Would you like to own that rural timberland you financed a few years back? Well, what if I told you that not only are you taking it into your real estate portfolio, but you’re taking it in exchange for a credit of three times its appraised value? This nightmare scenario is a possible reality in the Eastern District of North Carolina, where “dirt-for-debt” plans are a common strategy of debtors’ attorneys in chapter 11 bankruptcy cases. And, based on recent guidance from the Fourth Circuit Court of Appeals, you should not expect help on appeal if the trial court does not share your opinion of value.
The dirt-for-debt trend started from practical origins in the wake of the Great Recession, when developers were caught with a surplus of inventory and there was limited or no market for distressed properties flooding into bank REO departments. Rather than force an auction or foreclosure for a fire sale price, debtors sought to transfer the property to the bank for fair market value, which is permitted under the “cram-down” provisions of the Bankruptcy Code.
Section 1129(b)(2)(A)(iii) allows payment of a creditor’s claim through surrender of collateral. As part of a Chapter 11 reorganization, the debtor can compel a creditor to accept its collateral in full or partial satisfaction of its claim. What makes this treatment “fair and equitable” is the requirement that the surrendered property be the “indubitable equivalent” of the creditor’s claim. This means that the value assigned to the surrendered collateral must be certain to compensate the creditor for the credit the debtor receives in return.
On the surface, this sounds reasonable enough—the creditor is given its collateral in exchange for value and the parties are avoiding the legal process of liquidation. The reality, however, can be different. Dirt-for-debt is often employed strategically where the debtor believes the court might assign a value greater than the creditor’s appraisal. After all, if the objective was merely to monetize collateral, there are other mechanisms to do so under the Bankruptcy Code. The parties are always free to construct a sale or auction procedure.
The debtor, however, prefers to have the court determine value based on an evidentiary hearing. Using its own hired expert, the debtor makes the case the property has substantially appreciated in value. The debtor’s evidence can be as simple as a competing sales comparison analysis, but might also be more complex and premised on an alternative “highest and best use.” If a different use is accepted, valuation can change dramatically—consider the example of farmland valued as a burgeoning new subdivision.
The check against speculative valuation evidence is the Bankruptcy Code’s conservative standard of proof. Under the “indubitable equivalent” standard, anything less than certainty should be rejected. This distinguishes the dirt-for-debt analysis from an ordinary valuation analysis, where signs of ambiguity such as widely variant appraisals and disputed uses might be considered with less reservation. Under the indubitable equivalent standard, contrasting opinions are themselves an indication of insurmountable uncertainty.
In a departure from other jurisdictions, the bankruptcy court in the Eastern District has taken a softened view of the indubitable equivalent standard. In recent rulings, the court references the standard’s high bar, but undertakes an indistinguishable valuation analysis, taking into account all evidence and competing opinions as to possible uses. In doing so, the court strips away the safeguard of certainty. This approach has resulted in valuations based on future development uses that vastly exceed the creditor’s appraisal.
The Fourth Circuit reviewed one of these rulings for the first time in In re: Bate Land & Timber LLC . In this case, the debtor successfully convinced the bankruptcy court that vacant timberland should be valued for residential development. On appeal, the creditor argued that the disputed feasibility of this use and the related variance in appraisals could not satisfy the standard of indubitable equivalence. This was based on precedent in other jurisdictions holding that widely variant appraisals constitute proof of uncertainty.
On appeal, the Fourth Circuit found that “application of the indubitable equivalence standard involves more flexibility than the term suggests” and that “a bankruptcy court, acting as a fact-finder with specialized expertise, is well-equipped to arrive at a valuation that represents the indubitable equivalent of a secured creditor’s claim, in the face of disputed valuations.” It further found that review on appeal is limited to a “clear error” standard, meaning the bankruptcy court’s ruling is reviewed only for overt mistakes.
In sum, the Fourth Circuit held that the bankruptcy court is sufficiently capable of assessing the evidence before it, even in the face of widely variant appraisals and disputed uses. It further held that it would not second guess the bankruptcy court’s decision except in the most egregious circumstances. Thus, though indubitable equivalence remains the black letter standard, the Fourth Circuit’s ruling affords substantial discretion in its application.
For creditors, the take away from the Fourth Circuit’s ruling is that the stakes are higher than ever to win the valuation battle before the bankruptcy court. This first phase is critical since the outcome is unlikely to be disturbed on appeal. Selection of capable counsel and credible experts are of the utmost importance. Creditors who fail to appreciate this might find themselves the proud owner of a “can’t-miss development opportunity” . . . ahem, overvalued timberland.