In Re North Valley Mall, LLC
CORRECTED AMENDED MEMORANDUM OF DECISION ON CONFIRMATION OF DEBTOR’S SECOND AMENDED PLAN
Confirmation of the Debtor’s Second Amended Chapter 11 Plan of Reorganization (“plan”) came on for hearing May 6, 2010. The Court heard testimony from the parties’ expert witnesses, received documents and declarations into evidence, considered the arguments of the parties and took the matter under submission. The Court has also since received and considered the closing briefs and replies of both the debtor and of the only party objecting to confirmation, Key Bank National Association (“the bank”). The Court now renders its Memorandum of Decision on Confirmation.
Primarily the Court is required to decide two closely interrelated questions, i.e.: (1) is the plan “fair and equitable” because it complies with 11 U.S.C. § 1129(b)(2)(A)(i) 1 in that the promised monthly payments over the seven year term of the plan, inclusive of interest, when reduced to present value, yields a sum that is not less than the secured claim of the bank; and (2) is the plan “feasible,” or in words of the statute, not likely to be followed by liquidation or further need for reorganization, as is required under § 1129(a)(ll)? All of the other provisions of § 1129(a), with the exception of subsection (a)(7) [all impaired classes consent], are proven to the satisfaction of the Court. No other provisions save these two are contested by the bank.
1. Facts
The facts are largely undisputed. The debtor owns real property at 801 East Avenue in Chico, California known as “North Valley Plaza” (“the property”). The property is a 243,800 square foot “power center” with 29 retail suites. There are a number of existing tenants including Michaels, Cinemark Theater, Trader Joe’s, Ben & Jerry’s and Dollar Tree. Taco Bell, Panda Express and Wendy’s are adjoining businesses not part of the property. Financial troubles for the property began in December of 2008 when its anchor tenant, Mervyn’s, filed its bankruptcy petition and vacated its 84,414 sq. ft. space. This anchor space is still not under long-term lease although reportedly debtor has attempted to augment revenue with short term tenants in this location and is actively searching for a replacement long-term tenant. As of July 2009, the property was only about 59.5% leased. The property also contains about 5.34 acres of land allocated for parcels and future development.
The obligation to the bank began as a construction loan in the maximum amount of $26,250,000 secured by a first deed of trust recorded on or about March, 2005 against the property. According to the bank, the current balance owed on its loan is $25,373,640.34. There may be disputes about some post-petition default interest, fees and charges. There is relatively little dispute as to the value of the property. The two appraisers are very close in their respective opinions of value and the parties
2. “Or such other rate as the Court determines ...”
At the threshold the Court must deal with two subsidiary issues. First, there is the bank’s objection that the plan cannot be confirmed because the plan provides for an interest rate of “6% fixed,
or such other rate of interest as is necessary to comply with 11 U.S.C. § 1129(b)(2)(A)(i)(ii)
...” (Italics added). The bank argues that such an elastic provision is not consistent with law because it interferes with a party’s decision on which way to cast its vote, and/or because it creates a disincentive for the debtor to put forward its best rate because it can rely upon the court to “fix” its plan, thus necessitating extra time and expense, and/or because it warps the adversary process because it sets up the court as “an independent fact finder dictating a solution to the parties.” Conspicuously absent in the bank’s argument is any citation to authority. Moreover, the argument is not internally consistent; how can it be a net saving of time and expense if the court is left with only an “up or down” option? Forcing the proponent to file a whole new plan and disclosure statement simply to fix an interest rate issue, even if only off by a few basis points, in the Court’s view would wastefully consume even more time and expense. The Court has no doubt that debtor would have agreed to a higher rate given that its own experts acknowledge that 6% is too low; the real problem is that there is still a gap between what the bank thinks is minimally necessary and the debtor’s maximum ability to pay such a rate. Moreover, from day one it has been obvious that the cramdown rate of interest would be the primary issue in this case, so the bank cannot argue that it has been mislead or that, in the end, the Court would have to make hard decisions. Further, debtor cites cases where just such an approach has been embraced by bankruptcy courts as a practical solution to this dilemma.
