The Legal Anomaly of Non-Recourse Financing

By Professor Steven Schwarcz (Duke University School of Law) and Christina Trepczynski (Duke University School of Law JD ’24)

In The Legal Anomaly of Non-Recourse Financing (forthcoming in the American Bankruptcy Law Journal (2024)), we examine § 1111(b), one of the Bankruptcy Code’s most complex and challenging provisions. Most of the discussion of this section focuses on the so-called 1111(b)(2) election, in which an undersecured creditor, in order to protect against undervaluation of collateral, can sometimes opt to have its claim treated in Chapter 11 as a fully secured claim.

Our article, in contrast, focuses on what can happen if that election is not made. Absent that election, § 1111(b)(1) automatically converts debt claims that are non-recourse under state law into full recourse claims. The consequence of this conversion is that § 506 of the Bankruptcy Code now creates separate secured and unsecured claims out of the original loan amount. Under § 506, the claims of undersecured creditors—that is, creditors whose claims exceed the value of their collateral—are automatically bifurcated into secured and unsecured claims. The undersecured creditor has a secured claim up to the value of its collateral and an unsecured claim for the difference, or deficiency, between the total debt and the value of the collateral. Without that conversion, a non-recourse creditor’s claim would be limited to the value of the collateral, and any portion of the claim that exceeded that value would be disallowed. The conversion thus creates unbargained and unfair benefits for non-recourse lenders, to the detriment of debtors and unsecured creditors.

To appreciate this, one must understand non-recourse lending. The term “non-recourse” is somewhat of a misnomer because it does not mean without recourse; rather, it means that a lender or other creditor has recourse only to the collateral securing the financing. A significant amount of high-end financing is made on a non-recourse basis. For example, for the decade ending first-quarter 2021, the non-recourse debt associated with the financing activities of domestic finance companies averaged around half a billion dollars. Non-recourse loans also make up a significant portion of commercial real estate financing. In addition, virtually all securitization and other structured financing is made on a non-recourse basis.

Because of the limitation on recourse, non-recourse lenders tend to be more sophisticated and risk-seeking than typical lenders. Their quid pro quo for making non-recourse loans usually includes a higher interest rate. Borrowers may be willing to pay higher rates because the limited recovery on non-recourse financing should not alarm their other creditors and might also be needed to comply with their covenant restrictions.

Besides unfairly benefiting non-recourse lenders, the non-recourse to recourse conversion violates bankruptcy law’s principal policies. It violates the policy of debtor rehabilitation by granting a non-recourse creditor full repayment rights against the debtor if the collateral value is insufficient to repay the loan. It violates the policy of equality of distribution by granting a non-recourse creditor a new unsecured deficiency claim that would dilute the distribution to other creditors. Moreover, creating that new claim flouts the Bankruptcy Code’s general respect for the substantive state law rights of creditors.

The non-recourse to recourse conversion did not exist under the Bankruptcy Act of 1898, as amended, which was the main body of legislation governing bankruptcy law prior to enactment of the Bankruptcy Code. Under the Bankruptcy Act, a non-recourse claim remained non-recourse. Just prior to enactment of the Bankruptcy Code, however, the case of In Re Pine Gate Associates, Ltd., No. B75-4345A, 1977 WL 373413 (N.D. Ga. Mar. 4, 1977), vacated as moot, No. B75-4345A, 1977 WL 373414 (N.D. Ga. Sept. 16, 1977), provided the impetus for including § 1111(b).

In Pine Gate, a federal district court allowed a debtor to cash out a non-recourse creditor’s claim by paying only the appraised value of the collateral, which was less than the amount of the claim. This result outraged many creditors, especially members of the real estate lending lobby. They argued that a non-recourse creditor faced the risk of underpayment if the collateral was undervalued or if the valuation occurred during a temporarily depressed market, whereas the debtor could retain the collateral and benefit from any future increase in its value.

At the congressional hearings for the legislation that ultimately would become the Bankruptcy Code, the real estate lending lobby testified that the Pine Gate outcome would greatly reduce the availability of credit by essentially giving debtors too much power over creditors. To prevent this disruption, the lobbyists requested that Congress require appropriate appraisal methods to prevent unfair collateral valuation.

Section 1111(b)’s non-recourse to recourse conversion goes far beyond that. Our article shows how that section should be amended to fairly and accessibly protect non-recourse lenders without harming third parties or impairing bankruptcy policies.

Steven L. Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law. Christina Trepczynski is a Class of 2024 J.D. candidate at Duke University School of Law.

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