A recent decision out of the First Circuit Court of Appeals illustrates the importance of the value of the collateral of creditors with fulcrum security, as that value relates to creditors’ rights to pendency interest.

In re SW Boston Hotel Venture, LLC, et al. involved a failed construction project by SW Boston Hotel Venture, LLC to develop a mixed-used property that would become the W Hotel and Residences in Boston’s theater district.  The senior secured lender (“Prudential”) provided up to $192.2 million in financing pursuant to a construction loan agreement.  As security for the loan, Prudential took a mortgage and first priority blanket security interest in SW Boston’s real and personal property.  Prudential also took a security interest in the real estate and property of certain affiliates of SW Boston, and received a $17.3 million letter of credit issued by Sovereign Bank.

SW Boston lacked sufficient funding to complete the project, and the City of Boston stepped in to provide $10.5 million in junior financing.  However, the additional financing was not sufficient, and SW Boston and its affiliates filed for chapter 11 protection.  Prudential filed a proof of claim in the bankruptcy asserting a secured claim of not less than $180,803,186.00, plus fees, costs, and pre- and post-petition interest.  Upon drawing down the letter of credit, Prudential reduced its pre-petition claim to $165,592,659.00.

In August 2010, Prudential sought relief from stay with respect to the hotel and condominiums.  In connection with the lift-stay hearing, Prudential’s expert valued the remaining condominiums at $86 million and the W Hotel at $55 million.  The Debtors’ expert valued the same condominiums at $90.6 million and the hotel at $65.6 million.  After a three-day evidentiary hearing, the Bankruptcy Court concluded that the value of the condominiums was $88 million and the value of the hotel was $65 million, making the total value of SW Boston’s collateral $153 million.  The Bankruptcy Court estimated the outstanding debt owed to Prudential at $154 million, exclusive of fees, interest, and expenses.  The Bankruptcy Court denied the motion for stay relief on the grounds that while the Debtors didn’t have equity in the collateral, the property was necessary for a reorganization.

Throughout the bankruptcy case, the Debtors continued to sell condominiums to third-party buyers and paid over the proceeds to Prudential.  In March 2011, SW Boston also filed a motion to sell the hotel for $89.5 million, a price well above the Bankruptcy Court-determined value of $65 million.  The Debtors also filed their reorganization plan around this time, which plan precluded Prudential from receiving post-petition interest prior to the conclusion of the bankruptcy case.  Prudential objected to confirmation of the plan.  The sale of the hotel closed on June 8, 2011 and the net proceeds of $88,322,017.00 were paid to Prudential.

Around the time of confirmation, Prudential moved for a determination that it was oversecured and therefore entitled to post-petition interest under section 506(b) of the Bankruptcy Code.   Prudential argued that it should receive post-petition interest at the contractual default rate of 14.5%, accruing from the petition date.  The Debtors, on the other hand, argued that Prudential only became oversecured in the bankruptcy case when the hotel sale closed on June 8, 2011 for a sale price of $89.5 million, and therefore could only receive post-petition interest from that point forward.  The Debtors also claimed that the default rate was unenforceable and inequitable, and requested that any post-petition interest accrue at the non-default rate of 9.5% per annum.

On October 4, 2011, the Bankruptcy Court granted Prudential post-petition interest at 14.5% per annum commencing on the hotel sale date.  The Bankruptcy Court ruled that the hotel sale price, rather than its valuation at the lift-stay hearing, was the best indicator of the hotel’s value.  However, it also noted that the sale price was evidence of the hotel’s value on the date of the closing, rather than as of any earlier date.  Prudential appealed and the Debtors cross-appealed.

On appeal, the BAP (i) held that Prudential was entitled to post-petition interest from the much earlier petition date rather than the hotel sale date and (ii) affirmed the Bankruptcy Court’s determination that the contractual default rate of interest (14.5%) applied.  The Debtors and the City appealed the BAP’s decisions to the Circuit.

On appeal, the First Circuit vacated the BAP’s ruling and remanded to the BAP with instructions to affirm the Bankruptcy Court’s orders.  In its ruling, the First Circuit acknowledged the importance of when the valuation is made (i.e., “the choice can make the difference between a finding of oversecurity or undersecurity”).

This decision from the First Circuit illustrates a number of important points regarding valuation determinations in chapter 11 cases.

First, the Bankruptcy Code does not specify when collateral should be valued and that decision can be left to the Bankruptcy Court’s discretion.

Second, allowing the Bankruptcy Court to apply a flexible approach to determining the time that the assets should be valued enables the Court to account for the unique circumstances of each case and reflects the discretionary nature of Bankruptcy Courts as courts of equity.

Third, requiring Bankruptcy Courts to value such assets on a pre-determined fixed date (i.e., the petition date or the confirmation date) leads to absurdities.  If the petition date is always used, creditors who became oversecured one day after the petition date would not be allowed any post-petition interest.  Likewise, if the confirmation date is always used, a creditor who became oversecured one day prior to confirmation would obtain a windfall of post-petition interest for the entire case.

Fourth, Prudential only became oversecured in this case as a result of Debtors’ continued efforts to complete the hotel project and sell condominiums and pay the net sale proceeds to Prudential, and the sale date of the hotel was the first day on which it became clear that Prudential was oversecured and entitled to post-petition interest.  Prudential has the burden on this issue, and it didn’t meet its burden at any time prior to the sale date.

Fifth, Prudential’s argument that the Bankruptcy Court was somehow bound by its determination in the context of Prudential’s lift stay motion in August 2010 that Prudential was oversecured at that time misstates the law and the facts of the case.  In particular, the First Circuit noted that a valuation made at an earlier hearing was not binding on the Bankruptcy Court at a later hearing.

Finally, on the issue of post-petition interest, the First Circuit noted that “where the parties have contractually agreed to interest terms, those terms should presumptively apply so long as they are enforceable under state law and equitable considerations do not dictate otherwise.”  The First Circuit cited to a Ninth Circuit decision from 2008 that Bankruptcy Courts should apply a “presumption of allowability” for the “contracted for default rate” provided that the rate is not unenforceable under applicable non-bankruptcy law.