Bankruptcy

Applying Interest Rates to Cram-Down Proceedings

Bankruptcy Update

By Myron A. Bloom
Special to the Legal

A recent decision of the U.S. Supreme Court finally seems to have resolved an issue that has been the subject of much debate: the issue of what interest rate to apply to "cram downs" in Chapter 13 cases. The fact pattern presented to the court in Till v. SCS Credit Corp. was one typically faced by courts throughout the country, and one that brought the issue to a head in clear, precise terms.

Lee and Amy Till purchased a used truck from Instant Auto Finance. The total purchase price, including fees, was $6,725.75. After making a down payment of $300, the Tills owed the finance company, SCS, a total of $8,285.24 — $6,425.75 plus finance charges of $1,859.24 (a finance charge equating to 21 percent per year for 136 weeks, the length of the loan). The Tills agreed to pay the $8,285.24 in 68 bi-weekly payments. The finance company retained a purchase money security interest in the truck to allow it to repossess the truck in the event of default.

The Tills defaulted and eventually filed a joint Chapter 13 petition. In their Chapter 13 plan, they proposed to retain the truck. Both the Tills and SCS agreed that the truck had a value of $4,000. Accordingly, the plan called for SCS to receive $4,000 (the remaining amount owed was deemed to be an unsecured claim) with interest at the rate of 9.5 percent per year. The Tills proposed this rate, sometimes called the "prime plus rate" or the "formula rate," by taking the then-current prime rate of interest (at the time of the filing of the plan, 8 percent) and adding to it a "risk factor" to account for the possibility of non-payment by the Tills in the future.

SCS objected. It argued to the bankruptcy court that the appropriate interest rate to be applied to the treatment being "crammed down" on it should be 21 percent per year, the rate of interest provided for by the contract originally entered into between the Tills and the finance company. Its theory was that it should be entitled to a rate it could obtain if it foreclosed on the truck and reinvested the money in loans of equivalent duration and risk as that originally made to the Tills. At a hearing to consider the objection, SCS presented expert testimony that 21 percent was the uniform charge made on loans to borrowers, such as the Tills, who had poor credit ratings.

The Tills countered with their own expert, who testified that while he had only limited knowledge of the "sub-prime" market, the rate being proposed was fair since the plan, in order to be confirmed, had to be "feasible" and that SCS' exposure was fairly limited as the Tills were under the supervision of the court. The Tills' expert also stated that the "formula rate" being proposed by the Tills was supportable as being "easily ascertainable," "closely tied to the condition of the financial market" and "independent of the financial circumstances of any particular lender." The bankruptcy court, after considering the objection of SCS, overruled the objection and confirmed the plan.

SCS appealed to the District Court, which concluded that in its view that the 7th U.S. Circuit Court of Appeals had already concluded that the appropriate cram-down rate in such circumstances was the contract rate, a rate that had been established in this case by unrebutted testimony at 21 percent per year. It accordingly reversed.

This time, the Tills appealed, and the 7th Circuit reached yet another conclusion. The majority generally agreed with the District Court's view that in a cram-down proceeding, the inquiry should focus on the interest rate "that a creditor ... would obtain in making a new loan in the same industry to a debtor who is similarly situated, although not in bankruptcy." It stated that in reaching that rate, the pre-bankruptcy rate (here, 21 percent) should be a starting point.

However, the 7th Circuit stated that the contract rate would not precisely duplicate the present value of the collateral to the creditor because loans to debtors in bankruptcy involve some risks that would not be incurred in a new loan to a debtor not in default and at the same time may produce "some economies." To correct for these factors, the circuit court stated, the contract rate should be the "presumptive" rate, which either side could challenge by arguing for a higher or lower rate.

The circuit's decision was not unanimous. Circuit Judge Ilana Diamond Rovner dissented, arguing that the presumptive contract rate over-compensates creditors as it fails to take into account the costs to the creditor in issuing a new loan. Rovner argued instead for either the bankruptcy court's approach or a different approach — a "cost of funds" approach — which focuses on what it would cost the creditor to obtain the cash equivalent of the collateral from an alternative source.

She added that courts should "consider the extent to which the creditor has already been compensated for ... the risk that the debtor will be unable to discharge his obligations under the reorganization plan ... in the high rate of interest that it charged to the debtor in return for the original loan."

