In Chapter 11, value is king. Secured creditors have rights in proportion to the value of their collateral.
When a secured creditor and the debtor can't agree on value, appraisals and appraiser testimony become critical. In a recent bankruptcy dispute over the value of a golf and country club, the court provided important lessons to lenders. Lenders and their counsel must scrutinize their own appraisals, and the underlying assumptions made by their appraiser, before they get to the courthouse. Otherwise, they risk embarrassment and, worse, a bad valuation.
In bankruptcy, a creditor has a secured claim equal to the value of its collateral. When value is in dispute, then the court determines value "in light of the purpose of the valuation and of the proposed disposition or use of such property." This happens at a valuation hearing, where the parties can put on testimony by appraisers and fact witnesses. When faced with competing appraisals, the bankruptcy court need not "split the baby" by adding both appraisals and dividing in half. The bankruptcy court may reject an appraisal in its entirety and not give it any evidentiary weight if it is flawed.
Stockton Golf and Country Club – a golf course, country club, and event center -- had operated for over a century when it filed Chapter 11 to reorganize and stave off foreclosure by its primary lender, Bank of Stockton. The Bank asserted a secured claim of $8.2 million and contended the Club was worth $8 million. The Club contended it was worth $4 million and sought to cram down a plan that would give the Bank only a $4 million secured claim. (To confirm a Chapter 11 plan, a debtor must pay a creditor at least as much as the value of its collateral. The unsecured balance can be lumped into a class with all other general unsecured creditors and paid at pennies on the dollar.)
At the valuation hearing, the Court considered the "highest and best use" of the Club, which was continued operations as a private golf and country club. The Court tossed the Bank's appraisal based on several fundamental flaws that could – and should – have been caught before the hearing.
First, the Club had deferred maintenance of over $1 million. The Bank's appraiser assumed that the Club had completed the deferred maintenance, which he believed would increase and stabilize membership. But that had not occurred, and the other appraisers and the court determined that performing the deferred maintenance would require special assessments on members that would depress rather than increase membership. By not accounting for depressed membership, the court found the appraisal “overly optimistic and unrealistic.”
Second, the Club received non-recurring COVID relief of over $1 million from a PPP loan and Employee Retention Credits. The Bank's appraiser attributed these payments to Club revenue from golf operations, testifying that he was unfamiliar with PPP loans and ERC credits. The court found that the failure to adjust for this non-recurring revenue rendered the opinion not credible.
Third, the court concluded that the Bank’s appraiser had underestimated expenses when he pegged the cost of upkeep at $800,000. The court noted that $800,000 was the cost of course maintenance 20 years ago, and assuming costs had not increased over two decades was not credible or realistic.
Ultimately, the court rejected the Bank's valuation testimony in its entirety, leaving the Club's $4 million appraisal as “the only reliable, credible, probative, and persuasive evidence of the Golf Club’s value.”
Many secured lenders use a rotating pool of qualified appraisers, but just because an appraiser is in the pool does not mean he or she is infallible. Lenders need to make sure that the appraiser is qualified and experienced to appraise the particular collateral. Lenders also should inquire whether a court has ever excluded or discounted an appraiser's opinion. Finally, lender and counsel must scrutinize the opinion for flaws – be they accidental, inadvertent, or based on fundamental errors -- before relying on it in court.