Seventh Circuit Protects Creditor’s Choice To Gamble on Real Estate Over U.S. Treasuries

February 8, 2012 Authors: Berry D. Spears, Louis R. Strubeck, Jr., Bob Bruner

The Seventh Circuit recently affirmed a bankruptcy court decision that limits a debtor's ability to impair a secured creditor's lien rights by transferring the lien from the creditor's bargained-for collateral to substitute collateral bearing a different "risk profile." In re River East Plaza, LLC, 2012 WL 169760 (7th Cir. Jan. 19, 2012).

The River East Plaza case involved a single-asset real estate debtor whose lone asset was a downtown Chicago office building. LNV Corporation was the debtor's principal creditor, with an approximate $38 million claim secured by a lien on the office building. In its bankruptcy case, the debtor valued the building at $13.5 million, leaving LNV under-secured by over $20 million. LNV elected to have its entire $38 million claim treated as a secured claim pursuant to section 1111(b)(1)(A) of the Bankruptcy Code.

The debtor's plan proposed to pay LNV's claim over time and provided for the retention of LNV's lien. However, the plan proposed to transfer the lien from the office building to $13.5 million in 30-year U.S. Treasury Bonds that would arguably be worth $38.5 million after 30-years of accumulated compound interest.

LNV alleged that transferring its lien from the office building to the U.S. Treasuries failed to satisfy section 1129(b)(2)(A), the cram-down provision applicable to secured creditors. Section 1129(b)(2)(A) requires a plan that impairs a secured creditor to provide the creditor with either of the following: (i) the retention of the secured creditor's lien on the creditor's collateral and deferred cash payments equal to the value of the creditor's collateral on the plan's effective date; (ii) the right to credit-bid at any proposed sale of the creditor's collateral; or (iii) the "indubitable equivalent" of the creditor's claim.

The debtor alleged that the Treasury Bonds constituted the "indubitable equivalent" of the office building because the U.S. Treasuries would provide for full satisfaction of LNV's claim with minimal risk. The Seventh Circuit rejected this contention.

The Court first noted that substitute collateral inherently could not constitute the "indubitable equivalent" of the creditor's collateral. To be an indubitable equivalent, the substitute collateral would have to be at least as valuable as the creditor's collateral and the debtor's only reason to substitute collateral would be because the substitute collateral is worth less than the creditor's collateral. The Court also noted that the vastly different risks and rewards associated with the office building and U.S. Treasuries precluded an "indubitable equivalent" finding. The Court noted that the creditor arguably faced greater risk in receiving full recovery of its claim from the office building should the debtor default under the plan. However, the creditor also faced significantly greater returns from the office building should the debtor default and the creditor foreclose on the office building after the real estate market improved. Furthermore, the U.S. Treasuries, though arguably less risky, offered a substantially lower potential return to LNV as the secured creditor -- particularly when the effect of inflation over a 30-year period is taken into consideration.

Ultimately, the Court reasoned that creditors are entitled to choose their "risk profiles" and debtors cannot alter that risk profile by using the "indubitable equivalent" provision of section 1129(b)(2)(A)(iii) to strip creditors of rights they would otherwise have under either 1129(b)(2)(A)(i) or (ii). Significantly, when read with the Seventh Circuit's 2011 River Road Partners opinion, a case which holds that the "indubitable equivalent" provision cannot be used to strip a creditor of the credit-bid rights afforded by section 1129(b)(2)(A)(ii), the Seventh Circuit has arguably read the "or" out of section 1129(b)(2)(A) and held that a plan cannot satisfy the "indubitable equivalent" standard unless the plan also satisfies subsection (i) or (ii) of section 1129(b)(2)(A). See River Road Hotel Partners, LLC v. Amalgamated Bank, 651 F.3d 642 (7th Cir. 2011).

This article was prepared by Berry D. Spears (bspears@fulbright.com or 713 651 5201 in Houston and 512 536 5246 in Austin), Louis R. Strubeck, Jr. (lstrubeck@fulbright.com or 214 855 8040 in Dallas and 212 318 3159 in New York) and Bob Bruner (rbruner@fulbright.com or 713 651 5216) of the firm's Bankruptcy and Insolvency Practice Group. For further information please contact any of the authors listed above.