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In the recent decision Till v. SCS Credit Corp., 124 S. Ct. 1951 (2004), the U.S. Supreme Court waded into murky waters — the meaning of the Bankruptcy Code’s “cram down” provisions — and emerged with a 4-1-4 plurality decision that has far-reaching economic consequences for subprime lenders and secured creditors generally. The issue addressed in Till is common in bankruptcies: When the debtor seeks to cram down a plan over a secured creditor’s objection, what interest rate must the debtor pay to the secured creditor in order to have provided that creditor with the “net present value” of its claim? The Supreme Court (or at least the plurality opinion) adopted the so-called formula approach to the question of the applicable cram-down interest rate and allowed a borrower to write down a subprime loan to the prime rate, plus a small risk premium of 1.5 percent. The Till decision creates a mechanism for Chapter 13 debtors to cram down subprime lenders and reduce interest rates that likely exceed 20 percent per annum to something approaching that of a quality credit — the prime rate plus a small risk premium. Aside from individual creditors, the decision may affect the securitization market for portfolios of subprime loans secured by assets other than the principal residences of the individual borrowers, as those loans are now subject to significant readjustment in the bankruptcy process. Moreover, Till will also apply to business bankruptcies and will provide additional fodder for business debtors to squeeze secured lenders in contested bankruptcy confirmations. As with many bankruptcy cases decided by the Supreme Court, the matter involved a relatively minor amount — a secured loan on a 1991 Chevrolet S-10 truck purchased for the sum of $6,395, plus $330.75 in fees and taxes. As originally financed, the interest rate amounted to 21 percent per year for 136 weeks. The debtors defaulted and, subsequently, they filed a Chapter 13 bankruptcy case. At the time of the filing, the secured claim was $4,894.89, but the parties agreed that the truck securing the claim was worth only $4,000. Under �506(a) of the Bankruptcy Code, the claim was bifurcated, with the allowed secured claim set at $4,000 and the allowed unsecured claim (the balance) at $894.89. With respect to the secured portion of the claim, the proposed Chapter 13 plan provided that the debtors would keep the truck, and rather than pay the secured claim in full immediately, the debtors would provide the lender with the net present value of the claim by paying over time with interest. Rather than the original 21 percent rate though, the interest paid on that secured portion of the claim was proposed to be 9.5 percent per year, arrived at by augmenting the national prime rate of approximately 8 percent with a risk factor of approximately 1.5 percent. The hearing testimony adduced on the creditor’s objection to confirmation of the plan was not particularly informative. The debtors’ expert admitted that he had only limited familiarity with the subprime auto lending market, but offered the opinion that 9.5 percent was “very reasonable” given the fact that Chapter 13 clients “are supposed to be financially feasible.” 124 S. Ct. at 1957 The bankruptcy court overruled the creditor’s objection and confirmed the proposed plan. The district court reversed, finding that the cram-down interest rate should be set at the level the creditor could have obtained if it had foreclosed the loan, sold the collateral and reinvested the proceeds on loans of equivalent duration and risk (known as the “coerced loan” approach, as discussed below). Citing the unrebutted testimony of the creditor about the interest rate for subprime auto loans, the district court concluded that 21 percent was the appropriate rate. On appeal, the 7th U.S. Circuit Court of Appeals endorsed a slightly modified version of this coerced- or forced-loan approach and found that the contract rate should serve as the presumptive cram-down rate. The 7th Circuit found, however, that the debtors and their creditor should have the opportunity to rebut the presumptive contract rate (which would mean that the interest rate could be higher than the contract rate). By a 5-4 vote, the Supreme Court reversed and remanded the case. THE STATUTORY FRAMEWORK The term cram down is a bankruptcy term of art reflecting the confirmation of a plan (in this case, a Chapter 13 plan) over the objection of a creditor or class of creditors. In this context, with respect to secured claims, the debtor’s plan must provide that the creditor retain its lien on the property and receive distributions (often deferred cash payments) whose total value “as of the effective date of the plan … is not less than the allowed amount of such claim.” Bankruptcy Code �1325(a)(5)(B)(i) and (ii). The cram-down provision with respect to secured claims in a Chapter 11 case is substantially similar. The plurality took the view that Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate under any of the cram-down provisions of the Bankruptcy Code. 124 S. Ct. at 1958-59. The Supreme Court acknowledged the varying approaches of the lower courts in parsing the statutory requirement that a secured creditor receive property with a “total value, as of the effective date of the plan,” that equals or exceeds the creditor’s allowed secured claim. Those approaches include the coerced-loan, presumptive-contract-rate and cost-of-funds approaches. Rejecting each of those three approaches, Justice John Paul Stevens (writing for the plurality) instead adopted the so-called formula approach, reasoning that it “reflects the financial market’s estimate of the amount a commercial bank should charge a creditworthy borrower to compensate for the opportunity cost of the loan, the risk of inflation, and the relatively slight risk of default.” 