The Supreme Court’s Till Decision and Its Impact on Chapter 11

By Robert J. Mendes

On May 17, 2004, the United States Supreme Court issued its decision in Till v. SCS Credit Corporation, 124 S.Ct. 1951 (2004). Till resolved a split in authority regarding how bankruptcy courts should determine cram down interest rates in Ch. 13 cases. The decision has generated significant commentary, some of which has suggested that Till might not apply to Ch. 11 cases. As discussed below, the better reading of Till is that it does apply.

WHAT HAPPENED IN TILL?

In order to talk about the reasons Till applies to Ch. 11 cases, one first needs to understand the holding and the logic behind it. Till was a typical Ch. 13 case. The parties disagreed about what the cram down interest rate should be for the creditor who financed the Tills' purchase of a used truck. The Supreme Court ruled that the "formula approach" should be used. This approach starts with a relatively risk-free rate such as the prime rate and adds an appropriate risk adjustment. In adopting the formula approach, the Court rejected three competing approaches – the presumptive contract rate (which started with the contract rate and let parties argue for upward or downward adjustments), the coerced loan (which generally chose a market rate for a loan like the one contemplated in a reorganization plan, except to someone who had not filed bankruptcy) and the cost of funds approach (which provided only a relatively risk-free rate like the prime rate).

In choosing the formula approach, the Court explained that it wanted to compensate creditors for the time value of money without providing any upward adjustment for profit, transaction costs or any factors that were specific to the creditor. The only upward adjustment above the prime rate allowed now is for a "risk adjustment" based on the "estate's circumstances, the security's nature, and the reorganization plan's duration and feasibility." The Court ruled that the "[bankruptcy] court must hold a hearing to permit the debtor and creditors to present evidence about the appropriate risk adjustment." While the Court did not formally decide the issue, it stated in dicta that an appropriate risk adjustment would be 1-3% above the prime rate. The Court acknowledged that this approach puts the evidentiary burden "squarely" on a creditor to provide evidence supporting any upward risk adjustment that it proposes.

Because Till set the starting point for cram down interest rates at the prime rate, and placed the evidentiary burden on creditors to demonstrate the size of any upward risk adjustment, some institutional creditors are distressed about the decision. These creditors had been engaged in a long-term campaign to convince courts to adopt the more creditor-friendly presumptive contract rate approach. Till has now clearly ended that campaign in connection with Ch. 13 cases. However, since the Court did not expressly apply the holding to Ch. 11 cases, that debate continues.

PLURALITY, CONCURRENCE AND DISSENT

In addition to the basic holding, to understand Till, you have to be aware of the unusual alignment of the Justices. There was a plurality decision that endorsed the formula approach (Stevens, Souter, Ginsberg and Breyer). Justice Thomas concurred in the holding that the debtor should win the appeal, but argued for the cost of funds approach. There was also a dissent that preferred the presumptive contract rate (Scalia, Renquist, O'Conner and Kennedy).

Despite the fact that there was no majority opinion, the plurality and the dissent shared substantial philosophical common ground. Justice Thomas put it this way:

Both the plurality and the dissent agree that "[a] debtor's promise of future payments is worth less than an immediate payment of the same total amount because the creditor cannot use the money right away, inflation may cause the value of the dollar to decline before the debtor pays, and there is always some risk of nonpayment." Thus, the plurality and the dissent agree that the proper method for discounting deferred payments to present value should take into account each of these factors, but disagree over the proper starting point for calculating the risk of nonpayment. (internal citation omitted)

This common ground will likely shape the analysis regarding whether bankruptcy courts apply Till to Ch. 11 cases. It seems likely that, when discounting a stream of future payments in a Ch. 11 case, these eight Justices would decide that the proper discount method should take into account these same factors. It also seems likely that Justice Thomas's commitment to the cost of funds approach would not change in a Ch. 11 case.

WHAT WAS THE RATIONALE BEHIND TILL?

The last building block to thinking about whether Till will apply to Ch. 11 cases is the rationale behind choosing the formula rate. The Court described three important considerations.

First, the Court observed that the "Code includes numerous provisions that, like the cram down provision, require a court to 'discoun[t] . . . [a] stream of deferred payments back to the[ir] present value.'" The Court explained that it believed Congress intended to have bankruptcy courts choose discount rates in the same manner, no matter which of the numerous provisions was at issue.

