Things have been eerily quiet in the Phoenix bankruptcy market since the end of the Great Recession. In the past, the economy seemed to run in cycles of 6 to 7 years of prosperity, followed by a downturn. Though the Great Recession officially ended in 2009, the effects were felt for at least a few years after the turnaround began. The last downturn is now 12 years old, which seemingly defies the typical economic cycles we have seen in the past. Certainly, the economy has grown in complexity and we are now more intertwined with international markets than ever before. Whether this is the reason for less financial distress is still an open question.
One issue that impacts many bankruptcy proceedings are the values of the debtor’s properties. Because Phoenix tends to have large fluctuations in real estate values, it is imperative to understand the interplay between values and the bankruptcy process.
The Phoenix Market
Phoenix is an interesting market. Our economy is dependent on tourism and construction. It is not uncommon to see a run-up in real estate values in Phoenix, followed by an implosion. That was the pattern that was on full display during the Great Recession. Home values plummeted and so did commercial real estate values (after massive run-ups in the market in the early and mid-2000s). A real estate valuation, which can be essential in a bankruptcy proceeding, was only good for a month or two during the Great Recession, as values just continued to drop precipitously. According to recent news reports, on the residential side in 2020, the year-over-year increase was 18% in Phoenix. With returns like that, there is a good chance we are seeing another real estate bubble in Phoenix.
Many predicted that COVID would result in an onslaught of bankruptcy filings. But, so far, that has not seemed to be the case in Phoenix even though tourism took a nosedive in 2020 and construction slowed down too. Though bankruptcy courts in Delaware and the Southern District of New York have been busy with corporate mega-cases primarily focused on retail, that trend has not seemed to take hold out West – not yet anyway. Between massive amounts of stimulus and the moratoria on evictions and foreclosures in many states (and at the federal level too), an argument can be made that false floors have been put in place, and once government actions dwindle, we will see more corporate bankruptcy filings. There are also signs that we are starting to see some inflationary pressure, which could lead to higher interest rates. Companies with variable rate loans could be severely impacted by interest rate hikes – it could be the difference between prosperity and bankruptcy.
So, where does that leave us? Anecdotally, rumors have been circulating that Phoenix will start to see more hotel bankruptcy activity because of the massive decline in occupancy rates. As occupancy rates fall, so do values. Hotels and other asset classes that depend on occupancy rates (e.g., malls and office buildings) have a harder time meeting their debt service obligations as vacancy rates increase. Moreover, office buildings are presumably going to see financial stress as well. It is no secret that more people work from home now than before COVID. Companies will therefore need less space, and thus, office building owners may start having problems meeting their debt services demands. It would be surprising if we do not see a spike in insolvency proceedings (e.g., bankruptcy and receiverships) for occupancy-dependent asset classes.
Values in Bankruptcy Proceedings
But how do values impact a debtor that has filed bankruptcy? Assuming the debtor has a lender whose loan is collateralized with real property, the valuation of its properties is vitally important in the bankruptcy process. Under 11 § U.S.C. 506(a)(1), “An allowed claim of a creditor secured by a lien on property in which the estate has an interest …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 or the amount so subject to setoff is less than the amount of such allowed claim.” This statute allows a debtor to bifurcate a secured lender’s claim – the secured amount is the value of the property and the unsecured amount is the difference between the value of the property and the amount loaned to the debtor. As an example, if a lender loaned $1,000,000 secured by real property and the value of the property is $400,000, the lender’s claims would be – (1) a secured claim for $400,000, and (2) an unsecured claim for $600,000. Thus, when a plan of reorganization is proposed by the debtor, the secured lender will have claims in two different “classes”. To confirm a plan of reorganization, at least one impaired class must vote in favor of the plan. 11 U.S.C. § 1129(a)(10) (“If a class of claims is impaired under the plan [of reorganization], at least one class of claims that is impaired under the plan has accepted the plan, determined without including any acceptance of the plan by any insider.”).
The debtor also has the chance to “restructure” the pre-petition loan made by the secured lender through a plan of reorganization. The new loan amount will be the amount of the secured claim, and the debtor also has the chance to try to reduce interest rates and extend the loan term. To confirm a plan where not all “classes” have approved the plan, one requirement is that “the plan does not discriminate unfairly, is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” 11 U.S.C. § 1129(b)(1). Now, to be “fair and equitable” to a secured lender who has not accepted the plan, one of the most common ways to confirm the plan is under 11 U.S.C. § 1129(b)(2)(A)(i)(II). This statute provides “that each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property.” Thus, the “value” of the secured property becomes an important issue at plan confirmation. And, obviously, it becomes easier for a debtor to repay the loan when the principal amount and interest rates are reduced, and the term of the loan has been extended. Bankruptcy is an incredibly powerful tool.
It is not always advantageous for a debtor to have a reduced secured claim amount. For example, if a debtor is seeking debtor-in-possession financing (“DIP financing”), and the new lender is looking for a “priming” lien (a lien that comes ahead of existing lenders), then the debtor will often have to prove there is a sufficient “equity cushion” that protects the existing lenders. 11 U.S.C. § 364(d)(1)(B). In these instances, the debtor will try to convince the court that the existing secured lender(s) is “over-collateralized”, and thus, there is room to make a new loan to a lender whose lien will “prime” or come before the existing lender’s lien. In these type matters, where the debtor needs DIP financing, a debtor would like a very high valuation of its property.
So, value matters in bankruptcy for a multitude of reasons. And given Phoenix’s proclivity to real estate fluctuations, values can mean the difference between a bankruptcy plan confirmation and liquidation.