Whats the Cramdown Interest Rate in Chapter 13: Supreme Court to Decide
On Dec. 2, 2003, the U.S. Supreme Court heard oral argument in Till v. SCS Credit Corp., no. 02-1016. At issue is the appropriate method to be used to determine the cramdown rate of interest applicable to secured claims in chapter 13 cases. Section 1325(a)(5) of the Bankruptcy Code requires that if the debtor proposes in his or her plan to pay a secured claim over time, and the debtor and secured creditor do not reach agreement on the amounts to be paid, the debtor's payments must include interest so that the total payments of principal and interest over time have a present value equal to the current amount of the secured claim. The appeals courts that have addressed the issue are currently split on the proper method to use in setting this rate of interest.
Although there is a consensus among the courts that the standard should be a "market" rate of interest, there is broad disagreement over how a "market" rate should be determined and whether, in the absence of evidence demonstrating a particular market rate, the pre-petition contract rate should serve as the presumptive rate. The three main methods that courts use to approximate a "market" rate are the "cost of funds" method, the "formula" method and the "coerced loan" method. The Seventh Circuit applied the "coerced loan" method in the Till case, which is also used by the Third and Fifth Circuits. Only the Second Circuit has explicitly rejected the "coerced loan" method.2
On Oct. 2, 1998, the Tills purchased a used 1990 Chevrolet S-10 truck from Instant Auto Finance for $6,395, plus fees and taxes of $330.75. The Tills made a down payment of $300 toward their purchase and financed the balance of $6,425.75 on credit, executing a retail installment contract in which they agreed to pay this balance over time in 68 bi-weekly installments. The installment payments included interest on the financed debt at the rate of 21 percent.
As security for the debt, the Tills granted Instant Auto a purchase-money security interest in the Chevy,3 vesting Instant Auto with the rights of a secured creditor.4 Thus, in the event the Tills defaulted under the installment contract (e.g., failed to make any of the installment payments when due), Instant Auto had the right to take immediate possession of the Chevy, sell it and use the proceeds to satisfy the unpaid portion of the Tills' obligation.5 Instant Auto also enjoyed a priority right to its collateral (the Chevy) ahead of the Tills' other creditors.6
After the Tills purchased the Chevy, Instant Auto assigned the installment contract to SCS. As a result, SCS acquired all of Instant Auto's rights as a secured creditor in connection with the Chevy, and the Tills made their installment payments to SCS.
The Tills filed for chapter 13 protection on Oct. 25, 1999. By this time, the Tills had missed several payments under the installment contract and were in default under the agreement. After they commenced their bankruptcy case, the Tills retained possession of the Chevy, and SCS filed a proof of claim in the amount of $4,894.89. The claim stated that SCS's claim was secured by a lien on the Chevy, which had a value of $4,000. Under the Tills' plan, the Tills proposed to retain the Chevy and pay SCS's secured claim in monthly installments with interest. Using the "formula" method, the Tills proposed an interest rate of 9.5 percent—less than half the 21 percent rate specified in the installment contract. SCS objected to the proposed rate of interest. Applying the "formula" method, the U.S. Bankruptcy Court for the Southern District of Indiana overruled SCS's objection. SCS appealed. The district court reversed, concluding that the appropriate rate of interest to use was the "market" rate determined by the "coerced loan" method. On further appeal, a divided panel of the Seventh Circuit agreed with the district court's adoption of the "coerced loan" method, but remanded with instructions to apply the method in light of the panel's elaboration of its methodology.7 The Supreme Court granted the Tills' petition for certiorari on June 16, 2003.
The Parties' Arguments
In their brief to the court, the Tills argued that the proper rate of interest should be based on the prime rate on the theory that (1) the prime rate already takes into account risk of non-payment and inflation, and (2) the secured creditor is protected against default and nonpayment by its ability to benefit from such measures as an assignment order directing periodic deductions from a debtor's wages.8 The Tills also argued that permitting a secured creditor to recover more than the prime rate would burden the debtor's rehabilitation and would infringe upon the policy of equality of treatment among creditors. The Tills were joined in their argument by the United States, which filed an amicus curiae brief in support of their position. Several other organizations also filed amicus briefs in support of the Tills' position, specifically the National Association of Consumer Bankruptcy Attorneys, National Association of Chapter Thirteen Trustees and American Association of Retired Persons.
