Finding the Proper Chapter 11 Cramdown Rate of Interest Pick Your Experts Carefully

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Dec/Jan 1999

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Although numerous judicial opinions have addressed the appropriate cramdown market rate of
interest, the exact methodology of determining this rate remains a mystery despite the general
rule that the "market rate of interest" applies. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Security Assurance v. T-H
New Orleans Limited Partnership, 116 F.3d 790 (5th Cir. 1997)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hotel Associates of
Tucson, 165 B.R. 470 (9th Cir. BAP 1994)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Federal Land Bank of Wichita, 901
F.2d 858 (10th Cir. 1990)</a>; and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Neil Pharmacal Co., 789 F.2d 1283 (8th Cir.
1986)</a>. Thus, it is up to courts, practitioners and expert witnesses to determine the
appropriate market rate on a case-by-case basis.

<h3>Applying the Bankruptcy Code's Requirements</h3>

Section 1129(b)(2)(A)(i)(II) requires that a plan of reorganization's total deferred
payments have a present value equal to the amount of the secured claim. 11 U.S.C.
§1129(b)(2)(A)(i)(II); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Security Assurance v. T-H New Orleans Limited
Partnership, 116 F.3d 790, 801 (5th Cir. 1997)</a>. To ensure a present equal value, the Fifth
Circuit mandated that bankruptcy courts determine the appropriate method for calculating the
appropriate interest rate, no matter the methodology used, while stating that "[w]e will not tie
the hands of the lower courts as they make the factual determination involved in establishing an
appropriate interest rate; they have the job of weighing the witness's testimony, demeanor and
credibility." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… New Orleans, 116 F.3d at 800-01</a>. Thus, the exact measure of the
appropriate cramdown interest rate remains open for argument since so many differing methods
exist.

<h3>Methods of Determining Appropriate Cramdown Interest Rate</h3>

Since no per se rule for chapter 11 cramdowns exists, various methods may apply. These
methods include the Formula Method, the Prevailing Market Method, the Tranche Method and the
Workout Method.

1) The Formula Method. The Formula Method calculates the prevailing market rate for a
loan of equal term, with due consideration of the quality of the security and the risk of
subsequent default. In applying the Formula Method, therefore, most courts start with a base of
either the prime rate or the T-bill rate, adding basis points for various risk factors involved.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Neil Pharmacal Co., 789 F.2d 1283, 1285 (8th Cir. 1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v.
Southern States Motor Inns Inc., 709 F.2d 647, 651 (11th Cir. 1983)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Federal
Land Bank of Wichita, 901 F.2d 858, 860 (10th Cir. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fowler, 903 F.2d 694,
698 (9th Cir. 1990)</a>.

<blockquote><blockquote>
<hr>
<big><center>
While courts remain silent on the appropriate
cramdown interest rate, practitioners are left to
their own devices in deciding how to present their
arguments, and must wisely choose experts, as
their testimony proves so crucial.
</center></big>
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</blockquote></blockquote>

Consequently, as the base rate is finite, the bankruptcy court need only find the appropriate
risk components, since the risk factors vary with each case. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Way Apartments D.T., 201
B.R. 444, 454-55 (Bankr. N.D. Tex. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Camino Real Landscape Maintenance
Contractors, 818 F.2d 1503, 1507-08 (9th Cir. 1987)</a>. In determining the appropriate risk
component, however, courts typically look at the following factors as the basis for adding points:

<ul>
<li> type of property
</li><li> operating history
</li><li> quality and location of property
</li><li> status of the market and market factors
</li><li> risk of default and
</li><li> size and term of the loan.
</li></ul>
See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Doud, 869 F.2d 1144, 1145 (8th Cir. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Computer Optics Inc.,

126 B.R. 664, 672 (Bankr. D. N.H. 1991)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re E.I. Parks I Ltd. Partnership, 122 B.R. 549,
555 (Bankr. W.D. Ark. 1990)</a>.

These factors vary with each case, as do the facts of each case. Consequently, no blanket rule
exists and existing Formula Method precedent is merely persuasive authority. The lack of a
blanket rule has led many courts to use the Prevailing Market Method, which does not consider
the varying factors of each case.

2) The Prevailing Market Method. The Prevailing Market Method considers the expert
assessment, typically of a mortgage banker or other financial expert, of the interest rate
market to determine the current market rate for similar loans. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sunflower Racing Inc.,
226 B.R. 673, 686 (D. Kan. 1998)</a>. Generally, however, the debtor's circumstances are not as
advantageous as those of the average borrower, which leads many courts to find that no market
exists for such "forced loans." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Federal Land Bank of Wichita, 901 F.2d 858, 860
(10th Cir. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fowler, 903 F.2d 694, 697-98 (9th Cir. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v.
Neil Pharmacal Co., 789 F.2d 1283, 1287-88 (8th Cir. 1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… States v. Southern
States Motor Inns Inc., 709 F.2d 647, 651-52 (11th Cir. 1983)</a>. Other courts reject the idea
that the missing market for "forced loans" makes a determination of the cramdown interest rate
impossible. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Eastland Partners Ltd. Partnership, 149 B.R. 105, 106 (Bankr.
E.D. Mich. 1992)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Birdneck Apartments Associates II L.P., 156 B.R. 499, 508-09
(Bankr. E.D. Va. 1993)</a>.

