Written By: Ryan M. Davies
Bankruptcy Code Section 1111(b) is a tool that can be beneficial to lenders in certain circumstances. The section applies to secured claims in Chapter 11 cases other than those secured by primary residences. It is not a lengthy section, but its application and ramifications are complicated and frequently misunderstood. It is an optional provision by which the lender can impose upon the debtor a mandatory treatment of a lenders claim in the chapter 11 plan. The purpose of this article is to provide a very brief overview of issues to be discussed with your counsel when considering this section.
Section 1111(b) was formulated to deal with situations where lenders are undersecured, meaning that their collateral is worth less than the loan amount. Given the current economic climate, Section 1111(b) is particularly relevant to lenders and servicers at this time.
This article will focus on three primary effects of the election, but by no means are these effects the only relevant issues for consideration in making the election. First, 1111(b) requires that the lender receive the total amount of debt reflected in its proof of claim. This means that a debtor cannot separate a lender’s claim into secured and unsecured parts based on the actual cash value of the collateral. In typical parlance, this bifurcation of claims is referred to as “cramming down” the lender’s claim and results in a secured claim that is paid over time, with interest, and an unsecured claim that is paid pennies on the dollar, if at all. Avoiding the dreaded “cramdown” sounds great initially, and it can be, but the tradeoff is that the secured lender will receive only the total payoff amount on its proof of claim, and the amount will generally be paid over time. There is no interest paid on the proof of claim payoff amount. Whatever is the payoff at the time the bankruptcy case is filed will be the amount paid to the lender; no more, but also, no less. This becomes important when the value of the collateral is factored into the equation.
The second effect of the election is that the lender will retain its lien until the full proof of claim debt amount is paid in full. This gives the undersecured lender great leverage. In a typical chapter 11 plan, the debtor “crams down” the claim, essentially forcing a refinance of the loan with a new reduced principal amount based on the property’s current market value. Should the debtor desire to satisfy the loan prior to the new maturity date of the “crammed down” obligation, the debtor can do so by paying only the unpaid crammed-down principal balance, plus any accrued interest, late charges and the like; the lender’s original $600,000 claim becomes a wistful memory. If the 1111(b) election is made, the debtor would not be able to satisfy the claim until paying the aggregate amount of $600,000, but no more than that, i.e. whatever monthly payment amounts have been paid by the debtor prior to satisfying the loan will count in full toward the $600,000 aggregate. There is no “interest” involved. If the debtor has paid 50 payments of $2000, then $100,000 of the $600,000 has been paid, and there is $500,000 left for the debtor to pay before the lender must reconvey its lien.
Now that we know the total amount a debtor must pay over time, the question that arises is what is the rate at which this amount is paid? How much is to be paid monthly? This is a complicated aspect of the 1111(b) provision, and is ultimately determined in combination with the bankruptcy code sections governing plan confirmation. The debtor is required to protect the lender’s present fair market value in the collateral until the full proof of claim amount is paid. In order to “preserve” this amount, if paid over time, a discount rate must be factored in to account for the time value of money. This is accomplished by creating an arbitrary and hypothetical “interest” rate which is applied to the fair market value of the collateral with an assumed term of repayment. Based on these assumptions, a new loan amortization is run, which results in a monthly payment amount. In this sense, interest and appraised value do come into play, but only for the purpose of determining an appropriate monthly payment amount – each monthly sum paid by the debtor is still credited in full against the total proof of claim amount.
So what is the point of all this computation and hypothetical assumptions – why would a lender want to elect the 1111(b) treatment and give up real interest? The answer lies in the extent to which the lender is undersecured. A set of examples is helpful. Consider a $700,000 claim which is secured by a property worth $600,000 – the hypothetical 1111(b) calculations to be used in our example are a 5.0% discount rate, and a 30 year hypothetical amortization. Monthly payments required to protect the lender’s $600,000 collateral under those assumed variables would be approximately $3,220. The election would cap the lender’s total recovery at $700,000, but would ensure that the lender receive the full $700,000. The debtor would have to make 217 payments to reach $700,000 when paying only monthly amounts.
However, it is not unrealistic to presume that the loan will be refinanced prior to 217 monthly payments being made. If we assume that the debtor refinances in 10 years, then the Debtor will have paid $386,400 to that point, and will only have to pay an additional $313,600 to the lender upon the refinance to meet the total $700,000 that must be paid to the lender.
Looking at these same variables without the election, a typical chapter 11 plan treatment for this scenario would be for the lender to receive a secured claim of $600,000, paid over 30 years at 5% interest, and very little, if anything, paid on the unsecured balance. Payments would be the same $3,220 for the secured claim. At the same 10 year point, the lender will have received its gross $386,400 and there would be $488,000 of principal remaining. The gross revenue to the lender would be $874,400 through 10 years. If the debtor pays for the full 360 months (unlikely) under the non-election scenario, $600,000 of principal would be paid and $559,534 of interest would be paid, resulting in a gross of $1,159,534 over the 30 year period. In either the 10 year refinance, or the full 30 year repayment, the lender recovers much more without making the 1111(b) election. Given this claim balance to collateral value ratio, the lender should not elect to use 1111(b).
The scenario changes considerably for the same $700,000 claim if the collateral is only worth $350,000. Using our same hypothetical terms for everything other than the collateral’s value, monthly 1111(b) installments would be $1,878. If the election is made, it would take a debtor 372 payments to retire the $700,000 claim if only monthly payments are tendered. In the more likely scenario where the debtor wants to refinance at the 10 year point, the lender would have received $225,360 gross, and another $474,640 would be required to meet the full $700,000 required. On the other hand, if the election is not made and the debtor wants to refinance at the 10 year point, the lender would have received its same $225,360 gross over the 10 years, and there would then be $284,700 of unpaid principal remaining. The gross 10 year revenue without the 1111(b) election would be only $510,060. Under this scenario, making the 1111(b) election ensures that the lender receives more actual revenue over the same time period than the lender would without making the 1111(b) election.
Number crunchers will realize that the period of time that payments are actually made, and the value of the collateral vs. loan balance greatly impact the attractiveness of the 1111(b) option. While there is no absolute rule to determine when it should be used, with all things being equal the election is a better tool the greater the disparity between collateral value and loan payoff. With very undersecured loans, lenders should discuss the option with counsel when evaluating a chapter 11 plan.