Supreme Court Disappoints Secured Lenders

The Dissent

The dissent (Justice Scalia, joined by Chief Justice Rehnquist, Justices O'Connor and Kennedy) rejected the plurality's approach because it would “systematically undercompensate secured creditors for the true risks of default”. Id. at 1968. It preferred a market-based method, with the original contract rate of interest as the beginning point, subject to modification on a showing that a different rate should apply. Id.

Relevance of Ruling

In Till, the Seventh Circuit, like most of the other Courts of Appeals (other than the Second Circuit), had held that a coerced loan approach provided the appropriate interest rate on a secured creditor's cramdown claim. In re Till, 301 F.3d 583 (7th Cir. 2002). Although Till was a Chapter 13 case, the Supreme Court's plurality acknowledged that the Chapter 13 cramdown analysis should apply in Chapters 11 and 12 of the Code. See Till, 124 S. Ct. at 1958-59 and n. 10 citing, inter alia, 11 U.S.C. ' 1129(b)(2)(A)(ii); 11 U.S.C. ' 1225(a)(5)(B)(ii). The Seventh Circuit had come to the same conclusion. “Courts have considered all three provisions to be similar and have analyzed them interchangeably.” 301 F.3d at 589. Till is thus relevant to all business bankruptcy cases, but not necessarily dispositive, as noted below.

Facts

The debtors in Till had proposed a Chapter 13 plan enabling them to keep a car worth $4500. The lender, which specialized in subprime loans to borrowers with poor credit histories, had made a pre-bankruptcy loan with an interest rate of 21%, and had objected to having its loan repaid over 3 years at 9.5% per annum. The bankruptcy court accepted the 9.5% interest rate on the secured claim, which represented the prime rate plus a 1.5% risk premium. The lender had objected, arguing for a 21% interest rate, what it would have earned if it had foreclosed and then used the proceeds to make a new loan. The district court reversed, agreeing with the lender. The Seventh Circuit remanded the case to the bankruptcy court for further proceedings, 301 F.3d at 593, giving both parties the opportunity to “rebut the presumptive 21% rate.” 301 F.3d at 591. The Seventh Circuit had agreed that in a cramdown dispute, the focus of the court's inquiry should be the interest rate that the lender could obtain in a new loan in the same industry but to a similarly situated debtor not in bankruptcy. Id. at 592. The pre-bankruptcy contract rate would be presumptively correct but subject to adjustment for risks and economies associated with the borrower's bankruptcy that had not been taken into account in the rate's original determination. Id.

The Plurality's Reasoning

The Supreme Court's plurality reversed the Seventh Circuit, and remanded the case to the bankruptcy court. It rejected the coerced loan, presumptive contract rate, and cost of funds approaches because each was too complex, associated with substantial litigation costs, and was focused upon making the creditor whole, as opposed to ensuring that the payments made by the debtor were adjusted for present value. 124 S. Ct. at 1960. Although the Code provides no guidance on the methodology Congress intended, the plurality decided that a uniform method should be adopted for all sections of the Code. Id. at 1958. It reasoned, too, that Chapter 13 expressly authorizes the court to alter the rights of secured creditors (unless their claims were secured by the debtor's principal residence), and, from the lender's perspective, the cramdown provision required an objective inquiry, as opposed to a subjective one. Id. at 1959. According to the plurality, the formula method best serves each of these objectives. Id. at 1961-62.

