies, the “absolute priority rule” - which requires, in relevant part, that senior secured creditors must be paid in full before junior creditors receive anything - may be “adjusted” to allow the class right below the senior secured creditors to receive a “redemption option value.” The redemption option value would reflect “the possibility that, between the [chapter 11] plan effective date or the [asset] sale order date and the third anniversary of the [bankruptcy] petition date, the value of the [debtor] firm might have been sufficient to pay the senior class in full with interest and provide incremental value to such immediately junior class.” This is genuinely new thinking about creditor priorities in bankruptcy, and while it is aimed at large bankruptcy cases, presumably it could one day become part of small and medium-sized cases too.

However, not all of the Report’s recommendations have been controversial with lenders. For example, with respect to pursuing preference lawsuits against creditors, the Report recommends that (a) debtors and bankruptcy trustees be required to perform reasonable due diligence and to make good faith efforts to evaluate the merits of a preference case, including the creditor’s known or reasonably knowable defenses, before filing a lawsuit or even making a demand upon the creditor, and (b) payments aggregating less than $25,000 not be subject to recovery (the current cut-off is only $6,225).

[1] The Bankruptcy Code states, in effect, that (1) an allowed claim secured by a lien on property is a secured claim to the extent of the value of the creditor’s interest in the property (Bankruptcy Code section 506(a)), and (2) to the extent that a lien secures a claim that is not an allowed secured claim, it is void (Bankruptcy Code section 506(d)).[2] Ryan v. Homecomings Fin. Network, 253 F.3d 778, 782 (4th Cir. 2001); Talbert v. City Mortg. Servs. (In re Talbert), 344 F.3d 555 (6th Cir. 2003).