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Valuation

Proposal #1: Valuation of Collateral Under Section 506(a)

At the August meeting, the Commission discussed valuation of collateral in light of the recent decision of the United States Supreme Court in Associates Commercial Corp. v. Rash. [ FN: 117 S.Ct. 1879 (1997).] In Rash, the Supreme Court held that the amount of the allowed secured claim for a truck being retained by a chapter 13 debtor should be the vehicle’s "replacement value." Unlike other interpretations of the term "replacement value" that sometimes equate it with retail value, the Supreme Court’s definition clearly requires deductions for certain costs, such as warranties, inventory costs, storage, and reconditioning. This would entail a fact-intensive analysis, with the actual method of determination to be left to individual judges.

In the Rash decision, the Supreme Court interpreted the language of section 506(a), but did not make more comprehensive policy judgments, traditionally left to legislators and policy-makers, on what the appropriate valuation standard should be. On the basis of initial reactions that a clearer valuation standard was necessary to reflect relevant policy considerations and to reduce litigation, the Commission requested that a proposal be formulated to provide a clearer standard.

The Recommendation

A creditor’s secured claim in personal property should be determined by the property’s wholesale price.

A creditor’s secured claim in real property should be determined by the property’s fair market value, minus hypothetical costs of sale.

Reason for the Recommendation

Section 506(a) states as follows:

An allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under section 553 of this title, is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property, or to the extent of the amount subject to setoff, as the case may be, 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. Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and inconjunction with any hearing on such disposition or use or on a plan affecting such creditor’s interest.

Due to the flexibility inherent in this provision, the extent of the allowed secured claim may vary depending on the type of bankruptcy case, the type of property, and the proposed disposition. [ FN: " ’Value ’ does not necessarily contemplate forced sale or liquidation value of collateral; nor does it always imply a full going concern value. Courts will have to determine value on a case by case basis, taking into account the facts of each case and the competing interests in the case. " H.R. Rep. No. 95 - 595 at 356 (1977), reprinted in 1978 U.S.C.C.A.N. 5787, 6312.] However, with the method to make this determination left completely undefined, courts have applied disparate methods to similar circumstances, yielding results ranging from the highest (e.g., retail) to the lowest (e.g., forced sale) possible valuations, with many options in between, including replacement cost, wholesale, and "midpoint" (the average of net resale proceeds and retail, a compromise method derived from chapter 13 trustees). [ FN: See also "Stay Litigation After Rash, " Our Two Cents, http://www.stinson.com/2cents/rash.htm at 1-2 (1996), which provides further delineation of potential valuation standards: "replacement cost (the current cost of a similar item); fair market value (what a willing buyer would pay for a like item sold by a willing seller); liquidation value (the estimated amount that could be realized from a forced sale of the property at a public auction after proper advertising); orderly liquidation value (the amount that could be realized from a forced sale of the property intact with all related equipment not necessarily at an auction); retail value (the price for which an item is sold at retail); wholesale value (the price for which an item is sold at wholesale); and going concern or enterprise value (the value of an enterprise as a going concern, taking into account goodwill). "] In attempts to resolve the confusion, circuit courts of appeals have tried to provide more definitive answers, but they too have differed over the proper standard for determining the allowed secured claim. [ FN: Cf.In re Hoskins, 102 F.3d 311 (7 th Cir. 1996) (proper valuation was midpoint between wholesale and retail);In re Rash, 90 F.3d 1036 (5 th Cir. 1996) (en banc) (net foreclosure value), rev ’d, 117 S.Ct. 1879 (1997); Taffi v. United States, 96 F.3d 1190 (9 th Cir. 1996) (en banc) (fair market value for real property in individual chapter 11 case), cert. denied , 117 S.Ct. 2748 (1997);In re Trimble, 50 F.3d 530 (8 th Cir. 1995) (retail value of vehicle without deduction for costs of sale) . See alsoIn re Valenti, 105 F.3d 55 (2 nd Cir. 1997), in which the 2^nd Circuit held that it was within the bankruptcy court ’s discretion to value at midpoint between wholesale and retail, but "no fixed value, whether it be retail, wholesale, or some combination of the two, should be imposed on every bankruptcy court conducting a §506(a) valuation. " Id., at 62.] The announced standards have not always been clear, evidenced by the fact that judges reach conflicting interpretations of prior court decisions addressing valuation standards. [ FN: See Associates Commercial Corp. v. Rash, 90 F.3d 1036, 1060, 1062-63 (5 th Cir. 1996) (en banc), in which the majority and dissenting decisions reach differing conclusions on the number of circuit courts that have held in favor of retail valuation.]