The formula rate begins with the national prime rate that “reflects the financial market's estimate of the amount a commercial bank should charge a creditworthy commercial borrower to compensate for the opportunity costs of the loan, the risk of inflation, and the relatively slight risk of default.” Id. at 1961. Next, it requires the bankruptcy court to hold an evidentiary hearing to determine how to adjust the prime rate to account for the greater risk of nonpayment posed by the debtor. Id. At that hearing, the parties should present evidence regarding the “circumstances of the [debtor's] estate, the nature of the security, and the duration and feasibility of the reorganization plan”. Id. To the plurality, the formula approach, unlike the coerced loan or other methods, was straightforward, objective and familiar to lenders, entailing lower litigation costs. Id. The formula rate serves the “objective” criterion, reasoned the plurality, because it would not be influenced by the creditor's previous relationship with the debtor or the creditor's own circumstances but instead would be based on the “state of financial markets, the circumstances of the bankruptcy estate, and the characteristics of the loan … [.]” Id. Although a risk adjustment premium of 1.5% had been approved in Till, and other courts had generally approved 1% to 3%, a higher risk adjustment rate could still be deemed appropriate. Id. at 1962. “The [c]ourt must select a rate high enough to compensate a creditor for its risk but not so high as to doom the bankruptcy plan.” Id.

The Dissent's Reasoning

The dissenters preferred the “presumptive rate” approach (ie, the modified coerced loan method approved by the Seventh Circuit) because it was based on two fair assumptions: 1) The subprime lending market is “competitive and therefore largely efficient”; and 2) The “expected costs of default in Chapter 13 are normally no less than those at the time of lending.” Id. at 1969. In other words, the oversight of the debtor's plan by the court and the Chapter 13 trustee, factors deemed significant by the plurality, would only marginally benefit the secured lender. Id. To the dissenters, the Chapter 13 debtor had already shown a “financial instability and proclivity to seek legal protection that other subprime borrowers have not.” Id. Moreover, in bankruptcy, the lender's foreclosure costs are substantially greater than they are outside of bankruptcy because of court proceedings necessary to obtain relief from the automatic stay. Id. at 1969-70. It was simply implausible to assume that “Chapter 13 [was] widely viewed by secured creditors as some sort of godsend” that would justify using the prime rate as a starting point. Id. at 1970.

The contract rate, according to the dissent, should be viewed as a “decent estimate or at least the lower bound” (ie, presumptively correct) because it “reasonably reflects actual risk at the time of borrowing.” Id. This risk “persists when the debtor files for Chapter 13.” Id. The presumption could be overcome if, for example, a party chose to take issue with the contract rate of interest due to a large swing in market rates after the contract's execution, or if the car's vendor had conditioned an artificially low sale price upon its providing purchase-money financing (ie, at an artificially high, or non-competitive, interest rate). Id.

The Swing Vote

In his concurring opinion supporting the plurality, Justice Thomas reasoned that the 9.5% interest rate in Till would constitute sufficient compensation to the secured lender in exchange for its receiving monthly payments instead of a lump sum. Id. at 1968. The Bankruptcy Code required nothing more. According to Justice Thomas, the plain language of '1325(a)(5)(B)(ii) requires a court to determine, first, the allowed amount of the claim; second, the property to be distributed under the plan; and third, the “value, as of the effective date of the plan” of such property. Id. at 1965. It is the valuation of the property that should be determined, as opposed to the risk inherent in the promise to repay it. Id. The interest rate used to determine the time value of money should thus “compensate a creditor for the fact that if he had received the property immediately rather than at a future date, he could have immediately made use of the property.” Id. at 1966.

Justice Thomas also rejected the lender's argument that ' 1325(a)(5)(B)(ii) (Chapter 13's cramdown provision) protected creditors rather than debtors. Id. at 1967. In his view, that argument ignored the partial compensation given secured creditors for the risk of nonpayment when the secured claim is valued. Id. It was reasonable to assume, he reasoned, that in enacting this Code section, Congress deliberately did not require a risk adjustment premium because of other protections to secured creditors. Id.

