The city of Boston and Prudential Insurance Co. are locked in an acerbic, multi-million-dollar fight at the 1st U.S. Circuit Court of Appeals that will have major implications for New England lawyers involved in large Chapter 11 reorganizations.

The case, The Prudential Insurance Company of America v. City of Boston, is an outgrowth of the Chapter 11 bankruptcy filed in 2010 by the developer of the posh W Boston Hotel and Residences in the Theater District, and related entities. Prudential was the primary secured lender for the $200 million-plus project, and one of the central issues in the appeal of a 2012 Bankruptcy Appellate Panel decision is how much interest it stands to earn on its claim.

The 1st Circuit has yet to weigh in on the correct approach for determining how — and, importantly, when — an oversecured lender accrues post-petition interest in a Chapter 11 case. The issue has divided other courts across the country, and lawyers say the 1st Circuit’s ruling will have a significant impact on future cases. For an idea of how significant, consider that there is a $26.5 million difference in the value of Prudential’s claim depending on which approach is used.

“I’m not aware of this getting to the 1st Circuit before now,” said Boston lawyer Anthony A. Froio, who is not involved in the case. “Clearly, they’re being squarely asked to address this issue. … It’s going to be very important and will be a very significant decision for debtors’ and creditors’ lawyers in bankruptcy cases.”

If Prudential’s argument prevails, there will be no money left in the estate to compensate the hotel developer’s other creditors, including Boston taxpayers, as the city gave the developer an emergency $10.5 million loan to prevent the project from falling through at the 11th hour.

“Prudential has been paid the entire $180 million principal balance of its claim along with interest since June 2011,” states a brief filed by the debtors with the 1st Circuit. “Not content with this result, Prudential wants more. It seeks all the remaining value from these Debtors to the exclusion of all others, including the City, creditors and interest holders who enabled the Hotel and Residences to be completed and sold.”

Lawyers for the debtors, Prudential and the city of Boston all declined to comment while the 1st Circuit’s decision is pending.

Flip-floppers

The case has seen the involved parties, and even U.S. Bankruptcy Court Judge Joan N. Feeney, change their positions on the value of the W Hotel over the course of the proceedings.

Three months into the bankruptcy case, Prudential filed a stay relief motion, arguing that its claim was undersecured by its collateral and seeking permission to foreclose.

Feeney, however, concluded that the total value of Prudential’s collateral was worth $19 million more than its claim. Most importantly, Feeney set the value of the hotel at $65 million as of the petition date; the parties had stipulated to the value of other collateral.

While Prudential was denied its stay relief motion, the decision seemingly came with a silver lining because, under §506 of the Bankruptcy Code, an oversecured creditor is entitled to receive post-petition interest, fees, costs and other charges.

Any doubt as to Prudential’s oversecured status was erased when, two months later, a buyer offered to purchase the hotel for $89.5 million, establishing its value to be much higher than anyone expected.

Prudential’s claim also was being reduced over the course of the case by adequate protection payments and the proceeds of W Boston Hotel and Residences condominium sales, further increasing the degree to which its collateral out-valued its claim.

When Prudential filed a motion for interest fees and costs, the parties essentially flipped the positions they had taken while arguing the stay relief motion. Prudential, which had previously argued it was undersecured in hopes of foreclosing, now claimed it had been oversecured throughout the entire case in hopes of accruing interest from the petition date.

“Prudential repeatedly insisted that it was not oversecured as of the Petition Date,” states a brief filed by the city of Boston with the 1st Circuit. “It did not want to be oversecured because that would have undercut its efforts to oppose Debtors’ use of cash collateral and would have thwarted its efforts to foreclose on the W Hotel and Residences through its Motion for Relief. Only after the unexpected, fortuitous, inflated offer for the Hotel was received, did it become convenient for Prudential to assert a contrary position and insist that it always had been oversecured.”

The debtor and the city, which had argued Prudential was oversecured at the beginning of the case, now argued that the lender had not become oversecured until the sale of the hotel and that interest should begin to accrue from that date.

Feeney, too, decided to abandon her conclusion that the hotel was worth $65 million and Prudential had an equity cushion at the petition date — the basis for her denial of the stay relief motion — and sided with the debtor and city.

In its brief, Prudential rejects the accusation that its behavior has been disingenuous.

“The Debtors and the City of Boston attempt to preclude Prudential from relying upon the valuation result from the Lift Stay Motion, but a litigant is not judicially estopped from taking different position later in the case unless it prevails on its position in the first instance,” the brief states in a footnote. “The Debtors always asserted that Prudential was oversecured in the aggregate. The Bankruptcy Court adopted the Debtors’ position as its own. Prudential accepted the Bankruptcy Court’s conclusive finding on the subject and adapted its position accordingly.”

