Author’s Note: A famous Holmes book—Sherlock, not Oliver Wendell—is titled The 7% Solution. In this piece, we have borrowed from that title to point out that some recent case law under 11 U.S.C. §1326 seems inclined to a rather Holmesian solution to adequate protection—”The 1 ½ Percent Solution.” This article points out that such neatly crafted mathematical solutions for adequate protection do not work, or at least do not work fairly—for, as Holmes stated—Oliver Wendell, not Sherlock—”The life of the law has not been logic; it has been experience.”
Pursuant to 11 U.S.C. §§1325(a)(5)(B)(iii)(I), added by the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA), for a chapter 13 plan to be confirmed, adequate protection payments are required “in equal monthly amounts” for claims secured by personal property. Pursuant to new §1326(a)(1)(C), payments must commence within 30 days of the order for relief.
This article reviews two decisions related to the amount and timing of adequate protection payments post-BAPCPA; Fin. Md. LLC v Smith (In re Smith), 355 B.R. 519 (Bankr. D. Md. 2006), and In re Desardi, 340 B.R. 790 (Bankr. S.D. Tex., 2006). These cases form the current “polar extremes.” This author suggests that Smith is the more correct interpretation of the statute, and bases this position on three concepts closely related to adequate protection.
Three Principles of Adequate Protection
1. Depreciation is happening daily and at different rates.
2. With BAPCPA, Congress has enacted a “no leap-frogging” statute, 11 U.S.C. §1326, meaning that no class of creditor may be paid ahead of a subordinate class, and therefore the priority system for administrative expenses may not jump ahead of secured claims.
3. In adequate protection, “timing is everything.” Specifically, a dollar next month is not the same as a dollar today. (i.e., the concept of present value).[1]
It is axiomatic that personal property collateral depreciates over time, though at different rates depending on the property itself and economic conditions. Because of the concept of the time value of money, creditors have long lamented that adequate protection payments that do not commence at or near the petition date do not adequately protect their interest, in particular considering the dismal success rate of chapter 13 cases.[2] Thus, the timing of adequate protection is a crucial feature to its effectiveness at neutralizing depreciation, i.e., being adequate.
In Smith, supra, a creditor moved to dismiss the debtor’s case for failure to commence making adequate protection payments. The debtor argued that because the creditor had obtained a judgment against the debtor pre-petition, the creditor was not entitled to adequate-protection payments. The court ruled that when the creditor obtained a judgment pre-petition, the entire amount of the claim became due before the petition date. Thus, the creditor was not entitled to receive adequate-protection payments for any “portion of the obligation that becomes due after the order for relief … under §1326(a)(1)(C).”
In its discussion, the court reviews the statutory language of §1325 and §1326 (post-BAPCPA) and, as is usual in statutory interpretation, tries to directly apply the language of the statute. In doing so, the court interprets §1326 to direct that for adequate protection to be “adequate,” it must be consistent and ongoing. In doing so, it stated, “The secured claim is proposed to be dealt with in a manner permitted under §1325(a)(5)(B) and (C). These provisions allow a debtor to pay the entire secured claim by a plan funded in equal installments over the duration of the plan with periodic distribution by the trustee to claimants. Where the claim is secured by personal property, the amount of such periodic distribution must be sufficient to provide the holder of the claim adequate protection during the period of the plan. 11 U.S.C. §1325(a)(5)(B)(iii)(II). Thus, a creditor in the situation of the movant in this case can also enforce adequate protection by objecting to a plan that does not provide a level of payments which would constitute adequate protection.” Smith, supra at 524-525 (Emphasis added).
To the author, this does not seem like a revolutionary principle but rather one that is intuitive. Based on the very dictionary definition of the words “adequate” and “protection,” consistent, fair payment is required to counter depreciation. However, more than keeping up with depreciation is required. In the face of depreciating collateral, if protection is not immediate and ongoing, it can hardly be “adequate.” In furthering this goal, Congress also mandated prompt confirmation of chapter 13 plans. See 11 U.S.C. §1324(b).
The Smith court notes that a plan that does not propose to pay a timely, adequate amount to a creditor is not subject to confirmation under §1325 in the first instance, and further, a plan that fails to commence payments in a timely manner is now subject to dismissal under §1307(c)(4).[3]
How Adequate Is Adequate?
