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).

The Case Background

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.²

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.

What Till Says You Can and Can't Do

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."³ 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...."⁴ 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.

Implications for Chapter 11

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.⁵ 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.

Can a Rate Other than "Prime" Be Used as the Base Rate?

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,⁶ 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.

Is the Rate to Be Fixed or Variable over the Life of the Plan?

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.

How Does One Determine the Amount of the Risk Adjustment?

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.

What Can We Expect Now?

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.

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Footnotes

¹ 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 www.fticonsulting.com Return to article

² 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. Return to article

³ 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. Return to article

⁴ 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. Return to article

⁵ A view with which we disagree, as did the dissent. Return to article

⁶ 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.) Return to article