Thus, three different courts and four views. Certiorari was granted. And the U.S. Supreme Court, reflecting the variety of approaches, itself did not arrive at a majority; rather, its opinion found four justices finding in favor of the formula rate, one justice concurring in the concept of the formula rate and four justices dissenting.

Justice John P. Stevens, speaking for the plurality, began his analysis by recognizing that the Bankruptcy Code provides "little guidance" as to which rate to use. All Congress stated in section 1325(a)(5)(B) of the code was that a creditor receives over the life of a Chapter 13 plan a total value, as of the effective date of the plan, that equals or exceeds the vale of the creditor's allowed secured claim.

Obviously, stated Stevens, when a plan provides for a lump sum payment, this requirement is easily satisfied. However, when payments are proposed to be made over time, risks arise — not only the risk of non-payment, but also the risk that inflation may cause the value of the dollar to decline before payments conclude.

Three considerations, the court stated, govern the choice of a method. The first is that since the code contains many provisions that require courts to "present value" a stream of payments, it is likely that Congress would want courts to follow this methodology in circumstances such as this one. Second, it is clear that under Chapter 13, courts are authorized (with the exception of the debtor's principal residence) to modify the rights of a creditor whose claim is secured. Third, from the point of view of the creditor, the cram-down provision "mandates an objective rather than a subjective inquiry," citing Associates Commercial Corp. v. Rash.

In other words, although a creditor is entitled to receive property whose present value objectively equals or exceeds the value of the collateral, it does not require that the terms of the loan match the terms to which the parties agreed pre-petition, nor does it require that the terms make the creditor subjectively indifferent between present foreclosure and future payment. Courts, stated Stevens, should aim to treat similarly situated creditors similarly. An objective economic analysis will adequately compensate creditors for the time value of money and the risk of default.

Three of the four approaches, stated the court — the contract (or coerced loan) rate approach, the presumptive contract rate approach, and the cost of funds approach — do not further the above considerations. The coerced loan approach requires courts to consider evidence about the marketplace for comparable loans and over-compensates lenders because the market rate for loans of this type must be high to cover factors, like lenders' transactions and overall profits, which are not relevant in court-supervised and administered cram-down situations. The presumptive contract rate approach, like the coerced loan approach, improperly focuses on the creditor's potential use of the funds derived from a foreclosure.

Also, the ability to introduce evidence about a creditor to tailor the interest rate more closely to a creditor's financial circumstances, to be sure that the creditor is not overcompensated, would subject debtors to an expensive investigation into a creditor's costs of overhead, financial circumstances, and the like. Moreover, the use of this approach would produce "absurd results," entitling inefficient, poorly run lenders to obtain higher interest rates.

Finally, the cost of funds approach improperly focuses on the creditworthiness of the creditor, rather than the debtor, and itself has the same problem as the presumptive contract rate approach, requiring a debtor to expend significant resources to adequately determine details concerning the lender's financial condition. It actually would penalize a creditworthy lender with a low cost of borrowing.

By contrast, the formula approach has none of the problems set forth above. It starts by looking at a national rate — the prime rate — that is readily available. In adjusting that rate for a "risk factor," a court will clearly have to examine the circumstances of the estate, the nature of the security and the duration and feasibility of the plan. Some of this information, stated the court, will be in a debtor's bankruptcy filings. And by starting with a low number and adjusting upwards, the evidentiary burden is placed on the creditor, who has easier access to relevant facts (such as the liquidity of the collateral). This approach results in a much more straightforward and objective inquiry and minimizes the need for costly additional hearings, and does put the emphasis on the creditor's circumstances

SCS' core argument, stated the court, was that a risk adjustment in the range promoted by the plurality was "entirely inadequate" to compensate it for the real risk that the plan will fail. If that is true, stated Stevens, then a plan should never by confirmed in the first place, as it would likely not be found feasible and would not be confirmed in the first instance.

For all of these reasons, the formula rate approach was found in the plurality opinion to be the appropriate approach to take in determining the correct interest rate for Chapter 13 cram-downs. It remanded so that the Bankruptcy Court could fix the appropriate rate.

Justice Clarence Thomas concurred in the result. Emphasizing the need for a reading of the "clear text of the statute," he noted that Congress did not require a debtor-specific risk adjustment that would put secured creditors in the same position as if they had made another loan. The statute, stated Thomas, nowhere states that the proper interest payment must reflect the risk of non-payment.