The Supreme Court’s Decision in Rash

Rash was a chapter 13 case involving a tractor truck used by the debtor in his freight hauling business. To confirm the chapter 13 plan over the objection of the secured creditor, the debtors would have to pay the secured creditor the present value of its allowed secured claim,which entailed a valuation of the collateral. [ FN: See 11 U.S.C. §1325(a)(5)(B).] In an en banc opinion reversing the initial appellate ruling that retail value determined the allowed secured claim, the United States Court of Appeals for the 5^th Circuit held that the valuation of a secured creditor’s interest under section 506(a) "should start with what the creditor could realize if it repossessed and sold the collateral pursuant to its security agreement, taking into account the purpose of the valuation and the proposed distribution or use of the collateral." [ FN: 90 F.3d 1036, 1060 (5 th Cir. 1996) (en banc).] The court therefore determined that the bankruptcy court did not err when it valued the truck at wholesale; this price reflected the secured creditor’s hypothetical yield had it repossessed and sold the truck.

The Supreme Court reversed and remanded the 5^th Circuit’s en banc decision. Finding the first sentence of section 506(a) to be non-determinative regarding the standard of valuation, the Supreme Court looked to the second sentence of that provision, which requires a court to consider the proposed disposition or use of the property. In a chapter 13 cramdown, the debtor retains the collateral. At the same time, the creditor continues to be at risk of diminution of value from extended use. The proper valuation standard if the collateral remained with the debtor, said the Supreme Court with only one dissenter, was replacement value less certain costs.

The Supreme Court took a clear route in its statutory interpretation to reach replacement value less certain costs, and footnote five of the Supreme Court’s decision indicates that the Supreme Court aimed to clarify the law: the court "reject[ed] a ruleless approach allowing use of different valuation standards based on the facts and circumstances of individual cases." However, with this announced standard, the calculation of the allowed secured claim is again fraught with ambiguity. In footnote six, the court commented that the fact that the replacement value standard "governs in cramdown cases leaves to bankruptcy courts, as triers of fact, identification of the best way of ascertaining replacement value on the basis of the evidence presented. Whether replacement value is the equivalent of retail value, wholesale value, or some other value will depend on the type of property." The Supreme Court went on to describe the types of expenses that should be deducted when determining replacement value, each of which requires an independent valuation, which makes clear that a fact-intensive analysis and multiple valuations would be inevitable. Thus, while the court uses the term "replacement value," sometimes associated with retail, the explanation of its calculation indicates a somewhat different valuation.

Significance of Establishing a Standard to Determine the Allowed Secured Claim and the Problems with the "Replacement Value Less Certain Costs" Standard

Issues surrounding the valuation of property arise in almost every bankruptcy case,consumer or business. [ FN: "As Justice Stevens aptly points out in his dissent, section 506(a) is a ’utility ’ provision in that applies throughout the various chapters of the Code. This interpretation of the value of the secured claim also will apply to chapter 7, 11 and 12. " Robert F. Mitch, "The Rash Decision: A Question of Value, " 18, 19 (July\August 1997).] One therefore cannot overstate the significance of clarifying the method to determine the allowed secured claim. Although the Supreme Court interpreted section 506(a) in the context of a chapter 13 cramdown, setting the standard for valuing the allowed secured claim has significant implications in all cases. [ FN: See, e.g.,In re Inter-City Beverage Co., 209 B.R. 931 (Bankr. W.D. Mo. 1997) (applying Supreme Court ’s Rash decision outside context of chapter 13 cramdown to value property sold in section 363 sale in chapter 11 bankruptcy);In re Pepper, 1997 WL 358647, 97-10574 (Bankr. D. Col. June 27, 1997) (applying Rash to chapter 7 case in determining whether lien impaired exemption under section 522).] Valuation is central to adequate protection contests and the plan confirmation process, and thus greatly affects negotiations in complex business reorganization cases. [ FN: See generally Chaim J. Fortgang & Thomas Moers Mayer, "Valuation in Bankruptcy, " 32 U.C.L.A. L. Rev. 1061 (1985) (comprehensive review of valuation issues).] Although section 506(a) establishes that valuation is to be done on a case-by-case basis, the Supreme Court’s interpretation of section 506(a) calls into question the valuation standards heretofore used in all of these contexts. [ FN: The Supreme Court ’s decision in Rash potentially, although not definitively, calls into question all section 506(a) opinions interpreting the appropriate valuation standard. Some of these opinions are cited in this proposal not for their continuing precedential value, but rather to provide context or for their philosophical bases. ]

