Restructuring

Contributed by Charles Persons

Part Two: The Aftermath of Pine Gate

When we left off in last week’s Throwback Thursday entry, the year was 1977, and lenders across the country were in an uproar over a single asset real estate bankruptcy case from the Northern District of Georgia — In re Pine Gate Assocs., Ltd. The case had exposed a means by which debtors could “cash out” nonrecourse mortgage lenders under Chapter XII of the former Bankruptcy Act: (1) wait for a decline in property values and file a Chapter XII petition; (2) obtain sufficient exit financing to pay your nonrecourse lenders cash equal to the appraised (a.k.a. currently depressed) value of the property subject to their lien; (3) identify an accepting class of creditors to effectuate a cramdown over your lenders’ dissenting vote; and (4) smile broadly as the portion of your principal balance greater than the appraised value of the property disappears. In short, the Pine Gate casedemonstrated that the savvy debtor could use the Bankruptcy Act as a sword to cause a mortgage lender’s principal to evaporate whenever real estate prices were depressed. This became known as “the Pine Gate problem.”
But the strategy employed by the Pine Gate debtor did more than simply wipe the nonrecourse lenders out — “[b]y only repaying the undersecured, non-recourse creditor the appraised value of the property rather than returning the property to the lender or allowing him to foreclose, the Debtor received all future appreciation and the lender did not receive full payment of his debt or possession of the property (i.e. the benefit of its bargain).” Outside of bankruptcy, the Pine Gate lenders would have had the right to seize their temporarily undervalued collateral and hold a foreclosure auction, thereby realizing the true, market value of the collateral. If the foreclosure auction didn’t bring the results the lenders expected, they had two choices: (i) credit bid for their collateral and hold the property while its value rebounded or (ii) take the money and run.
Most troubling to lenders, there was little or nothing they could do about the Pine Gate problem once a Chapter XII proceeding had begun. Unlike the undersecured recourse lender, the undersecured nonrecourse lender had no right to an unsecured deficiency claim under the Bankruptcy Act. The undersecured nonrecourse creditor could still vote to reject the plan on the basis of its secured claim, but the Pine Gate debtor had just drafted the blueprint for rendering such a vote meaningless. With little chance of overturning Judge Norton’s well-reasoned (and legally correct) Pine Gate opinion on appeal, and recognizing the circumstances underlying the case were ubiquitous amidst the American economic slump that served as Pine Gate’s backdrop, lenders lobbied Congress for relief.
Pine Gate Is Handed Down Late in the Game
By the 1970s, the Pine Gate problem was hardly the only problem with the Bankruptcy Act. “[T]he law governing reorganizations in the United States was largely dysfunctional. Old Chapter X was slow, expensive, and unwieldy. Old Chapter XI did not allow for the restructuring of secured debt.”
To address these issues and many more, Congress was already hard at work on the Bankruptcy Reform Act, an enormous piece of legislation that contained more than 300 sections and amended more than half of the titles of the United States Code. Indeed, Congress had been hard at work on this new Bankruptcy Code for nearly a decade, beginning with debates as early as 1968. By 1970, it created the Commission on Bankruptcy Laws to “study, analyze, evaluate, and recommend changes” in the bankruptcy laws in light of the “technical, financial, and commercial” changes of the previous 20 years. This Committee’s 1973 report, along with the recommendations of the National Conference of Bankruptcy Judges and other academics, formed the backbone of what would be the most comprehensive revision to our nation’s bankruptcy laws in decades. Just as Pine Gate was turning the stomachs of nonrecourse lenders everywhere in 1977, the House and Senate finally introduced their competing versions of title 11 — the perfect statutory vehicle to address the Pine Gate problem. Unfortunately for the lenders, the time for additions essentially had passed.
