Valuation is a critical and indispensable part of the bankruptcy process. How collateral and other estate assets (and even creditor claims) are valued will determine a wide range of issues, from a secured creditor's right to adequate protection, postpetition interest, or relief from the automatic stay to a proposed chapter 11 plan's satisfaction of the "best interests" test or whether a "cram-down" plan can be confirmed despite the objections of dissenting creditors. Depending on the context, bankruptcy courts rely on a wide variety of standards to value estate assets, including retail, wholesale, liquidation, forced-sale, going-concern, or reorganization value.
Certain assets, however, may be especially difficult to value because valuation depends on factors that may be difficult to quantify, such as the likelihood of success in litigating estate causes of action. The U.S. Court of Appeals for the First Circuit recently addressed this issue in In re Montreal, Maine & Atlantic Railway, Ltd., 956 F.3d 1 (1st Cir. 2020) ("MMA Railway"). The First Circuit affirmed a ruling that a secured creditor failed to satisfy its burden of establishing that collateral in the form of indemnification claims settled by the estate had any value entitled to adequate protection. According to the court, a showing of possible damages with respect to a disputed claim is not enough. Instead, the creditor must establish the likely validity of the claim and the likelihood of recovery.
Valuation of Collateral in Bankruptcy
The Bankruptcy Code classifies a debtor's obligations in terms of "claims" rather than "debts." This means that a creditor who is owed money on the basis of a prebankruptcy transaction is generally treated under the Bankruptcy Code as the holder of either an unsecured prepetition claim or a secured prepetition claim, or sometimes both.
Whether a claim is secured or unsecured is determined in accordance with section 506(a) of the Bankruptcy Code. Section 506(a)(1) provides that a secured creditor's claim is "a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property ... and is an unsecured claim to the extent that the value of such creditor's interest ... is less than the amount of such allowed claim." The provision goes on to mandate that "[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property."
The extent to which a claim is secured, therefore, turns on the valuation of the collateral. Section 506(a) is silent, however, as to the valuation method that a court should employ. As noted by the U.S. Court of Appeals for the Third Circuit in In re Heritage Highgate, Inc., 679 F.3d 132 (3d Cir. 2012), the legislative history of section 506(a) suggests that Congress's silence on this point was intentional, to enable bankruptcy courts to "choose the standard that best fits the circumstances of a particular case." Id. at 141 (citing H.R. Rep. No. 95–595, at 356 (1977)). Even so, the court wrote, the valuation method should be employed in light of the proposed disposition or use of the collateral, language that is "of paramount importance to the valuation question." Id. (citation and internal quotation marks omitted).
Neither section 506(a) nor the Federal Rules of Bankruptcy Procedure allocate the burden of proof as to the value of secured claims. In the absence of any express direction, courts have developed divergent approaches to the issue. See, e.g., In re SW Bos. Hotel Venture, LLC, 748 F.3d 393, 408 (1st Cir. 2014) (a secured creditor must demonstrate the value of its collateral under section 506(a) by a preponderance of the evidence); Heritage Highgate, 679 F.3d at 139-40 (acknowledging a three-way split of authority regarding the burden of proof as to the value of secured claims under section 506(a), but adopting a "burden-shifting framework" whereby: (i) once a secured creditor has established the validity and amount of its claim, the party challenging the amount of the secured claim bears the initial burden of proof with regard to valuation; and (ii) if the challenger establishes that the secured claim is overvalued because the collateral is of insufficient value, the burden then shifts to the creditor to prove the value of the collateral securing its claim by a preponderance of the evidence); see generally Collier on Bankruptcy ¶ 506.03 (16th ed. 2020).
In MMA Railway, the First Circuit considered whether a creditor satisfied its burden of proving the value of certain disputed contractual and regulatory indemnification claims allegedly securing the debtor's obligations.
In the aftermath of the July 2013 train accident and massive crude oil fire that engulfed Lac-Mégantic, Quebec, killing 48 people, the Montreal, Maine & Atlantic Railway Ltd. ("debtor") filed a chapter 11 petition in the District of Maine as well as an ancillary insolvency proceeding in Quebec for the purpose of liquidating its assets. At the time of the bankruptcy filings, the debtor's secured creditors included Wheeling & Lake Erie Railway Co. ("Wheeling"), which extended a $6 million secured line of credit to the debtor in 2009. Wheeling's collateral included the debtor's "[a]ccounts and other rights to payment (including Payment Intangibles)," which extended to any non-tort claims belonging to the debtor.
Recognizing the likelihood that the estate would face significant liability arising from the train derailment, a chapter 11 trustee appointed for the debtor sued various entities, including Western Petroleum Company ("Western"), the shipper of the crude oil, in an effort to establish a fund for the derailment victims. In a January 2014 adversary proceeding, the trustee alleged that Western negligently mislabeled the crude oil as less volatile than it actually was, causing the debtor to implement inadequate safety measures. The complaint did not state any contract or regulatory claims.
