UnTill We Meet Again Why the Till Decision Might Not Be the Last Word on Cramdown Interest Rates

Journal Issue

Dec/Jan 2004

Column Name

Journal HTML Content

t is often said that
"hard cases make bad law." When confronted with difficult
economic and financial questions, courts often render decisions that bear
little understanding of the actual workings of the market. Such decisions
frequently introduce unintended consequences and confuse, rather than
clarify, the issue at hand. This is the likely result of the recent Supreme
Court case that mandates the formula approach as the appropriate method for
determining interest rates on cramdown loans and imposes significant new
evidentiary burdens on secured creditors. Till
v. SCS Credit Corp., 124 S.Ct. 1951, 158
L. Ed. 2d 787 (2004).

<h4>The Case Background</h4>

The central holding in Till concerns the rate of interest to be applied in connection
with the chapter 13 reorganization plan proposed by the debtors, Lee and
Amy Till of Kokoma, Ind., on a $4,895 subprime loan secured by a used truck
worth $4,000. The debtors proposed a rate of 9.5 percent based on a
prime-plus formula approach supported by expert testimony of an Indiana
University-Purdue University-Indianapolis economics professor.<a href="#2" name="2a">2</a>

The bankruptcy court confirmed the plan over secured
lender SCS Credit Corp's objection that it was entitled to the
contract rate of 21 percent, the rate it would achieve if the creditor
foreclosed and reinvested the proceeds "in loans of equivalent
duration and risk...." The U.S. District Court reversed, finding the
creditor's coerced or forced-loan approach persuasive, and ruled that
21 percent was the appropriate rate. On appeal by the debtor, the Seventh
Circuit went further. It held that the contract rate should be the
presumptive rate that either party—debtor or creditor—could
challenge, and remanded the case to the bankruptcy court. The debtors
petitioned the Supreme Court, and certiorari was granted.

The Supreme Court found the formula approach to be the
proper method of determining the cram-down rate of interest on a secured
loan pursuant to a chapter 13 reorganization plan. In his plurality
opinion, Justice Stevens wrote that the formula approach "looks to
the national prime rate, which reflects the financial market's
estimate of the amount a commercial bank should charge a creditworthy
commercial borrower to compensate for the loan's opportunity costs,
the inflation risk and the relatively slight default risk. A bankruptcy
court is then required to adjust the prime rate to account for the greater
nonpayment risk that bankrupt debtors typically pose."<a href="#3" name="3a">3</a> Id. at 1953-1954. The amount of
the risk adjustment will depend on "such factors as the
estate's circumstances, the security's nature and the
reorganization plan's duration and feasibility...." Id. The Supreme Court ruled that
prime is the presumptive rate and concluded that "starting with a
concededly low estimate and adjusting upward places the evidentiary burden
squarely on the creditors, who are likely to have readier access to any
information absent from the debtor's filing...."<a href="#4" name="4a">4</a> Id. at 1961.

Not only did the Court find the prime-plus or formula
approach to be the proper basis for determining the interest rate on
cramdown loans, it critiqued the costs of funds, coerced loan and
presumptive contract rate approaches, setting forth the defects of these
methods. In general, the Court found these approaches objectionable for two
reasons: (1) They were complicated and thus would entail costly evidentiary
hearings and (2) they sought to make the creditor "whole"
rather than determine what rate would provide the creditor the present
value of its claim.

<h4>Implications for Chapter 11</h4>

The Court's mandate in favor of the formula
approach clarifies, to a great extent, how interest rates on cramdown loans
generally should be determined. However, for the practitioner, particularly
in a chapter 11 context, Till raises a host of issues and contains numerous internal
contradictions that inevitably will only be resolved upon application and
appeal.

Till involves a chapter 13 debtor and a $4,895 claim secured by a
used truck. Did the Supreme Court intend for its ruling to apply to chapter
11 cases that (1) involve businesses rather than individuals, (2) can be
exceedingly complex and (3) usually involve relatively sophisticated
parties and significantly greater amounts of debt?

