I recently had an email exchange with a fellow bankruptcy attorney who was a little confused about something called the § 1111(b) election in a Chapter 11 bankruptcy. Her confusion was easy to understand because there are some interesting wrinkles in the statutory language that are worth exploring.
Before we get into the somewhat arcane aspects of today’s topic, it might be worth defining a few important terms that we’ll be using, and then summarizing the salient features of Chapter 11 bankruptcy.
- Secured debt — this is a debt that is secured by a tangible asset (the collateral or security), meaning that if the debtor fails to make the payments the creditor can repossess the property. Typical examples are a car loan and a real estate mortgage.
- Undersecured debt — this is a secured debt where the value of the collateral is less than the current balance on the loan. This has happened a lot with real estate that was purchased at the height of the market, after which the real estate values plummeted.
- Unsecured debt — this is a debt where there is no collateral securing the debt.
- In rem claim — this is a claim against a thing (the Latin word for “thing” is “res,” and in the appropriate objective case — Latin has four — it’s “rem”). When a debtor takes out a secured loan, the creditor gets the right to repossess the thing in the event of a default.
- In personam claim — this is a claim against a person. Most of the time when a debtor takes out a secured loan, the creditor gets the right to go after the debtor to collect any post-resale deficiency after exercising its in rem claim against the collateral.
- Recourse debt — a secured debt in which the creditor has an in personam claim against the debtor in the event of a post-default liquidation.
- Nonrecourse debt — a secured debt in which the creditor does not have an in personam claim against the debtor. Examples include certain types of real estate purchase money debt for California real estate, and secured debts in which the in personam liability was discharged in a bankruptcy.
II. Chapter 11 Bankruptcy
Most people who have some knowledge of bankruptcy know about Chapters 7 and 13 bankruptcies.
A. Chapter 7
In a Chapter 7 case those debts which are dischargeable are extinguished without the debtor paying anything to the creditors. The whole process typically takes just a few months, and in the process the in personam liability on secured debts is discharged as well (unless the debtor formally reaffirms the in personam liability). The in rem claim still remains: the debtor will not get a free car or house in the process. As part of a Chapter 7 case, the Chapter 7 Trustee assigned to the case seizes and liquidates nonexempt assets for the benefit of creditors. I have written about these ideas many times. See, e.g., my May 28, 2013 post.
B. Chapter 13
In a Chapter 13 case the debtor enters into a multi-year debt repayment plan that is administered by the Bankruptcy Court. The Chapter 13 Trustee assigned to the case receives the monthly payments and disburses the money to the creditors pursuant to the judge-confirmed plan. In a Chapter 13 the debtor keeps all assets, the trade-off being that the debtor must pay back the general unsecured creditors through the plan at least the dollar value of the nonexempt assets. To participate in the payout a creditor must timely file a proof of claim with the Court. Otherwise, it is left out in the cold, and doesn’t get paid anything through the plan. Only individuals and married couples can file under Chapter 13.
C. Chapter 11
In a Chapter 11 case there is no Chapter 11 Trustee appointed by the Court, unless things have gone terribly wrong and the judge appoints a Trustee pursuant to 11 U.S.C. § 1104. Instead, the debtor serves as a quasi-trustee, called the Debtor-in-Possession (the DIP — no, that’s not a juvenile insult, just an acronym). I’ll discuss this oddity, and its potential for creating a split personality, in my next post. But before you conclude that the fox has been put in charge of guarding the henhouse, I should mention that the U.S. Trustee and the judge are closely involved in the case, so there is a leash on the debtor.
The Chapter 11 debtor proposes a plan of reorganization that is intended to make dealing with debts manageable. The plan classifies debts in separate classes based on the similarity of claims in a given class. And there is a hierarchy of claims: not all claims are treated the same way; some get better treatment than others. At the top of the heap are the secured claims. This is because secured creditors have special rights attached to the collateral securing the debts.
One of the most important aspects of a Chapter 11 bankruptcy, which is also a fundamental difference between it and a Chapter 13 bankruptcy, is that the creditors get to vote on the plan. They vote by the class in which they are placed. The Court cannot confirm a Chapter 11 plan unless enough creditors (in a way that can be made precise — I’ll discuss it in a subsequent post) vote in favor of the plan.
At this point a question may have popped up in your mind: How are undersecured creditors treated in the plan? After all, an undersecured creditor has a secured part to its claim and an unsecured part to its claim. It is this bifurcated nature that led to the enacting of 11 U.S.C. § 1111.
III. Section 1111
Section 1111 is not a particularly long section, but it is a bit confusing. Here is that statutory language:
(a) A proof of claim or interest is deemed filed under section 501 of this title for any claim or interest that appears in the schedules filed under section 521 (a)(1) or 1106 (a)(2) of this title, except a claim or interest that is scheduled as disputed, contingent, or unliquidated.
(A) A claim secured by a lien on property of the estate shall be allowed or disallowed under section 502 of this title the same as if the holder of such claim had recourse against the debtor on account of such claim, whether or not such holder has such recourse, unless—
(i) the class of which such claim is a part elects, by at least two-thirds in amount and more than half in number of allowed claims of such class, application of paragraph (2) of this subsection; or
(ii) such holder does not have such recourse and such property is sold under section 363 of this title or is to be sold under the plan.
