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December 10, 2012 Articles

Cram-Down Interest Rates: What Till Tells Us (or Not)

A used pickup truck may provide guidance for a multi-billion-dollar commercial mortgage portfolio.

By Jeffrey L. Baliban

The last two installments in this series focused on discount rate determination in assessing the solvency of a business. The dscount rate is applied to reduce forecast future cash flows to their present value and is designed to account for both the time value of money and a hypothetical buyer’s risk that actual cash flows may be different from the forecast. Cram-down interest rates present another circumstance where a series of future cash flows must be reduced to their present value, and an appropriate discount or interest rate must be determined and applied.

The decision to which most courts currently default on cram-down interest rates is Till v. SCS Credit Corp., 541 U.S. 465 (2004). This matter related to the purchase of a used truck by petitioners Lee and Amy Till in October 1998. The cost to the Tills was $6,725.75 ($6,395 for the truck and $330.75 in fees and taxes). They put $300 down and financed the remainder under a retail installment contract that was ultimately assigned to SCS Credit Corp. Within about a year, the petitioners were in default and filed a joint petition for relief under Chapter 13 of the U.S. Bankruptcy Code.

Cram Downs
Under Chapter 13, the Bankruptcy Code protects the interests of a secured creditor in the following ways:

  1. by giving the secured creditor the opportunity to consent to the debtor’s proposed repayment plan,
  2. by allowing the claim to be resolved by the debtor simply surrendering the property that is securing the claim, or
  3. by having the secured creditor retain a lien on the property and force it to accept payments that equal the present value of the secured creditor’s allowed claim.


See 11 U.S.C. § 1325(a)(5)(B).


Although you will not find the term “cram down” in any Bankruptcy Code section, that is what is being described in (3) above (the court is determining a solution that is feasible for the petitioners and cramming it down the objecting secured creditor’s throat). Chapter 11 allows for a similar cram-down process. See 11 U.S.C. § 1129(a)(7). Both sections 1129 and 1325 say that holders of a secured claim can receive deferred cash payments totaling an amount at least equal to the value of the allowed claim as of the effective date of the plan. This means that the present value of the deferred cash payments must at least equal the allowed claim amount. These deferred cash payments represent a series of future cash flows over some extended period; so, to state them at their present value, a risk-adjusted discount rate must be applied. First, it must be calculated, and here is where the fun begins.


What Till Tells Us
I read in a recent bankruptcy blog that, at a conference on restructuring commercial real estate loans, one financial advisor asked rhetorically, “Do you mean to tell me that I should look to a Chapter 13 case that set the cramdown interest rate on a used pickup for guidance on the correct rate under a Chapter 11 plan for a multi-billion-dollar commercial mortgage portfolio?” A fair question, the answer to which is yes, but perhaps not solely. See Adam Strochak, “A Cram Session on Cramdown Interest Rates,” Bankruptcy Blog, June 22, 2011. For an excellent matrix of reported cram-down decisions, see Weil, Gotshal & Manges, “Summary of Cramdown Interest Rate Cases.”


The U.S. Supreme Court receives about 10,000 petitions for certiorari each year. It grants and hears oral argument in only about 75–80 cases, so I always find it interesting how the Court determines which ones to hear. Even though this case was over a $4,000 used pickup, I understand the Court’s interest in this matter given the inability of the bankruptcy court, the district court, or the Seventh Circuit Court of Appeals to agree even on the proper methodology by which the discount rate should be determined, let alone what that rate should be.


The petitioners proposed a debt adjustment plan that would require payments over three years, including interest at 9.5 percent. (Note that the initial interest rate on the loan with SCS Credit Corp. was 21 percent.) The rate of 9.5 percent was based on a “formula” methodology that took the then 8 percent prime rate of interest (the interest rate that commercial banks charge their most creditworthy customers) and added an extra 1.5 percent premium to account for the risk of nonpayment. SCS objected to the proposed rate, saying it was entitled to the 21 percent rate because that is the rate it would obtain if it foreclosed on the vehicle and reinvested the proceeds on a loan of similar duration and risk.


At a hearing on its objection, SCS presented expert testimony that lenders in the subprime auto market at the time were actually making loans at 21 percent. The petitioners presented evidence on the overall reasonableness of 9.5 percent. The bankruptcy trustee also filed comments supporting the formula-based 9.5 percent rate, saying it was “easily ascertainable, closely tied to ‘the condition of the financial market,’ and independent of the financial circumstances of any particular lender.” Till, 541 U.S. at 472 (citing the appendix to the Petition for Certiorari at 41a–42a). The bankruptcy court accepted the petitioners’ evidence and overruled the respondent’s objection.


The district court reversed. It viewed the deferred payments made under the restructured loan as being imposed on the creditor. Therefore, the applied rate should be the rate the respondent would obtain if it foreclosed and reinvested the proceeds on a loan of similar duration and risk. Under this “coerced loan” theory, the court cited the respondent’s unrebutted testimony that 21 percent was not unusual for the subprime auto loan market, and concluded that 21 percent was an appropriate rate. This finding was appealed to the Seventh Circuit. There, the court modified the “coerced loan” theory, saying that the contract loan rate would not necessarily duplicate precisely the present value of the collateral to the creditor. In re Till, 301 F.3d 583, 591 (7th Cir. 2002). It noted that loans to bankrupt, court-supervised debtors involve some risks that would not be incurred in a new loan to a debtor not in default, and could also produce some economies as well. The court did say that the original contract rate could serve as a “presumptive rate” in cram-down circumstances, which either the creditor or the debtor could challenge with evidence that a higher or lower rate should apply.


