Ten years ago, this writer, with Judge John Pearson and Tim Nohr, delved into the fantasyland of the cramdown interest rate. 1 The practice involved hearings that proceeded like Alice’s Tea Party in search of the market rate for a 100 percent loan-to-value loan to a debtor with execrable credit and even poorer management skills.
The decision of the Supreme Court in Till gave hope that this exercise in futility might finally end, and it struck fear in lenders’ hearts by redefining their interest expectations as “prime plus a few points for risk.”2 By embracing the so-called “formula test,” Till arguably validates the key concepts of interest theory and the definition of present value.
In representing secured creditors, I take little comfort in desperate advocacy pieces that attempt to distinguish Till on various grounds. These writers clasp Footnote 14 to their breast as a ray of hope and a justification to litigate as before in the hunt for the elusive “market rate.” For review:
- FN14. This fact helps to explain why there is no readily apparent chapter 13 "cramdown market rate of interest": Because every cramdown loan is imposed by a court over the objection of the secured creditor, there is no free market of willing cramdown lenders. Interestingly, the same is not true in the chapter 11 context, as numerous lenders advertise financing for chapter 11 debtors-in-possession (DIPs). See, e.g., Balmoral Financial Corp., http://www.balmoral.com/bdip.htm (all Internet materials as visited March 4, 2004, and available in clerk of court's case file) (advertising DIP lending); Debtor-in-Possession Financing: 1st National Assistance Finance Association DIP Division, http://www.loanmallusa.com/dip.htm (offering "to tailor a financing program...to your business' needs and...to work closely with your bankruptcy counsel"). Thus, when picking a cramdown rate in a chapter 11 case, it might make sense to ask what rate an efficient market would produce. In the chapter 13 context, by contrast, the absence of any such market obligates courts to look to first principles and ask only what rate will fairly compensate a creditor for its exposure.
Till concerned a loan on a pickup truck. We will pass, for today, the fact that the Court ignored the active market in bad-credit, zero-equity consumer car financing at interest rates bearing little resemblance to prime. Instead, the Court looked to the “efficient market” that it imagined existed in chapter 11 debtor financing.
What are the practical issues for the lender going into trial on the cramdown interest rate? The reference to the debtor-financing market is encouraging because in all but the mega deals, the interest rates are likely to approach, if not exceed, double digits.
But ironically, when the ratios get so bad as to eliminate the debtor from any consideration by the “efficient market,” the secured creditor cannot offer market testimony. This leaves the creditor with nothing but the “formula method,” under which the creditor must fight to add a few points to prime. Not surprisingly, lenders may be constrained to make plan feasibility their primary front in the confirmation battle.
The premise of this article is that practitioners can no longer rely on the tried-and-true “layers of credit” and “blended-rate” models commonly presented before Till.
By way of review, we return to Alice’s Tea Party of old. We would present an “expert” who would testify as to the interest rates at various loan-to-value ratios and thus derive a (satisfyingly high) blended rate of interest. Our “expert” would testify with what Irving Younger termed the “confidence of a Christian holding four aces,” that the blended rate (and thus the appropriate cramdown rate) was precisely 12.16 percent. Typically, this “expert” was a consultant who had never underwritten a loan—a veritable poster child for a Daubert objection.3 But what choice did we have—forced by case law and practical concerns to deliver something that might help the court in determining a “market rate of interest” for a loan that never was and never would be made?
We are perhaps already grasping for straws in relying on Footnote 14, and it appears to this writer that bankruptcy courts will no longer accept testimony on the blended rate. A common-sense interpretation of the Till plurality opinion is that the Supreme Court would have little appetite for rejecting the formula method absent proof of an “efficient” (read “REAL”) market. The blended-rate presentation is a theoretical construct, not a “market rate.” We can only hope in the absence of a real market that the formula method can give the trial court ample room to adjust the risk to reality and still permit confirmation. One court’s eye-popping interest rate may seem perfectly appropriate to another. 4
Facing a trial on cramdown interest rates, the lender makes a risky (if not foolhardy) decision in presenting the tread-worn blended-rate ploy. 5
1 Pearson, Jackson & Nohr, “Ending the Judicial Snipe Hunt: The Search for the Cramdown Interest Rate,” American Bankruptcy Law Journal, Spring 1996.
2 Till v. SCS Credit Corporation, 124 S.Ct. 1951, 541 U.S. 465, 158 L.Ed.2d 787 (2004).
3 See www.daubertontheweb.com (providing all you ever wanted to know about busting or protecting phony experts).
4 Till at 1962 (“Together with the cramdown provision, this requirement obligates the court to select a rate high enough to compensate the creditor for its risk, but not so high as to doom the plan. If the court determines that the likelihood of default is so high as to necessitate *481 an "eye-popping" interest rate, 301 F.3d, at 593 (Rovner, J., dissenting), the plan probably should not be confirmed”).
5 For more on tread-wear, see Kumho Tire Co. v. Carmichael, 526 U.S. 137 (1999), but that is perhaps for another day.