In In re Sunnyslope Housing Ltd. Partnership, No. 12-17241, 2016 WL 1392318 (9th Cir. Apr. 8, 2016), a divided panel of the Ninth Circuit held that affordable housing restrictive covenants should not affect the valuation of a creditor’s secured interest in the property in a Chapter 11 bankruptcy cram down where the covenants are subordinate to the mortgage.

The 150-unit Sunnyslope project was financed in 2008 by an $8.5 million senior loan—funded through municipal bonds, secured by a deed of trust and guaranteed by the Department of Housing and Urban Development (HUD)—and smaller junior loans from the State of Arizona and City of Phoenix. The project qualified for a Low Income Housing Tax Credit (LIHTC). All three loans, the HUD guarantee and the LIHTC approval obligated Sunnyslope to record restrictive covenants that required the property to be operated as affordable housing. However, the junior loans and restrictive covenants were expressly subordinate to the senior loan, and in the event of foreclosure of the senior loan, all restrictive covenants would be extinguished.

In 2009, Sunnyslope defaulted on the senior loan, which HUD took over as guarantor and resold to First Southern National Bank for $5 million in 2010. First Southern then moved to foreclose and appointed a receiver who secured a commitment to purchase the property post-foreclosure for $7.6 million. Before the sale could be consummated, Sunnyslope filed for Chapter 11 bankruptcy1 and proposed a plan where it would retain ownership of the property. To do so, Sunnyside would need to confirm an extended re-payment plan over the objection of First Southern under the Bankruptcy Code’s cram-down provision, § 1129(b)(2)(A)(i).2

The parties disputed the valuation of First Southern’s secured claim under the cram down. Sunnyslope proposed a $2.5 million valuation, taking into account the affordable housing restrictive covenants, which limit the amount of rent that can be charged. First Southern then moved to determine valuation under section 506(a), offering a value of $7 million without accounting for the restrictions because a foreclosure of First Southern’s mortgage would extinguish the restrictions, allowing a purchaser to own the property unrestricted. The bankruptcy and district court sided with Sunnyslope, and the issue before the Ninth Circuit on appeal was whether the restrictive convents should affect the valuation.

Section 506(a)(1) governs the valuation of secured claims in a cram down and provides in part:

Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor's interest.

The central issue on appeal centered on the Supreme Court’s seminal decision in Associates Commercial Corporation v. Rash, 520 U.S. 953 (1997). In Rash, the Supreme Court held that the replacement-value standard, not the foreclosure-value standard, governs in cram-down cases where the debtor will retain ownership of the collateral. In Rash, the debtor elected to retain ownership of a truck for use in his hauling business but proposed a valuation at the foreclosure value rather than the higher replacement value. The Supreme Court held that Section 506(a)'s "proposed disposition or use" language was of paramount importance to valuation. Because the debtor proposed to continue using the truck, the proper value was the cost the debtor would incur to obtain a like asset for the same proposed use, or the price a willing buyer in the debtor's business would pay to obtain like property from a willing seller.

In Sunnyslope, the three-judge panel of the Ninth Circuit disagreed on the proper interpretation of Rash. According to the majority, the starting point of the analysis was First Southern’s senior status. Just because there had not yet been a foreclosure did not mean that a senior secured claim may be suppressed by conditions subordinate to its position. Under Rash, "use" means simply an alternative to surrender, not the particular use or revenue-generating proposed by the debtor.

Moreover, Rash applied the replacement-value standard in light of the "double risks" of cram down to creditors: the debtor may default again and the property may deteriorate. But, the majority in Sunnysope observed that a replacement valuation with the restrictive covenants failed to account for the double risks underpinning the holding of Rash; rather it imposed these double risks on the creditor while also providing a value one-third of what could be obtained in foreclosure. Finally, the majority pointed out that HUD could have conditioned the loan sale to First Southern on the continuing application of the restrictions but did not.

The dissent criticized the majority for committing the same error corrected in Rash: starting from the creditor's rather than the debtor's perspective and valuing at what was essentially a foreclosure valuation. According to the dissent, the majority mistakenly focused on the fact that the debtor retained ownership rather than how the debtor proposed—and indeed was required by law—to use the property. While the majority was concerned that the bank, in the dissent’s words, "got a raw deal", the dissent noted that First Southern acquired the loan knowing that covenants restricted the property's use—which is why it was able to purchase an $8.5 million loan for $5 million. Here, a "like property," as required by Rash, would include like rent restrictions.

Sunnyslope claimed that the higher unrestricted valuation would essentially eliminate its ability to provide affordable housing. While the majority conceded that was an unfortunate result, it noted that, from a broader perspective, this decision would reduce the cost of financing for affordable housing because banks would not have to factor in the risk that their secured interest might be substantially diminished.

This decision will make it more difficult for affordable housing entities to restructure under Chapter 11 where the property has a higher value without the restrictions. However, in many cases, LIHTC projects have a greater value with the restrictions because of the value of the remaining tax credits. The decision also means affordable housing lenders will have greater ability to protect their secured claims in bankruptcy. That should reduce the cost of financing and allow more projects to start up. To receive the benefit of this decision, affordable housing lenders are advised to ensure that all property restrictions and covenants are subordinated to their interests in the property.


1One of Sunnyslope’s general partners filed for involuntary bankruptcy, but this was converted to a voluntary Chapter 11 bankruptcy.
2The court mistakenly cited to Chapter 13’s cram-down provision, 11 U.S.C. § 1325(a)(5)(B). The court’s reference to §1325(a)(5)(B) does not impact the majority’s holding which is based on 11 U.S.C. §506(a).