Prior to BAPCPA, adequate protection for personal property had, to quote Judge Isgur’s term, “failed.” (i.e., arguably; payments had not fully protected the creditor’s contractual property rights.) However, this lack of protection was not universal. In the real estate mortgage arena, adequate protection on residences rarely “failed” because of the protection Congress has given under §1322 to first mortgage liens. Yet other creditors, specifically those secured by personal property, have not been as lucky. For instance, it was not unusual pre-BAPCPA to have a proposed adequate-protection payment (on, say, a late-model high-end truck) be a small fraction of the amount due under state law on the vehicle. The contrast with monthly real estate mortgage payments here is a stark one. The small (and late) payments received by personal property lenders did not adequately protect them. This was particularly so for a vehicle, such as our truck, that is more subject to either high use or abuse, or perhaps both.
The Smith court held that the provisions of §1325 and, under the right circumstances, §1326, though not always easy to discern under BAPCPA, were clearly discernable here. It was intended that if collateral were to be kept by debtors in chapter 13, they would pay adequate funds not only to meet depreciation, but also to adequately protect creditors who suffer from chapter 13’s ill effects. Otherwise, the property was to be returned to allow realization on the collateral security.
Enter Desardi
In Desardi, supra, the court took on the issues of both timing and priority of adequate-protection payments, as well as the appropriate interest rate for 910 car claims. Unfortunately, Desardi completely ignores the second principle, i.e., the “no leap-frogging” rules that Congress placed throughout BAPCPA, specifically in §§1325(a)(5)(B)(iii)(I) and 1326(a)(1)(C) (e.g., where DSO obligations are now ahead of all other claims to address prior concerns about unpaid support[4]).
Section 1326(a)(1)(C) makes it clear that irrespective of the plan administrative expense regime, somebody (debtor or trustee) has to immediately begin meaningful adequate protection or the debtor faces dismissal or relief. Nevertheless, the Texas court in Desardi has rejected this process; rather, there, the court found that Congress did not say anything about when payments to secured creditors need start. Desardi further advocates a 1½ percent “solution” as adequate for protection in all cases.[5] Apparently, the Desardi court believed that all vehicles depreciate at the amount of 1½ percent per month. Local rule or not, it would therefore appear that the Desardi court believes that there is no time value to money, or not much anyway, because its holding allowed adequate protection to commence later in the case, forcing the secured creditor to bear the entire risk of nonpayment.
The 1½ percent solution is arbitrary and not rooted to a fair system of repayment; even its math is questionable.[6] Such an analysis seems to ignore the fact that there is a time value to money and that the personal property being used is depreciating, although at varying rates, as is suggested herein. Further, this depreciation can only fairly be met through timely payments of adequate protection. This is what Congress seemed to be saying in §§1325(a)(5)(B)(iii)(I) and 1326(a)(1)(C).
The U.S. Supreme Court analyzed this adequacy issue, although in a different framework, and hit the nail right on the head. In the case of Till v. SCS Credit Corp., 124 S. Ct. 1951, 158 L. Ed. 2d 787, 541 U.S. 465 (S.Ct. 2004), the court struggled with setting a fair discount rate for payments by a debtor in chapter 13 on an under secured claim. As will be recalled in Till, the court set the “prime rate plus the risk factor” and reiterated that the reason for the payment stream, after all, is grounded in a constitutional property rights analysis. Adequate protection, and the income stream it supports, is a substitute for the creditor’s property that is being kept from them during the pendency of the case. Because the creditor is entitled to either the property or payment, the Till court reached a compromise, allowing an adjustment factor for risk and allowed the parties to prove up that risk. Desardi’s analysis ignores variable risk.[7]
With BAPCPA, the concept of adequate protection drastically changed, from a prior–to-confirmation analysis (all risk on the secured creditor) to the Till-oriented analysis of spreading the default risk to all parties in the case throughout the pendency of the plan. To pass constitutional muster now, adequate protection must not only be adequate until the time of confirmation, it must be adequate throughout the entire term of the plan.
As appeared to be the case in Desardi, in many cases it is no secret that the reason adequate protection payments are withheld decreased or “stair-stepped” is to pay attorney’s fees, although an accelerated mortgage cure or a tax claim could just as easily be present. While it is certainly understandable that the debtors’ counsel, or any creditor, might want to “front load” the plans and be paid as quickly as possible, it is a real policy concern as to whether or not that is appropriate or equitable. For instance, why shouldn’t the itinerant mortgage creditor or debtor’s attorney share the risk of default along with all the other parties as Till seems to dictate?[8] In a Desardi front-loaded plan, there is considerably less risk to the debtor’s counsel being paid than a plan where debtor’s counsel and all secured creditors get a substantial level payment over time. However, §§1325(a)(5)(B)(iii)(I) and 1326(a)(1)(C) contain a clear policy of “no leap-frogging” and will lead to equitable treatment.