124 S. Ct. at 1961. The formula approach, wrote Stevens, begins by looking to the national prime rate and adds to that a “risk factor” for a “prime-plus” rate. Stevens acknowledged that this approach should comprehend the fact that bankruptcy debtors typically pose a greater risk of nonpayment; yet the plurality placed the evidentiary burden squarely on the creditors to demonstrate the proper risk adjustment. The Stevens opinion focused on the debtor’s circumstances, rather than the circumstances of the creditor and noted that each of the rejected approaches was “complicated, impose[d] significant evidentiary costs, and aim[ed] to make each individual creditor whole rather than to ensure the debtor’s payments have the required present value.” 124 S. Ct. at 1960. The formula approach focuses on the objective criteria of the prime rate and the characteristics of the bankruptcy estate and the loan (as restructured), and does not focus on the creditor’s circumstances or its prior interactions with the debtor. Id. at 1961. However, the prime rate represents a short-term borrowing (often on a floating-rate basis), as opposed to a treasury bill rate, which may reflect inflation expectations and other economic expectations with respect to long-term indebtedness on a fixed-rate basis. A number of lower courts have used treasury bills and other “riskless rate” debt securities of equivalent maturity to reflect these kinds of economic factors. In addition, the Stevens opinion did not decide the “proper scale” for the risk adjustment although it did cite to cases approving a risk adjustment (in unrelated fact patterns) of 1 percent to 3 percent. 124 S. Ct. at 1962 (citing General Motors Acceptance Corp. v. Valenti, 105 F.3d 55, 64 (2nd Cir.) (collecting cases), abrogated on other grounds by Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997)). Chapter 11 litigants should be aware of those lower court decisions, especially those that use the so-called band-of-investment analysis in which the formula approach was utilized to the various tranches of indebtedness proposed by the debtor. See, e.g., In re Deluca, 1996 WL 910908 (Bankr. E.D. Va. Apr. 12, 1996); In re Birdneck Apartment Assocs. II LP, 156 B.R. 499 (Bankr. E.D. Va. 1993). Under the band-of-investment approach, different risk factors may be assigned to different portions of the indebtedness. Those lower court cases (which would include the 7th Circuit’s opinion in Till and a number of other circuit court opinions) adopting the coerced-loan approach or the cost of funds to the creditor will likely have little, if any, persuasive authority in a post- Till litigation environment. Finally, the Stevens opinion does note the tension between the present value calculation and feasibility, and notes that “[t]ogether with the cram down provision, this requirement [of feasibility] obligates the court to select a rate high enough to compensate the creditor for its risk but not so high as to doom the plan. If the court determines that the likelihood of default is so high as to necessitate an ‘eye popping’ interest rate … the plan should not be confirmed.” 124 S. Ct. at 1962. It is not clear how the lower courts will apply this particular bit of guidance, as a number of lower court decisions in the context of relief from the automatic stay have relied upon the inability of the debtor to fund a plan at an appropriate interest rate as “cause” to terminate the automatic stay to allow the lender to foreclose. See 11 U.S.C. 362(d)(1) and (2). See also, e.g., Travelers Life and Annuity Co. v. Ritz-Carlton of D.C. Inc., 98 B.R. 170 (S.D.N.Y. 1989) (noting that the court must analyze a plan with sufficient depth to determine whether the debtor can pay or service the indebtedness at a market rate of interest); In re Eighth St. Village Ltd. Partnership, 88 B.R. 853 (Bankr. N.D. Ill. 1988) (terminating the automatic stay when the debtor failed to show the possibility of an effective reorganization and the court concluded that under any realistic analysis, the debtor could not service the creditor’s allowed secured claim at a reasonable market rate of interest), aff’d, 94 B.R. 993 (N.D. Ill. 1988). Thus, the plurality’s comment may undercut well-established authority on the proper approach in connection with motions for relief from the automatic stay. Justice Clarence Thomas concurred in the judgment to reverse the 7th Circuit’s decision — with an approach that should send a chill down the spine of every secured creditor. Thomas distinguished between the value of the promise to pay over time and the property to be distributed under the plan over time. As a matter of statutory construction, Thomas found that the plain