See, e.g., In re Good,
3. Does § 1129(b)(2)(A)(i) apply?
Similarly, the bank argues that § 1129(b)(2)(A)© cannot apply because, as originally written, debtor proposed in the plan that future sales of the undeveloped pads on the property be free of liens, with portions of the proceeds remitted to the
4. Is the plan “fair and equitable”?
If not all impaired classes consent, the proponent may still confirm a plan under § 1129(b) if, as to the non-consenting class, the plan is “fair and equitable.” “Fair and equitable” in cramdown as against a class of secured claims can be any of three kinds as described at § 1129(b)(2)(A). The channel pertinent here is found at subsection (A)(i), which in turn has two subparts, i.e.: (I) that the secured class retains its lien [which has now been resolved as provided above] and (II) “That the holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property ...” Restated in basic terms, “present value” is the mirror image of “interest rate,” and the plan cannot impose uncompensated risk upon the bank by paying too low an interest rate under the plan. Of course, determining a sufficient rate of interest in any individual case depends on quantifying risk, which in turn depends on issues such as collateral value, credit history, term of the loan and the market rates of interest generally. A fixed rate such as proposed here creates its own quantum of risk because, as the parties recognize in their briefs, a fixed rate of interest creates the possibility that, aside from risk of default, the market generally may move to a more inflationary environment where the crammed-down creditor may be left illiquid and thus without the ability to reinvest its capital at currently prevailing rates. All risks must be identified and compensated to a reasonable degree; what the law seeks is that elusive equilibrium between the value of the funds invested in the plan through interest vs. the value to the creditor of being able to retrieve its capital for reinvestment elsewhere, or stated differently, the non-consenting creditor must receive a value under the plan not less than the value of its right to immediately foreclose upon its collateral.
In both the literature and in many of the cases there is much unfortunate discussion of “market rates.” Markets by definition imply a willing buyer and a willing seller. But by definition cramdown implies an wit-willing seller who is compelled by the court to make a loan to the debtor under the plan; also implied is debtor’s inability to
Although there are many “formula” cases,
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the Court believes the approach that is best utilized in a commercial real estate case like ours is the “blended rate” approach in
Pacific First Bank v. Boulders on the River, Inc. (In re Boulders on the River, Inc.),
Although
Boulders
involved only two tranches, and was decided in a different business era with different prevailing rates and percentages of loan to value, there is no conceptual obstacle to further blending the rate comprised not only of standard and mezzanine rates, but perhaps of a third equity return rate as well, as necessary, where it becomes unrealistic to believe that any lender will loan up to a very high percentage or even 100% of value. See Reehl and Milner,
Cram Down Interest Rates: The Quest Continues,
David Hahn, one of the debtor’s experts,
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testified that he broke the bank’s
The bank’s expert, Andrew Manley, in coming up with his senior tranche, adopts much more conservative assumptions. First, he ascribes an initial tranche to only 50% of value, and then applies this to only the “as is” (not the stabilized) value 10 of either $27,800,000 ($13,900,000) or $28,250,000 ($14,125,000). Manley Declaration ¶ 23-25. Mr. Manley comes up with a senior tranche rate of 7.5%. 11 Although mention is made of “my surveys of market participants” no direct testimony is given as to who were these “market participants” or how many were canvassed, but it appears that very few were actually market participants [Tr. Vol. 2, 62:24-64:8]. It appears that much weight instead was given to Mr. Manley’s own assumptions based on his admittedly long experience in the real estate investment field and on interviews with people he already knew. [Tr. Vol. 2 61: 15-17; 61: 18-25; 62:11-16; 69: 1-6; 84: 3-22] In sum, the Court is more persuaded by the Hahn testimony and the Court finds that a senior tranche at 6.25% equal to the first 65% of the bank’s loan, is the more sound approach than is the hyper-conservative approach used by Mr. Manley. As noted in footnote 11, when adjusted for the stabilized vs. “as is” valuations, Mr. Manley’s rate becomes 6.5%, relatively close to Mr. Hahn’s.