Consequently, as lenders mobilized their lobbyists in late 1977 and early 1978 to descend on Capitol Hill, it appeared they had already missed the boat on getting the Pine Gate problem addressed in the new Bankruptcy Code. The House debated and passed its version of the Bankruptcy Reform Act — H.R. 8200 — on February 1, 1978 without addressing the Pine Gate problem. The Senate’s version of the legislation — S. 2266 — passed on September 7, 1978, and contained only a token attempt to remedy the Pine Gate problem by allowing nonrecourse creditors a deficiency claim. From the lenders’ perspective, the Senate’s quick fix was an improvement over the current state of affairs, but it really didn’t guarantee them much more than a chance to vote against a plan twice. It seemed clear that an issue as complex as the Pine Gate problem probably required significant debate in the legislature, artful and thoughtful drafting that ensured the provision wouldn’t overreach, and perhaps even consultation with a committee similar to the long-since disbanded Commission on Bankruptcy Laws.
An Answer from Behind Closed Doors — the Creation of Section 1111(b)
Unfortunately, there wasn’t time for such luxuries. Both the House and the Senate were already under considerable pressure to present a reconciled version of the legislation to President Carter before the end of the Congressional session — in part for fear the already decade-old legislative effort would lose momentum over the break and in part because the consumer credit industry, the SEC, and even Chief Justice Warren Burger were reportedly mounting an effort to convince Carter to veto the bill. Because of the need for expediency and the difficult compromises necessary to reconcile the over 300 differences between the bills, “[t]he conventional procedure of utilizing a conference committee was not followed.” From September 7 to October 6, 1978, “under tremendous pressures,” Representatives Don Edwards and Caldwell Butler and Senators Dennis DeConcini and Malcolm Wallop, along with Congressional staffers Kenneth Klee and Richard Levin, “hammered out a resolution of the differences” between each chamber’s version of the Bankruptcy Code.
This abridged reconciliation process permitted the Congressmen more than just an opportunity to synthesize the two bills; it permitted the drafters one final chance to consider issues that had not been adequately addressed in either the House or Senate versions of the Bankruptcy Reform Act. Taking full advantage, “the legislation underwent a number of important changes that could not be described as reconciliation of the diverse provisions of the bills that passed the House and Senate.” Chief among these changes was the decision to address Pine Gate by drafting section 1111(b).
The resulting provision attempted to solve the Pine Gate problem in two ways. First, in a nod to the Senate bill, section 1111(b)(1) treated all undersecured debt as recourse debt for the purposes of chapter 11, giving undersecured nonrecourse lenders an unsecured deficiency claim they could use to vote. Second, section 1111(b)(2) afforded both undersecured recourse and nonrecourse creditors a choice: (i) bifurcate their claims into a secured claim and an unsecured deficiency claim or (ii) elect to have their whole claim treated as a secured claim. By introducing this novel “1111(b) election,” the group tasked with reconciling the bills had addressed the other issue exposed by the Pine Gate decision—the ability of the savvy debtor to secure for itself the benefits of a post-confirmation increase in the value of the collateral.
After just a few short weeks of round-the-clock work, primary architects Congressman Edwards and Senator DeConcini each stood before their respective chambers of Congress and announced the results of the backroom reconciliation process. Memorialized in the Congressional Record of September 28 and October 6, 1978, the two referenced the single asset real estate case from Georgia as they described the purpose and intent behind the previously unconsidered section 1111(b). Pine Gate had created law.
The Aftermath of the Addition of § 1111(b)
At least due in part to its rapid, unconventional path from case law to statutory law, section 1111(b) suffers from enigmatic language considered so unwieldy that the provision was criticized before it even took effect. To this day, modern bankruptcy courts lament that “[a] literal reading of the statute, without reviewing the legislative history or carefully analyzing those decisions dealing with nonrecourse creditors, can result in a misunderstanding of the statute.” It also turned out to be almost too effective, as Congress was forced to draft an entire new chapter of the Bankruptcy Code less than a decade later in part to eliminate its burdensome effects on farmers.
These problems and criticisms, however, should be viewed less as a testament to Congress’ drafting abilities and more as a testament to the severity of the Pine Gate problem and the speed with which it had to be addressed. Considered in this light, we hope the readers of this blog approach section 1111(b) with a newfound appreciation for its purpose, as well as a newfound appreciation for In re Pine Gate — the little case that nearly blew the Bankruptcy Act wide open.