What the Supreme Courts Prime Plus Ruling Means for Chapter 11

<b>Editor's Note:</b>
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Also see a related article in this issue by Thomas J. Yerbich.
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<p>The Supreme Court recently issued a ruling of considerable importance for chapter 13 debtors seeking to invoke the
cramdown provisions of §1325(a) (5)(B)(ii) of the Code to modify secured claims. In <i>Till v. SCS Credit Corp.,</i> 124
S.Ct. 1951 (2004), a four-justice plurality of the Court ruled that the appropriate interest rate to be applied to
installment payments under a chapter 13 plan is the national prime rate as adjusted to reflect the risks associated
with the debtors. This column will briefly describe the ruling and focus on what it may mean for chapter 11 debtors
seeking to invoke the cramdown provisions in §1129. (For a more detailed examination of the ruling as it affects
consumer debtors, see Tom Yerbich's article.)

</p><p>The <i>Till</i> case concerned a used truck purchased by the debtors for around $6,400 one year before their chapter 13
filing. They obtained a loan from SCS Credit for the full amount of the purchase price with a 21 percent interest
rate that was to be repaid over a period of around two and a half years. At the time they filed their chapter 13
petition, they owed around $4,900 on the loan. The plan called for the debtors to retain the truck and make deferred
payments over a two-year period based on the agreed replacement value of $4,000. The interest rate proposed in the
plan was 9.5 percent, which was 1.5 percent greater than the prime rate of 8 percent that was in effect in late 1999
when the plan was presented. SCS Credit did not accept the plan, so the bankruptcy court needed to decide whether
the chapter 13 cramdown provision in §1325(a)(5)(B)(ii) was satisfied. Under that section, the court needed to
decide whether "the value, as of the effective date of the plan, of property to be distributed under the plan on account
of such claim is not less than the allowed amount of such claim." The bankruptcy court confirmed the plan over the
objection of SCS Credit, which had advocated for use of its 21 percent contract rate, a rate that its expert testified
was the prevailing rate for subprime vehicle loans in Indiana at that time.

</p><p>After appeals with varying results in the district court and the Seventh Circuit, the Supreme Court was presented
with the question of whether the presumptive contract rate contended by the creditor or the formula approach
advocated by the debtor should govern. In its examination of the issue, the court also considered the cost-of-funds
approach, the coerced-loan approach and the riskless-rate method of discounting future plan payments to present
value. The four-justice plurality approved the formula approach under which the national prime rate serves as a base
rate and is adjusted for risk of default. In <i>Till,</i> the risk adjustment was only 1.5 percent, and the Supreme Court did
nothing to displace that adjustment, noting that other courts had generally approved adjustments of 1 to 3 percent.
The plurality was joined by Justice Thomas, who authored a concurring opinion rejecting the Seventh Circuit's
presumptive contract rate approach. Justice Thomas read §1325(a)(5)(B)(ii) to require only an adjustment for the
time value of money and would have approved using the prime rate with no upward adjustment. The four dissenting
justices would have established a rebuttable presumption that the rate in the original loan contract should be used to
make the present value determinations required by the Code. Thus, although the formula approach and the
presumptive contract rate approach were endorsed by equal numbers of the justices, the formula approach carried the
day due to Justice Thomas's concurrence.

</p><h4>Implications for Chapter 11</h4>

<p>Given the similarity of chapter 13's present value requirement and the provisions of §1129(c) defining "fair and
equitable" treatment for secured claims, one's first instinct might be to think that the Supreme Court's ruling would
establish "prime plus one and one-half" as the presumptive discount rate to be used in evaluating cramdown plans
under chapter 11. As explained below, there are many reasons why the <i>Till</i> ruling should not affect existing
precedents under chapter 11. Most courts already use the formula approach to arrive at the discount or interest rate
under chapter 11, and the Supreme Court expressly did not decide the appropriate risk adjustment. Beyond the
inherent limits in the Supreme Court's ruling, there are other reasons why the Court's comments should not apply
to chapter 11.

</p><p>Implicit in the Supreme Court's ruling is the public policy notion that the chapter 13 process needs to be a
streamlined one that does not impose undue burdens on debtors in obtaining confirmation of a debt-adjustment
plan. In the plurality's opinion, the justices consciously put the burden on the creditor to rebut the proposed risk
adjustment because lenders will have superior information on financial markets and are better equipped than
financially strapped debtors to provide evidence that a higher risk adjustment should be used. The presumptive
contract rate and coerced loan approaches were rejected because they would have imposed excessive evidentiary
burdens on debtors. The plurality also observed that the job of the court is "to select a rate high enough to
compensate the creditor for its risk, but not so high as to doom the plan." <i>Id.</i> at 1962. They acknowledged that a
plan probably should not be confirmed if the risk of default was so high as to demand an eye-popping discount rate,
but the Court's approach resolves most issues in favor of the consumer debtors.

</p><p>Chapter 11 cramdowns do not implicate the same public policy concerns. Courts have recognized a congressional
preference for reorganization over liquidation, but the entire structure of chapter 11, and the confirmation
requirements of §1129 in particular, establish a comprehensive statutory regime that is not susceptible to
modification based on general pro-reorganization policy grounds. There are many requirements that a chapter 11
debtor must meet before invoking the cramdown provisions, including the requirement that a class of impaired
non-insider creditors affirmatively must accept the plan. Within the cramdown provisions, a plan must be fair and
equitable and not discriminate unfairly against creditors or equity security-holders. There are several avenues that
chapter 11 debtors may use to reorganize as of right, but those require that creditors be left unimpaired. For secured
creditors, that most often means curing defaults and reinstating the original maturity of the loan. Instead of
rewriting the interest rate, this avenue leaves the original contract rate and other terms intact.