Western and the trustee settled the litigation. As part of the settlement: (i) Western agreed to pay $110 million for the benefit of the derailment victims; (ii) Western and the trustee agreed to release all claims and counterclaims against each other arising from the derailment; and (iii) Western agreed to assign to the debtor's estate any claims it had against other carriers involved in transporting the crude oil. The settlement was conditioned on U.S. and Canadian court approval of the debtor's plan of liquidation.
Wheeling objected to the settlement, claiming that it released the debtor's non-tort claims against Western, including contract and regulatory claims based on indemnification obligations under the bills of lading, and that those claims constituted part of Wheeling's collateral. According to Wheeling, it was entitled to compensation for the release of the non-tort claims as a form of "adequate protection." The bankruptcy court approved the settlement and confirmed the debtor's liquidating chapter 11 plan in 2015. However, the plan and confirmation order reserved Wheeling's right to contest whether its collateral included the released claims.
During a trial of the issue, the parties stipulated that, assuming the contract claims against Western existed: (i) the train derailment caused the debtor to suffer "economic damages" in an amount no less than $25 million; and (ii) had the trustee pursued the claims, the net "economic damages" for breach of contract by Western would not have been less than $10 million after subtracting attorneys' fees and expenses. The stipulation did not address the likelihood that the trustee would prevail on the claims or his ability to collect on any judgment. Wheeling did not offer expert testimony at trial concerning the value of the claims, but instead relied on the stipulation to show that the value of the claims exceeded the face value of its claim against the debtor under the line of credit.
The bankruptcy court ultimately ruled in favor of the trustee. It concluded that the trustee did not use Wheeling's collateral when he agreed to release Western as part of the settlement because the estate did not have any cognizable non-tort claims against Western. Alternatively, the court ruled that Wheeling failed to satisfy its burden of proving the value of the claims.
The district court affirmed on appeal. Wheeling appealed to the First Circuit.
The First Circuit's Ruling
A three-judge panel of the First Circuit affirmed.
Writing for the panel, Circuit Judge Bruce M. Selya declined to decide "arcane and unsettled" questions of law governing the transport of goods or secured transactions, or to address Wheeling's argument that it was entitled to adequate protection under section 363(e) of the Bankruptcy Code due to the estate's use of Wheeling's non-tort claim collateral. Instead, even assuming that the estate possessed cognizable non-tort claims against Western and that the trustee used Wheeling's collateral when he released the claims as part of the settlement, Judge Selya found "no clear error in the bankruptcy court's finding that Wheeling failed to carry its burden of proving the value of the non-tort claims."
According to Judge Selya, Wheeling's argument was based on the "erroneous premise that the value of a claim is the amount of damages suffered by the claimant, net of prosecution costs." "Valuing a claim, at least for settlement purposes," he wrote, "is not so simple."
To prove damages arising from a disputed claim, Judge Selya explained, the creditor must demonstrate, among other things, the probability of recovery, which depends on "a gallimaufry of factors," including the strength of the evidence, the viability of any defenses, the ability of the defendant to satisfy a judgment, the cost of litigation, and the parties' staying power, relative desire to avoid litigation and bargaining leverage. As such, Judge Selya wrote, "even a claim alleging a substantial figure for damages may have no settlement value at all if the cost, difficulty, or uncertainty of litigation makes it not worthwhile to pursue."
Judge Selya explained that, in this case, "recovery was far from certain" because, if there had been no settlement, Western would have faced significant tort liability based on wrongful death claims, likely leaving it with insufficient assets to satisfy all monetary judgments. According to Judge Selya, Wheeling's stipulated "net economic damages" estimate was "plainly insufficient" to satisfy its burden of proving the value of its collateral. He wrote that Wheeling "offered no evidence that would have allowed the bankruptcy court either to assess [the likelihood of recovery] or to gauge any of the relevant factors other than the estate's potential recovery that may have affected the settlement value of the non-tort claims." Nor did Wheeling offer any expert testimony concerning a range of value for the settlement of non-tort claims.
The First Circuit panel accordingly affirmed the ruling below.
MMA Railway is a cautionary tale for secured creditors. Creditors bear the ultimate burden of proof in establishing the value of their collateral under section 506(a) of the Bankruptcy Code—a determination that has important consequences in many contexts in a bankruptcy case. The First Circuit's ruling highlights the importance of building a strong evidentiary record to support valuation. It also indicates that certain types of collateral (e.g., disputed litigation claims) are more difficult to value than others.
Interestingly, Wheeling's decision to pursue its appeal for more than five years after the bankruptcy court confirmed the debtor's liquidating chapter 11 plan in 2015 is curious. The plan provided that Wheeling's secured claim would be paid in full (and was therefore unimpaired) from the proceeds of the sale of its collateral. Although it is not evident from the district court and First Circuit opinions, the proceeds of the sale of Wheeling's collateral other than the contractual and regulatory indemnification claims must not have been sufficient to satisfy Wheeling's $6 million secured claim in full.
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