The Purpose of the Valuation and the Debtor’s Proposed Use Drives Analysis
A lessee’s bankruptcy filing can create uncertainty and risk for even the most experienced equipment lessor with secured party rights under equipment finance agreements. Apart from repayment risk, a lessor’s contractual and state law remedies are indefinitely stayed while the value of the lessor’s collateral hangs in the balance. The Bankruptcy Code provides secured creditors with a variety of remedies, but the ability to successfully exercise such remedies will necessarily turn on the value of the secured creditor’s interest in the collateral. Valuation of collateral in a chapter 11 case is critical to understanding and assessing a lessor’s litigation strategy while minimizing risk and, as discussed below, is far from an exact science. Expert valuation opinions and methodologies may vary and a bankruptcy court’s selection of an appropriate valuation methodology may turn on witness credibility among other factors. Notwithstanding such vagaries, courts uniformly agree that the purpose of the valuation and the debtor’s proposed use or disposition of the collateral will guide the court’s inquiry.
Valuation of a Secured Creditor’s Interest Generally
The valuation of secured claims in bankruptcy is governed by § 506(a) of the Bankruptcy Code, which provides that value “shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.” The legislative history of Bankruptcy Code section 506 reveals an intent to adequately protect the value of a secured creditor’s lien rights by stating that “secured creditors should not be deprived of the benefit of their bargain” and the “purpose [of section 506]… is to insure that the secured creditor receives in value essentially what he bargained for.” The legislative history of section 506 further reveals that the issue of valuation is a matter that should be “left to case-by-case interpretation and development [and] it is expected that the courts will apply the concept in light of facts of each case and general equitable principles. It is not intended that the courts will develop a hard and fast rule that will apply in every case.”“Valuation in bankruptcy may be more of an art than exact science, but understanding the ground rules is key to maximizing the value of a lessor’s secured claim.”
Valuation Standards Will Differ Based on the Purpose of the Valuation and Proposed Use of Collateral
Because there are different reasons a lessor may seek a bankruptcy court’s valuation of its collateral, the appropriate valuation standard to be applied by the court will turn on the purpose of the valuation and the debtor’s proposed use of the collateral. For example, the lessor may seek a valuation for purposes of determining that it is not adequately protected and, therefore, entitled to relief from the automatic stay. Alternatively, a lessor may seek to have its collateral valued for purposes of determining the amount of its secured claim in connection with confirmation of a debtor’s chapter 11 plan. Generally speaking, the proper valuation standard will be based on either a hypothetical sale of the collateral by the secured creditor or a hypothetical purchase of the collateral by the debtor.
i. Valuation for Purposes of Adequate Protection
Adequate protection is designed to compensate a secured creditor if a debtor fails to pay. Where the debtor fails to pay, the secured creditor will not realize the debtor’s use from its collateral, but instead will realize the foreclosure sale value. Any valuation inquiry undertaken to determine the extent to which a secured creditor is entitled to adequate protection should be based on a hypothetical sale (where the reasonable costs of sale are deducted). This standard protects the secured creditor against nonpayment and ensures that the secured creditor will receive the same value it would have received if it had exercised enforcement remedies against the collateral.
ii. Valuation in Connection with Chapter 11 Plan
Where the purpose of the valuation is to determine the amount of a lessor’s secured claim in connection with a chapter 11 plan, the proper valuation standard will turn on the debtor’s proposed use or disposition of the collateral. If the plan contemplates the continued use of the lessor’s collateral over the lessor’s objection (also referred to as a “cramdown plan”), the appropriate valuation standard would be a replacement value standard premised on a hypothetical purchase by the debtor. The U.S. Supreme Court has held that in a cramdown, the value of collateral should be based on “replacement-value” because that standard accurately gauges the debtor’s use of the property and recognizes that in such scenario “the creditor obtains at once neither the property nor its value and is exposed to double risks: The debtor may again default and the property may deteriorate from extended use.”
The Supreme Court has defined “replacement value” as “the price a willing buyer in the debtor’s trade, business, or situation would pay a willing seller to obtain property of like age and condition.” The Supreme Court further held that “the value of the property retained . . . is the cost the debtor would incur to obtain a like asset for the same proposed use.” Bankruptcy courts have routinely rejected valuations premised on a use other than the debtor’s proposed use under its plan. Often a debtor will rely upon the lowest possible valuation so the stream of payments required to be paid to the secured creditor under any plan will be lower. With this in mind, lessors should carefully evaluate appraisal evidence to confirm that the value conclusion properly reflects what it would cost the debtor to replace the collateral with like collateral in similar age and condition. It may be the case that the equipment collateral has a greater value in the debtor’s hands—and used in the debtor’s business operations—than it would be if liquidated piecemeal. In such case, lessors should aggressively challenge any debtor valuation premised on a disposition of the collateral (i.e., sale) or conversion of the collateral to a use other than the debtor’s proposed continued use.
Key Takeaways and Considerations
When seeking a value determination as a secured creditor in chapter 11, secured creditors should carefully consider the reason for the valuation (whether it be for adequate protection or to determine the amount of the secured claim for a chapter 11 plan) and should guide expert appraisers as to the proper valuation standards. When faced with a chapter 11 plan proposing to value a lessor’s secured claim based on an objectionably low value, lessors should obtain a copy of the debtor’s appraisal and other valuation evidence and analyze with scrutiny. To the extent a debtor’s valuation is premised on a use or disposition other than what is proposed by its plan, a lessor should swiftly obtain an independent valuation premised on continued use to comply with the replacement value standard and use such evidence to challenge the debtor’s proposed plan. In the end, valuation in bankruptcy may be more of an art than an exact science, but understanding the ground rules is key to maximizing the value of a lessor’s secured claim.
