What the Supreme Courts Prime Plus Ruling Means for Chapter 11
The Supreme Court recently issued a ruling of considerable importance for chapter 13 debtors seeking to invoke the cramdown provisions of §1325(a) (5)(B)(ii) of the Code to modify secured claims. In Till v. SCS Credit Corp., 124 S.Ct. 1951 (2004), a four-justice plurality of the Court ruled that the appropriate interest rate to be applied to installment payments under a chapter 13 plan is the national prime rate as adjusted to reflect the risks associated with the debtors. This column will briefly describe the ruling and focus on what it may mean for chapter 11 debtors seeking to invoke the cramdown provisions in §1129. (For a more detailed examination of the ruling as it affects consumer debtors, see Tom Yerbich's article.)
The Till case concerned a used truck purchased by the debtors for around $6,400 one year before their chapter 13 filing. They obtained a loan from SCS Credit for the full amount of the purchase price with a 21 percent interest rate that was to be repaid over a period of around two and a half years. At the time they filed their chapter 13 petition, they owed around $4,900 on the loan. The plan called for the debtors to retain the truck and make deferred payments over a two-year period based on the agreed replacement value of $4,000. The interest rate proposed in the plan was 9.5 percent, which was 1.5 percent greater than the prime rate of 8 percent that was in effect in late 1999 when the plan was presented. SCS Credit did not accept the plan, so the bankruptcy court needed to decide whether the chapter 13 cramdown provision in §1325(a)(5)(B)(ii) was satisfied. Under that section, the court needed to decide whether "the value, as of the effective date of the plan, of property to be distributed under the plan on account of such claim is not less than the allowed amount of such claim." The bankruptcy court confirmed the plan over the objection of SCS Credit, which had advocated for use of its 21 percent contract rate, a rate that its expert testified was the prevailing rate for subprime vehicle loans in Indiana at that time.
After appeals with varying results in the district court and the Seventh Circuit, the Supreme Court was presented with the question of whether the presumptive contract rate contended by the creditor or the formula approach advocated by the debtor should govern. In its examination of the issue, the court also considered the cost-of-funds approach, the coerced-loan approach and the riskless-rate method of discounting future plan payments to present value. The four-justice plurality approved the formula approach under which the national prime rate serves as a base rate and is adjusted for risk of default. In Till, the risk adjustment was only 1.5 percent, and the Supreme Court did nothing to displace that adjustment, noting that other courts had generally approved adjustments of 1 to 3 percent. The plurality was joined by Justice Thomas, who authored a concurring opinion rejecting the Seventh Circuit's presumptive contract rate approach. Justice Thomas read §1325(a)(5)(B)(ii) to require only an adjustment for the time value of money and would have approved using the prime rate with no upward adjustment. The four dissenting justices would have established a rebuttable presumption that the rate in the original loan contract should be used to make the present value determinations required by the Code. Thus, although the formula approach and the presumptive contract rate approach were endorsed by equal numbers of the justices, the formula approach carried the day due to Justice Thomas's concurrence.
Implications for Chapter 11
Given the similarity of chapter 13's present value requirement and the provisions of §1129(c) defining "fair and equitable" treatment for secured claims, one's first instinct might be to think that the Supreme Court's ruling would establish "prime plus one and one-half" as the presumptive discount rate to be used in evaluating cramdown plans under chapter 11. As explained below, there are many reasons why the Till ruling should not affect existing precedents under chapter 11. Most courts already use the formula approach to arrive at the discount or interest rate under chapter 11, and the Supreme Court expressly did not decide the appropriate risk adjustment. Beyond the inherent limits in the Supreme Court's ruling, there are other reasons why the Court's comments should not apply to chapter 11.
Implicit in the Supreme Court's ruling is the public policy notion that the chapter 13 process needs to be a streamlined one that does not impose undue burdens on debtors in obtaining confirmation of a debt-adjustment plan. In the plurality's opinion, the justices consciously put the burden on the creditor to rebut the proposed risk adjustment because lenders will have superior information on financial markets and are better equipped than financially strapped debtors to provide evidence that a higher risk adjustment should be used. The presumptive contract rate and coerced loan approaches were rejected because they would have imposed excessive evidentiary burdens on debtors. The plurality also observed that the job of the court is "to select a rate high enough to compensate the creditor for its risk, but not so high as to doom the plan." Id. at 1962. They acknowledged that a plan probably should not be confirmed if the risk of default was so high as to demand an eye-popping discount rate, but the Court's approach resolves most issues in favor of the consumer debtors.
Chapter 11 cramdowns do not implicate the same public policy concerns. Courts have recognized a congressional preference for reorganization over liquidation, but the entire structure of chapter 11, and the confirmation requirements of §1129 in particular, establish a comprehensive statutory regime that is not susceptible to modification based on general pro-reorganization policy grounds. There are many requirements that a chapter 11 debtor must meet before invoking the cramdown provisions, including the requirement that a class of impaired non-insider creditors affirmatively must accept the plan. Within the cramdown provisions, a plan must be fair and equitable and not discriminate unfairly against creditors or equity security-holders. There are several avenues that chapter 11 debtors may use to reorganize as of right, but those require that creditors be left unimpaired. For secured creditors, that most often means curing defaults and reinstating the original maturity of the loan. Instead of rewriting the interest rate, this avenue leaves the original contract rate and other terms intact.