Instead, it states that the court must value the "property to be distributed." "Thus, in order for a plan to satisfy section 1325(a)(5)(B)(ii), the plan need only propose an interest rate that will compensate a creditor for the fact that if he had received the property immediately rather than at a future date, he could have immediately made use of the property. In most, if not all, cases, where the plan proposes simply a stream of cash payments, the appropriate risk-free rate should suffice."

It makes no sense, stated Thomas, to speak of a debtor's risk of default being inherent in the value of property. As to SCS' argument that Congress included the requirements of Section 1325(a)(5)(B)(ii) for the protection of creditors, not debtors, Thomas said that the clear language of the statute suggested no such thing, adding that secured creditors are already compensated in part for the risk of non-payment through the valuation of the secured claim (citing Rash, in which the replacement value, rather than foreclosure value, was utilized in valuing secured claims). Risk of non-payment, though, can be a factor in determining the value of the property to be distributed. If the property to be distributed under the plan is a promise to pay, the value of that promise necessarily includes a risk that the debtor will not make good on the promise.

Accounting for that risk is not the same, however, as reading a risk adjustment into the statute. The only matter for discussion, therefore, was to determine whether the Tills' offer of a 9.5 percent interest rate to compensate for payments over time would sufficiently compensate SCS for the fact that it was not receiving $4,000 in cash on the effective date of the plan. Thomas concluded that it did.

Justice Antonin Scalia authored the dissent. Is the starting point appropriately set at the prime rate, a rate the dissent stated as something "we know is too low" and have judges in every case increase it? This approach, stated the dissent, will systematically under-compensate secured creditors. Better, stated the dissent, to start with the contract rate — the rate at which the lender actually loaned money to the borrower — and presume this is the correct rate for cram-down, which a bankruptcy court could revise on motion of either party. Using this rate, which the dissent states is generally a good indicator of actual risk, disputes should be infrequent and will provide a "quick and reasonably accurate standard."

This approach makes two assumptions, both of which the dissent found to be sound: First, it assumes that the sub-prime lending markets are competitive and thus efficient; and second, it assumes that the expected costs of default in Chapter 13 are no less than those at the time of lending. Court and trustee oversight, upon which the plurality rely in part, are over-weighed by two facts. One is that a borrower that has already resorted to the bankruptcy court for debt relief has already demonstrated financial instability. The other is that the costs of foreclosure in bankruptcy are higher than in the non-bankruptcy context since a creditor must obtain relief from the automatic stay.

The sum of these observations is that the contract rate reasonably reflects the actual risk at the time of borrowing, and the risk persists when a Chapter 13 case is filed. It follows, states the dissent, that the contract rate is a decent estimate — if not the lower boundary — for a cram-down interest rate. The argument advanced by the plurality, namely, that high interest rates should not become a substitute for confirming high-risk plans, does not supplant the fact that there is a high incidence of failure of Chapter 13 plans.

The most relevant factors in assessing risk premium, states the dissent, are (a) the probability of plan failure, (b) the rate of collateral depreciation, (c) the liquidity of the collateral market, and (d) the costs of enforcement. Under the formula approach adopted by the plurality, these "imponderables" will be left to judges. By contrast, under the contract-rate approach, the market will assess these risks.

As Scalia stated: "In sum, the 1.5 percent premium adopted in this case is far below anything approaching fair compensation. That result is not unusual ... it is the entirely predictable consequence of a methodology that tells bankruptcy judges to set interest rates based on highly imponderable factors. Given the inherent uncertainty of the enterprise, what heartless bankruptcy judge can be expected to demand that the unfortunate debtor pay triple the prime rate as a condition of keeping his sole means of transportation?"

Thus, to effectuate the intent of Congress that secured creditors require full risk compensation and because the valuation method proposed by the plurality does not have a realistic prospect of enforcing that intent, Scalia, joined by three other justices, dissented.

While the decision appears to be good news for Chapter 13 debtors, only time will tell whether the overall results will be of significance. Starting with the prime rate rather than the contract rate will in most cases be helpful to debtors. However, can debtors withstand the likely avalanche of contests to challenge plans with low interest rates? We will have to wait and see.

This article is reprinted with permission from the June 11, 2004 issue of The Legal Intelligencer.  Copyright 2004 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.