(B) A class of claims may not elect application of paragraph (2) of this subsection if—
(i) the interest on account of such claims of the holders of such claims in such property is of inconsequential value; or
(ii) the holder of a claim of such class has recourse against the debtor on account of such claim and such property is sold under section 363 of this title or is to be sold under the plan.
(2) If such an election is made, then notwithstanding section 506 (a) of this title, such claim is a secured claim to the extent that such claim is allowed.
A. Part (a): No Proof Of Claim Is Required
Part (a) isn’t too confusing. It just says that if the debtor has scheduled a debt in the bankruptcy papers, the creditor does not have to file a proof of claim to participate in the plan payout. This is in clear contradistinction to Chapter 13. The only caveat is if the scheduled claims is listed as disputed, or as contingent on some triggering event for its validity, or as unliquidated, then the creditor must file a proof of claim and do battle with the DIP over the legitimacy of the claim.
B. Part (b) And The Election
It’s part (b) that produces the bewilderment. Rather than do a word-by-word analysis, let me give you the gist.
1. The Context
First, the context for part (b) is very limited. It only applies to undersecured debts, i.e., the value of the debt exceeds the value of the collateral.
Second, the debt is treated as a recourse debt, even if it is a purchase money real estate mortgage in a nonrecourse state such as California, and even if the in personam liability was discharged in a previous bankruptcy.
2. The Election
In this limited context the creditor has a choice: It can elect to have the debt treated as completely secured — the so-called § 1111(b) election — or it can allow the claim to be bifurcated into unsecured and secured portions.
3. The Reason For The Recourse Status
Why is the debt declared a priori to receive recourse status, regardless of say a previous bankruptcy discharge?
To answer the question let us suppose that the creditor opts to allow the debt to remain bifurcated. Suppose further that the debtor’s in personam liability was discharged in a previous bankruptcy, thus making the debt nonrecourse. Then without the wording in § 1111(b) the unsecured portion of the debt would have no voting rights, and would not be eligible to participate in the plan payout to the general unsecured creditors. However, § 1111(b) resurrects that unsecured debt for the purpose of allowing the creditor to vote as a member of the general unsecured class, and to participate in the payout to the general unsecured creditors to the extent of its unsecured amount, since the debt has been converted to recourse status. Of course, the secured portion is treated as a fully secured debt up to the value of the collateral.
If the property is liquidated as part of the plan, then if the debt was nonrecourse prepetition, it reverts back to that nonrecourse status upon the liquidation.
4. Treatment With The Election
What happens if the creditor elects to have the entire debt treated as completely secured? Then the creditor does not get to vote with the class of general unsecured creditors, nor to participate in their payout. Instead, it is paid a stream of payments that total at least the current value of the secured claim.
5. A Simple Example
For example, suppose the collateral is a piece of rental property, worth $400,000. And suppose the debt is a mortgage with a $450,000 balance. (By the way, I chose rental property because a Chapter 11 debtor cannot modify a debt that is secured solely by his principal residence. See 11 U.S.C. § 1123(b)(5).
(i) No Election Is Made
On the one hand, if the creditor does not make the election, the creditor will have a secured claim for $400,000 and a general unsecured claim for $50,000. The secured claim is entitled to a stream of payments with interest. In other words, it’s like starting with a mortgage of $400,000, with an interest of say 4%, perhaps amortized over thirty years. Using a standard mortgage payment calculator (see, e.g., the calculator at Bankrate.com), that will produce monthly payments of $1,909.66, which over thirty years will total $687,477.60 (= $1,909.66 × 360).
The unsecured portion is then treated like any other general unsecured debt, with the advantage that it is $50,000, meaning that it may have a swaying vote in the class of general unsecured creditors. A class is deemed to vote for the plan if one half in number and two-thirds in dollar amount of the class members that vote, vote for the plan. See 11 U.S.C. § 1126(c). And it will get paid at the same percentage as the other general unsecured debt.
(ii) An Election Is Made
On the other hand, if the creditor does make the election, then it does not vote with the general unsecured creditors. Instead, it will receive a stream of payments totaling at least $450,000, the face amount of the claim, perhaps over decades. Thus, if the payout is over thirty years, the creditor will get monthly payments of at least $1,250 ($450,000 = $1,250 × 360), with no interest. Based on these numbers it makes more sense for the creditor not to make the election, since the total payout will be larger.
Then why would a creditor make the election?
If the creditor believes that market prices are rising rapidly, the election can prevent the debtor from stripping off the unsecured portion of the debt. Then if the property value goes up, and the reorganization is unsuccessful and the property is liquidated, the election preserves the full value of the claim rather than the value of the collateral on the effective date of the plan.
As you can see, some issues in bankruptcy are a bit complicated. Therefore, if you are in debt and wish to use bankruptcy protection to get real relief, it will behoove you to retain the services of a first-rate bankruptcy attorney rather than trying to go it alone.