Cramming Down in a Credit Crunch

By Robert J. Mendes

Cramdown interest rates in Chapter 11 bankruptcy cases are often speculative, hypothetical, and inexact.  Calculation of a suitable rate consistently poses challenges for bankruptcy courts; the task becomes even more daunting against the backdrop of an economic recession and a credit crunch.  Bankruptcy courts will have their work cut out for them in determining the appropriate cramdown interest rates for the bankruptcy cases headed their way in the current economic crisis.   This article examines how courts have applied Till v. SCS Credit Corp., 541 U.S. 465 (2004) to Chapter 11 cases and how current economic conditions may affect the analysis moving forward.

I.     Remembering Till

Since 2004, the applicability of the Supreme Court's plurality holding in Till to Chapter 11 cramdown cases has been hotly debated by bankruptcy  professionals.  Till was a Chapter 13 case in which the Court evaluated four of the most widely-used approaches for calculating a cramdown interest rate:  the coerced loan approach, the presumptive contract rate approach, the formula rate approach, and the cost of funds approach.

In Till, the Court concluded that all but the formula rate approach suffer serious flaws.  The formula approach, also referred to as the prime-plus approach, uses the relatively risk-free national prime interest rate as the starting point and adjusts upward based on certain factors, such as the debtor's creditworthiness.  According to the Court, the formula approach "entails a straightforward, familiar, and objective inquiry, and minimizes the need for potentially costly additional evidentiary hearings," (Till at 466) while the other approaches "[are] complicated, impose[] significant evidentiary costs, and aim[] to make each individual creditor whole rather than to ensure the debtor's payments have the required present value."  Till at 477.  Accordingly, the Court adopted the formula rate as the sole method for determining Chapter 13 cramdown interest rates.

After Till, some commentators doubted whether the holding would apply in Chapter 11 cases.  Skeptics pointed to Till's footnote 14, in which the Court noted that, while there is no readily apparent market interest rate in Chapter 13 cramdowns, "the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession."  Id.  The footnote contains internet links to market sources of interim financing, also known as DIP financing (as opposed to sources of long term exit financing).  The Court did not clarify whether the appropriate market rate should assume the feasibility of the debtor's long term financial plan, or not.  However, the Court's point seemed to be that, if there were an "efficient market" by which a rate could be determined, the market rate should be used.

This led some to conclude that Chapter 11 cases call for an efficient market rate of interest rather than a formula rate.  Others argued that the Till formula rate should apply to Chapter 11 cases.  They based their argument on the identical nature of the cramdown provisions and the fact that the underlying purpose of efficiency exists in both Chapters.  They also argued that there is no more of a free market of willing cramdown lenders in Chapter 11 than Chapter 13 cases.

II.     The "Hybrid" Approach

A review of post-Till case law reveals that both sides of the debate were right. That is, most courts currently apply, or claim to apply, a hybrid approach in which they use Till's formula rate in Chapter 11 cramdowns, but only if no efficient market exists.  See Bank of Montreal v. Official Comm. of Unsecured Creditors (In re American Homepatient, Inc.), 420 F.3d 559, 568 (6th Cir. 2005); General Electric Credit Equities, Inc. v. Brice Road Dev., L.L.C. (In re Brice Road Dev., L.L.C.),  392 B.R. 274, 280 (B.A.P. 6th Cir. 2008); Interim Capital, LLC v. Hank's Dock, Inc. (In re Seaspan Dev. Corp.), 2006 WL 2672298, *3 (E.D. Tenn. 2006); Mercury Capital Corp. v. Milford Connecticut Assoc., L.P., 354 B.R. 1, 13 (D. Conn. 2006); In re Winn-Dixie Stores, Inc., 356 B.R. 239, 255 (Bankr. M.D. Fla. 2006); In re Northwest Timberline Enter., Inc., 348 B.R. 412, 434 (Bankr. N.D. Tex. 2006).

An "Efficient Market"

The hybrid approach has led to a whole new wave of questions, including one that becomes increasingly important with the worsening of the nation's economy and credit markets: "What is an efficient market?"   Unfortunately, courts have yet to fully answer this question.  Even when courts hold that an efficient market does or does not exist in a particular case, they rarely provide reasoning.  Courts have taken a variety of approaches.

For example, in Mercury Capital Corp. v. Milford Connecticut Assoc., L.P., 354 B.R. 1 (D. Conn. 2006), the district court reviewed a bankruptcy court's decision to apply the formula rate after it had determined that no efficient market existed.   The bankruptcy court had considered the original contract rate of interest, as well as testimony that the debtor would have trouble finding a loan under current conditions from a third party at less than double the rate proposed by the debtor.  The district court held that the bankruptcy court "did not necessarily err as a matter of law" in applying the Till formula rate approach to a Chapter 11 plan, but nevertheless remanded because there was not enough evidence in the record to determine if an efficient market rate existed.  Mercury, 354 B.R. at 12.

According to the district court, "[n]either piece of evidence [offered]...[wa]s sufficient to establish whether or not an efficient market rate exist[ed] for the type of loan [the creditor] must give the debtor under the debtor's plan, and if so, what that interest rate [wa]s."  Id.  On remand, the bankruptcy court denied confirmation of the plan for lack of feasibility and never discussed the efficient market issue.  In re Milford Connecticut Assoc., L.P., 2008 WL 687266 (Bankr. D. Conn. 2008).  What evidence would have been sufficient in order to determine if an efficient market existed?  The court left this question unanswered.

