By: Donald L Swanson
Wow—didn’t expect to see an § 1111(b) election opinion under Subchapter V this soon!
But here it is: In re Body Transit, Inc. d/b/a/ Rascals Fitness, Bky. No. 20-10014 in Eastern Pennsylvania Bankruptcy Court (decided August 7, 2020, by Hon. Eric. L. Frank, Doc. 200).
And for those of us confused about § 1111(b) elections (there are lots of us), this opinion provides a most-helpful analysis.
Sec. 1111(b) Election
Judge Frank begins explaining the § 1111(b) election process with these two points.
First, § 1111(b) of the Bankruptcy Code is a complex statutory provision, with a number of moving parts that interact with other Code provisions.
Second, its operation effects two modifications in the ordinary process of allowing claims in bankruptcy cases:
- Sec. 1111(b)(1) converts, with some exceptions, nonrecourse deficiency claims into unsecured claims; and
- It allows holders of certain partially secured claims to waive their unsecured deficiency claims and, contrary to section 506(a), have their entire debt treated as a secured claim.
The case before the Court involves an undersecured creditor. So, this opinion is limited to, (i) the election that an undersecured creditor is permitted to make under §1111(b)(2), and (ii) circumstances in which the creditor is ineligible to make such an election.
The opinion then explains the §1111(b) election by describing its effect:.
- An undersecured creditor making an 1111(b)(2) election is entitled to have its entire claim treated in the plan as secured;
- That means, (i) the plan must pay the full face amount of the electing creditor’s claim, and (ii) the electing creditor will retain its lien until the full face amount is paid;
- The electing creditor no longer has an unsecured claim and is not part of the unsecured class; and
- The claim is still bifurcated, with two separate-but-overlapping requirements: (i) the secured portion of the claim must be paid in full over time, with interest, and (ii) total payments on the entire claim must equal the face amount of the claim, without including post-petition interest.
[Editorial Note: The opinion provides a “simple” and detailed illustration of how an 1111(b) election works on an undersecured claim at pages 25-27.]
Why 1111(b) Exists
Here’s why the Bankruptcy Code contains § 1111(b), which overrides the operation of 11 U.S.C. §506(a):
- The real benefit of the election is that it protects the creditor against a quick determination of its collateral’s value at a time when such value is temporarily depressed;
- Without the election, the debtor could sell the collateral when its value quickly rebounds and net a considerable gain; and
- By making the election, the creditor guards against such an opportunistic sale because it retains a lien on the collateral equal to the full amount of its claim, albeit without interest.
And here are the “trade-offs” in an § 1111(b) election:
- The electing secured creditor gives up a vote (perhaps a controlling vote) in the unsecured class in exchange for the benefit of post-confirmation appreciation of its collateral; and
- By retaining its lien as security for its entire claim, the electing creditor holds its collateral hostage from debtor’s effort to benefit from any post-confirmation appreciation of collateral until the entire amount of the creditor’s claim is paid.
Inconsequential Value Exception
The opinion then discusses the “inconsequential value” prohibition against an 1111(b) election. [Fn. 1]
Creditor argues that, (i) “inconsequential value” means “no value,” and (ii) $80,000 value is consequential. The opinion declares this “no value” argument as “easily rejected on textual grounds” because the adjective “inconsequential” modifying the noun “value” implies that the value does not have to be zero.
Creditor also argues that the court should compare the value of its lien to the value of its collateral. Some courts adopt this approach on textual grounds. This opinion responds: “Respectfully, I disagree.” Here’s why:
- The statutory text does not state how to make a determination of inconsequentiality; and
- To determine inconsequentiality, the value of the collateral must be compared to something else, and the statutory text offers no guidance.
“The correct methodology” for determining inconsequentionality, the opinion says, is to compare the creditor’s collateral value to the total amount of its claim. That’s because 1111(b) is intended to preserve creditors’ non-bankruptcy rights, not enhance them:
- A creditor whose lien is almost, but not quite, out-of-the-money would likely view itself, outside of bankruptcy, as wholly unsecured; and
- Therefore, if a creditor’s collateral value is inconsequential, compared to its total claim, the creditor should be treated as wholly unsecured for 1111(b) purposes.
Denying the 1111(b) Election
The undersecured Creditor, in In re Body Transit, makes an 1111(b) election, and Debtor objects.
Here’s how the Bankruptcy Court applies the 1111(b) election rules to the facts of the case—to deny the election.
The opinion bifurcates the electing Creditor’s claim into:
- $ 80,000 Allowed secured claim, based on a going-concern value; and
- $890,000 Allowed general unsecured claim.
Then the opinion applies the 1111(b)(1)(B)(i) “inconsequential value” exception and finds the Creditor’s $80,000 allowed secured claim to be of “inconsequential value.” Here’s how.
Precedents. Precedents exist for the proposition that Creditor’s $80,000 secured claim, which represents 8.2% of its total claim, is sufficient. But the opinion rejects such precedents because:
- those other opinions rely on a methodology that this opinion rejects;
- any precedent has limited value in such a mixed fact-law question; and
- the “key point” is that “inconsequential value” is not a “bean counting exercise”—it “cannot be based solely on a mechanical, numerical calculation.”
Policies. While the numbers provide an important starting point, the court also must consider “the purpose and policy” of statutes governing a Chapter 11 case.
- This case does not resemble the fact pattern Congress designed §1111(b) to prevent: this is not a secured creditor being cashed out during a temporary decline in the value of its collateral, with the Debtor seeking to retain such collateral and obtain the windfall of a future market correction.
- Instead, the value of this Creditor’s collateral may be permanently contracted. The current pandemic caused a precipitous decline in the value of the Debtor’s business and assets. The entire fitness industry faces an uncertain future, with no quick rebound in sight that would provide a windfall.
- Such circumstances support a more elastic application of the term “inconsequential value” in §1111(b)(1)B)(i).
The Role of Subchapter V
To some degree, Judge Frank writes, Debtor’s Subchapter V status and the purposes and policies of Subchapter V “influence my determination” that the value of Creditor’s collateral is “inconsequential.”
- The purpose of Subchapter V is “to broaden the opportunity for small businesses to successfully utilize the benefits of chapter 11 of the Bankruptcy Code.” So, permitting Debtor to stay in business by bifurcating Creditor’s claim and permitting payment under Subchapter V provisions “is consistent with both the explicit confirmation standards of subchapter V” and its “underlying purpose.”
- Creditor using the §1111(b) as a device to block confirmation and compel the Debtor to liquidate underscores the inconsequential value of its interest in the Debtor’s property: (i) the liquidation value of Creditor’s collateral is only $30,000, and (ii) receipt of $30,000.00 on a $917,000.00 debt is almost, but not quite, out of the money.
- Judge Frank emphasizes, in the opinion, “I do not mean to suggest that the term ‘inconsequential value’ has a different meaning in a Subchapter V case as compared to a traditional chapter 11 case.” But since this is a mixed fact-law question of an “ultimate fact,” the policy behind Subchapter V is “a factor in applying the statutory term to a particular set of facts.”
The foregoing is a fascinating and instructive look into one of the rarely-used and often-confusing provisions of the Bankruptcy Code. And seeing that provision applied in the Subchapter V context is an added benefit for bankruptcy professionals.
Footnote 1. The “inconsequential value” prohibition against utilizing the 1111(b) election is from 11 U.S.C. § 1111(b)(1)(B)(i), which reads (emphasis added): “A class of claims may not elect application of paragraph (2) of this subsection if—(i) the interest on account of such claims of the holders of such claims in such property is of inconsequential value.”
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