The "Devil's Dictionary
" is a quick-reference guide for commercial lenders and other restructuring professionals. In this series, we highlight many of the buzz words found in the Dictionary
and used in today's bankruptcy arena.
The right of a secured creditor that believes its collateral has been under-valued in the bankruptcy process to elect to be treated in a Chapter 11 plan as “fully secured” (in the limited sense discussed in more detail below) rather than partially secured and partially unsecured (see Oversecured Creditor and Undersecured Creditor).
Once upon a time there was a debtor (“Devil’s Spawn”) who “crammed down” its nonrecourse lender by persuading the bankruptcy court to value the creditor’s collateral at millions of dollars less than the loan amount, paying nothing on the unsecured portion of the creditor’s claim in Devil’s Spawn’s Chapter 11 plan (since the claim was, after all, nonrecourse), then selling the property shortly after the confirmation of the plan for more than the creditor’s re-valued secured claim and pocketing the difference. The authors of the Bankruptcy Code of 1978 remedied this injustice in two ways—first, by making a nonrecourse claim recourse in Chapter 11 under certain circumstances and, second, by providing secured creditors the 1111(b) election.
The 1111(b) election affords real but limited protection against under-valuation. If the creditor makes the election, the plan must provide for payments to the creditor equal to at least the total amount of its claim. But those payments need only have a present value of at least the court-determined value of the creditor’s collateral. Thus, although the electing creditor’s claim is initially fully secured by the collateral, it is not entitled to interest on the entire amount of its claim—only on the portion of its claim that would be its secured claim absent the election.
Assume, for example, that a secured creditor is owed a total of $10 million but the court values the creditor’s collateral at only $8 million. If the creditor does not make the 1111(b) election and the property is sold the day after the plan becomes effective, the creditor is entitled to receive only $8 million—payment of the court-determined value of the collateral. The creditor will receive payment on its $2 million unsecured claim only to the extent provided in the plan. But if the creditor had made the 1111(b) election, it would be entitled to payment of the entire amount of its $10 million claim.
Now assume, however, that the creditor made the 1111(b) election but the property is not sold until one year after the effective date of the plan. Assume further that the creditor is paid under the plan monthly interest only payments at the rate of 10 percent per annum. The creditor will receive $800,000 in interest payments over the one-year period. The interest payments are, in effect, credited against what might be called the “excess principal” amount of the claim (i.e., the $2 million above the court’s $8 million valuation of the creditor’s collateral). At the end of the one-year period, the “payoff” amount to the creditor in a sale (including a foreclosure sale) if the creditor made the 1111(b) election would be $9,200,000 ($10 million in principal minus $800,000 in payments). Absent the election, the payoff would be only $8 million, so the creditor would be better off for having made the election (unless the creditor received a return on its unsecured claim under the plan of $1.2 million, a 60 percent return over a one-year period—not likely!).
Continuing with the example, after 30 months of payments at 10 percent interest, the creditor would receive interest payments of $2 million and there would no longer be any “excess principal.” After that point the creditor would be entitled only to $8 million plus interest. Also at that point, if the creditor had received anything on its unsecured claim, it would have been better off not to have made the election.
Absent the 1111(b) election, an undersecured creditor holds both a secured claim and an unsecured claim in the case, a situation that may enable the undersecured creditor to control voting in the unsecured class of creditors and block confirmation of a plan. This is a strategy designed to defeat confirmation of the plan entirely (the strategy adopted by the great majority of secured creditors in Chapter 11 cases), while the 1111(b) election strategy assumes that a plan that undervalues the creditor’s collateral will be confirmed and protects the creditor against that downside. Yet the very existence of 1111(b) operates as a powerful deterrent to the strategy employed by Devil’s Spawn.
The 1111(b) election is not available to a secured creditor whose interest in the collateral is of inconsequential value. The election is also not available to a secured creditor whose claim is fully recourse against the debtor and whose collateral is to be sold under a plan or pursuant to Section 363. The creditor must make its 1111(b) election before the conclusion of the hearing on the debtor’s disclosure statement (see Disclosure Statement) or within any later time set by the court.
Bankruptcy Code § 1111(b). See also Absolute Priority Rule, Cramdown, Oversecured Creditor, Secured Claim, Undersecured Creditor, Unsecured Claim, Valuation of Collateral.
"The Devil's Dictionary" is an excellent reference tool that reflects the collective wisdom of its four authors, Brett Anders, Jim Bird, David Ferguson and Dan Flanigan, and digital editor, Christopher Ward, who have a combined total of more than 130 years working in the forefront of real estate and other commercial finance, loan enforcement, financial restructuring and bankruptcy law.