Competing approaches

But Feeney noted that §506 states “value shall be determined in light of the purpose of the valuation and of the proposed disposition,” and emerging caselaw that holds collateral and claim value determinations at one point in a case are not binding on later determinations for other purposes.

Feeney embraced what has been called the “flexible approach” for determining value for §506 purposes, whereby a judge has great leeway to consider evidence and determine a particular point in time at which a lender becomes oversecured and entitled to accrue post-petition interest.

While the issue has not been addressed in the 1st Circuit, most courts have decided the flexible approach is best when compared to other options, such as the “single-valuation approach” used by other courts, whereby valuation is determined at one point for all purposes. Such an approach has been criticized as overly simplistic, especially in bankruptcies like the hotel developer’s, where the value of collateral and claims are fluctuating over the course of the proceedings.

On appeal, the BAP rejected Feeney’s determination that Prudential’s post-petition interest should not begin accruing until the hotel sale date.

While the BAP judges agreed that the hotel sale price was the best evidence of its value, they disagreed that Prudential only became oversecured as of the closing date, believing the unexpectedly high sale price established Prudential had been oversecured all along.

Notably, the BAP determined that Feeney’s valuation of the hotel for purposes of the stay relief motion provided additional evidence of that. The panel also adopted the flexible approach, but said Feeney had misapplied it.

Flexible but flawed

Christopher J. Giaimo of Baker Hostetler in Washington, D.C., co-authored an article on the BAP decision for the American Bankruptcy Institute. He said the bankruptcy ruling had a number of flaws in it, which the BAP corrected, “but unfortunately not with a lot of analysis.”

Giaimo hopes the 1st Circuit will take the opportunity to provide more clarity.

“It’s fairly important,” he said. “Depending on the case, you may be talking about a lot of money.”

Giaimo is particularly troubled by Feeney’s decision to disregard her prior valuation of the hotel.

“How the Bankruptcy Court could completely ignore that ruling in a contested matter left me scratching my head,” he said. “How could it possibly be that their right to post-petition interest only began to accrue at that later point in time?”

Or, as Prudential argues in a brief filed with the 1st Circuit: “Value is inherent. It does not spring into existence only when cash trades hands.”

“For there to be even a colorable argument that Prudential was undersecured as of the Petition Date,” Prudential’s brief states, “the Bankruptcy Court would have had to identify evidence that Prudential’s collateral — consisting largely of real estate assets, cash and securities — increased in value by more than $20 million in less than six months.”

While he is a fan of the flexible approach as applied by the BAP, Giaimo said it is not without its faults. Specifically, it invites a secured creditor to seek multiple valuations in order to establish all the dates over which the creditor was oversecured and entitled to accrue interest.

“The amount of debt and the value of collateral will fluctuate throughout the case, so I agree that a flexible approach should be utilized,” he said. “Unaddressed, however, is how often and when you perform the valuation. Do you have to do it on a monthly, weekly or daily basis? What is it you have to do to prove you’re oversecured at X date? The concept of having to prove your collateral position, in essence, every day of the case would be unduly costly and burdensome not only to the lenders, but also the estate. It’s begging for a major battle of the experts. Bankruptcy is already a very expensive endeavor for both parties.”

The Mortgage Bankers Association of America, which has filed an amicus brief in the case, shares Giaimo’s concern.

Pamela Smith Holleman of Sullivan & Worcester in Boston, who co-authored the association’s brief, said lender attempts to seek multiple valuations could cause reorganizations “at the margins” to fail because it would create an “incentive to litigate.”

As such, Holleman said mortgage bankers are hesitant to endorse the flexible approach without a better understanding of what “flexible” means exactly.

“Such an approach, if generally accepted by the courts, would create a perverse incentive: well-counseled secured creditors — even if substantially oversecured — will routinely request adequate protection hearings in the first days of the case to preserve the right to post-petition interest under a plan,” the mortgage bankers’ brief states. “The resulting litigation would further burden the courts and increase costs to debtors and lenders — costs that would likely be passed on to borrowers. The whole point of Chapter 11 is to allow the debtor breathing room and time to fashion a reorganization plan. Encouraging oversecured creditors to act aggressively at the inception of a case, at the risk of pushing an estate into liquidation, is entirely at odds with that purpose.”

Froio, however, said lenders should be aggressive at the beginning of a bankruptcy case and too often “find themselves in a losing position because they sit on their hands.”

The regional managing partner at Robins, Kaplan, Miller & Ciresi in Boston said it is important to establish value at the outset of a case, but that doing so does not always have to result in a fight. It could be the basis for reaching out to the debtor and debtor’s counsel to start striking some agreements.

“The real incentive, then,” Froio said, “is to try early on to stipulate to value.”