Recent Developments in Cramdown of Secured Claims in Chapter 11
October 31, 2005
For the first time, a bankruptcy court has ruled that the “formula method” followed by the United States Supreme Court for determining the interest rate to be paid on secured claims as part of a chapter 13 plan of reorganization (see Till v. ASCS Credit Corp., 541 U.S. 465 (2004)), also may apply to a chapter 11 plan of reorganization under certain circumstances. See In re Prussia Assocs., 322 B.R. 572 (Bankr. E.D. Pa. 2005). We emphasize the word “may” because the Prussia court (i) determined that Till only suggested that the “formula method” should be used in chapter 11, and did not mandate its application; and (ii) Till allowed for exceptions to the application of the formula method under certain circumstances, which were present in the Prussia case but suffered from a lack of proof. As a result, Prussia may be read as generally supporting the application of Till to chapter 11, but not standing for the proposition that no other interest rate calculation method is permitted. See also In re LWD, Inc., 2005 WL 567460 (Bankr. W.D. Ky. Feb. 10, 2005) (court “takes its cue” from Till in using formula approach in chapter 11 case, although application was not in plan context); but see In re American Homepatient, Inc., 420 F.3d 559, 568 (6th Cir. 2005) (Till does not mandate use of formula method in chapter 11).
Under the Bankruptcy Code, a chapter 13 plan cannot be confirmed over the objection of a dissenting secured creditor unless the plan provides that the creditor (i) retain the lien securing its claim; and (ii) “the value, as of the effective date of the plan, of property to be distributed under the plan on account of such claim is not less than the allowed amount of such claim. ...” 11 U.S.C. § 1325(a)(5)(B)(i) and (ii). Substantively identical language is found in the Bankruptcy Code governing chapter 11. See 11 U.S.C. § 1129(b)(2)(A)(i)(II) (creditor must receive on account of its claim “deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property.”). Since most chapter 13 and 11 plans provide for payment over time, courts have interpreted the phrase “value, as of the effective date of the plan” as requiring secured creditors to be paid interest on their allowed claims in order to ensure that the stream of payments equals or exceeds the present value of such claims. See Prussia, 322 B.R. at 585-86.
Before Till, courts assessing plans of reorganization had developed various methods of determining the appropriate interest rate to be paid on secured claims including, but not limited to: (i) the “coerced loan rate,” which is based on the rate the creditor could obtain if it was permitted to foreclose and reinvest the proceeds (see, e.g., GMAC v. Jones, 999 F.2d 63 (3d Cir. 1993)); (ii) the “presumptive contract rate,” which is based on the interest rate set forth in the underlying contract, subject to adjustment up or down depending on the circumstances (see, e.g., In re Briscoe Enter., Ltd., II, 994 F.2d 1160 (5th Cir.), cert. denied, 510 U.S. 992 (1993)); (iii) the “cost of funds rate,” which is based on the interest rate the creditor would have to pay on a loan in the amount equal to the value of the collateral; and (iv) the “formula method,” which is based on a readily accessible or national risk-free rate of interest to which a “risk premium” is added at the court’s discretion depending, inter alia, on the nature of the collateral and the duration and feasibility of the plan. See, e.g., GMAC v. Valenti (In re Valenti), 105 F.3d 55 (2d Cir. 1997).
In 2004, the U.S. Supreme Court held that for purposes of confirming a chapter 13 plan, the “formula method,” using the national prime rate as the risk-free base rate, was the appropriate method for calculating interest. See Till, supra. The Supreme Court did not explicitly state that its decision was binding in chapter 11, although it suggested that the use of virtually identical “present value” language in Bankruptcy Code sections 1325 and 1129 made it likely that “Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate under any of these provisions.” 541 U.S. at 474-75 & n.10. Nevertheless, the Supreme Court pointed out that there were differences between chapter 13 and chapter 11 that could warrant a different approach for determining an appropriate rate of interest in a chapter 11 case, noting that by definition, a creditor forced to accept a cramdown loan with terms significantly different than those he or she originally agreed to, would prefer instead to foreclose on its collateral, thus:
This fact helps to explain why there is no readily apparent Chapter 13 “cramdown market rate of interest”: Because every cramdown loan is imposed by a court over the objection of the secured creditor, there is no free market of willing cramdown lenders. 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 cramdown rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce. In the Chapter 13 context, by contrast, the absence of any such market obligates courts to look to first principles and ask only what rate will fairly compensate a creditor for its exposure.