As a consequence of the approach taken by the Supreme Court majority, commentators fear that the decision will exacerbate litigation on valuation. There are numerous practical difficulties of determining replacement value, [ FN: See Hon. Frank H. Easterbrook, "Bankruptcy Reform, " Luncheon Address to the National Bankruptcy Review Commission Chicago Regional Hearing, at 4 (July 17, 1997) ( "Replacement value cannot be looked up. It must be litigated; and in the process the value of the asset will be paid out to the lawyers rather than to the creditors ")..] particularly under the open-ended approach set forth in footnote six of the decision. [ FN: See Letter from G. Ray Warner, Re: "Valuation - Need to Establish Statutory Guidelines, " at 1 (July 30, 1997) (noting that Supreme Court left to each bankruptcy court the proper method of determining value).] The inquiry prescribed entails many factual determinations regarding the amounts that must be deducted from the retail price. In many cases, the secured claim will be determined after a protracted "battle of the experts," [ FN: See Robert F. Mitch, "The Rash Decision: A Question of Value in Context, " ABI Journal, 18, 19 (July/August 1997).] which can dissipate assets that otherwise would be available for distribution to other creditors.

A clearer standard that does not shift from one factual setting to another is warranted to provide certainty and consistency for all valuation determinations. Simplicity is a prerequisite to any standard to be considered for adoption. A relatively simple standard reduces litigation costs while it increases the predictability of outcomes, permitting parties to settle their differenceswithout always turning to the courts. A simple standard also promotes consistency in application among different judges and different districts, increasing the likelihood that similar cases will be analyzed using similar legal principles.

When choosing between alternative standards that are equally clear, the appropriate standard is then best determined by an assessment of the policy considerations underlying valuation questions. To start, this proposal recommends that the same baseline standards be employed for all valuation purposes. While the language of section 506(a) has been interpreted to permit -- and perhaps mandate -- different standards depending on the context of the valuation, it is not entirely clear why the same piece of property should be valued by various standards in multiple proceedings depending on the nature of each proceeding. Although valuation can be necessary in a variety of legal contexts, the factual circumstances warranting valuation are limited: valuation is required in the absence of a sale when the debtor will retain the property, for an independent valuation is rarely needed if the property is being sold. [ FN: This is particularly true given the Commission ’s recommendation to clarify section 363(f).] There has been little explanation for why one valuation standard should be used for adequate protection and another for plan confirmation, one for determining the value of non-exempt property and another for the redemption of exempt property. Without a clearly-articulated principle to justify the propriety of various valuation standards in different procedural contexts, confusion is simply compounded.

The variety of applications of valuation standards demonstrate that no particular method can be deemed "pro-debtor" or "pro-creditor." Depending on the circumstances, parties have different stakes in favoring a high or low valuation. For example, people might assume that the full "replacement value" standard is favorable to creditors. However, if the replacement value standard is used in automatic stay hearings, a court is more likely to find that the debtor has equity in the collateral and thus not lift the stay to permit the creditor to proceed with its rights against the property. Likewise, a creditor is less likely to be entitled to adequate protection payments using the replacement value standard even though the creditor may not be fully protected in the event of a foreclosure. [ FN: See Letter from G. Ray Warner Re: "Valuation - Need to Establish Statutory Guidelines, " at 2 (July 30, 1997). See generally United Sav. Ass'n of Tex. v. Timbers of Inwood Forest Assoc., 484 U.S. 365, 371 - 72 (1988) (interpreting section 506(a) in considering creditors ’ entitlement to adequate protection and determining that loss of right of immediate foreclosure is not factor to be considered in valuing creditor ’s interest in collateral).] Depending on the context, the valuation standard can yield quite different consequences.

