Third Circuit Clarifies How to Value Collateral

Seal of Lehigh County, Pennsylvania

In In re Heritage Highgate, Inc., No. 11-1889 (3d Cir. March 20, 2012), the Third Circuit Court of Appeals recently determined how bankruptcy courts should value collateral retained by a chapter 11 debtor in order to establish the amount of the creditor’s secured claim pursuant to section 506(a) of the Bankruptcy Code.  In doing so, the Third Circuit clarified the burden of proof with respect to valuations under section 506(a).

A detailed discussion regarding various valuation approaches in different contexts under the Code appears in an earlier submission in this blog.


The Debtors, Heritage Highgate, Inc. and Heritage-Twin Ponds II, L.P., were in the business of developing a residential subdivision in Lehigh County, Pennsylvania, into townhouses and single-family detached homes.  In order to finance the project, the Debtors entered into a series of construction loans, whereby the initial lenders advanced funds secured by a lien on substantially all of the Debtors’ assets.   Subsequent lenders, known as the “Cornerstone Investors,” obtained subordinated liens on the same collateral.

On January 20, 2009, after building and selling a quarter of the planned units, the Debtors filed bankruptcy.  Six months later, the Debtors filed a chapter 11 plan of reorganization, pursuant to which they would complete the development project and make distribution to creditors based on a set of projections of future home sales.

Procedural Context

During the bankruptcy case, the official committee of unsecured creditors (“Committee”) filed a motion to value the secured claims of the Cornerstone Investors pursuant to section 506(a) of the Code and Federal Rule of Bankruptcy Procedure 3012.  The Committee argued that the bankruptcy court should value the secured claims at zero because the collateral securing the Cornerstone Investors’ claims was worth less than the first priority liens held by the initial group of lenders.

The Cornerstone Investors argued that their claims should be deemed wholly secured because the financial projections underlying the plan estimated that the Debtors would derive revenue from the development project sufficient to pay the Investors’ claims in full.  Indeed, the Debtors submitted a chapter 11 plan that included a projected budget that anticipated the full payment of all secured claims through the sale of lots with completed improvements over the course of 47 months.  The plan projection even included distribution to unsecured creditors.

The bankruptcy court confirmed the plan, specifically finding that such plan was feasible.  At the post-confirmation hearing on the motion to value the secured claims of the Cornerstone Investors, the Committee maintained its position that, at the time of plan confirmation, the appraised value of the collateral was worth less than the secured claims held by the first priority lenders, meaning that the Cornerstone Investors’ claims were unsecured.  The Committee relied primarily on an earlier appraisal used in connection with the Debtors’ request to use cash collateral of the secured lenders.

The Cornerstone Investors maintained that, pursuant to the text of the Code, the value of property must “be determined in light of [its] proposed disposition or use” and the plan budget demonstrated that the Debtors would be able to pay their secured claims in full over time.

The Bankruptcy Court agreed with the Committee, finding that the appropriate method of valuing the Cornerstone Investors’ claims was fair market value at plan confirmation, as established by the earlier appraisal.  And since the fair market value of the collateral at confirmation exceeded the value of the first priority secured claims, the second-priority, secured claims of the Cornerstone Investors were deemed unsecured.  On appeal, the district court affirmed the bankruptcy court.

Rash Decision

In affirming the lower courts, the Third Circuit acknowledged the Supreme Court’s decision in Associated Commercial Corp. v. Rash, 520 U.S. 953 (1997), where the Court held that under section 506(a) the value of property (i.e., collateral) retained is the cost a debtor would incur to obtain a like asset for the same proposed use.  This is known as the replacement value standard.    While the Rash decision involved a chapter 13 case, the Third Circuit found, like other Circuits, that similar reasoning applied to chapter 11 cases.

In accordance with Rash, The Third Circuit held that where a chapter 11 plan of reorganization provides for a debtor to retain and use collateral to generate income with which to make payments to creditors, a section 506(a) valuation based upon a hypothetical foreclosure would be inappropriate, as it would be inconsistent with section 506’s literal meaning.  Quoting a First Circuit Court of Appeals opinion, In re Winthrop Old Farm Nurseries, 50 F.3d 72, 75 (1st Cir. 1995), the Court found that “[i]n the ordinary circumstances the present value of the income stream would [instead] be equal to the collateral’s fair market value.”

Nonetheless, the Third Circuit determined that the Cornerstone Investor’s approach was a market based, wait-and-see, approach, requiring a secured creditor to waits and see how much the collateral is ultimately sold for to determine whether there are sufficient funds to pay its secured claim in full.  In other words, according to the Third Circuit, the Cornerstone Investors suggested that because the Debtors proposed to continue to develop and sell lots during the chapter 11 plan’s life, the extent to which their claims are secured should similarly be calculated over time.  But, the Third Circuit could find under any circumstance where such approach advocated by the Cornerstone Investors was used in the context of section 506(a), even after the Rash opinion.

Burden Shifting

The Court held for the first time that when a party moves to value a secured claim pursuant to section 506(a), a burden shifting framework governs, where the debtor bears the initial burden of proof to overcome a presumed validity and amount of the creditor’s secured claim, but the ultimate burden of persuasion lies with the creditor to demonstrate by the preponderance of evidence both the extent of its lien and the value of the collateral securing its claim.

The Old Senate Chamber during the US Supreme C...

In this case, the Third Circuit held that the Committee met its burden  of proof based on the earlier appraisal that valued the collateral at fair market value as of the date the plan was confirmed.  This value rebutted the chapter 11 plan’s projection of future income stream.  It was therefore up to the Cornerstone Investors to prove, by the preponderance of the evidence, the secured value of their claims–but they failed to do so.


The timing of the valuation appeared to be a key component in the Third Circuit’s opinion.  According to the Court, Congress expressly provided under the section 506(a) context  for the division of allowed claims supported by liens into secured and unsecured portions during the reorganization, before the chapter 11 plan’s success or failure.  However, the fact that the language in section 506(a) requires a court to factor in the “proposed disposition or use” of collateral does not mean that the time as of which property is valued is to be postponed or altered for the duration of a plan.

Ultimately, the Third Circuit limited the applicability of plan’s projection, even though such projections provided for payment in full of all secured claims.  The Court limited the use of the projection toward proving the feasibility of the plan, a separate confirmation requirement.  According to the Court, “the [plan] projections regarding monies to be realized from the sale of lots over time do not equate to ‘value’ as of confirmation because they anticipate Debtors spending time and money to realize value at a later date . . . That future value should not be credited to the secured creditor at confirmation.”

So, in this case, plan projections of future income stream did not outweigh an earlier pre-confirmation appraisal of collateral.  But, perhaps important to the outcome was the fact that the Cornerstone Investors neglected to present a separate expert opinion–besides the appraiser’s–at the hearing on the Committee’s valuation motion.  In the end, given the burden shifting regime adopted by the Third Circuit, the Cornerstone Investors failed to carry their burden of proving the value of their collateral at confirmation.