Ramifications for Secured Lenders

• Secured Lender Has Burden of Proof. The difference between the two major approaches in Till turns on which party bears the burden of proof. The plurality places the burden on the secured lender from an arguably artificially low beginning point. The dissent would require the debtor to bear the burden. Causing the lender to bear this burden in a consumer bankruptcy case, however, is quite different from requiring the lender to bear it in the business reorganization context. It will likely lead to more mischievous litigation (eg, unrealistic reorganization plans with lengthy payment periods and below-market interest rates).
• Till Was Fact-Specific. The only legal issue here was the proper method for determining the cramdown interest rate. Not at issue were the risk adjustment premium, the term of the repayment or the debtor's ability to repay. In future cases, lenders are still free to challenge these issues. Given the plurality's acknowledgement of an efficient market for Chapter 11 DIP financing (which presumably it understood to exist for exit facilities as well), lenders may still challenge the application of the formula approach in business reorganizations.
• Till Was A Consumer Case. The Court was split, we suspect, because this case involved a consumer debtor. Although Chapter 13's cramdown provision is theoretically identical in substance to Code ' 1129(b)(2)(A), we doubt the Court would have reached the same conclusion if the secured lender were the United States with a tax lien or if the debtor were a business debtor.

The U.S. Supreme Court's recent Till decision on the proper cramdown interest rate will disappoint secured lenders. Till v. SCC Credit Corp. , 124 S. Ct. 1951 (2004). As we show below, Till should be limited to its narrow fact pattern, but is still bad news for lenders. They now will be forced to fight an uphill battle to prove that a higher risk premium should be added to the prime rate applicable to their crammed down secured claim. In Till, the plurality accepted a risk adjustment premium in the range of 1% to 3% (Justice Thomas, concurring, could accept no premium at all). Commercial lenders will thus have to overcome Till by showing that they are entitled to a truly “market” interest rate.

Holding

A plurality (Justice Stevens, joined by Justices Breyer, Ginsburg and Souter) held on May 17, 2004, that the prime-plus, or formula, approach, requiring adjustment of the prime national interest rate for the risk of the borrower's nonpayment, was the best method for fixing the cramdown interest rate on a secured loan. Id. at 1968. (“Cramdown” refers to the alternative plan confirmation standard “by which a plan may be confirmed notwithstanding the failure of an impaired class to accept the plan.” See 124 Cong. Rec. H 11,103 (Sept. 28,1978); S 17,420 (Oct. 6, 1978) discussing Code section 1129(b).) Previously, only the Second Circuit had endorsed the formula approach. See, e.g., GMAC v. Valenti (In re Valenti) , 105 F.3d 55, 64 (2d Cir. 1997) (imposing formula approach at treasury security rate, because “it is easy to apply, it is objective, and it will lead to uniform results”); abrogated on other grounds by Assoc. Commercial Corp. v. Rash , 520 U.S. 953 (1997), 117 S. Ct. 1879, 138 L. Ed. 2d 148; Key Bank Nat'l Assoc. v. Milham (In re Milham), 141 F.3d 420, 424 (2d Cir. 1998) (formula rate applied in cramdown for oversecured creditor). Justice Thomas concurred in Till, reasoning that the 9.5% cramdown interest rate adequately compensated the lender for the present value of its claim, and that the Bankruptcy Code did not require secured creditors to be compensated for the risk of nonpayment. Id. at 1965.

The Dissent

The dissent (Justice Scalia, joined by Chief Justice Rehnquist, Justices O'Connor and Kennedy) rejected the plurality's approach because it would “systematically undercompensate secured creditors for the true risks of default”. Id. at 1968. It preferred a market-based method, with the original contract rate of interest as the beginning point, subject to modification on a showing that a different rate should apply. Id.

Relevance of Ruling

In Till, the Seventh Circuit, like most of the other Courts of Appeals (other than the Second Circuit), had held that a coerced loan approach provided the appropriate interest rate on a secured creditor's cramdown claim. In re Till, 301 F.3d 583 (7th Cir. 2002). Although Till was a Chapter 13 case, the Supreme Court's plurality acknowledged that the Chapter 13 cramdown analysis should apply in Chapters 11 and 12 of the Code. See Till, 124 S. Ct. at 1958-59 and n. 10 citing, inter alia, 11 U.S.C. ' 1129(b)(2)(A)(ii); 11 U.S.C. ' 1225(a)(5)(B)(ii). The Seventh Circuit had come to the same conclusion. “Courts have considered all three provisions to be similar and have analyzed them interchangeably.” 301 F.3d at 589. Till is thus relevant to all business bankruptcy cases, but not necessarily dispositive, as noted below.