The Seventh Circuit remanded the case to the bankruptcy court so that the petitioners and respondent could provide evidence on the presumptive 21 percent rate. In a dissenting opinion, Seventh Circuit Judge Rovner advocated either the bankruptcy court’s formula approach or a “cost-of-funds” rate based solely on what it would cost the creditor to obtain the cash equivalent of the collateral from an alternative source. She also pointed out that neither the “coerced loan” method nor the “presumptive rate” method gave consideration to the extent to which the original 21 percent loan rate had already compensated the creditor for the risk that the debtor would be unable to pay the original loan.


The Supreme Court pointed out that the Bankruptcy Code provides little insight into what Congress had in mind when it adopted the various cram-down provisions. It then rejected the “coerced loan,” “presumptive rate,” and “cost-of-funds” approaches, observing that each of these is complicated, could impose significant evidentiary costs, and improperly focuses on making creditors whole rather than on ensuring an appropriate present value of a debtor’s payments while maintaining the feasibility of the plan. The Court stated that the “formula” approach has none of these defects. It also supported uniformity by citing several provisions in the Bankruptcy Code that require a court to discount a stream of future cash flows to its present value. “We 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.” Till, 541 U.S. at 474. “Moreover, we think Congress would favor an approach that is familiar in the financial community and that minimizes the need for expensive evidentiary proceedings.” Id. Adopting the “formula” approach, the Supreme Court reversed the court of appeals’ judgment and remanded the case to the bankruptcy court for further proceedings “consistent with this opinion.” Id. at 465.


What Till May Not Tell Us
It must be recognized that the Supreme Court’s decision in Till was based on the specific set of circumstances in that Chapter 13 proceeding—things like the ability to ascertain with relative ease the state and the value of the collateral and to maintain control of its condition (or at least easily ensure it). Also, the debt adjustment plan here called for the Tills to submit their future earnings to the supervision and control of the bankruptcy court for three years so that the trustee could distribute as the plan required. This would give the trustee an effective ability to monitor the adequacy of the Tills’ capital and the continuing feasibility of the plan. Further, the expected volatility in the Tills’ expected earnings for the three-year period would likely be better known at the time of plan confirmation than, say, for a large multifaceted corporation emerging restructured from a lengthy and complex Chapter 11 proceeding. In such a case, the challenge of forecasting corporate earnings or cash flow into the future, maintaining control of capital adequacy, and evaluating the impact both the general and the local economies could have on expected earnings could be quite different. Where collateral is not a single asset but is instead a diverse portfolio of real estate, plant assets and equipment, and financial and derivative assets, the task of maintaining control of the collateral, or of predicting depreciation (or appreciation) of its value, could also be quite different. Further, many of the cash flow and financial condition projections of a complex corporate restructuring plan are often based on what other companies have demonstrated are possible or even likely. This leaves the court with the risk of whether or not current management will be able to create and maintain similar results.


This tells us what we already know—that it is easier to manage or hedge risk when you have a better idea of what the risks are and have clearer insight into the boundaries of how much or how little, whatever your expectations were when confirming the plan, could go awry in the fullness of time. Although the hope was that a Supreme Court decision in Till would provide clear, once-and-for-all guidance to be applied in every other circumstance on this issue, the basics of beginning with a known rate of low or no risk and then adding a premium to account for higher risk associated with the specific circumstances of the debtor makes good sense. Whether or not the base interest rate must be the national prime rate and any risk premium should be limited to an extra 1–3 percent, the facts and circumstances of each debtor and each property might require a further analysis.


For instance, many in the valuation profession were perplexed when the guidance on the “formula” approach was based on the prime rate. One may have thought that, if uniformity with other sections requiring a court to set a discount rate was what Congress intended, a better place to start may have been a risk-free Treasury bill. Most formulaic approaches to discount rate determination (such as the build-up method and CAPM) eschew the consensus nature and changeability of a national prime rate for the objectively stated value of a T-bill, especially because T-bills come in a variety of term lengths, which makes matching to any specific circumstances easier. Further, Till does not make clear the specific nature of the risks for which a premium over prime is necessary, nor does it show how the 1.5 percent risk premium over prime was selected or what risks specifically it was intended to ameliorate. It is unlikely that the Court is suggesting that adding a premium of 1–3 percent over prime can universally compensate for any and all nonpayment risks, no matter what the specific parties, collateral, or circumstances. It is more likely that the Court was limiting secured creditors to a basic time-value-of-money interest rate return plus a nominal adjustment for the risk of nonpayment. What it seemed to exclude was a profit margin (hence, the cram down). This would, however, ensure no development of a free market of willing cram-down lenders. The Court does, however, observe (in a footnote) that “[i]nterestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession.” Till, 541 U.S. at 476 n.14.


Leaving for another discussion the issue of what a market for debtor-in-possession financing says about the availability of secured “exit” financing, the interesting point is the section of the footnote that states “when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce.” In all likelihood, this puts things squarely back into the realm of significant evidentiary costs.


Last, the Sixth Circuit subsequently distinguished Chapter 11 from Chapter 13 in In re American Homepatient, Inc., 420 F.3d 559 (6th Cir. Aug. 16, 2005), aff’g 298 B.R. 152 (M.D. Tenn. May 15, 2003). In that instance, the court clearly felt that current generally applicable market rates are the best approximation of the present value of a secured claim. The story continues.


Keywords: bankruptcy and insolvency litigation, interest rates, repayment plan, formula approach, cost of funds, present value, deferred cash payments, bankruptcy, cash equivalent, capital adequacy, section 1129, section 1325

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