Moreover, it would be an oversimplification to suggest that any standard of valuation is "pro-creditor." The chosen method of valuation of collateral greatly affects the return to unsecured creditors, and valuation is rarely a struggle between only a debtor and a single securedcreditor. [ FN: "If a bankruptcy court assigns a liquidation value to the collateral of secured creditors, it thereby awards the surplus to the unsecured creditors or to the debtor. " David Gray Carlson, "Car Wars: Valuation Standards in chapter 13 Bankruptcy Cases, " 13 Bankr. Dev. J. 1, 2 (1996).] This can be seen readily in chapter 13 cases: under the present system, every dollar of "disposable income" must be made available to unsecured creditors. The smaller the secured claim of a car lender, the larger the pro rata return to the unsecured creditors. [ FN: Rash, 117 S.Ct. at 1887 (Stevens, J. dissenting)( "Allowing any more than the foreclosure value simply grants a general windfall to undersecured creditors at the expense of unsecured creditors);In re Hoskins, 102 F.3d 311 (7 th Cir. 1996) (Easterbrook, J. concurring) (noting that retail valuation does not result in unjustified wealth transfer to debtors because valuation standard in chapter 13, like chapter 11, implicates only "relative stakes of secured and unsecured debts "). See also David Gray Carlson, "Secured Creditors and the Eely Character of Bankruptcy Valuations, " 41 Am. U. L. Rev. 63, 79 (1991) (choice of determinative price depends on whether one believes that secured creditors or general creditors should receive the bonus associated with going concern; "logic alone cannot settle such questions in an uncontroversial manner ").] All parties have an important stake in the outcome of a valuation dispute.

One issue that is equally critical to this debate, although slightly beyond the scope of this particular proposal, is the proper timing of valuation, particularly in chapter 11 reorganization. The chosen timing rule determines which parties benefit from property appreciation and reduction of secured debt principal during the pendency of the case. Some bankruptcy courts value property on a date certain (e.g., the petition date or the date of confirmation). However, the Court of Appeals for the 5^th Circuit recently held that a bright line rule for timing is inappropriate because the Code does not so provide. [ FN:In re T-H New Orleans Partnership, 16 F.3d 790 (5 th Cir. 1997).] A creditor or other party can request valuation, or multiple determinations, at any time during the case. If the creditor becomes oversecured during that period, it will be so treated thereafter. Therefore, with no restraints on the timing of valuation and the opportunity for successive determinations, the secured creditor always can receive the benefit of appreciation of its collateral, even if the appreciation is more properly attributed to the increasing efficacy of the debtor as a going concern or particular contributions of unsecured creditors. Although the instant proposal contains no recommendation on timing, the implications of timing should be kept in mind when considering the proposed valuation standards.

Wholesale Price as a Compromise Bright-Line Standard

Among the spectrum of various options for valuation, from retail (the highest reasonable value) to forced sale (the lowest reasonable value), this proposal recommends that a price in the middle -- wholesale price -- be used to determine the allowed secured claim for personal property under section 506(a). This approach is supported by policy considerations and offers several advantages.

To start, many items of personal property have a readily identifiable wholesale price. TheNADA blue book for motor vehicles is one example. [ FN: "Wholesale and retail values can be looked up in tables. They are simple to administer and satisfy my test for a good rule. " Hon. Frank H. Easterbrook, "Bankruptcy Reform, " Luncheon Address to the National Bankruptcy Review Commission Chicago Regional Hearing, at 4 (July 17, 1997).] Other types of personal property in both the business and consumer contexts have relatively easily ascertainable wholesale prices. Wholesale price satisfies the first fundamental requirement for a bright line rule -- that it be workable -- and thus helps to avoid transaction costs in bankruptcy. [ FN: See, e.g., Edith H. Jones "Recommendations for Reform of Consumer Bankruptcy Law, " at 18 (August 6, 1997 draft) (recommending adoption of simple standard for valuing collateral) .]