</p><p>Another difference between the chapter 11 and chapter 13 confirmation regimes is that in the chapter 11 context, the
court views the feasibility of a plan in a more detailed fashion and is far more aware of the future uncertainties
facing the debtor, and hence, the risk of future default under the plan. The chapter 13 court must find that the
debtors will be able to make the payments under their plan. The analysis is largely based on the debtors' scheduled
income, expenses and resulting disposable income as compared to the proposed plan payments. In chapter 11, the
court needs to determine that confirmation will not likely be followed by the need for liquidation or further financial
reorganization. To make that determination, the courts usually receive cash-flow projections covering the life of the
plan and expert testimony supporting the myriad of assumptions that go into building the projections. Thus in
chapter 11, the court will have sufficient evidence to evaluate the risks that the debtor's business may fail due to
factors like declining rents or sales or increasing labor or health care costs for workers.

</p><h4>Establishing the Proper Base Rate</h4>

<p>The debt structure of most chapter 11 debtors should not justify the use of the prime rate as the base rate in any
formula-based determination of cramdown interest rates. The <i>Till</i> case endorsed the prime rate as the base rate in
chapter 13, even though it is far from a perfect starting point in economic terms, as it is the rate that banks charge to
creditworthy commercial borrowers where there is slight risk of default. 124 S.Ct. at 1961. For example, prime is a
variable rate for unsecured loans to the most credit-worthy borrowers, and chapter 13 plans invariably include fixed
rates where secured creditors retain their security. The dissent's opinion points out that the prime rate has
historically tracked three-month treasury yields plus a margin of 2-3.5%, confirming that it is a short-term rate. 124
S.Ct. at 1974 n.10. Using this rate as the starting point for three- to five-year chapter 13 plans is problematic, but
with modest amounts at stake in any given case, the court's approach has the benefit of expediency and supports the
public policy of promoting consumer debt-adjustment plans.

</p><p>In chapter 11, the prime rate will rarely, if ever, be the appropriate starting point for setting a cramdown interest
rate. Using a variable rate like prime as the base rate would inject serious uncertainty into the debtor's feasibility
analysis if the plan proposes to let the interest rate float with changes in the underlying prime rate. The risk could
be covered by purchasing derivatives to hedge the risk, but the use of such hedges is far beyond the means of most
chapter 11 debtors. As long as there is a market for fixed-rate term loans, there would seem to be little justification
for using a variable rate like prime as the base rate in a chapter 11 cramdown analysis. Take the example of a
neighborhood shopping center with a $20 million mortgage loan that the debtor proposes to pay off over 10 years.
The far better starting point would be the market for fixed-rate mortgage loans with similar maturity. If the debt in
question is a $1 million financing on high-tech manufacturing equipment used in a debtor's operations, the starting
point should be the market for fixed-rate loans on comparable equipment with maturities most closely tracking the
proposed payout period. The chapter 11 debtor can satisfy its burden of setting the correct base rate by market
surveys or expert testimony from loan brokers or other financial sources.

</p><h4>Setting the Risk Adjustment Factor after Till</h4>

<p>The <i>Till</i> case provides little guidance on how courts should set the risk-adjustment factor, but it is clear that the
focus needs to be on the individual debtor's risk of future default. The dissenting opinion included a detailed
analysis using generalized probabilities of default and resulting loss to the creditor to support the presumptive
contract rate approach. 124 S.Ct. at 1973-76. Under the plurality's decision, however, it may be quite difficult for
creditors to prove risk of future default by an individual consumer debtor by reference to averages or other
generalized data.

</p><p>In a chapter 11 cramdown, the risk premium to be added to the base rate will often be determined by a battle of the
experts. If the base rate is chosen based on comparable collateral and loan maturity, it will undoubtedly need to be
increased to compensate for risk under the chapter 11 plan. Uncertainties identified in testing the debtor's
projections in the feasibility analysis will provide the basis for quantifying the risk of future default. The plurality
in <i>Till</i> suggests that debtor-in-possession (DIP) financing rates might provide good evidence of a competitive market
rate that could be used in a cramdown situation. Even there, the court ignores the fact that DIP lenders may require
substantial overcollateralization, demand high up-front and exit fees, and only be willing to make short-term loans.
If the cramdown plan involves the secured portion of an undersecured claim, the risk adjustment will be substantial.
Unlike markets for 100 percent financing that may exist for vehicle loans and residential home-equity loans,
mortgage lenders often required loan-to-value ratios of 80 percent or more and reserve their best rates for loans with
ratios in the 60 to 70 percent range. Other factors that will require an upward adjustment of a base rate include the
presence of any interest-only period at the outset of a loan, balloon payments due at the end of the term or the
absence of late charges, default rates or remedy provisions found in normal commercial loans.

</p><p>In short, chapter 11 debtors should not expect approval of cramdown plans at prime plus one and one-half based on
the <i>Till</i> case. The debtor will have the burden of establishing a rational base rate, and debtors and objecting creditors
will need to provide expert testimony to quantify the appropriate risk adjustment.

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<h3>Footnotes</h3>

<p><small>^{<a name="1">1</a>}</small> Board Certified in Business Bankruptcy Law by the American Board of Certification. <a href="#1a">Return to article</a>

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