In a recent decision addressing valuation issues, the First Circuit has issued an important reminder – and warning – to creditors seeking to establish a secured claim in settlement proceeds based on a security interest in the settled claim. In short, the key lesson for would-be secured creditors is this – the value of a claim is not equal to the value of damages!
The decision, a copy of which is available here, arises out of the bankruptcy case of Montreal, Maine & Atlantic Railway Ltd. (the “Debtor”) and represents the third trip to the First Circuit by the parties. In this latest dispute, secured creditor Wheeling & Lake Erie Railway Co. appealed a decision by the bankruptcy court finding, among other things, that it had not proven that its pre-petition security interest attached to certain settlement proceeds. Prior to the bankruptcy, Wheeling received a security interest in “accounts and other rights to payment (including Payment Intangibles)” in connection with a $6 million line of credit it had extended to the Debtor. It was the creditor’s theory that this pre-petition security interest attached to a $110 million global settlement negotiated by the Debtor’s chapter 11 trustee because the settlement released (among other things) certain claims that constituted its original collateral, i.e. “non-tort claims”.
Following a 2-day trial, the bankruptcy court held (a) that the settlement did not release any claims that constituted the creditor’s collateral because the estate did not have any non-tort claims against the settling parties, and (b) even if such claims did exist, the creditor failed to carry its burden of proving the value of such claims. Assuming for the purpose of its decision that non-tort claims were released as part of the settlement, the First Circuit narrowed the issue before it to whether the creditor had adequately established the value of its secured claim.
As a quick reminder, a secured creditor’s claim is secured to the extent of the value of its collateral, and the burden is on the creditor under section 506 of the Bankruptcy Code to establish its claim with a preponderance of the evidence. In this case, the collateral at issue was the settled and released non-tort claims. Thus, in order to establish the value of its secured claim, Wheeling “bore the burden of showing the settlement value of the non-tort claims, that is, their value as a bargaining chip to secure the settlement[.]”
The parties had stipulated prior to trial that the “net economic damages (economic damages minus legal fees and costs) for the non-tort claims was at least $10 million,” yet the First Circuit agreed with the bankruptcy court that the stipulation alone was insufficient to demonstrate the value of Wheeling’s secured claim. How is that possible?
Although the stipulation identified the “net economic damages” suffered by the estate related to the alleged non-tort claims, the First Circuit held that the creditor’s argument that the stipulation was sufficient to prove settlement value “relies 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, is not so simple.” As the court goes on to note, “even a claim alleging a substantial figure for damages may have no settlement value at all if the cost, difficultly, or uncertainty of litigation makes it not worthwhile to pursue.” In other words, evidence of the value damages is not evidence of the settlement value of the resulting claim.
So then how can a creditor demonstrate settlement value? As the First Circuit states, “at its most elementary, the settlement value of a claim is the amount that the claimant would recover if he prevails in litigating the claim multiplied by the probability of recovery. In turn, the probability of recovery depends on a gallimaufry of factors, such as the strength of the claimant’s evidence, the visibility of any defenses, and the ability of the defendant to satisfy a judgment.” While the stipulation accounted for litigation costs, it did not account for the “likelihood (or lack of likelihood) that the estate representative would have secured such a recovery.” It was, therefore, insufficient to prove settlement value.
The First Circuit’s decision may be unsurprising to some, but will be concerning to others. That the value of a security interest in settlement proceeds is based on the settlement value of the settled claim is, by itself, not surprising, yet this becomes more problematic when the settlement, like the one in this case, involves “all claims” – a common occurrence in bankruptcy (especially in connection with plans of reorganization). A primary factor in the court’s ruling was that the creditor did not offer any evidence regarding the collectability of the settled claims – an important factor in determining settlement value – which the court suggests could have been establish through experts. Experts, however, can be costly. Another approach to establish value may be for creditors to use discovery in connection with a debtor’s request for the approval of a global settlement to gather evidence necessary to determine the settlement value of specific claims; however, this raises a number of other issues. Claims traders may also take notice of this decision, which may increase their costs. The key takeaway, however, is that evidence of damages alone is insufficient to establish the settlement value of the resulting claims, and thus the value of a creditor’s claims secured by such claims.