Facts

The debtors in Till had proposed a Chapter 13 plan enabling them to keep a car worth $4500. The lender, which specialized in subprime loans to borrowers with poor credit histories, had made a pre-bankruptcy loan with an interest rate of 21%, and had objected to having its loan repaid over 3 years at 9.5% per annum. The bankruptcy court accepted the 9.5% interest rate on the secured claim, which represented the prime rate plus a 1.5% risk premium. The lender had objected, arguing for a 21% interest rate, what it would have earned if it had foreclosed and then used the proceeds to make a new loan. The district court reversed, agreeing with the lender. The Seventh Circuit remanded the case to the bankruptcy court for further proceedings, 301 F.3d at 593, giving both parties the opportunity to “rebut the presumptive 21% rate.” 301 F.3d at 591. The Seventh Circuit had agreed that in a cramdown dispute, the focus of the court's inquiry should be the interest rate that the lender could obtain in a new loan in the same industry but to a similarly situated debtor not in bankruptcy. Id. at 592. The pre-bankruptcy contract rate would be presumptively correct but subject to adjustment for risks and economies associated with the borrower's bankruptcy that had not been taken into account in the rate's original determination. Id.

The Plurality's Reasoning

The Supreme Court's plurality reversed the Seventh Circuit, and remanded the case to the bankruptcy court. It rejected the coerced loan, presumptive contract rate, and cost of funds approaches because each was too complex, associated with substantial litigation costs, and was focused upon making the creditor whole, as opposed to ensuring that the payments made by the debtor were adjusted for present value. 124 S. Ct. at 1960. Although the Code provides no guidance on the methodology Congress intended, the plurality decided that a uniform method should be adopted for all sections of the Code. Id. at 1958. It reasoned, too, that Chapter 13 expressly authorizes the court to alter the rights of secured creditors (unless their claims were secured by the debtor's principal residence), and, from the lender's perspective, the cramdown provision required an objective inquiry, as opposed to a subjective one. Id. at 1959. According to the plurality, the formula method best serves each of these objectives. Id. at 1961-62.

The formula rate begins with the national prime rate that “reflects the financial market's estimate of the amount a commercial bank should charge a creditworthy commercial borrower to compensate for the opportunity costs of the loan, the risk of inflation, and the relatively slight risk of default.” Id. at 1961. Next, it requires the bankruptcy court to hold an evidentiary hearing to determine how to adjust the prime rate to account for the greater risk of nonpayment posed by the debtor. Id. At that hearing, the parties should present evidence regarding the “circumstances of the [debtor's] estate, the nature of the security, and the duration and feasibility of the reorganization plan”. Id. To the plurality, the formula approach, unlike the coerced loan or other methods, was straightforward, objective and familiar to lenders, entailing lower litigation costs. Id. The formula rate serves the “objective” criterion, reasoned the plurality, because it would not be influenced by the creditor's previous relationship with the debtor or the creditor's own circumstances but instead would be based on the “state of financial markets, the circumstances of the bankruptcy estate, and the characteristics of the loan … [.]” Id. Although a risk adjustment premium of 1.5% had been approved in Till, and other courts had generally approved 1% to 3%, a higher risk adjustment rate could still be deemed appropriate. Id. at 1962. “The [c]ourt must select a rate high enough to compensate a creditor for its risk but not so high as to doom the bankruptcy plan.” Id.