But upon what value should this 65% tranche be calculated? Mr. Manley applies this only to “as is” values as he testifies this is what lenders in today’s market actually evaluate, and (by implication) nothing else. Manley Declaration ¶ 21. Mr. Hahn in contrast goes to an average of the “stabilized values” and compensates for the extra risk
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by referring to the guaranty from Lucia Parks; he considers the two issues to be about a wash. Hahn Declaration ¶¶ 24, 36. It seems to the Court that again Mr. Manley is being very conservative, but on balance he may be more correct. In reality, the vacancy left by Mervyn’s will not last forever, as even the bank’s appraiser recognizes. Whether the vacancy will last 18 months, two years or even longer, is, of course, difficult to quantify. But
some
The experts disagree also on whether there should be three tranches, to include a mezzanine debt tranche, or only two. Again Mr. Manley adopts the very conservative approach of assuming that everything junior to the senior debt tranche should be regarded at high equity rates. He does so mostly because reportedly there is little or no mezzanine financing available in today’s market. Mr. Manley in his Supplemental Declaration cites to “Emerging Trends in Real Estate 2010” from the Urban Land Institute, a Price-Waterhouse Coopers publication at its page 22. There the Urban Land Institute authors opine that mezzanine debt is not available at any price in this market.
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From this proposition Mr. Manley feels justified in regarding everything over the senior tranche at equity rates which he estimates at 20% per annum. But the Court agrees with the debtor that this again distorts the picture toward the conservative. As stated above, the blended rate approach suggested in cases like
Boulders
and in the Reehl and Milner articles is not an attempt to mirror an
actual
market that exists. Rather, it is an attempt by principled approach to create a proxy for a market extrapolated from current data such that the court can reach the ultimate question of “present value.” The problem with Mr. Manley’s approach is that it evaluates the first ten percent of loan value junior to the initial debt tranche as if it had the same inherent risk as the last ten percent, a very dubious assumption. That a property might decline in value by, say 10% is a real and profound risk to any position dependent on that most junior position in the property, such as equity; but this decline might not be so severe to the interests represented by the first 10% or 20% of debt junior to the 65% senior tranche which could, in this example, still emerge unscathed. So it is safe
Mr. Hahn, in contrast, admits that there is no active mezzanine market currently available but he does not stop there. True to the blended rate approach he extrapolates from other data including reference to the Korpacz Real Estate Investor Survey. From this he concludes that the average investment yield on unleveraged shopping centers similar to the property was 10.8% nationally for the 4th quarter of 2009. From this data he calculates a proxy for the mezzanine layer of debt by subtracting a cost of 6.25% for the first 65% of property value to derive a 17.18% yield on the remaining 35% of value. Hahn Declaration ¶¶ 26-27. But recognizing as discussed above that even this approach does not adequately differentiate between the last position in the collateral value and the least junior just behind the senior tranche, which positions face markedly different degrees of risk, he breaks this 35% tranche into two parts. He weights the intermediate mezzanine layer at 11.18% for a tranche between 65% and 85% of value and the last “equity” layer at 25.18% 15 attributable to the last 15% of value. He then blends these on a weighted basis to equate to the derived 17.18% Korpacz average which assumed an initial tranche of debt for 65% at 6.25%. Hahn Declaration ¶¶ 28-30. Clearly there is a large measure of arbitrariness in this line-drawing but the Court is persuaded that Mr. Hahn’s approach is a sound one in that, unlike Mr. Manley’s, it makes some reasonable attempt to recognize that the level of risk changes depending upon whether a lender is at the 66% mark on the collateral, or the 99% mark. Just because the marketplace right now does not quote on mezzanine debt does not change this reality nor should it, in the Court’s view, constrain the parties from interpolating data in a principled way to recognize this difference. 16 As stated above, the formula or blended rate approach is not merely a mirror of market conditions; rather, it is a principled derivation from current data of a proxy rate where no market currently exists.