Yet Desardi clearly comes down on the side of withholding payments to the secured creditor, resulting in a front-loaded plan paying debtor’s counsel or other special parties first. Frequently, the creditor loses in this depreciation equation. If one looks at the other changes with regard to priority that were also passed with BAPCPA, such as the revised administrative expense treatment for unpaid alimony and child support (DSO), it would seem that the existence of these legislative exceptions could also, by their very nature, demand consistent monthly payments. Congress has mandated that child support and alimony are priorities and therefore must be paid first. It seems inconsistent to suggest that these important payments can be retarded, for example, six, eight or more months, while tax claimants or debtor’s counsel or other preferred claims might get paid in full. There are certainly other reasons the debtor might want to retard payment to unsecured or secured creditors- i.e., there could be nondischargeable debts, or the debtor may wish to cure a mortgage on real estate or pay taxes. There are literally as many reasons for the delayed payment as there are types of debt. However, Congress, in changing the law and requiring prompt payment in §1326(a)(1)(C), has made a clear policy decision. The Desardi ruling with its form of analysis seems to have either given this policy less importance, or ignored it completely. The Desardi court holds that car creditors are to be paid before debtor’s counsel, but this is cold comfort if all payments are held until confirmation and then disbursed on the 1½ percent basis.
The Smith Solution
In Smith on the other hand, the court attempts to apply amended §§1325 and 1326 language and states that adequate protection must be paid every month for it to be adequate and consistent. Smith also reiterates a secured creditor’s right to relief in the absence of such payments. It held that although a dismissal motion was denied, in chapter 13 plans, adequate protection payments must begin within the 30 days after filing, and continue, for any creditor with a right to receive adequate protection payments that became due after the relief order. Otherwise, the debtor may face relief or dismissal under 11 U.S.C. §1307(c)(4).[9]
The Desardi court finds nothing in 11 U.S.C. §1326 mandating when secured creditors must be paid adequate protection. It holds that other claims may be paid before adequate protection per 11 U.S.C. §§507 and 503(b), allowing some claims not mandated by Congress to be paid first, to the prejudice of all other creditors. Smith holds that this violates 11 U.S.C. §§1326 and 1307(c)(4), and will lead to unnecessary relief motions.[10]The Desardi 1½ percent solution to balance these payments is no “solution” at all but rather a “watering down” of 11 U.S.C. §1326’s new requirement. It is an attempt to put “old wine in new bottles” and return to the pre-Code status that Congress rejected. Smith upholds the concept of immediate level payment to provide adequate protection, or risk dismissal. This is consistent with the Code and the legislative intent of 11 U.S.C. §§1325 and 1326, under the BAPCPA changes.
Should Adequate Protection Be an Administrative Expense?
One recent commentator, when discussing DeSardi, indicated that an argument exists that delayed §1326(a) adequate protection payments may qualify as administrative expenses. And why not? As Carlson puts it:
… His justification is that car lenders can be paid immediately upon confirmation because adequate protection is an administrative expense of the bankruptcy estate. “Debtors in chapter 13 often need their vehicles to drive to work, which in turn allows for preservation of the estate.” [n. omitted].
…According to Judge Isgur, not only is depreciation an administrative expense but a superpriority administrative expense, thanks to §507(b)[n. omitted]. On this premise, the car lender should outrank the other administrative creditors and should receive the first distributions from the chapter 13 trustee’s funds.
…But in chapter 13, all we learn is that the administrative creditors can be paid over time (but must be paid in full). [n. omitted]. This rule does not mention §507(b), but presumably it too can be paid over time. Meanwhile there is no reason to suppose other creditors cannot be paid before the §507(b) claim is fully paid. [n. omitted].
…Yet §1326(b) requires that administrative creditors be paid before the ex-spouse. [n. omitted]. If this is so, it is hard to see how the invocation of §507(b) justifies senior adequate protection payments for car lenders. [n. omitted].
Judge Isgur’s conclusion requires the view that, if depreciation exceeds the secured claim at any time, adequate protection has “failed,” thereby triggering the remedy of the §507(b) superpriority. [n. omitted].