The answer would appear to be a qualified
"yes." Early in his opinion, Justice Stevens points to the
numerous provisions of the Bankruptcy Code that incorporate a present-value
concept that necessarily requires an appropriate interest rate be
determined. He cites to chapters 11, 12 and 13 and writes, "[w]e
think it likely that Congress intended bankruptcy judges and trustees to
follow essentially the same approach when choosing an appropriate interest
rate under any of these provisions." Id. at 1958-1959.

So, why a qualified "yes"? In footnote 14 to the
decision—what certainly will be secured lenders' most
frequently cited reference to Till—the Court suggests that the market might provide
guidance in a chapter 11 context. The Court's decision to use the
formula approach appears very much influenced by what it viewed as an
inefficient market for subprime auto loans.<a href="#5" name="5a">5</a> In footnote 14, Justice
Stevens discusses the availability of DIP financing as evidence of a
readily observable market in the chapter 11 context. He then comments,
"[t]hus, when picking a cramdown rate in a chapter 11 case, it might
make sense to ask what rate an efficient market would produce." Id. at 1960 (fn. 14). So we are
left to wonder if footnote 14 nullifies Till in a chapter 11 context (or at least in instances
where efficient markets exist), modifies its application or is merely an
irrelevant musing.

<h4>Can a Rate Other than "Prime" Be Used as the Base Rate?</h4>

If footnote 14 opens the door for a market approach
(albeit in a manner devoid of the deficiencies associated with the
alternative interest rate-setting methods rejected by the Court), then
might a base rate other than prime be justified in certain circumstances?
Although prime (or, to go by the term more frequently used today, the
"reference rate") often is used by commercial banks and others
as a base rate for lending, it is by no means customary for long-term loans
or secured loans for certain asset classes, such as non-construction real
estate lending.

Prime is an administered rate established by each
bank. A "national" prime rate is published in the Wall Street Journal as the base
rate on corporate loans posted by at least 75 percent of the nation's
30 largest banks. As the Supreme Court correctly acknowledges, it already
includes some adjustment for the risk of borrower default,<a href="#6" name="6a">6</a> albeit the
very low default risk associated with commercial borrowers with excellent
credit.

Many commercial lenders have moved away from using
prime as a base rate to those that are more directly driven by the market.
Other common base rates, the use of which depends on the type of loan, its
duration (length) and lender circumstances, include LIBOR (London Interbank
Offering Rate), Federal Home Loan Bank District Cost of Funds Index (COFI)
and U.S. Treasuries. Financial markets generally consider these to be
"risk-free" or nearly risk-free rates. Lenders typically add an
adjustment or "spread" to the base rate to account for the risk
and other attributes associated with a particular loan in question.

<h4>Is the Rate to Be Fixed or Variable over the Life of the Plan?</h4>

In Till, the reorganization plan provided for the secured loan
to be repaid in equal installments over a 23-month period. The Supreme
Court does not say definitively whether the applicable prime rate plus risk
adjustment is to be a fixed rate over the 23-month period or if it will
vary with changes in prime. Given the relatively short time remaining on
the loan in question and the absence of any discussion regarding changes in
the prime rate (and, consequently, changes in the cramdown rate during the
life of the plan), the Supreme Court may have intended for the rate to be
fixed (or simply failed to recognize the issue).

An approach that sets prime at a specific rate for
the life of a plan is inherently problematic since prime, a variable rate
(often termed an "overnight" rate), fluctuates periodically and
does not incorporate any factor for the market's long-term
inflationary expectations. If prime is used as the base rate on a loan, the
customary market practice is to structure it as a variable rate loan.

Till provides little guidance for resolving this question. The
plurality cites plan duration as one of the factors to be considered in
determining the amount of the risk adjustment. There are two most likely
potential options. Either prime can be applied as a variable rate, or the
risk associated with the length of the loan (discussed further below)
should be considered as part of the risk adjustment.

