A debtor's goal in a Chapter 11 Bankruptcy is to confirm a "plan of reorganization," which permits it to continue in business or liquidate its assets in an orderly manner. Creditors usually have the right to vote for or against a plan, and in many cases, plans are confirmed consensually through affirmative votes by classes of creditors and equity interests. But in other cases, a plan can be confirmed over the objection of one or more classes of creditors. This is called a "cram-down."

The Bankruptcy Code's rules governing cram-down are complex and differ for secured and unsecured classes of creditors. This article shows how bankruptcy courts have ruled on a particular method of cram-down known as a "dirt-for-debt" plan.

A Chapter 11 plan of organization must be "fair and equitable" to all classes of creditors, especially if the plan will be crammed down over the creditor's objections. For creditors whose claims are secured by real or personal property, a plan is "fair and equitable" if it satisfies at least one of these three criteria:

(i) The secured creditor retains its lien on property and is paid the present value of its claim over time;

(ii) the property securing the claim is sold and the secured creditor's lien attaches to the proceeds of the sale; or

(iii) the secured creditor realizes the indubitable equivalent of its secured claim.

See 11 U.S.C. §1129(b)(2)(A)(i)-(iii) (emphasis added.).

Substantial litigation has occurred over the meaning of "indubitable equivalent," and determination often hinges on a court's valuation of the secured party's collateral. A "dirt-for-debt" plan is one tactic used by debtors to satisfy the "indubitable equivalent" standard in a plan of reorganization. In a dirt-for-debt plan, the debtor proposes to return all or part of a secured creditor's collateral to satisfy all or part of a creditor's claim. Plans may include (1) a "full" dirt-for-debt plan in which the debtor returns to the creditor all of its collateral in satisfaction of the creditor's claim; or (2) a "partial" dirt-for-debt claim, in which the debtor returns only a portion of a secured creditor's collateral in partial or full satisfaction of the creditor's claim.

For example, imagine a debtor has borrowed $10 million from a lender secured by 10 parcels of real property. In a full dirt-for-debt plan, the debtor would return all 10 parcels in satisfaction of the debt. In a partial dirt for-debt plan, the debtor would return to the creditor some of the collateral, e.g., five of the 10 parcels, in full satisfaction of the claim. Alternatively, a debtor would return the five parcels, plus give the creditor a note secured by all or some of the remaining parcels or other collateral.

How can a debtor get away with this? By proving to the court that the value of the partial return of property equals the full or partial value of the creditor's claim.

The U.S. Court of Appeals for the Fourth Circuit upheld a partial dirt-for-debt plan in a 2017 case. Bate Land Co., LP v. Bate Land & Timber LLC (Bate Land & Timber LLC), 877 F.3d 188 (4th Cir. 2017). Seven years prior to the bankruptcy filing, the debtor purchased 79 tracts of land for $65 million by paying $9 million in cash and providing a note for $56 million secured by a deed of trust. The debtor defaulted after paying all but approximately $13 million of the note, and then filed bankruptcy. In its plan of reorganization, the debtor offered to return two of the tracts of land and retain the remaining tracts free and clear of all liens, including the creditor's lien. The debtor claimed the two tracts provided the creditor with the "indubitable equivalent" of its claim.

A court's determination of value includes analysis of the property's "highest and best use" usually through a "battle of experts" at an evidentiary hearing. In Bate Land, the creditor's expert argued the highest and best use of the property was for production and harvesting of timber, but the debtor claimed at least some of the parcels had a highest and best use as residential property. The court agreed with the debtor on residential use for some of the property, but ruled the plan must provide indubitably equivalent value to the creditor by returning eight properties to it: The initial two tracts offered as residential real estate property for a value of $8.8 million; one additional tract for the same use valued at $3.3 million; and five tracts for agricultural use valued at $1.1 million, for a total of $13.7 million. The court also determined the creditor was entitled to $1.356 million in post-bankruptcy interest plus attorney fees and costs, and required the debtor to pay this difference in cash payments. Id. at 193-95. (Normally, creditors in a bankruptcy are not entitled to interest and attorneys' fees after the bankruptcy filing date. But under Section 506 of the Bankruptcy Code, a creditor whose collateral exceeds its claim is entitled to recover interest and fees from this date to the date of payment.)

Following Bate Land and other cases, courts last year continued to approve dirt-for-debt plans. For example, a creditor's claim was secured by four tracts of land and personal property in a North Carolina case, In re Wiggins. 2018 Bankr. LEXIS 550 (Feb. 28, 2018, Bankr. E.D. N.C.). The debtor's plan provided for the return of part of the land—101.26 acres—as a credit toward the secured creditors' $1,674,916.41 claim. After mediation, the parties resolved all disputes except the amount of the credit, and agreed to a valuation hearing to determine the amount.

The court applied a three-step "highest and best use" inquiry, and considered three types of use: (1) agricultural; (2) residential; and (3) wetlands. The court rejected the debtor's witnesses' contention that all or most of the land could be residentially developed, and apportioned the property among the three types, resulting in net present value for the property of approximately $445,000, and credited this amount toward the creditor's claim. Id. at 34-35.

Another 2018 dirt-for-debt case applied the concept to personal property. See In Re Nat'l Truck Funding, 2018 Bankr. LEXIS 550 (Feb. 28, 2018, Bankr. E.D. N.C.). In that case, a Mississippi bankruptcy court confirmed a plan's treatment of a secured creditor's claim where the collateral was leased semi-trucks. The Nat'l Truck court approved a plan in which the creditor had two options: (1) the creditor could retain its lien on the truck collateral and the debtor would sell the trucks and provide deferred payments to the creditor (§1129(b)(2)(A)(i)); and/or (2) the debtor could return the truck collateral to the creditor to dispose of the trucks (§1129(b)(2)(A)(iii)). Id. at *19-22.

In July 2019, an Idaho court applied a "dirt for debt" analysis in a case under Chapter 12 of the Bankruptcy Code, which applies to certain family farmers or fisherman. In re Holland, 2019 Bankr. LEXIS 2037 (Bankr. D. Idaho, July 3, 2019). The Holland debtor borrowed approximately $3.9 million from Bank of Idaho (BOI), secured by two ranches and personal property. The debtor's cramdown plan sought to satisfy BOI's secured claim by surrendering only one ranch to it. Although the fair market value of that ranch higher than the loan ($4,350,000), the court found a lower liquidation value was appropriate because potential buyers would know BOI would not operate the ranch and would have to sell quickly, and denied confirmation. Id. at *30-32. See also In re Ainsworth, 2018 Bankr. LEXIS 3291, at *13. (Bankr. S.D. Texas Oct. 22, 2018) (Based on valuations, court rejected debtor's dirt for debt proposal and granted creditor partial relief from the automatic stay).

For secured lenders, dirt-for-debt cases show the need to anticipate all possible uses for property securing a loan at the time credit is extended, and to consider that the use stated when the loan was made may be re-evaluated later. They also highlight the very critical role of experts at valuation hearings where the highest and best use of property will be determined.

Peter Janovsky is a partner in the commercial litigation and bankruptcy groups at Zeichner Ellman & Krause. He represents institutional and individual clients, including domestic and international financial institutions, real estate developers, and family businesses.