Supreme Court Ruling on Cram-Down Interest Rates Creates Uncertainty - PDF document

Supreme Court Ruling on Cram-Down Interest Rates Creates Uncertainty for Secured Creditors Mark G. Douglas The ability to win court approval of a repayment plan or plan of reorganization over the objection of a secured lender by complying with the Bankruptcy Code's "cram-down" requirements is one of the most important debtor-friendly benefits of U.S. bankruptcy law. The Code's provisions governing cram-down of a secured claim strive to strike a balance between the "fresh start" policy imbued in federal bankruptcy law and the competing desire to compensate a secured creditor adequately for the risk of non-payment going forward and its inability to obtain immediate possession of its collateral. A ruling recently handed down by the U.S. Supreme Court, however, may have tipped the balance considerably in favor of debtors. In Till v. SCS Credit Corp. , the High Court ruled that the appropriate rate of interest that a debtor must pay when it confirms a chapter 13 repayment plan over the objection of a secured creditor should be determined according to the so-called "formula approach." Although the decision applies to debts secured by a lien on property other than a primary residence in consumer bankruptcy cases, whether or not it may have significant implications for lenders in other contexts remains to be seen. Cram-Down in Bankruptcy Chapters 11, 12 and 13 of the Bankruptcy Code contemplate the formulation of a repayment plan or plan of reorganization to deal with all creditor claims, both secured and unsecured. The plan must specify how the claim of each creditor (or class of creditors) is to be treated. Unsecured claims can be paid in full or paid a pro rata share of whatever unencumbered assets are available in the estate, in both cases either at the time the plan is approved, or "confirmed," by the NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016

bankruptcy court, or over time. A plan can provide for payment in full of a secured claim, surrender of the collateral to the secured creditor or, most commonly, the restructuring of a defaulted loan and the post-confirmation debtor's resumption of debt-service payments. If the plan treatment of a secured claim involves the cure of existing defaults, compensation of the creditor for losses occasioned by the breach and reinstatement of the debt in accordance with the terms of any pre-bankruptcy instruments or agreements that governed the loan, the secured claim is classified as "unimpaired." In a chapter 11 case, this means that the secured creditor is deemed to accept the plan, and it does not have the right to vote on it. By contrast, if a chapter 11 plan varies any of the creditor's legal rights and remedies by, for example, altering the interest rate or maturity of a loan or substituting new collateral, the claim is said to be "impaired," and the creditor has the right to vote to accept or reject the plan. If an impaired secured creditor votes to reject a chapter 11 plan, or a secured creditor in a chapter 12 or 13 case objects to the plan's treatment of its claim, the plan can be confirmed only if it satisfies the Bankruptcy Code's non-consensual confirmation, or "cram-down," requirements. Among other things, the statute — in chapters 11, 12 and 13 — allows a plan to be confirmed over the objection of a secured creditor if the creditor retains its lien on the collateral and receives property ( e.g. , a note) on the effective date of the plan valued at (at least) the full allowed amount of the creditor's secured claim. The intent underlying this provision is to place the secured creditor in the same position economically as if the debtor had chosen to surrender the collateral instead of retaining it. Given that the creditor will receive a stream of deferred cash payments rather than a lump sum of cash on the effective date, the maturity and interest rate of any new instrument governing the post-confirmation debtor's obligation are of NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016

vital importance in determining whether the creditor is getting property valued at the full amount of its secured claim. It is incumbent on the bankruptcy court to arrive at an appropriate discount factor that fairly discounts value that a plan proposes to pay a secured creditor over time. Courts disagree on how to do it. Some take the approach — the "presumptive contract rate approach" — that the interest rate originally specified in the debt instrument should govern the loan going forward. Others reject this method, preferring an approach that focuses on the creditor's cost of funds in its business lending transactions. Another method relied on by many courts — the "coerced loan approach" — is to set an interest rate by looking at the terms of comparable loans to similar (though non-bankrupt) debtors. Finally, some courts employ a "formula approach," whereby the cram-down interest rate is determined by augmenting a base rate (usually the national prime rate) with a risk factor add-on that can vary depending on the circumstances of the case. Which of these approaches is the right one was the question addressed by the Supreme Court in Till v. SCS Credit Corp. The Supreme Court's Ruling in Till Till involved an automobile loan in the amount of less than $7,000 secured by a lien on a pickup truck valued at approximately $4,000. The loan bore an annual interest rate of 21 percent. Under its chapter 13 plan, the debtor proposed to keep the truck, and to pay off the lienor's secured claim (bifurcated pursuant to section 506(a) into a $4,000 secured claim and an unsecured claim for the balance) over time with interest. The interest rate proposed was 9.5 percent, rather than 21 percent, a figure arrived at by augmenting the national prime rate of approximately 8 percent with a risk factor of approximately 1.5 percent. NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016

The lender objected, but the bankruptcy court confirmed the debtor's chapter 13 plan. That determination was reversed on appeal to the district court, which ruled that the original contract rate was the appropriate one. On further appeal by the debtor to the Seventh Circuit, the Court of Appeals endorsed a slightly modified version of the coerced loan approach, holding that the 21 percent contract rate should serve as the presumptive cram-down rate. The Supreme Court later agreed to hear the case to resolve a split in the circuits concerning the proper method to apply. The upshot was a plurality opinion. Four of the Justices joined by a concurring Justice ruled that the formula approach was the appropriate method to arrive at a cram-down interest rate. The remaining four Justices filed a dissenting opinion in which they argued that the rate specified in the original contract should be the presumptive cram-down rate to compensate the secured creditor adequately for the risk of non-payment going forward. Writing for the plurality, Justice John Paul Stevens rejected each of the other methods, reasoning that the formula approach "reflects the financial market's estimate of the amount a commercial bank should charge a creditworthy borrower to compensate for the opportunity cost of the loan, the risk of inflation, and the relatively slight risk of default." Stevens acknowledged that this approach should be applied with the recognition that debtors in bankruptcy typically pose a greater risk of non-payment. Still, the plurality opinion emphasized, the secured creditor bears the burden of demonstrating what the proper risk adjustment should be. The plurality rejected the other approaches because, in its view, they are "complicated, impose significant evidentiary costs, and aim to make each individual creditor whole, rather than to ensure that the debtor's payments have the required present value." By contrast, Justice Stevens wrote, the formula approach entails a straightforward and objective inquiry into the NYI-2168917v1 TillCramDownBRRArticleOctNov2004 JP003318 079983 - 041016