Second, many parties have seen merit in a compromise standard for valuation. [ FN: See, e.g., id. (recommending midpoint between wholesale and retail). In re Hoskins, 102 F.3d 311 (7 th Cir. 1996) (adopting midpoint valuation);In re Valenti 105 F.3d 55 (2 nd Cir. 1997) (bankruptcy court did not err by upholding midpoint valuation).] Wholesale price provides such a compromise between the lower repossession/resale price and the higher retail value. [ FN: Forced sale value should not be equated with wholesale value. Taffi, 68 F.3d 306, 308 (9th Cir. 1995), aff ’d en banc, 96 F.3d 1190 (9th Cir. 1996). "Such sales are notoriously poor in producing cash proceeds. " David Gray Carlson, "Car Wars: Valuation Standards in chapter 13 Bankruptcy Cases, " 13 Bankr. Dev. J. 1, 2 (1996). Forced sale prices tend not to adequately value property, and the failure to obtain the best price for collateral does not, by itself, permit a sale to be set aside as commercially unreasonable. U.C.C. §9-507(2). See, e.g., Chavers v. Frazier, 93 B.R. 366 (Bankr. M.D. Tenn. 1989) (airplane that was insured for $700,000 sold at Article 9 sale for $415,000). "The overlooked problem, of course is that ’retail ’ and ’wholesale ’ blue book prices have never been proxies for ’replacement ’ and ’forced sale ’ values. Wholesale value has never represented the amount that a creditor recovers after repossession and resale. Similarly, retail value has little to do with what a consumer would have to pay to buy a replacement automobile of like condition without a warranty from another consumer. " Gary Klein, "Opinion Raises More Questions Than it Answers, " ABI Journal 18 (July/August 1997).] Wholesale price can be viewed as a midpoint valuation since forced sales often do not yield even the wholesale price. [ FN: But see Rash, 90 F.3d at 1051, n 20 (secured creditor presented testimony that it regularly received 92% of retail price for its trucks at foreclosure sales).] It has an advantage over the so-called "midpoint" compromise in that it requires the identification of only one price rather than two, but accomplishes much of the same goal insofar as it permits the parties to share in the benefit of the reorganization. A compromise approach also is consistent with the notion that the chosen valuation standard should not create perverse incentives to use bankruptcy strategically. If creditors can count on property valuations well in excess of the creditors’ state law entitlements, then they have an incentive to push for bankruptcy rather than out-of-court workouts. At the same time, if property valuations in bankruptcy will be far below what the debtor could yield by selling the property, the debtor can use bankruptcy to extract value from creditors in ways that are not consistent with bankruptcy principles. A clear standard pegged at a compromise point is most likely to keep strategic maneuvering by either party to a minimum.

Quite significantly, using wholesale price ensures that a creditor’s secured claim will coverat least what it would have received under state law, which properly defines property rights in the absence of an overriding bankruptcy policy. [ FN: Butner v. United States, 440 U.S. 48 (1979);In re Hoskins, 102 F.3d 311 (7 th Cir. 1996) (Easterbrook, J. concurring). Associates Commercial Corp. v. Rash, 90 F.3d 1036, 1042, (5 th Cir. 1996) (en banc) (if creditor is entitled to replacement cost, would modify extent to which creditor is secured under state law), rev ’d, 117 S.Ct. 1879 (1997).] The Uniform Commercial Code entitles the creditor to seize and sell the collateral in a commercially reasonable fashion, such as an auction. [ FN: U.C.C. §§9-502 - 9-505.] If the creditor is entitled to a higher replacement cost or retail, the creditor has a larger entitlement than if the debtor surrendered the property, without having to incur the expenses necessary to fetch a retail price. Choosing wholesale protects secured creditors at least for the resale price, which some argue is the most accurate reflection of state law entitlements, [ FN: Rash, 90 F.3d at 1042 (en banc), rev ’d 117 S.Ct. 1879 (1997); Hoskins, 102 F.3d 311 (Easterbrook, J. concurring). "If the debtor must pay the secured creditor the retail value of the collateral in order to retain the collateral under Section 1325(a)(5)(B), the apparent congruence of protection afforded by Sections 1325(a)(5)(B) and (C) [providing option to surrender collateral] would be lost. " In re Maddox, 200 B.R. 546, 553 (D. N.J. 1996) (affirming bankruptcy court ’s application of wholesale value to vehicles to be retained in chapter 13).] and potentially provides them a bit more as well. Therefore, by looking to wholesale price, a secured creditor should be protected at least for "the equivalent of recourse to the collateral," [ FN: S. Andrew Bowman & William M. Thompson, "Secured Claims Under Section 1325(a)(5)(B): Collateral Valuation, Present Value, and Adequate Protection, " 15 Ind. L. Rev. 569. 577 (1982), cited in Rash, 90 F.3d at 1047, rev ’d , 117 S.Ct. 1879 (1997). "A debtor may cram down a plan either by abandoning the collateral to the secured party (so that a foreclosure sale can occur under state law), or by retaining the collateral but distributing legal rights with a comparable value to the secured creditor. These two cram down options should be the same, from the perspective of the secured creditor. " David Gray Carlson, "Car Wars: Valuation Standards in chapter 13 Bankruptcy Cases, " 13 Bankr. Dev. J. 1, 8-9 (1996).] when the creditor gets, in effect, its best price.