In sum, the Court believes the Hahn approach to be the more correct overall, although a few corrections should be made such as to the “as is” value used and to the actual balance owed the bank. Corrected for these issues, the calculation using Mr. Hahn’s approach would be:
1. senior tranche: .65 x $28,000,000 = $18,200,000 @ 6.25% = $1,137,500
2. mezzanine tranche: .20 x $28,000,000 = $5,600,000 x 11.18%=$626,080
3. equity tranche: $1,573,640 x 25.18%= $396,242.55
4. blended rate: $1,137,500 + $626,-080+396,242.55 = $2,159,822.55 + $25,373,640= 8.512 % rounded to 8.5% 17
We are left with the issue of loan covenants, which the bank complains affects the degree of risk if left out from the reorganized debtor’s set of obligations. While this proposition is certainly true logically, little or no evidence is presented from which the Court might quantify that degree of risk. The Court notes from page 24 of the debtor’s Reply to Key Bank’s Post Trial Brief that there remain an array of covenants protecting the bank, and the Court is given no basis for concluding that the absence of a few here or there, or modification of some existing covenants, will magnify the risk to the bank in any appreciable way, nor can their absence be translated into some few basis points of interest here or there to equate for this vague level of risk. While the Court believes the blended interest rate formula approach to cramdown is a sound one, we should not delude ourselves into thinking that it is a precise science.
For the reasons stated, the Court finds that an interest rate of 8.5% per annum, fixed for seven years, will provide the “present value” of the bank’s secured claim within the meaning of § 1129(b)(2)(A)(i)(II).
5. Is the plan feasible?
The remaining issue before the Court is whether the plan is likely to be followed by liquidation or further need of financial reorganization, as described at § 1129(a)(ll). In common parlance, is the plan feasible? The debtor argues that even at a rate of 8.25% the plan is still feasible in that on its projections there is only a temporary shortfall of $23,000, and this could be met either by delaying payment of this sum to the bank temporarily (in effect temporarily negatively amortizing) or by the principals advancing this sum. See Debtor’s Closing Brief, pp. 25-26 n. 7 and 8, citing Exhibit “A” @ p. 33. The Court notes that even with as high an interest rate as 9%, debtor claims to be able to temporarily fund a projected shortfall of $334,000 if absolutely required. Debtor’s Closing Brief, page 26, n. 7; Exhibit “A” @ p. 34.
There are a few areas where the debtor, if pressed, could find the money to deal with projected shortfalls in the first year of the plan, 2011. The Court, using the numbers found in debtor’s Exhibit “A” to its brief @ p. 32, calculates debtor will experience a shortfall (described as ending cash balance) after spending all of its $200,000 available cash of about <$ 83,-352> if the yearly debt payments to the bank are adjusted for a 8.5% rate ($2,156,-759). But these numbers assume that debtor will also pay $75,000
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that year in
Predictably, the bank attacks the projections and points out the many areas where the debtor’s projections may be somewhat optimistic. But the Court is left persuaded that on balance the projections are more likely to be met than not, and that the debtor has access to sources of capital of the amounts probably needed to deal with minor shortfalls either through its principals or by delaying some payments and expenses where there is some leeway to do so under the plan. The bank cites to
In re SM 104 Ltd.,
There is also the issue of the projected refinance at the end of year 7 under the plan. First, the Court notes that plans that provide for such a refinance or sale at the end of their term are not unusual.
See, e.g., Boulders,
“Feasibility” does not mean certainty. The standard has been interpreted in the Ninth Circuit to mean that the plan has a “reasonable probability of success.”
In re Acequia, Inc.,
6. Conclusion
The debtor’s Second Amended Plan complies with all of the applicable provisions of §§ 1129(a) and 1129(b)(2)(A). The
Notes
. All statutory citations are to 11 U.S.C., unless otherwise designated.
. Transcript of Hearing ("Tr”) 21-22.
. This lesser value is for the property without an anchor tenant. The "stabilized” value assumes a more normal compliment of tenants, including a long-term anchor tenant.
. With apologies to William Shakespeare’s Falstaff in Hemy the Fourth, Part 1 Act 5, scene 4, 115-121.
. This is not true, however, with respect to any attempt to withdraw the Lucia Parks guaranty. The bank in its post trial reply brief, p. 6, infers an attempt to modify the plan respecting the guaranty depending on what the Court might rule on interest rate issues. The Court is not called upon to rule on this specific issue at this time, but it would seem to be not only a material change to the plan but possibly an impermissible non-debt- or discharge as well.