In its brief, SCS argued that the essential purpose of interest, no less than the cramdown interest requirement of §1325(a)(5), is to compensate a secured creditor for the risks associated with a debtor's payment proposal. SCS contended that, given the high rate of default associated with chapter 13 plans, together with the associated costs of collection, the prime rate of interest does not come close to meeting the statutory standard. Although a secured creditor's lien in its (typically depreciating) collateral serves as a partial hedge against ultimate nonpayment, a secured creditor's compensation for the risks and costs associated with a debtor's chapter 13 plan is the interest that a secured creditor is entitled to receive. In order to properly compensate a secured creditor as the statute requires, SCS argued that the relevant interest rate should be a true market rate based on the rate that a particular debtor would pay to a willing lender on a loan of similar amount, duration and security. In the absence of evidence of a true market rate, SCS contended that the presumptive rate should be the rate of interest specified in the original contract between the parties on the theory that the contract rate is the alternative best evidence of a market rate between the parties. A group of commercial lenders filed an amicus brief in support of SCS's position.
During argument, the court focused questioning on the strengths and weaknesses of the different methods used to determine cramdown interest rates and the fairness of treating various creditors differently. The court asked why the bankruptcy judge should not use the prime rate as the starting point, with appropriate upward adjustments, to determine the proper cramdown rate. Counsel for SCS explained that, in practice, using the prime rate as the starting point has resulted in interest rate determinations that have systematically undervalued the true risks and costs associated with chapter 13 plans. Absent evidence of a true market rate, counsel argued that "the contract rate is the single best evidence of the market rate."9 Counsel also argued that, although the contract rate might not be a perfect measure, it is superior to the formula method because, "taking the extremely high risks of default and the costs of actually having to foreclose in the chapter 13 context, the relevant market rate for the value of the stream of payments is always going to be at least the pre-bankruptcy contract rate."10
Focusing on the equality-of-treatment issue, the court asked a hypothetical question involving two lenders that lent a subsequently bankrupt debtor $4,000, but one lent at the prime rate and the other at a subprime rate: "Why shouldn't those two lenders, both with $4,000 principals, be treated the same?"11 Counsel for SCS responded that if the two lenders had different risks, then their treatment should be different. Counsel added that the Tills had, in fact, broken down their four secured creditors into four different classes, and proposed to pay them different rates. "The concept of equality of distribution is precisely equality of distribution among similarly situated creditors," counsel explained, adding that secured creditors with different collateral and different payment terms face different risks, and thus may be entitled to different interest rates.12
The Justices asked additional questions regarding the risks involved in a chapter 13 bankruptcy, and in particular, why a party's solvency, income and record of payment should not be taken into account when determining the appropriate interest rate.13 Counsel for the Tills responded that the prime rate is appropriate because there are "provisions under chapter 13 that cover the types of risks that would normally be included in a contract." Counsel for the Tills later stated that there may be certain circumstances when an additional risk factor would be required, prompting the court to ask, "What is that premium going to be? Why shouldn't it depend on the transaction? Why shouldn't it depend on the risk of default?"14 When counsel for the Tills again discussed the lowered risk of a chapter 13 debtor with a wage assignment, the court asked if counsel really thought that "it makes a safer loan when you're...owed money by somebody who has already been through bankruptcy once?" The court similarly quizzed counsel for the government, asking why it wanted to "start with a figure that you know for sure is wrong. You know for sure that this person who got a 21 percent car loan because he was a bad credit risk was never going to get the prime rate of 8 percent... Why begin with something that you know is going to be abysmally low?"15
The issue of how to determine a cramdown rate of interest applicable to secured claims has fostered a great deal of disagreement and litigation not only in chapter 13 cases, but also in chapter 11 proceedings. Both parties urged the court to adopt a standard that would be both efficient and faithful to the governing statutory regime. Not surprisingly, each party challenged the efficiency and legitimacy of the method urged by the other side. A decision from the court is expected within the next few months.
1 G. Eric Brunstad Jr. argued the case on behalf of SCS Credit Corp. He is a partner at Bingham McCutchen LLP and the Macklin Fleming Visiting Lecturer of Law at the Yale Law School, where he teaches courses on bankruptcy law and secured transactions. Return to article
2 The Second Circuit uses the "formula" approach. Under this approach, a court derives the relevant rate of interest by taking the current prime rate (or treasury bill rate) and adding one, two or three percentage points to account for the debtor's risk of default and nonpayment. The Eighth and Ninth Circuits have endorsed the "formula" method, but have not set a strict formula. Instead, the Eighth and Ninth Circuits give discretion to the bankruptcy courts to determine the proper rate. Return to article