Bankruptcy law affords debtors the opportunity to reduce the balance owed on a loan and to restructure their indebtedness over the objections of certain creditors. This is called a “cram down.” Not long ago, this right was invoked in connection with the bankruptcy of an entity that owns a qualified low-income housing tax credit (LIHTC) development in Phoenix. A recent appellate level decision, First Southern National Bank v. Sunnyslope Housing Limited Partners (In the Matter of Sunnyslope Housing Limited Partnership), issued April 21, 2016, by the Ninth Circuit Court, however, reversed confirmation of the cram-down plan opposed by the current first lien lender related to the 150-unit affordable housing apartment complex known as “Sunnyslope.” 

The decision has important implications for potential future bankruptcy filings by LIHTC properties, on how lenders may perceive the value of their collateral on LIHTC developments and may impact valuations agreed to in workout discussions.

Lower Court Rulings

At the bankruptcy court level, the entity owning the development, Sunnyslope Housing Limited Partnership, was able to confirm a cram down Chapter 11 plan over the objection of its current first lien lender.  The plan, as confirmed, provided, among other things, that the development would be valued at $2.6 million, with a 4.4 percent annual interest rate (compared to the original interest rate of 5.35 percent per annum) and that the restructured loan would be paid over a 40-year period with a sizable portion of the loan payable as a balloon payment at the end of Year 40. There would no longer be a guarantee of the restructured loan by the U. S. Department of Housing and Urban Development (HUD) going forward. In the meantime, the new investor contributing $1.2 million of new tax credit equity would get the benefit of the remaining LIHTCs on the property. The district court affirmed the plan confirmation on slightly different grounds at a $3.9 million valuation (due to considering an extra $1.3 million of value for the remaining LIHTCs in the overall valuation of the property).

The initial $2.6 million valuation (and subsequent revised $3.9 million valuation) was both based on the affordable-housing rent and other restrictions remaining in place for the balance of the compliance period. The current first lien lender noted that those restrictions were expressly subordinate to its lien and could be eliminated in a foreclosure and therefore, argued that a foreclosure based value should be used. It was undisputed at trial that on a foreclosure-based value, using market rental rates (free from the affordable-housing restrictions), the complex was worth $7 to $8 million at the time of the bankruptcy case. Indeed, there was a pending offer to buy the development from a receiver appointed in a foreclosure proceeding initiated by the current first lien lender for $7.65 million at the time the bankruptcy case was filed.

It is also well settled that a foreclosure generally wipes out the low-income housing use restrictions on a property and enables the lender or its successor entities, as the subsequent owner, to charge market rentals for units in the development, though the so-called “three-year rule” prohibits owners from raising rents and evicting tenants for three years after foreclosure. The debtors here nonetheless sought to maintain the affordability restrictions and therefore the LIHTC tax benefits for a subsequent investor for the full compliance period.

Ninth Circuit Court of Appeal Majority Ruling

In a split decision, the majority opinion for the Ninth Circuit Court of Appeals reversed confirmation of the plan and remanded the case back to the bankruptcy court, finding that the bankruptcy court and district court erred in not using the higher replacement value for the property (which here happened to be the foreclosure value). The Ninth Circuit concluded that the lower courts did not properly apply binding U.S. Supreme Court precedent. The majority opinion also expressed concerns that original lenders would be discouraged from making new loans and loan buyers would be discouraged from buying HUD defaulted loan pools if the developments in the pool were bound by lower affordable housing rents and related restrictions and could not enforce the senior lender’s right to cause a release of the affordability restrictions including the extended-use agreement. Here, First Southern was not the original first lender on the property, but rather bought this loan at a discount ($5,050,186.24) from HUD as part of a loan package sale after HUD honored its guarantee of the original first mortgage loan for this property from the original lender.

The new LIHTC investor further argued that the appeal should be dismissed as equitably moot (i.e., given the Chapter 11 plan was implemented, it would be impractical and inequitable to undo the plan now). The new investor contended it would be subject to tax liabilities of more than $1.5 million, including penalties and interest, if the plan confirmation were reversed. The new investor also argued it would be unable to recover a substantial part of the $1.2 million that it invested in the property. The majority opinion concluded the appeal was not equitably moot, noting that (i) the first lien lender diligently pursued its appeals and sought (unsuccessfully) stays pending appeal and (ii) the new investors were sophisticated investors who knew the risks they were running in proceeding with implementing the Chapter 11 plan despite the first lien holder’s objections. The court ruled they were not innocent third parties who needed to be protected by the doctrine of equitable mootness. The majority opinion also included that there was no need to use equitable mootness to protect the city of Phoenix and state of Arizona as junior secured creditors, given they made no new investments under the plan and they also are able to protect themselves.

Conclusion

In the Ninth Circuit, and to the extent followed by other courts, elsewhere, the Sunnyslope appellate decision may make pursuing a cram-down plan against a first lien lender with subordination rights (meaning rights to acquire the property through foreclosure without LIHTC use or rental restrictions other than the three-year rule) much more difficult. On the one hand, this should facilitate continued first mortgage lending in the LIHTC market, as traditional foreclosure rights with the opportunity to operate a market rate property post-foreclosure remains available to first mortgage lenders and the cram-down right should not have a materially dampening impact (as it has not had thus far in the LIHTC program). On the other hand, this may also impact the social imperative of the LIHTC program making it more difficult to maintain housing stock once properties are distressed assets. It is also likely that the decision may also result in more negotiated workouts at higher valuations for the first lien lender.;