Id. at 477 n.14 (emphasis in original) (internal citations omitted). Since Till, numerous courts have applied its “formula method” to chapter 13 cases, but until Prussia, there had been no reported decision adopting the approach of Till and the formula method as “the preferred means for setting the interest rate” under a contested chapter 11 plan.
In Prussia, the debtor was the owner of certain hotel property located in Pennsylvania. The debtor’s principal secured creditor was owed approximately $19 million secured by a lien on the hotel. The interest rate on the secured creditor’s underlying promissory note provided for a variable rate of interest that could fluctuate between a floor of 8 percent and a ceiling of 16.97 percent. Under the terms of the debtor’s chapter 11 plan, the secured creditor would retain its lien, and receive monthly principal and interest payments, with an interest rate of 6.25 percent. The secured creditor challenged the debtor’s plan, arguing that under section 1129 of the Bankruptcy Code, the creditor was entitled to an interest rate of at least 9.72 percent, the “market rate” for similar hotel refinancing. The debtor argued that the “market rate” was not 9.72 percent, but actually between 5 and 6.5 percent. Both sides presented extensive expert testimony on hotel refinancing and valuations to support their respective theories, but, as the court noted later, such testimony was based largely on anecdotal stories about other transactions in which the experts were involved or on the experts “visceral” instincts about the market. Neither side presented the testimony of an actual lender. The experts did agree, however, that there was a strong and active market for post-confirmation hotel financing.
The debtor also asserted that any argument with respect to the correct “market rate” of interest was misplaced because the use of a market rate of interest had been rejected under Till. The creditor, on the other hand, insisted that Till did not affect existing chapter 11 law. The Prussia court found that while it had no doubt Till was relevant to a chapter 11 case, there was still a question as to the degree to which it was controlling. Thus, although finding that Till was “instructive” and that there was “slight doubt” that the “formula approach” would probably make sense in most chapter 11 cases, the Prussia court determined that Till is “not controlling, insofar as mandating the use of the ‘formula’ approach described in Till in every Chapter 11 case.” Prussia, 322 B.R. at 585. The Prussia court continued:
The Court is convinced that had the Supreme Court intended mandatory observance of the formula approach in every Chapter 11 case, it would not have bothered to discuss the existence of a scenario in which resort to an alternative should be considered, and perhaps used. Under the present circumstances, therefore, the Court has attempted to discern from the evidence adduced what the market rate of interest is for present purposes.
Id. at 589. Unfortunately, the Prussia court found that given the experts’ “widely divergent” opinions as to the appropriate market rate, and the absence of any loan commitments or other hard evidence of the appropriate market rate, the court had insufficient information to make a meaningful comparison between the two suggested market rates. Thus, while the case presented an occasion in which it made sense for the court to look at what the actual market rate would be, it was unable to do so:
Put differently, this case demonstrates that the mere existence of an efficient market does not guarantee that the shortcomings of the coerced loan approach to rate setting, as described in Till, will automatically be overcome. The Court will thus fall back on Till, and the formula approach, as the preferred means for setting the interest rate herein.
Id. at 590.
The Prussia case suggests that bankruptcy courts should follow Till and apply the “formula method” as the preferred method for determining interest rates under chapter 11 plans unless an “efficient market” exists. See id. at 588-89 (“In Till, the Court suggests, that other things being equal, the formula approach should be followed in Chapter 11 just as in Chapter 13.”); see also In re LWD, Inc., 2005 WL 567460, *10 (Bankr. W.D. Ky. Feb. 10, 2005) (court “takes its cue” from Till in determining appropriate rate of interest to assess defendant in adversary proceeding who is required to pay value to estate of former estate asset obtained improperly by defendant). Nevertheless, this case also demonstrates that bankruptcy courts remain free to craft a different result using a market rate approach if appropriate under the circumstances and there is sufficient credible evidence in the record to base such a finding. See American Homepatient,
420 F.3d at 568 (“market rate should be applied in Chapter 11 cases where
there exists an efficient market”).
For more information, e-mail Peter A. Zisser at
peter.zisser@hklaw.com or call toll free, 1-888-688-8500.
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