Contributed by Charles Persons
Part One: The Pine Gate Problem
Since the inception of the Bankruptcy Code, certain “celebrated” cases have come to be so significant that their holdings are practically part of the Code itself. For instance, the Fifth Circuit’s In re Greystone III opinion shapes section 1122(b) so significantly (“thou shalt not classify similar claims differently in order to gerrymander an affirmative vote on a reorganization plan”) that almost 25 years later it essentially remains a required citation in any brief challenging classification. Likewise, a bankruptcy practitioner would be foolish to write a brief about the duty to maximize value without at least a tip of the hat to Commodity Futures Trading Comm’n v. Weintraub. These types of cases serve an important role by filling in the gaps inevitably left in the Code.
On the contrary, In re Pine Gate Assocs., Ltd. didn’t so much fill a gap in the bankruptcy law as it exposed a crater — one so large that Congress was forced to quickly piece together legislation it hoped would solve what quickly became known as “the Pine Gate problem.” Decided on the eve of the Bankruptcy Act’s replacement in favor of the modern Bankruptcy Code, the result of Pine Gate was the last-minute addition of Bankruptcy Code section 1111(b)— a provision so confusing that courts have admitted to “struggling” with the provision’s “apparent confusion in language” and have called it “one of the most difficult sections of the Code.” Nonetheless, section 1111(b) is essentially unchanged since its creation, a testament to the severity of the Pine Gate problem and the provision’s ability to protect the rights of undersecured creditors effectively — especially where the debtor seeks to continue using the collateral of an undersecured nonrecourse creditor after reorganization. Without the context of Pine Gate, however, section 1111(b) is not just confusing, but also appears almost unnecessarily overprotective of the undersecured creditor. Considered in the context of Pine Gate, however, this difficult provision reveals its true merits and intended purpose.
A Problem Exposed
Pine Gate was a Chapter XII single asset real estate bankruptcy filed at a time when real estate prices were depressed throughout the United States. The Pine Gate debtor was a limited partnership that owned and operated apartments outside of Atlanta—apartments that were apparently too far outside of Atlanta. In violating the three golden rules of real estate (location, location, location), the debtors never brought in enough tenants to stay afloat, forcing the Chapter XII filing in December 1975.
Chapter XII had found limited use since its creation in 1938, until new bankruptcy rules in August 1975 did away with requirements that a Chapter XII debtor must both file its plan with its petition and immediately surrender corporate control to a trustee. These new rules, coupled with a depressed economy, high interest rates, and the advantage of the so-called “cramdown” provisions particular to Chapter XII caused an explosion of Chapter XII filings in 1975 and 1976, especially among owners of distressed real property.
Recognizing an opportunity to take advantage of these new rules, Chapter XII’s “cram down” provisions, and the temporarily depressed value of its sole asset, the Pine Gate debtor secured exit financing from a third party willing to lend an amount that matched the value of the apartments’ most recent appraisal — $1.2 million. With this financing assured, the debtor proposed a plan that paid its nonrecourse mortgage creditors the $1.2 million, an amount well below both the lenders’ original $1.45 million lien and the asset’s expected future value. The plan contemplated that the undersecured creditors would get their $1.2 million, but as nonrecourse creditors, the Bankruptcy Act didn’t allow them a deficiency claim for the remaining $250,000 they were owed. Most importantly, with their lien extinguished, the lenders would be unable to enjoy the asset’s expected post-confirmation upswing in value.
Unsurprisingly, the lenders opposed the debtor’s tactic and voted against the plan, but the small class of unsecured creditors entitled to vote (who otherwise would have been swamped by a $250,000 deficiency claim) voted in favor of the plan. Facing a cram down, the secured lenders argued that the plan could only be confirmed over their objection if they were paid the full amount of their debt, or in the alternative, if the debtor surrendered the property. Surrender of the property, the lenders argued, was the most accurate approximation of the rights they would be afforded outside of bankruptcy—where they could have foreclosed on the apartments, bought the asset at auction, and held onto the asset as property values rose.
After considering the arguments, Judge William L. Norton, Jr. held as follows:
When the dissenting secured creditors have, by contractual agreement, exculpated the Debtor and all persons associated with it from personal liability for any part of the debt, Section 461(11)(c) may be constitutionally applied to extinguish the debt of the dissenting secured creditors, and a Plan of Arrangement confirmed in spite of such dissenting class, so long as the dissenting class of creditors is compensated by the payment in cash of the value of the debt; i.e. the value of the secured property.
As Judge Norton recognized, the Bankruptcy Act was clear—there was nothing that required undersecured nonrecourse creditors be given an opportunity to reclaim their collateral or assert a deficiency claim. The debtor could “hold and keep the property to use in the debtor’s business enterprise . . . provided the plan offer[ed] ‘adequate protection’ to the nonassenting secured creditor;” receiving the appraised value of their collateral in cash constituted adequate protection under the prevailing law. With no dissenting class of unsecureds and the secured creditors crammed down, the Pine Gate court confirmed the plan, effectively permitting the debtor to retain ownership of the property while making $250,000 worth of the lenders’ principal disappear.
The Bankruptcy Act’s shortcomings had been laid bare for all to see, and the immediate threat to nonrecourse lenders nationwide was apparent:
As a result of the Pine Gate decision, it became clear that (under the former Bankruptcy Act) a debtor could file bankruptcy proceedings during a period when real property values were depressed, propose to repay secured indebtedness only to the extent of the then appraised value of the property, “cramdown” the secured lender class and thereby preserve all potential future appreciation for the debtor.
The decision threatened to destroy the viability of nonrecourse loans entirely. The year was 1977, and lenders nationwide turned to Congress for relief. There they found the legislature hard at work, preparing to reconcile disparate versions of a piece of legislation Congress had been working on for half a decade—the Bankruptcy Code.
* * *
In our next Throwback Thursday installment, we’ll dive into the peculiar aftermath of Pine Gate and explain how the unfortunate timing of a district court case from Georgia resulted in one of the least understood provisions of the Bankruptcy Code.
More from the Bankruptcy Blog
Copyright © 2020 Weil, Gotshal & Manges LLP, All Rights Reserved. The contents of this website may contain attorney advertising under the laws of various states. Prior results do not guarantee a similar outcome. Weil, Gotshal & Manges LLP is headquartered in New York and has office locations in Beijing, Boston, Dallas, Frankfurt, Hong Kong, Houston, London, Miami, Munich, New York, Paris, Princeton, Shanghai, Silicon Valley, and Washington, D.C.