The wholesale standard also is fair to debtors. A debtor that retains collateral will have to pay more than liquidation value on the allowed secured claim, but has the opportunity to keep the property, and thus also receives a benefit it would not have if the property had been repossessed under state law.

The wholesale standard also should promote overall economic efficiency. The purpose of collateral is to serve as a source of payment for a loan in the event that the borrower defaults. Providing at least the resale value of that particular collateral reflects that purpose. In the event that a high valuation relative to the actual value precludes the confirmation of a feasible plan, a debtor will forfeit the collateral to a creditor that will get only the much lower foreclosure price when it repossesses and sells at a foreclosure sale. Thus, a higher valuation standard would force the transfer of property to a party that would yield a lower return for it. Wholesale valuation may be more economically efficient because the debtor will able to keep the property in those cases where the debtor values it most.

When determining how to calculate the allowed secured claim, it also is important to recognize the goal of the valuation exercise: an accurate valuation of the asset to capture the present value of the asset’s future cash flows. Wholesale price best approximates the collateral’s actual value because retail price reflects the an extra component of a retailer’s value-adding attributes, which are not relevant or appropriate in this context, especially when the secured creditor is not a retailer itself. [ FN: "The distinction between wholesale and retail prices is a false one. Retail prices reflect value added by the retailer. If the cost of value added by the retailer were to be removed from retail value, the remainder would be wholesale value. Hence, wholesale is simply retail minus the transaction costs of retailing . . .these transaction costs ought to be removed. David Gray Carlson, "Car Wars: Valuation Standards in chapter 13 Bankruptcy Cases, " 13 Bankr. Dev. J. 1, 8 (1996) "The retailer adds value to the transaction. The retailer maintains an inventory of automobiles, reducing the number of sites a buyer must visit to complete a transaction and thereby reducing the buyer ’s search costs. The retailer, like the securities dealer, also stands ready to buy and sell automobiles, thereby providing liquidity to the marketplace. A retailer also may provide explicit or implicit certifications of quality, perhaps through the retailer ’s reputation in the community. " Robert M. Lawless & Stephen P. Ferris, "Economics and the Rhetoric of Valuation, " 5 J. Bankr. L. & P. 3, 16-18 (1995) ( "We believe that a value that approximates wholesale price should be the relevant measure of [lender] ’s claim for purposes of the chapter 13 cramdown . . . Because the value of an automobile sold in the market at the wholesale level comes almost directly from the manufacturing activities of the dealer, the wholesale price of the automobile likely comes closest to representing the automobile ’s true worth ").] Even when the secured creditor is a retailer, there are very real expenses that the creditor must undertake to resell an item for a retail price. This seems to be the principle underlying footnote six of the Supreme Court’s Rash decision.

