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Do you want to own that rural timberland you financed a few years back? Well, what if I told you that not only are you taking ownership, but you’re taking it in exchange for a credit of three times its appraised value? The reason is your borrower filed Chapter 11 bankruptcy and convinced the court that timber tract is prime for a new subdivision.

This nightmare scenario is a possible reality in the Eastern District of North Carolina, where “dirt-for-debt” plans are a common strategy of debtors’ counsel. And, based on recent guidance from the Fourth Circuit Court of Appeals, you should not expect help on appeal if the trial court does not share your opinion of value.

The dirt-for-debt trend started from practical origins in the wake of the Great Recession, when developers were caught with a surplus of inventory. There was limited or no market for the flood of properties coming into bank REO departments. So, rather than force an auction or foreclosure for a fire sale price, debtors sought to transfer the property to the bank for fair market value. This is permitted under the “cram-down” provisions of the Bankruptcy Code.

Section 1129(b)(2)(A)(iii) allows payment of a creditor’s claim through surrender of collateral. In sum, a debtor in the context of a Chapter 11 reorganization can compel a creditor to accept its collateral in full or partial satisfaction of its claim. What makes this treatment “fair and equitable” is the requirement that the surrendered property be the “indubitable equivalent” of the creditor’s claim. This means that in situations where less than all of the creditor’s collateral is surrendered, the assigned value must be certain to compensate the creditor for the credit the debtor receives in return.

On the surface, this sounds reasonable enough. The creditor is taking its collateral for value and the parties are avoiding the legal process of liquidation. In reality, however, it’s not always as it seems. Dirt-for-debt is often employed strategically where the debtor believes it can put on a case for a value that exceeds the creditor’s valuation. After all, if the objective was merely to monetize collateral, there are mechanisms to do so under the Bankruptcy Code. The parties are always free to construct a sale procedure.

The debtor, however, prefers to have the court assign a value based on an evidentiary hearing, where it believes it might obtain a more favorable outcome than what might be realized from a sale. And it’s through this process that Cinderella meets her fairy godmother. Using expert testimony, the debtor makes the case that the property has substantially appreciated in value because the market has turned in favor of a new “highest and best use” for development.

Under the indubitable equivalent standard, anything less than certain should be rejected. This heightened standard of proof is the check to protect the creditor’s interest and requires a conservative valuation. This is what distinguishes a dirt-for-debt analysis from an ordinary valuation analysis, where signs of ambiguity such as widely variant appraisals and disputed uses might be considered with less reservation.

The bankruptcy court in the Eastern District, however, has taken a softened view of this standard in recent rulings. The court references the standard’s high bar, but then undertakes an indistinguishable valuation analysis, taking into account all evidence and competing opinions as to possible uses. In doing so, the court strips away the safeguard of certainty and functions, in a sense, as the appraiser itself. This approach has resulted in valuations at multiples of the creditor’s appraisal.

In December, the Fourth Circuit reviewed one of these rulings for the first time in In re: Bate Land & Timber LLC. In this case, the debtor successfully convinced the bankruptcy court that vacant timberland should be valued for residential development. On appeal, the creditor argued that the disputed feasibility of this use and the related variance in appraisals could not satisfy the standard of indubitable equivalence. This was based on precedent in this and other jurisdictions finding widely variant appraisals constitute proof of uncertainty.

On appeal, the Fourth Circuit found that “application of the indubitable equivalence standard involves more flexibility than the term suggests” and that “a bankruptcy court, acting as a fact-finder with specialized expertise, is well-equipped to arrive at a valuation that represents the indubitable equivalent of a secured creditor’s claim, in the face of disputed valuations.” It further found that review on appeal is limited to a “clear error” standard, meaning the bankruptcy court’s ruling is reviewed only for overt mistakes.

In sum, the Fourth Circuit refused to adopt a bright-line rule against dirt-for-debt approval and held that the bankruptcy court is sufficiently capable to assess the evidence before it, even in the face of widely disparate opinions of value. It further held that it would not second guess this determination except in the most egregious circumstances. Thus, though indubitable equivalence remains the black letter standard, the Fourth Circuit’s ruling affords the bankruptcy court significant discretion in its consideration.

For creditors, the take away from this ruling is that the stakes are higher than ever to win the valuation battle before the bankruptcy court. This phase is critical since the appellate court is unlikely to disturb the outcome. Selection of capable counsel and credible experts are of the utmost importance. Creditors who fail to appreciate this might find themselves the owner of a can’t-miss development opportunity . . . ahem, overvalued timberland.

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