Some courts claim to follow the hybrid approach while actually applying other already-rejected approaches, such as the presumptive contract rate approach.  For example, at least two courts since Till have deemed the original loan between the debtor and creditor evidence of the existence of an "efficient market," and then used that rate as the cramdown rate.  See e.g., Interim Capital, LLC v. Hank's Dock, Inc. (In re Seaspan Dev. Corp.), 2006 WL 2672298, *3 (E.D. Tenn. 2006) (District court affirmed a bankruptcy court decision to use the 4 percent contract interest rate, reasoning that the contract rate between the parties established "the market" and therefore should be applied to the secured creditor's claim.); see also, In re Sylvan I-30 Enter., 2006 WL 2539718, *7 (Bankr. N.D.Tex. 2006) (applying the variable rate set forth in the original loan to the cramdown loan).

In 2008, the Bankruptcy Court for the Southern District of Ohio put forth the following criteria for evaluating a proposed efficient market rate: (1) the priority of the lien securing the loan; (2) whether there exists an open, well-developed market for loans of the kind between the debtor and secured creditor; (3) the type of collateral involved; (4) the quality, age, and life expectancy of the collateral; (5) short or long term nature of the proposed term of the loan; (6) and the amount financed.  See General Electric Credit Equities, Inc. v. Brice Road Dev., L.L.C. (In re Brice Road Dev., L.L.C.),  392 B.R. 274, 280 (B.A.P. 6th Cir. 2008).  The second factor looks objectively to the existence of a market, while the other five seem to focus on a subjective evaluation of the rate's reasonableness.  The Bankruptcy Appellate Panel for the Sixth Circuit upheld the Bankruptcy Court's finding under these criteria that the interest rate proposed by the debtor's plan was appropriate.  Id. at 281.  It remains to be seen whether these criteria will be used by other courts.  However, courts that wish to use these criteria still must determine whether an "open, well-developed market for loans of the kind between the debtor and secured creditor" exists.

At least one court has focused on the difficulties with term "efficient" to support using the formula or prime-plus approach.  In re Northwest Timberline Enter., Inc., 348 B.R. 412, 434 (Bankr. N.D. Tex. 2006).  In Timberline, the court held that even if "there were a ready market of lenders willing to make an exit loan to the[] [d]ebtors similar to what [was] proposed" under the plan, the "market would have to be efficient for it to be all controlling."  Id.  The Court recognized that "[t]he market might, in fact, too highly assess the risk of (or unfairly put a taint on) the debtors coming out of bankruptcy."  Id.  After holding that no efficient market existed because there were no lenders willing to provide an exit loan "identical" to what was being offered under the plan, "other than perhaps a [wealthy] individual lender," the court applied the formula rate.  Id.

It appears then that Till has left room for courts to readily stake out both ends of the spectrum - that an efficient market exists or that one does not.  With the current credit crunch, it stands to reason that frequency of decisions determining that there is not an efficient market may increase.

Risk Adjustments

To the extent that a court may determine that there is no efficient market on which to base a rate, the risk adjustment process (or calculation of the "plus" in the prime-plus approach) may become the real battleground in the cramdown fight.  This is important because small changes in risk adjustments can mean the difference between a successful plan and a failing one.

Till did not specify the proper level of upward adjustment, but noted that courts have generally approved adjustments in the range of 1 to 3 percent. The rate should be ''high enough to compensate the creditor for its risk, but not so high as to doom the plan.''  Till, 541 U.S. at 467.  Many courts have stayed within the 1-3% range, but some courts have awarded risk adjustments well over 3 percent.   The court in Timberline, for example, held that the prime rate with an upward adjustment of 5.75 percent was appropriate.  348 B.R. at 434.  The primary factors courts consider are: (1) the estate's circumstances, (2) the security's nature, and (3) the duration and feasibility of the reorganization plan.   Till, 541 U.S. at 479.  Of these factors, the nature of the security and the plan's feasibility will probably provide the biggest challenges ahead for debtors because these are the factors most dependent upon the economy.

Evaluating the nature of the security, for example, entails appraising the value and assessing the liquidity of the collateral, and considering the uncertainty of the collateral's estimated value.  Each of these considerations is intertwined with economic conditions.  Instability in the economy creates uncertainty about the nature of the security, which translates to higher risk.

The economy also has an impact on the feasibility factor.  The Code defines "feasibility" as the likelihood that a plan will not result in the need for further reorganization.  Bankruptcy courts must determine whether a plan will likely generate sufficient cash flow to meet payment obligations.  Ordinarily, the court can rely on financial ratios, proxies, and other financial indicators in making this determination.  However, a credit crunch introduces new variables into the equation.  Businesses may be unable to take out loans in order to purchase the equipment, property or services they needs for daily operations, revenues may plummet due to consumer spending cuts, or a company on which the debtor's business relies may shut down.  For these reasons and probably many more, a credit crunch creates additional questions about the feasibility of a reorganization plan.

A declining economy puts all businesses at a higher risk for failure, and the debtor in a Chapter 11 case is no different.  During this downturn, risk adjustments may reflect this higher uncertainty.

III.     Conclusion

With the economy in disarray, it may be more likely for courts to conclude that there is no efficient market for loans in question.  This may result in greater reliance on the formula approach.  Under the formula approach, creditors will undoubtedly urge courts to make large upward risk adjustments, citing high uncertainty about the value of the security and low likelihood of the feasibility of a proposed plan.  Whether courts will apply a consistent analysis remains to be seen.