Originally published May 28, 2004

Article by Daniel M. Glosband, Michael J. Pappone and Jon D. Schneider.

"Cram down", the non-consensual restructuring of secured debt, has just become much easier for a debtor in reorganization due to the Supreme Court’s adoption of a "prime plus" rule. While the May 14, 2004 opinion deals with a chapter 13 "wage earner" case, it will apply in commercial chapter 11 cases.

In allowing Lee and Amy Till to restructure the payments on their $4,000 truck, the Supreme Court exposes commercial secured lenders and mortgagees to significant reductions in the interest rate to be paid by a reorganizing borrower.1 The Tills were debtors in proceedings under chapter 13 of the Bankruptcy Code, which applies only to debtors (or debtors and their spouses) who have regular income and who owe unsecured debts of less than $307,675 and secured debts of less than $922,975. They proposed a plan under which their truck finance debt would be split into a secured claim for the $4,000 value of the truck and an unsecured claim for the $894.89 debt balance. The secured debt would be paid over three years from an assignment of wages and would bear interest at prime plus 1.5% instead of the 21% rate at which they borrowed the money.

The Supreme Court ultimately approved the Tills’ plan and said that the same methodology for the determination of the interest rate necessary to preserve a present value should apply under all of the sections of the Bankruptcy Code which invoke the present value concept. Because the provisions which permit chapter 13 debtors to modify secured debt (other than residential mortgages) and those which allow chapter 11 debtors to "cram down" restructurings on non-consenting secured creditors both involve a present value determination, the same rules will apply to set interest rates in both cases.

  • Claims of secured creditors are treated by the Bankruptcy Code as "allowed secured claims" in an amount equal to the value of the collateral and unsecured claims for the amount of any deficiency.2
  • An allowed secured claim can be restructured through a chapter 11 plan of reorganization without the lender’s consent if (a) another impaired class of creditors accepts the debtor’s plan and (b) the plan satisfies the rules for "cram down" on the secured claim.3
  • To cram down a secured claim, the plan must (a) not discriminate unfairly4 and (b) be "fair and equitable" with respect to each non-accepting impaired class.
  • To be fair and equitable to a class of secured claims (or in the typical real estate case, to the one allowed secured claim), the plan must provide for the secured creditor to receive deferred cash payments with a present value equal to the value of the collateral.

The requirement to preserve the present value of the collateral traditionally invited disagreement over both collateral value and the rate of interest necessary to preserve present value. Valuation would lead to a battle of appraisers while the interest rate determination would invoke philosophical (how to set a rate on a coerced 100% loanto- value mortgage) as well as market considerations. The Supreme Court’s Till decision will pre-empt most of the debate on interest rates.

Justice Stevens wrote the Till opinion as spokesman for a group of four Justices (himself and Justices Souter, Ginsburg and Breyer) who were joined in the result by a fifth (Justice Thomas). Justice Scalia wrote a scathing dissent for the other four. The Stevens’ opinion notes that many provisions of the Bankruptcy Code are similar to the cram down provisions in chapter 13 in requiring a court to "discount …a stream of deferred payments back to the[ir] present dollar value."5 Among the similar provisions are the chapter 11 secured creditor cram down rules.6 As to all of these provisions, he says : "We think Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate under any of these provisions. Moreover, we think Congress would favor an approach that is familiar in the financial community and that minimizes the need for expensive evidentiary proceedings."

The Court was presented with several different methods to determine whether a stream of payments satisfied the Bankruptcy Code’s requirement that the secured creditor receive the present value of its allowed secured claim. The debtors proposed the "formula approach," the formula starting with the prime rate (then 8% but as of the May 14, 2004 date of the opinion, 4%) and adding an adjustment of 1.5% to compensate for risk of non-payment. The Bankruptcy Court approved this proposal and the resulting 9.5% interest rate. At the first level of appeal, the United States District Court followed the "coerced loan" approach and approved the 21% contract rate since that was what the lender would receive if it foreclosed and made another loan (in this case, a forced loan to the debtors) with the proceeds. Its 21% rate was market for a subprime loan. At the next level of appeal, the Court of Appeals adopted the "presumptive contract rate" approach stating that the contract rate should be presumed to be appropriate, but the presumption could be challenged with evidence showing that the rate should be higher or lower. Justice Stevens added a fourth methodology based on the lender’s cost of funds, which he denominated the "cost of funds" approach. He then rejected the coerced loan, presumptive contract rate and cost of funds approaches and endorsed the formula approach. According to his opinion, the Bankruptcy Code does not require the cram down terms to match the pre-bankruptcy contract and/or to consider the creditor’s individual circumstances. He found that these approaches were complicated, imposed expensive evidentiary costs and improperly aimed to make the individual creditor whole instead of just preserving the required present value of the collateral. In support of the formula approach, he touted the ready availability of the prime rate "reported daily in the press."