Another difference between the chapter 11 and chapter 13 confirmation regimes is that in the chapter 11 context, the court views the feasibility of a plan in a more detailed fashion and is far more aware of the future uncertainties facing the debtor, and hence, the risk of future default under the plan. The chapter 13 court must find that the debtors will be able to make the payments under their plan. The analysis is largely based on the debtors' scheduled income, expenses and resulting disposable income as compared to the proposed plan payments. In chapter 11, the court needs to determine that confirmation will not likely be followed by the need for liquidation or further financial reorganization. To make that determination, the courts usually receive cash-flow projections covering the life of the plan and expert testimony supporting the myriad of assumptions that go into building the projections. Thus in chapter 11, the court will have sufficient evidence to evaluate the risks that the debtor's business may fail due to factors like declining rents or sales or increasing labor or health care costs for workers.
Establishing the Proper Base Rate
The debt structure of most chapter 11 debtors should not justify the use of the prime rate as the base rate in any formula-based determination of cramdown interest rates. The Till case endorsed the prime rate as the base rate in chapter 13, even though it is far from a perfect starting point in economic terms, as it is the rate that banks charge to creditworthy commercial borrowers where there is slight risk of default. 124 S.Ct. at 1961. For example, prime is a variable rate for unsecured loans to the most credit-worthy borrowers, and chapter 13 plans invariably include fixed rates where secured creditors retain their security. The dissent's opinion points out that the prime rate has historically tracked three-month treasury yields plus a margin of 2-3.5%, confirming that it is a short-term rate. 124 S.Ct. at 1974 n.10. Using this rate as the starting point for three- to five-year chapter 13 plans is problematic, but with modest amounts at stake in any given case, the court's approach has the benefit of expediency and supports the public policy of promoting consumer debt-adjustment plans.
In chapter 11, the prime rate will rarely, if ever, be the appropriate starting point for setting a cramdown interest rate. Using a variable rate like prime as the base rate would inject serious uncertainty into the debtor's feasibility analysis if the plan proposes to let the interest rate float with changes in the underlying prime rate. The risk could be covered by purchasing derivatives to hedge the risk, but the use of such hedges is far beyond the means of most chapter 11 debtors. As long as there is a market for fixed-rate term loans, there would seem to be little justification for using a variable rate like prime as the base rate in a chapter 11 cramdown analysis. Take the example of a neighborhood shopping center with a $20 million mortgage loan that the debtor proposes to pay off over 10 years. The far better starting point would be the market for fixed-rate mortgage loans with similar maturity. If the debt in question is a $1 million financing on high-tech manufacturing equipment used in a debtor's operations, the starting point should be the market for fixed-rate loans on comparable equipment with maturities most closely tracking the proposed payout period. The chapter 11 debtor can satisfy its burden of setting the correct base rate by market surveys or expert testimony from loan brokers or other financial sources.
Setting the Risk Adjustment Factor after Till
The Till case provides little guidance on how courts should set the risk-adjustment factor, but it is clear that the focus needs to be on the individual debtor's risk of future default. The dissenting opinion included a detailed analysis using generalized probabilities of default and resulting loss to the creditor to support the presumptive contract rate approach. 124 S.Ct. at 1973-76. Under the plurality's decision, however, it may be quite difficult for creditors to prove risk of future default by an individual consumer debtor by reference to averages or other generalized data.
In a chapter 11 cramdown, the risk premium to be added to the base rate will often be determined by a battle of the experts. If the base rate is chosen based on comparable collateral and loan maturity, it will undoubtedly need to be increased to compensate for risk under the chapter 11 plan. Uncertainties identified in testing the debtor's projections in the feasibility analysis will provide the basis for quantifying the risk of future default. The plurality in Till suggests that debtor-in-possession (DIP) financing rates might provide good evidence of a competitive market rate that could be used in a cramdown situation. Even there, the court ignores the fact that DIP lenders may require substantial overcollateralization, demand high up-front and exit fees, and only be willing to make short-term loans. If the cramdown plan involves the secured portion of an undersecured claim, the risk adjustment will be substantial. Unlike markets for 100 percent financing that may exist for vehicle loans and residential home-equity loans, mortgage lenders often required loan-to-value ratios of 80 percent or more and reserve their best rates for loans with ratios in the 60 to 70 percent range. Other factors that will require an upward adjustment of a base rate include the presence of any interest-only period at the outset of a loan, balloon payments due at the end of the term or the absence of late charges, default rates or remedy provisions found in normal commercial loans.
In short, chapter 11 debtors should not expect approval of cramdown plans at prime plus one and one-half based on the Till case. The debtor will have the burden of establishing a rational base rate, and debtors and objecting creditors will need to provide expert testimony to quantify the appropriate risk adjustment.