<h4>How Does One Determine the Amount of the Risk Adjustment?</h4>

In choosing the formula approach over others, the
Supreme Court identifies four factors to be considered in determining the
amount of the risk adjustment over the prime rate: (1) circumstances of the
estate, (2) nature of the security, (3) plan feasibility and (4) plan
duration. In applying these factors, the Court makes frequent reference to
the need for an objective approach. It concludes that Congress intended
"an approach that is familiar in the financial community and that
minimizes the need for expensive evidentiary proceedings" (Id. at 1959) and makes clear the
Code's mandate for "an objective rather than a subjective
inquiry," one that ensures that "the debtor's interest
payments will adequately compensate all such creditors for the time value
of their money and the risk of default...." Id. at 1959-1960.

How does one quantify these factors in an objective
manner to determine the rate that provides creditors the present value of
their claims? In reviewing the factors cited by the Court, one is struck by
the similarity of these factors to customary loan underwriting criteria
applied by financial markets in evaluating credit risk. The logical
conclusion, then, is that one would look to the financial markets to help
quantify the risk adjustment. These markets are highly adept at pricing
risk, have developed sophisticated methods for doing so and apply readily
observable mechanisms for analyzing its various components, as discussed
below. Nevertheless, this approach cannot be applied with pure objectivity,
nor is it possible without significant evidentiary procedures,
particularly in complex chapter 11 cases.

Circumstances of the Estate. Although the Supreme Court gave little
guidance regarding its intent, we suggest that consideration of this factor
requires courts to evaluate plan sponsorship and characteristics of the
plan proponents. This is analogous to lenders' consideration of the
borrower and its sponsorship and, applied in a bankruptcy context, should
take into account such factors as the proponents' experience,
motivation, commitment and financial capacity to effectuate the plan (i.e., to repay the loan).

Nature of the Security. Courts must evaluate the value of collateral relative
to the amount of creditors' claims. Secured lenders determine the
value of collateral through appraisals and other objective methods, and
customarily apply measures such as loan-to-value ratios and advance rates
to determine maximum loan amounts and pricing. In doing so, lenders also
consider the uncertainty of the estimated value and its prospective
variability. Loans with higher loan-to-value ratios or advance rates are
relatively more risky than those with lower loan-to-value ratios since they
leave less cushion should a creditor need to foreclose in the event of
default. In evaluating security for a loan, lenders consider the liquidity
of the collateral, costs to foreclose and likely net recovery should they
need to exercise remedies.

Feasibility. The Code defines "feasibility" as the
likelihood that a plan will not result in the need for further
reorganization. Courts must determine whether a plan likely will generate
cash flow sufficient to meet payment obligations. Financial markets
customarily use measures such as debt-service coverage ratios and ratios
based on cash-flow proxies such as EBITDA (earnings before interest, taxes,
depreciation and amortization) to determine whether an enterprise is likely
to produce sufficient cash flow to meet debt service payments. A loan with
a higher coverage ratio is relatively less risky than a loan where the
cushion between cash flow and debt service is smaller. Credit ratings
criteria for publicly traded debt (published by agencies such as Standard
& Poors and Moody's), pricing on various tranches of asset-backed
securitizations and criteria published by lenders and third-party financial
research firms indicate how financial markets price this differential (as
well as the differential associated with differing loan-to-value ratios).

Duration. Duration requires that the risk and other factors
associated with the length of the plan be considered. The interest rate on
a dollar repaid in one year and the interest rate on a dollar repaid in
five years, all other things being equal, will be different. This is
because of (1) the market's inflationary expectations and interest
rate uncertainty and (2) the enhanced risk of non-payment associated with
longer duration. We can look to the yield curve on U. S. Treasuries to
ascertain the first of these. Because the treasury yield curve is
considered free of repayment risk, it does not address the second component
of duration risk, which might appropriately be considered in connection
with feasibility.