Wholesale value is most consistent with relevant Supreme Court precedent. It is the closest "bright line" to the Supreme Court’s prescription for valuation in Rash. Following the Supreme Court’s instructions in footnote 6, a court likely would start with retail and subtract most costs that comprise the difference between the retail and wholesale prices. [ FN: See Hon. Frank H. Easterbrook, "Bankruptcy Reform, " Luncheon Address to the National Bankruptcy Review Commission Chicago Regional Hearing, at 5 (July 17, 1997).] Examples of such costs offered by the Supreme Court included warranties, inventory, storage, reconditioning, and costs associated with modifications to the property that would not be subject to the creditor’s lien under state law. [ FN: Rash, 117 S.Ct. at 1886, n 6.]

Fair Market Value Minus Hypothetical Costs of Sale

A parallel standard for real property is fair market value minus hypothetical costs of sale. [ FN: This standard will not apply to mortgages on the primary residence of a chapter 11 or 13 debtor retaining the residence when such mortgages are protected from modification. This standard presumably would apply , however, to personal property forms of holding real property, such as land trusts.] Like wholesale price, this would provide a bright line -- but compromise -- standard between the lowest and highest standards, foreclosure value and a fair market price that included hypothetical sales costs. A number of circuit courts of appeals have adopted the fair market value standard forassessing the allowed secured claim on real property. [ FN: See, e.g., Taffi v. United States, 96 F.3d 1190 (9 th Cir. 1996) (en banc), cert. denied , 117 S.Ct. 2748 (1997);In re Trimble, 50 F.3d 530 (8 th Cir. 1995) ; Winthrop Old Farm Nurseries v. New Bedford Institution for Savings, 50 F.3d 72 (1st Cir. 1995) ; In re McClurkin, 31 F.3d 401, 405 (6th Cir.1994) . Cf.In re Balbus, 933 F.2d 246, 250 - 52 (4th Cir.1991) (where purpose of valuation was to determine whether debtor had too much unsecured credit to qualify as chapter 13 debtor, and where debtor would retain house under plan, value of creditor's interest in house was amount creditor would receive at foreclosure sale).] A fair market value standard properly sets the allowed secured claim at an amount that represents what a willing and fully informed buyer would pay under fair market conditions. It is the best approximation of the property’s actual value and reflects that in the context of real property there is less of a difference between the prices that a debtor and another party could obtain for the property outside the context of a foreclosure sale.

The proposed approach diverges from approaches of courts that have not deducted hypothetical costs of sale. [ FN: See, e.g.,Taffi v. United States, 96 F.3d 1190 (9 th Cir. 1996) (en banc);In re Trimble, 50 F.3d 530 (8 th Cir. 1995) ; Winthrop Old Farm Nurseries v. New Bedford Institution for Savings, 50 F.3d 72 (1st Cir. 1995) ; In re McClurkin, 31 F.3d 401, 405 (6th Cir.1994) (section 506(a) "does not require or permit a reduction in the creditor's secured claim to account for purely hypothetical costs of sale" of chapter 13 debtor's residence) .] Refusing to deduct hypothetical costs generally has been justified by the same arguments employed to support retail valuation of personal property: because these courts focus on the debtors’ intended use of the property, e.g., continued possession, they have found that it would be unreasonable to deduct costs when no sale is intended. This premise is refuted by courts that base their inquiry on the creditor’s interest in the property and note that a secured creditor could not realize fair market value without incurring disposition costs, and thus these must be factored into the valuation. [ FN: See, e.g., Bank of America, Illinois v. 203 N. LaSalle St. Partnership, 195 B.R. 692 (N.D. Ill. 1996), aff ’g 190 B.R. 567 (Bankr. N.D. Ill. 1995) (valuing real property at its fair market value but deducting disposition costs).]

Deducting sales costs from the fair market price is recommended for several reasons. Assuming that the price yielded at a foreclosure sale often is well below the fair market value, [ FN: See, e.g., Armstrong v. Csurilla, 817 F.2d 1221 (N.M. 1991) (discussing low prices that foreclosure sales often bring and when they can be deemed inadequate); Lynn LoPucki & Elizabeth Warren, Secured Credit; A Systems Approach at 71, 87 (1995) ( "judicial valuation does a poor job of valuing the collateral ").] it provides a reasonable parallel approach to the wholesale standard. Fair market value is higher than a foreclosure or forced sale price, but slightly less than a non-adjusted fair market price. This again offers a "compromise" valuation method that is easier to administer than another midpoint standard that would require two valuations.