In an apparent nod to reality, he noted that "bankrupt debtors typically pose a greater risk of nonpayment than solvent commercial borrowers" and that a risk adjustment on top of the prime rate was appropriate. While the opinion declines to decide "the proper scale for the risk adjustment" saying that the issue was not before it, the Court appears to find the 1.5% proposed by the Tills to be satisfactory7. It notes that "other courts" have approved adjustments of between 1% and 3% and provides the following guidance: "Together with the cram down provision, th[e] requirement [that the court find that debtor will be able to make all of its payments] obligates the court to select a rate high enough to compensate the creditor for risk but not so high as to doom the plan."

The logic of this statement is terminally infirm. As noted in the dissent, the risk adjustment should be proportional to the debtor’s ability to pay and if the debtor’s payment prospects are too chancy, the consequence should not be a reduction in the risk adjustment but rather a denial of confirmation of the plan. The lacerating dissent, written by Justice Scalia would warm the heart of any secured or mortgage lender. However, by virtue of being a dissent, it means that Justice Scalia and his three colleagues (Justices Rehnquist, O’Connor and Kennedy) lost and the Stevens’ opinion is now the law.

The implications of this ruling are enormous, at least in a market where the prime rate is below the rate on outstanding fixed-rate loans. Any debtor with a cash flow problem or a desire to improve its bottom line will analyze its prospects for satisfying the other cram down requirements. If those prospects are good, it can look forward to reducing its interest costs at the expense of the lender. The lender will still have a number of strategic options available and should explore its diminished arsenal with experienced counsel. 

Footnotes 

1 Till , et ux v. SCS Credit Corp. __U.S.__(May 17, 2004).

2 The Supreme Court’s most recent discussion of collateral valuation occurred in another chapter case involving a truck. There, the Court held that replacement value, as opposed to liquidation value, was the appropriate standard. Associates Commercial Corporation v. Rash, 117 S. Ct. 1879 (1997). For commercial real estate to be retained by a debtor under a plan of reorganization, the proper valuation standard is fair market value, determined by traditional appraisal methodologies, James F. Queenan, Jr., Standards for Valuation of Security Interests in Chapter 11, 92 Com. L.J. 18.

3 A debtor’s plan must designate classes of claims and specify the treatment proposed for each class which is "impaired" (has its rights modified in any way). Classes may only contain claims which are "substantially" similar. An allowed secured claim will be in a class by itself; whether a deficiency claim will or must be included in a class with other general unsecured claims is uncertain. All classes of impaired claims and interests vote on a plan. For a class to accept, more than one-half in number and at least two-thirds in amount of those creditors in the class that vote must accept. If not all impaired classes accept the plan, there must be at least one accepting impaired class whose acceptance is determined without counting the votes of any insider.

4 Differing treatment of similarly ranked classes must be necessary and fair in terms of value to creditors of similar rank.

5 Citing to its earlier opinion in Rake v. Wade, 508 U.S. 464, 472, n.8 (1993) which involved the accrual of interest on an oversecured mortgage in a chapter 13 case.

6 Bankruptcy Code section 1129(b)(2)(A).

7 Since Justice Stevens’ opinion was joined by only three other Justices, he needed a fifth vote for the opinion to be controlling. The fifth vote came from Justice Thomas who believed that no risk adjustment was required by the plain language of the Code. The law only requires the consideration of the time value of money and not the risk of repayment. 

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 650 attorneys and offices in Boston, New York and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. (c) 2004 Goodwin Procter LLP. All rights reserved.