language of the statute does not take into account the risk of nonpayment. Accordingly, the analysis would be limited to an objective analysis of the discount rate without regard to any risk of nonpayment. This approach, to the certain consternation of secured creditors, turns the typical underwriting analysis on any secured loan on its head to only reflect macroeconomic factors (such as inflation and the money supply) and rewrites a contract to reflect those broad macroeconomic trends, rather than the specific underwriting circumstances of the loan, the collateral and the debtor — a problem also created by the approach taken in the Stevens opinion, although somewhat mitigated by allowing a creditor to demonstrate some risk analysis. The dissent instead advocated the presumptive-contract rate approach as reflecting the risk of default as well as the cost of collection upon default. The dissent criticized the plurality opinion for undercompensating the creditor and criticized the Thomas approach as ignoring the context of plan confirmation and the balance of the statute. In this respect, the dissent recognized the broad economic effects of this decision. “There are very good reasons for Congress to prescribe full risk compensation for creditors. Every action in the free market has a reaction somewhere. If subprime lenders are systemically undercompensated in bankruptcy, they will charge higher rates or, if they already charge the legal maximum under state law, lend to fewer of the riskiest borrowers.” 124 S. Ct. at 1978. Without question, the decision will have an impact on the subprime market. There is almost a perverse incentive for Chapter 13 debtors to rewrite the terms of the loan to obtain a substantially reduced interest rate. The “risk premium” will likely develop in each district almost as a matter of course that will be difficult for the creditor to disprove (remembering that the Stevens approach required the creditor to challenge and to demonstrate that the risk premium was even necessary). A CHAIN OF CONSEQUENCES Indeed, in one case, the U.S. District Court for the District of Kansas has already reversed the confirmation of a Chapter 13 plan that had used a formula of the treasury bill rate plus a 3 percent risk adjustment — finding that the bankruptcy court was required to conduct a case-by-case evidentiary hearing to determine the proper risk adjustment. In re Smith, 310 B.R. 631 (D. Kan. 2004). Not only will transaction costs increase, but also yields on such loans will decrease. This may have a secondary effect on the securitization market, as investors will require more of a cushion to address bankruptcy issues, with a consequent reduction in liquidity and yield in these markets. The plurality opinion recognized (and the United States argued) that the same approach would apply under any of the applicable deferred payment provisions of the Bankruptcy Code (which would include Chapter 12 for family farmers and Chapter 11 for business debtors). Secured creditors in the Chapter 11 context will also be put to the Till test. The litigation of Chapter 11 cram-down confirmations typically focused on similar evidentiary issues, with larger dollars at stake. In many courts, the formula approach was utilized to a greater or lesser extent, and the litigants typically used a riskless rate (a T-bill rate of equivalent maturity) and then added risk factors such as quality of the underlying asset as collateral for the now-restructured loan, amortization, market issues and related matters. Till provides greater leverage for the debtor by now allowing it to argue that the burden is on the creditor, not the debtor, to demonstrate the so-called risk premium. Moreover, creditors very often argue in a motion for relief from the automatic stay that the debtor cannot service the allowed secured claim at a reasonable or market rate of interest and, as a result, cause exists to terminate the automatic stay to allow the creditor to foreclose on the property. The discussion in the Stevens opinion, in noting the tension between feasibility and the risk premium, may undercut the secured creditor’s position with respect to whether the property is necessary for an effective reorganization — that is, whether an effective reorganization can in fact be accomplished by the debtor as the debtor will argue that the court should reduce the risk premium in order to enhance feasibility. In addition, it should be expected that certain debtors will advocate the appropriateness of the Thomas “plain language” approach to argue that no risk premium is necessary. Ultimately, the decision leaves significant uncertainty in the area of valuation of deferred payment streams. As a result, in addition to the likely contraction of credit for the riskiest borrowers as noted by the dissent, the liquidity for subprime lenders may be adversely affected and commercial real estate loan yields may suffer by virtue of the decision. Dennis J. Connolly ([email protected]) is a partner, resident in the Atlanta office of Alston & Bird (www.alston.com), where he concentrates on commercial litigation and commercial bankruptcy. If you are interested in submitting an article to law.com, please click here for our submission guidelines.

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