Ninth Circuit Rules Subordinated Affordable Housing Covenants Do Not Affect Valuation of Secured Claim in Bankruptcy Cram DownA divided three-member Ninth Circuit bankruptcy panel has ruled that restrictive covenants for affordable housing do not affect the valuation of a lender’s secured claim in a Chapter 11 bankruptcy cram down when those covenants are subordinate to a senior loan.

The case — In re Sunnyslope Housing Ltd. Partnership — concerns a 150-unit housing project that was financed by Sunnyslope with an $8.5 million senior loan guaranteed by the U.S. Department of Housing and Development (HUD) and junior loans from the City of Phoenix and the State of Arizona.

The project was qualified for a Low Income Housing Tax Credit (LIHTC), which — with the HUD and other loan guarantees — required Sunnyslope to record restrictive covenants that mandated the project be operated as affordable housing. The covenants and the junior loans were recorded as subordinate to the senior loan. In the event of foreclosure on the senior loan, all restrictive covenants would be extinguished.

Sunnyslope defaulted on the senior loan, which HUD assumed and resold to First Southern National Bank for $5 million. First Southern prepared to foreclose on the property and a receiver was appointed, who then found a buyer for the property for a sale price of $7.6 million. Before the sale occurred, Sunnyslope filed for Chapter 11 bankruptcy and included retainership of the property in its reorganization plan. In order to retain the property over First Southern’s objection, Sunnyslope was required to implement a repayment plan under the cram-down provision of the Bankruptcy Code.

First Southern and Sunnyslope disagreed over the property’s valuation under the cram down, with Sunnyslope proposing a $2.5 million valuation due to the affordable housing covenants that restrict the amount of rent that could be charged. First Southern proposed a valuation of $7 million under Section 506(a), contending that a foreclosure would extinguish the restrictive covenants that capped rent amounts.

Both the bankruptcy court and district court agreed with Sunnyslope. First Southern appealed to the Ninth Circuit, which reversed with a strong dissent. The majority noted that the restrictive covenants impairing the property’s value were found only in mortgages that were junior to the senior loan and, relying on the 1997 U.S. Supreme Court decision in Associates Commercial Corp. v. Rash, “that it was erroneous to factor the restrictive covenants into the replacement value of Sunnyslope.”

The panel split on the meaning of the word “use” in determining the value of secured claims as decided in Rash and as used in Section 506(a)(1):

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 majority found “use” to mean simply an alternative to the surrender of the property to the secured creditor, and not to mean a particular use that the debtor had planned for the property. The majority said that there was nothing in Rash that “”supports the proposition that the replacement value of the property should be measured by the income that can be generated when used in the specific way that the debtor elects to use it.”

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