Deducting costs of sale also better reflects a secured creditor’s state law entitlement, which must be considered in this type of analysis. [ FN: See Butner, 440 U.S. 48 (1979).] If the secured creditor foreclosed andexercised its state law remedies, its return would be far less than fair market value without cost adjustments.

A balance between secured and unsecured creditors is more fairly established when the secured creditor’s allowed secured claim is adjusted for the costs it did not have to incur to be protected for the fair market price. Again, this permits all parties to participate and share in the benefits of the reorganization.

In addition, section 506(c), which permits costs of sale to be surcharged to a secured creditors’ collateral, arguably supports the notion that costs of sale decrease the value of collateral to a secured creditor. [ FN: David Gray Carlson, "Car Wars: Valuation Standards in chapter 13 Bankruptcy Cases, " 13 Bankr. Dev. J. 1,51 (1996).]

Competing Considerations

Some would criticize the wholesale and fair market standards as being too high. These standards, it has been argued, provide a windfall to secured creditors that bargained for and would receive only foreclosure value under state law, where they also would have to bear the costs and burdens attendant to those collection activities.

At the same time, it also has been suggested that wholesale valuation permits the debtor to obtain a windfall in the event that she resold the property for retail price. [ FN: Associates Commercial Corp. v. Rash, 31, F.3d 325 (5 th Cir. 1994), rev ’d on rehearing en banc, 90 F.3d 1036, rev ’d, 117 S.Ct. 1879 (1997).] This argument is particularly tenuous in the context of a consumer debtor or any debtor that is not in the business of selling that particular type of collateral; the debtor is ill-equipped to take the steps that add the requisite value that would be necessary to fetching a retail price, such as providing a warranty, reconditioning the property, offering credit terms, or being well located in a shopping area. [ FN: Robert M. Lawless & Stephen P. Ferris, "Economics and the Rhetoric of Valuation, " 5 J. Bankr. L. & Prac. 3, 18 (1995) (consumer debtor, as one-time dealer, cannot provide services to marketplace that would permit her to charge higher retail price).] More significantly, this circumstance is economically unlikely in a competitive market, according to some scholars and economists: "[i]f such opportunities did exist, we would expect to see persons enter the market to take advantage of them. These new market entrants would bid up the wholesale price until it eventually equaled the retail price." [ FN: Lawless & Ferris, 5 J. Bankr. L. & Prac. at 5 (1995); Rash, 90 F.3d at 1054 ( "no evidence on the record that the Rashes could sell their truck for a higher price than ACC could obtain at a commercially reasonable sale ").]

Some have argued that property valuation should be sufficiently high to offset the risk of loss of the creditor. However, there are other superior ways to compensate for risk of loss, suchas adjustment of the interest rate [ FN: See Letter from Hon. Eugene R. Wedoff Re: "Valuation of collateral for cramdown, " at 2 (July 16, 1997) citing Rash, 117 S.Ct. at 1887 (Stevens J., dissenting).] or the amortization rate, calculation of adequate protection payments, or changes in other terms of the agreement. In any event, compensation should be based on actual risk, not a universally-presumed risk incorporated into a valuation standard applicable to all debtors and all situations.

Some have questioned whether the costs of sale should be deducted from the fair market value of real property. It might be improper to allocate the hypothetical costs to the creditor when outside of bankruptcy, such costs might be added to a debtor’s deficiency and not deducted from the first dollar of proceeds from the sale. [ FN:In re McClurkin, 31 F.3d 401, 404 (6th Cir. 1994).] However, creditors bear at least initial responsibility for these costs, [ FN: See David Gray Carlson, "Car Wars: Valuation Standards in chapter 13 Bankruptcy Cases, " 13 Bankr. Dev. J. 1, n 187 (1996) (noting that positive transaction costs reduce amount secured party obtains from collateral , to which size of deficit is unrelated).] and deducting these hypothetical costs from the allowed secured claim best comports with reality under state law and prevents a greater burden from being shouldered by the unsecured creditors.