The Dissent's Reasoning

The dissenters preferred the “presumptive rate” approach (ie, the modified coerced loan method approved by the Seventh Circuit) because it was based on two fair assumptions: 1) The subprime lending market is “competitive and therefore largely efficient”; and 2) The “expected costs of default in Chapter 13 are normally no less than those at the time of lending.” Id. at 1969. In other words, the oversight of the debtor's plan by the court and the Chapter 13 trustee, factors deemed significant by the plurality, would only marginally benefit the secured lender. Id. To the dissenters, the Chapter 13 debtor had already shown a “financial instability and proclivity to seek legal protection that other subprime borrowers have not.” Id. Moreover, in bankruptcy, the lender's foreclosure costs are substantially greater than they are outside of bankruptcy because of court proceedings necessary to obtain relief from the automatic stay. Id. at 1969-70. It was simply implausible to assume that “Chapter 13 [was] widely viewed by secured creditors as some sort of godsend” that would justify using the prime rate as a starting point. Id. at 1970.

The contract rate, according to the dissent, should be viewed as a “decent estimate or at least the lower bound” (ie, presumptively correct) because it “reasonably reflects actual risk at the time of borrowing.” Id. This risk “persists when the debtor files for Chapter 13.” Id. The presumption could be overcome if, for example, a party chose to take issue with the contract rate of interest due to a large swing in market rates after the contract's execution, or if the car's vendor had conditioned an artificially low sale price upon its providing purchase-money financing (ie, at an artificially high, or non-competitive, interest rate). Id.

The Swing Vote

In his concurring opinion supporting the plurality, Justice Thomas reasoned that the 9.5% interest rate in Till would constitute sufficient compensation to the secured lender in exchange for its receiving monthly payments instead of a lump sum. Id. at 1968. The Bankruptcy Code required nothing more. According to Justice Thomas, the plain language of '1325(a)(5)(B)(ii) requires a court to determine, first, the allowed amount of the claim; second, the property to be distributed under the plan; and third, the “value, as of the effective date of the plan” of such property. Id. at 1965. It is the valuation of the property that should be determined, as opposed to the risk inherent in the promise to repay it. Id. The interest rate used to determine the time value of money should thus “compensate a creditor for the fact that if he had received the property immediately rather than at a future date, he could have immediately made use of the property.” Id. at 1966.

Justice Thomas also rejected the lender's argument that ' 1325(a)(5)(B)(ii) (Chapter 13's cramdown provision) protected creditors rather than debtors. Id. at 1967. In his view, that argument ignored the partial compensation given secured creditors for the risk of nonpayment when the secured claim is valued. Id. It was reasonable to assume, he reasoned, that in enacting this Code section, Congress deliberately did not require a risk adjustment premium because of other protections to secured creditors. Id.

Ramifications for Secured Lenders

• Secured Lender Has Burden of Proof. The difference between the two major approaches in Till turns on which party bears the burden of proof. The plurality places the burden on the secured lender from an arguably artificially low beginning point. The dissent would require the debtor to bear the burden. Causing the lender to bear this burden in a consumer bankruptcy case, however, is quite different from requiring the lender to bear it in the business reorganization context. It will likely lead to more mischievous litigation (eg, unrealistic reorganization plans with lengthy payment periods and below-market interest rates).
• Till Was Fact-Specific. The only legal issue here was the proper method for determining the cramdown interest rate. Not at issue were the risk adjustment premium, the term of the repayment or the debtor's ability to repay. In future cases, lenders are still free to challenge these issues. Given the plurality's acknowledgement of an efficient market for Chapter 11 DIP financing (which presumably it understood to exist for exit facilities as well), lenders may still challenge the application of the formula approach in business reorganizations.
• Till Was A Consumer Case. The Court was split, we suspect, because this case involved a consumer debtor. Although Chapter 13's cramdown provision is theoretically identical in substance to Code ' 1129(b)(2)(A), we doubt the Court would have reached the same conclusion if the secured lender were the United States with a tax lien or if the debtor were a business debtor.