The Court's list of "numerous provisions" included seven subsections of §1129(a) and (b), including the Ch. 11 cram down provisions analogous to the Ch. 13 cram down provision being analyzed by the Court. The implication is clear – to the extent that §1129 requires discounting a stream of payments, and to the extent that Congress intended bankruptcy courts to determine interest rates in a consistent manner, then a case about a cram down interest rate in a Ch. 13 case should apply in a Ch. 11 case.

The Court's second consideration was that Ch. 13 "expressly authorizes a bankruptcy court to modify the rights of any creditor whose claim is secured by an interest in anything other than 'real property that is the debtor's principal residence.'" For this, the Court cited §1322(b)(2) of the Code. While not mentioned in Till, Ch. 11 has an identical provision at §1123(b)(5). So, this second consideration appears to apply in Ch. 11 cases as well.

The third consideration was that cram down should provide an objective inquiry, not a subjective one. By this, the Court meant that the Code simply provides that secured creditors are entitled to the present value of their collateral. The Code does not require debtors to match the terms of the pre-bankruptcy loan, "nor does it require that the cram down terms make the creditor subjectively indifferent between present foreclosure and future payment." So, instead of considering a creditor's individual circumstances, the cram down analysis should endeavor to "adequately compensate all such creditors for the time value of their money and the risk of default." This consideration should also apply in Ch. 11 cases.

FOOTNOTE 14: THE COURT LEFT THE DOOR OPEN TO FURTHER DEBATE

In discussing the third consideration – that a creditor's specific circumstances are not relevant to determining the cram down interest rate, the Court observed that Ch. 13 creditors subject to cram down would, by definition, prefer to foreclose and get their collateral back. The Court then dropped footnote 14, which states in part: "Interestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. * * * Thus, when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce."

This footnote, which describes in dicta one of the three considerations that led the Court to choose the formula approach, has been interpreted by some to mean that Till will not apply to Ch. 11 cases. This conclusion is premature and perhaps overstated.

TILL APPLIES TO CH. 11 CASES

As an initial matter, the suggestion in footnote 14 that "it might make sense to ask what rate an efficient market would produce" is based on the premise that there are lenders that provide financing for Ch. 11 debtors. In support of this premise, the Court referred to two web sites offering debtor-in-possession ("DIP") financing. Several commentators have pointed out that this premise is flawed. The two web sites cited by the Court refer to interim financing based on collateralizing receivables for the period while a case is pending. This sort of DIP financing (which is governed by §364 of the Code and requires consent between debtor, lender and the bankruptcy court) is fundamentally different than a cram down loan over a creditor's objection. Except to the extent that a creditor can somehow show the existence of an efficient market for loans to debtors for the full value of collateral, the analytical crack in the door may be small.

Second, even assuming that there exists an efficient market for exit financing in Ch. 11 cases, then what? How would that fit in with the three considerations that led the Court to the formula approach? Remember that the Court held that creditors should be compensated only for the time value of money and a risk adjustment. The plurality was clear that it is not appropriate to compensate "lenders' transaction costs and overall profits that are no longer relevant in the context of court-administered and court-supervised cram down loans." And, remember that Justice Thomas opposed providing any return greater than the relatively risk-free prime rate.

So, with at least five Justices opposing the inclusion of profit or transaction costs in the discount rate for cram down, it would appear that a rate that our hypothetical efficient market might produce would be too high. It would have to be adjusted downward to eliminate profit and transaction costs. If faced with such a case, the Court would be right back to Till – should it start with prime and adjust upward for the risk of default, or should it start with the supposedly efficient market's rate and adjust downward to eliminate profit and transaction costs? There is little reason to think that the Court would do anything different than it did in Till.

Third, it is important to remember that footnote 14 introduces uncertainty regarding only one of three considerations that led the Court to adopt the formula approach. The other two considerations – that Congress intended bankruptcy courts to determine discount rates in a similar fashion regardless of the Code section involved, and that the Code expressly grants the power to modify a creditor's rights – remain unchallenged by footnote 14.

Last, especially in the context of the factors described above, it seems unlikely that dicta in a footnote will be enough to derail the long-standing practice of courts applying Ch. 13 cram down case law to Ch. 11 cases.

In conclusion, practitioners should expect creditors to explore the crack that the Court left open. However, the better analysis is that the Court's considerations described in Till will have a major impact on cram down interest rate calculations in Ch. 11 cases.