. At its footnote 14, the Till court notes that in Chapter 11, in contrast to Chapter 13, there might exist a true market by reference to various lenders specializing in DIP loans. But the kinds of loans referenced are usually ones bankable early in the case using some traditional criteria concerning collateral value and demonstrated payment ability, not so much on the kind of issues confronting us in this cramdown. In the context at bench, we are asked to make sense of present value and interest rate concepts at the extreme, well beyond what any sensible lender would do on a consensual basis.
. See e.g.
Till,
. How the resulting blended rates may differ depending on the assumptions used is demonstrated by comparing footnotes 5 and 6 in
Boulders,
.The Court was interested by, but not persuaded by, the very able testimony of Mr. J. Michael Issa. While a few workout arrangements from a variety of troubled loans of only passing similarity to this one might have
some
bearing on the interest rate calculation, the resulting average stated in his declaration is
.In contrast, Mr. Manley opines that on "stabilized” properties the initial loan tranche might extend up to 65% of value, which is closer to the Hahn opinion. [Tr. 72:16-23]
. Interestingly, on stabilized properties Mr. . Manley’s rate is 100 basis points less or 6.5%, not that different from Mr. Hahn's 6.25%. [Tr. Vol. 2, 73:1-7]
. The risk spoken of here is that the property will be absent an anchor tenant for a protracted period beyond the 18 months estimated in the appraisals.
. Little or no evidence was presented on critical issues such as collectability of the guaranty and/or the amount of other debt which may have recourse to Ms. Parks' assets. Moreover, Mr. Manley opined that lenders on the senior tranche are likely all to require recourse. [Tr. Vol. 2, 64:19-25]
. Interestingly, even here there is equivocation. The actual cite provides: "In the new world order, mezz will reincarnate as a mid-tier product, at 400-500 basis point spreads over equity 'like it used to be.’ ” Moreover, even Mr. Manley concedes that mezzanine financing will return at some point. [Tr. Vol. 2, 76:20-24]
. This equity rate is higher than the 20% equity rate chosen by Mr. Manley, but the two numbers may not be fundamentally different if adjusted for what is respectively represented. Mr. Manley’s number equates to a broader swath of ''equity” involving less leveraged deals while Mr. Hahn's ‘'equity” tranche looks only at the narrow band of highly leveraged deals.
. Upon the Court’s questioning even Mr. Manley admitted that given the right circumstance and the right borrower, obviously a mezzanine loan could be arranged at some price, although he thought the rates would be higher, say 15%. [Tr. Vol. 2, 77:13-25; 78]
. The Court feels comfortable in rounding down since only the most pessimistic would argue that the "as is” value will last forever. If the calculation were readjusted at $31,000,000 for a stabilized value, the calculation looks like this: senior tranche .65 x $31,000,000= $20,150,000@ 6.25%=$1,259,375; mezzanine tranche $25,-373,640 - 20,150,000 = $5,223,640@11.18% = $584,002.96; blended rate= $1,259,-375 + 584,002.96 = $1,843,377.96+ $25,373,-640= 7.265%. If one were to arbitrarily assume that half of the seven year term were at the lower rate because the property were leased up, an average of the two derived rates would be 8.512% + 7.265% + 2 = 7.8885%. While the Court is not prepared to find that this arbitrary averaging is appropriate, because the property is still not stabilized and we cannot be sure when it will be, it is fair to comment that there is considerable reason to believe that the rate can be viewed as conservative if applied for the entire term of the plan.
. At page 24 of the debtor’s Closing Brief the sum of $114,000 to the professionals and to the Franchise Tax Board is identified.
. The Court understands that at least some of the management is provided by Mr. David Klein, the son of Lucia Parks, one of the debtor's principals.
. It is asserted that Lucia Parks, principal and guarantor, has cash and cash equivalents of $415,000 as part of a net worth of between $6.2 and 7.9 million. Debtor's Exhibit "4”, Hahn Declaration ¶ 36.
. The additional value of establishing an ability to service debt as an aid to refinancing was noted in
In re SM 104 Ltd..,
. As stated at footnote 5 above, however, any attempt to alter the Lucia Parks guaranty is not immaterial and may, in fact, be impermissible as a matter of law as a non-debtor discharge.