The four factors set forth by the Court are routinely
used by financial markets in pricing risk and generally are readily
observable in the market for commercial loans. This market-based approach
would appear to satisfy the Court's mandate for objective criteria,
although it takes subjective professional judgment to apply to each
debtor's circumstances. It also would be consistent with an approach
that "depends only on the state of financial markets, the bankruptcy
estate's circumstances and the loan's characteristics, not on
the creditor's circumstances or its prior interactions with the
debtor." Id. at
1961.

<h4>What Can We Expect Now?</h4>

The Court concludes in Till that the formula approach "entails a straightforward,
familiar and objective inquiry, and minimizes the need for potentially
costly additional evidentiary proceedings." Id. Precisely the opposite result is
likely to occur. By shifting the burden of proof to lenders and starting
with a presumptively low rate, Till virtually mandates that creditors mount
"potentially costly" oppositions to debtors' plans (and
that debtors respond accordingly) or risk being regularly undercompensated
for risk. Moreover, certain ambiguities in the opinion also mean that
inquiries as to the appropriate risk adjustment may be less than
"straightforward."

Wisely, Till stops short of dictating the amount of the risk adjustment.
However, in noting that courts "have generally approved 1-3
percent" as the proper risk adjustment (Id. at 1954), Till will inevitably, and perhaps inappropriately, frame
discussions as to the range of this adjustment.

The Supreme Court decided Till during a time when interest rates
were lower than most Justices can remember during their professional
careers. Against this backdrop, the respondent's contract rate of 21
percent may have struck some as "eye-popping." We are left to
speculate whether the outcome of Till would have differed had it been decided in
less-extraordinary financial times, the environment likely to prevail as
the decision's progeny are argued and decided.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> Ronald
Greenspan (West Region leader) and Cynthia Nelson are both senior managing
directors in FTI's Corporate Finance/Restructuring practice in Los
Angeles. For more information, please go to <a href="http://www.fticonsulting.com">www.fticonsulting.com</a> <a href="#1a">Return to article</a>

<a name="2">2</a> The
professor admitted that although he had limited familiarity with the
subprime lending market, the prime-plus formula approach of 9.5 percent was
"very reasonable." Prime rate at the time was about 8 percent. Till v. SCS Credit Corp., 124
S.Ct. 1951 at 1957. <a href="#2a">Return to article</a>

<a name="3">3</a> As will be
discussed further herein, Justice Stevens incorrectly states that the prime
rate takes into account inflation risk. The prime rate is a variable rate,
either used for short-term loans or reset as market conditions change, and
by its nature does not include a compensation for duration risk, which
includes long-term inflationary expectations. <a href="#3a">Return to article</a>

<a name="4">4</a> Stevens
writes that the adjustment over prime is required, since "bankrupt
debtors typically pose a greater risk of nonpayment than solvent commercial
borrowers...." Id. at 1961. However, he fails to acknowledge that many solvent
commercial borrowers who are not in bankruptcy may not qualify for a loan
at the prime rate. <a href="#4a">Return to article</a>

<a name="5">5</a> A view with
which we disagree, as did the dissent. <a href="#5a">Return to article</a>

<a name="6">6</a> The
Court's clarification in Till that prime is not a risk-free rate is welcome. The case
law has been burdened by numerous courts' mistaken usage of prime
rate as a risk-free rate. (See, e.g., In re
Fowler, 903 F. 2d 694, 697 (9th Cir. 1990),
the prior precedential case in the Ninth Circuit that endorsed the formula
approach and called for the interest rate to be determined by adding a risk
premium to a risk-free rate (sic), such as prime.) <a href="#6a">Return to article</a>

Journal Authors

Cynthia Nelson

Ronald F. Greenspan

Journal Date

Wednesday, December 1, 2004 - 12:00

Bankruptcy Rule

2004