…Sometimes, attorneys and other professionals are given provisional payments under Bankruptcy Code §330, but later it turns out the bankruptcy estate is not large enough to pay all the administrative creditors. In such cases, at least some courts are prepared to call back the interim compensation so that the professionals have to share the loss pro rata with the other administrative creditors. [n. omitted]. But, if adequate protection payments are administrative claims, then these too would have to be called back, in case of shortfall. No one would dream of requiring this, yet it is the consequence of terming adequate protection an administrative expense of the bankruptcy estate. Per this reductio ad absurdum, adequate protection cannot be founded on administrative priority. [n. omitted].
Carlson, David G., "Cars and Homes in Chapter 13 After the 2005 Amendments to the Bankruptcy Code," 14 Number 2 Am. Bankr. Inst. L. Rev. 301, pp. 327-330, (Winter 2006).
This article argues that all pat formulae such as the 1½ percent solution are suspect, if not patently unconstitutional. However, for those who need a formula to approach the adequate protection issue, this author suggests the following one as more tied to the depreciation experienced:
Adequate Protection = Claim Principal x Discount Rate ÷ Applicable Commitment Period.
This formula reflects the principle that depreciation happens at different rates. This formula has much to recommend it. First, it is simple. Second, it reflects the statute. Third, it lends itself to plan completion. It is based on the repayment of the income stream in the amount of the claim over time. It is not based on an arbitrary number; but rather on the amount required to be repaid at an agreed interest or discount rate per Till. It also subsumes the amount required to repay the creditor for the collateral over time per §1325(a)(5) in a confirmable plan. This is not new; it is textbook chapter 11 fare. The collateral’s value, paid at a fair discount rate for the time value of money. It need be no more complicated than this.
Conclusion
Smith and Desardi each provide a lens through which to view adequate protection. Although not harmonizing with the new Code, the comparison with an administrative expense analysis focuses the issue. Congress did not wish to give secured creditors too favorable treatment, as an administrative expense might provide, but did require “fair” treatment as set out by Smith.
BAPCPA and experience dictate that the amount of the monthly payment to the plan should start immediately, and in an amount that will compensate for depreciation over the entire plan. The 1½ percent solution is arbitrary and does not reflect the experience of chapter 13 cases.
The national adequate protection debate must be solved in a fair but practical manner. To find some way to “frontload” the plan for any creditor for any reason is, per se, prejudicial to others unless Congress has approved the discrimination such as with the treatment of domestic support obligations. If anyone is being paid first, or at a more rapid rate than the plan can amortize, chapter 13 nationally will not harmonize the rights of all parties and may continue to experience its current completion rate, one that we all believe can and should be better.
[1] For those who need formulae: present value is PV=FV/(l+r)n, where PV is the present value, FV is the value at time “n,” r is the rate to be compounded each period and n is the number of periods.
[2] Carlson, David G.,"Cars and Homes in Chapter 13 After the 2005 Amendments to the Bankruptcy Code," 14 Number 2 Am. Bankr. Inst. L. Rev. 301, (Winter 2006), see page 381, n. 494, (37-60%).
[3] See, Smith, supra at 521, 523.
[4] 11 U.S.C. §507(a)(1).
[5] As the opinion recites, the 1½ percent figure followed by the Desardi court is ordained by local rule 4001. The Fifth Circuit invalidated a similar formula rule in In re Smithwick, 121 F.3d 211 (5th Cir. 1997).
[6] See Carlson, supra, at note 356, which states in applying the Desardi rule, which is now part of the Local Rule: “Actually, the $300 straight-line depreciation is 1.5 percent only for the first month. In the second month, it is 15.22 percent, because the numerator of $300 stays constant while the denominator decreases to $19,700. The local rule in question does require payments of 1.5 percent per month, which, if taken literally, would constitute $300 only in the first month and lesser amounts thereafter. Under the local rule read literally, the car never loses all its value.”
[7] The local rule also contains a 10-day notice provision of the setting of this adequate protection, but the 1½ percent figure is the basis of the amount applied.
[8] This risk sharing also requires debtors’ counsel to take a closer look at cases she is filing choosing those with a chance to complete, not just a chance to go five months to pay fees, or a preferred creditor.
[9] In Smith, under the facts 11 U.S.C. §1326(a)(1)(C) did not apply because a judgment had been obtained pre-petition and it was not being decelerated. Thus, although Smith explains the proper application of 11 U.S.C. §§1325 and 1326, its explanation of §1326’s broader effect is arguably obiter dictum.
[10] 11 U.S.C. §1307(c)(4) itself was not new law. Failure to make payments is a historic ground for dismissal.