Due to this split of authority, many courts blend the Formula Method and the Prevailing
Market Method. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Villa Diablo Associates, 156 B.R. 650 (Bankr. N.D. Cal. 1993)</a>
(wherein the court suggested blending the Formula and Prevailing Market Rate Methods). Because of the practical examinations of blending methods, the Tranche Method arose.

3) The Tranche Method. The Tranche Method was developed because there was no true
market for zero percent loan-to-value (LTV) loans, because of the subjective approach of the
Formula Method's risk factors, and because of the appeal of blending the Formula and Prevailing
Market Rate Methods. In determining the appropriate cramdown interest rate, the Tranche
Method creates a theoretical loan market when none exists.

To create this market, the Tranche Method uses a weighted average of interest rates from
three different levels, or tranches, of financing, which theoretically gives an accurate interest
rate. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Crosscreek Apartments Ltd., 213 B.R. 521, 543-44 (Bankr. E.D. Tenn.
1997)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Cellular Information Systems Inc., 171 B.R. 926, 943-44 (Bankr. S.D.N.Y.
1994)</a>.

The First Tranche is derived from the market rate for adjustable rate loans from lenders
who make first loans of up to 70-75 percent LTV. Typically, pension funds, banks and
insurance companies provide First Tranche financing.

The Second Tranche is derived from the yields that investors seek for loans that provide
junior debt financing of up to 85 percent LTV of the underlying collateral. Typically, private
finance companies, who seek to secure an overall internal rate of return between 15-30
percent, provide Second Tranche financing.

The Third Tranche is derived from the yields that investors seek in the most "junior
tranche," which includes the remainder of the loan up to 100 percent LTV. The Third Tranche is
a highly leveraged position most often characterized as equity, whose investors are typically
entrepreneurial investors seeking the smallest amount of risk with a high overall internal rate
of return of between 18-40 percent.

The appropriate interest rate for the proposed plan is then calculated by averaging the three
interest rates. See, e.g., <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Bloomingdale Partners, 155 B.R. 961, 984-85 (Bankr. N.D. Ill.
1993)</a>. Therefore, the Tranche Method proves useful in calculating the allegedly appropriate
market rate of interest where financing vehicles on comparable loan collateral are readily
available in relation to each Tranche.

Despite the appeal of these calculations, though, expert testimony remains pertinent to
determine each Tranche's interest rate. Further, although the Tranche Method attempts to
determine the market rate for a non-existent market, certain courts remain unimpressed and
deem the Tranche Method as another "forced loan." These critics claim that the closest interest
rate that applies is that in a workout situation.

4) The Workout Method. Some argue that the interest rate that theoretically applies in a
workout situation most closely resembles the involuntary relationship created in a cramdown
situation. After all, in a typical workout situation, the debtor and lender are stuck with one
another and must work out the default, which usually entails the application of a higher interest
rate to compensate for the lender's forbearance, similar to a plan of reorganization's pay-out
proposal. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Landing Associates Ltd., 157 B.R. 791 (Bankr. W.D. Tex. 1993)</a>.

In Landing Associates, the court determined the appropriate interest rate by comparing the
interest rate applicable to the bank under the loan agreement, the bank's costs of funds for five
years or more, the prime rate as of the confirmation hearing, and the interest rates at which
the bank made new apartment loans during the previous 42 months. The court found these rates
to be the "touchstone for what is a reasonable rate of interest as between the two parties."
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Associates, 157 B.R. at 821</a>. In calculating this interest rate, the court stated that
"cramdown is most analogous to a loan workout and, therefore, the interest rate on a similar
loan should refer to a workout rate of interest." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 821-22</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Stratford
Associates Ltd. Partnership, 145 B.R. 689 (Bankr. D. Kan. 1992)</a>.

However, the Workout Method closely resembles the Prevailing Market Rate Method in its
determination of the appropriate workout market rate. Further, although used by certain
courts, the Workout Method has not been as widely adopted as the Formula Method or the
Tranche Method.

<h3>Conclusion</h3>

While courts remain silent on the appropriate cramdown interest rate, practitioners are left to
their own devices in deciding how to present their arguments, and must wisely choose experts,
as their testimony proves so crucial.

In choosing an acceptable expert, practitioners should carefully examine his or her background,
experience and methodologies. Particularly, beware of methodologies that are novel and not
often used, as they may prove fatal. Further, it may prove wise to closely examine the
opponent's methodology for later attack, leaving yours the only expert testimony in evidence.

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Journal Authors

Bruce H. White

William L. Medford

Journal Date

Wednesday, December 1, 1999 - 12:00