In real estate bankruptcy proceedings, the determination of a post-bankruptcy interest rate is often a critical element of the repayment or restructuring plan. The appropriate rate is typically not one that can be observed or obtained in the regular markets — the debtor in possession is already in bankruptcy and consequently, a commercial loan is very likely unfeasible. The U.S. Supreme Court provides guidance to addressing this issue in Till v. SCS Credit Corp., which states that:
"the approach begins by looking to the national prime rate … which reflects the financial market’s estimate of the amount a commercial bank should charge a credit-worthy commercial borrower to compensate for the opportunity costs of the loan, the risk of inflation and the relatively slight risk of default. … the approach then requires a bankruptcy court to adjust the prime rate accordingly … on such factors as the circumstances of the estate, the nature of the security and the duration and feasibility of the reorganization plan."[1]
Ultimately, Till does not provide specificity as to what variables should be considered under each of these factors, nor how the rate should actually be computed. This article (a reduced-form summary of another article[2]) superimposes economic principles on the Till decision to provide legal scholars and practitioners with a formal (though not necessarily exhaustive) list of those economic variables.
Circumstances of the Estate
The phrase “circumstances of the estate” can be reasonably taken to encompass any issue that will impact the debtor’s ability to service the loan or that affects the risk of the loan.[3] These include, but are not necessarily limited to, the following: (1) market rates for comparable loans and projects, which may provide information about the market’s assessment of risk; (2) characteristics of the borrower, such as whether the borrower is a well-established developer or the depth of their resources; (3) industry considerations, such as the overall state of the industry, strength of the local market or type of development (e.g., office space vs. residential); (4) initial loan terms provided to the debtor prebankruptcy, which serve to inform estimates of risk of the project; (5) the type of loan, such as whether it is amortizing, has balloon payments or has other built-in contingencies; (6) the borrower’s post-confirmation ability to function and access credit markets; (7) lender returns and yields, which may provide insight into perceived market risk; and (8) lender-offered terms, which may serve to provide insight into perceived market risk.[4]
Nature of the Security
Till indicates that the “nature of the security” (or equivalently, the collateral used to secure the loan) should be carefully considered. These variables may include (1) characteristics of the project and project-specific risks, such as whether the project is high or low end, occupancy rates, rental rate trends or rental rates relative to market averages; (2) the status of the project, such as whether the bankruptcy has been caused by an unrelated short-term problem or whether a project is near completion or at an earlier stage; (3) a loan-to-value ratio, which indicates the extent to which the creditor is exposed to volatility in pricing; and (4) liquidity of the collateral, which is a measure of how easily the asset can be converted into cash.[5]
Duration of the Reorganization Plan
This element of the Till decision encompasses risks and other factors that are associated with the length of the plan and may include (1) term and duration of the plan where, all things being equal, loans of shorter duration have lower interest rates; and (2) the term structure of interest rates, which can be used to assess inflation risk. If the inflation risk is high, then the interest rate should be higher. Conversely, low inflation risk would result in a lower interest rate.
Feasibility of the Reorganization Plan
The Bankruptcy Code entitles a creditor to a present value of the stream of future payments that equals or exceeds the value of a creditor’s claim. While Till states that the rate decided upon does not need to meet the prebankruptcy terms (which is the idea behind the cramdown), it should not allow businesses to have the opportunity to enter into outlandish deals that an otherwise-solvent debtor would not be able to obtain. In short, the creditor should get a fair rate but it should be a rate that allows the reorganization plan to succeed.
Variables to consider may include (1) the reasonableness of underlying assumptions (e.g., a plan properly incorporating local housing trends/forecasts into the projected earnings of a high-end apartment complex will have a greater chance of success and pose less risk than a plan requiring a 50 percent increase in sales despite recent quarterly decreases and a poor economic outlook to barely cover the proposed debt service); (2) earnings before interest, taxes, depreciation and amortization, a measurement of the cash flow produced by the continuing operations of a business; (3) debt-service coverage, which measures the net operating income, as determined in the plan, in terms of the scheduled debt service over a specific period of time (a higher debt-service-coverage ratio indicates that the debtor has more financial resources to commit to the repayment of the loan, and thus indicates reduced risk); and (4) the rates allowed by the plan (i.e., a sensitivity analysis to determine whether the cramdown interest rate will satisfy the net present value criteria but also allow the debtor with enough margin for error such that the probability of another default is minimized).[6]
[1] 541 U.S. 465, 124 S. Ct. 1951, 309 19 B.R. 1951 (2004) (emphasis added).
[2] C. Paul Wazzan, Keith Mendes and Gabriel Green, “Determining the Appropriate Interest Rate under Till in a Bankruptcy Case,” California Bankruptcy Journal 31 (2), 2011.
[3] See, e.g., Hon. Michael G. Williamson, “Determining Cram Down Interest Rates Post-Till,” ABI Southeast Bankruptcy Conference, July 27-30, 2005.
[4] C. Paul Wazzan, Keith Mendes and Gabriel Green, “Determining the Appropriate Interest Rate under Till in a Bankruptcy Case,” California Bankruptcy Journal 31 (2), 2011.
[5] C. Paul Wazzan, Keith Mendes and Gabriel Green, “Determining the Appropriate Interest Rate under Till in a Bankruptcy Case,” California Bankruptcy Journal 31 (2), 2011.
[6] C. Paul Wazzan, Keith Mendes and Gabriel Green, “Determining the Appropriate Interest Rate under Till in a Bankruptcy Case,” California Bankruptcy Journal 31 (2), 2011.