The traditional response before the current financial meltdown to what a potential Chapter 11 Debtor could expect in a successful cram-down plan of reorganization (assuming that all of the very technical hurdles were successfully navigated) was: “Market rate of interest, seven year term, and some principal amortization.” Extending a matured or defaulted loan for seven years with some amortization of principal was in and of itself very understandable, but establishing a market rate of interest was always the litigation flashpoint. Experts would clash on what the marketplace would demand for the placement of a forced loan, with the interest rate often times the same or higher than the existing interest rate on the troubled loan. With the collapse of the commercial finance marketplace in 2008, the landscape forever changed, to the clear benefit of borrowers in the context of what a Chapter 11 case can accomplish.
September 2008 as a watershed month
What happens when the marketplace for commercial loans has essentially become nonexistent? Warning signs that a financial crisis was brewing for a long time before the commercial lending marketplace collapsed in September 2008. The ‘subprime’ crisis began a panic in financial sectors beginning in the summer of 2007. Things continued to pick up speed on a downward spiral. The Lehman Brothers bankruptcy that occurred in September, 2008 was in fact only one of several events that, in the space of just 19 days, signaled the end of an era and conventional wisdom in the Chapter 11 arena about what a cram-down plan of reorganization should look like. On September 7, 2008 the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corp. (Freddie Mac) were essentially nationalized. On September 14, 2008, Merrill Lynch was acquired by Bank of America with government prodding. The very next day – to avoid a lethal chain reaction in the market for credit default swaps – the insurance giant AIG was granted an $85 billion bailout by the Federal Reserve. On September 22, 2008 the “investment bank” went extinct as a species when Goldman Sachs and Morgan Stanley converted themselves into bank holding companies. Finally, on September 25, 2008, Washington Mutual (itself a significant source of commercial lending) was placed into the receivership of the Federal Deposit Insurance Corp. (FDIC). In the 24 hours after Lehman failed, the London Interbank Offered Rate (“LIBOR”) – the rate that financial institutions charge each other for unsecured borrowing – soared 3.33 percentage points to 6.44 percent. The commercial-paper market literally froze. The resulting credit crunch set off a chain reaction of negativity in the financial world not seen since the great depression.
The subsequent impact upon the interest rate analysis in the Chapter 11 cram-down context
While various theoretical approaches have existed relative to the determination of applicable bankruptcy interest rates, the formula approach has historical precedent including but not limited to the decisions in Till v. SCS Credit Corp., 541 U.S. 465; 124 S. Ct. 1951; 158 L.Ed. 2d 787 (2004) (“Till”), and In re Fowler, 903 F.2d 694 (9th Cir. 1990). Other theoretical approaches used in the cram-down context included the cost of funds, coerced loan and presumptive contract rate (generally considered as using the existing contract rate). Those other approaches were rejected by the Supreme Court in its landmark bankruptcy interest rate decision in the Till matter that later became center stage when the commercial loan market collapsed in late 2008.
Till, a Chapter 13 wage earner case, involved a proposed five year payment program involving a truck valued at $4,000. The original “subprime” contract interest rate for the vehicle loan was 21%. The Till Court settled on a “cramdown” fixed interest rate of 9.5% which was 1.5% higher than the then existing national prime rate of 8%. As the Supreme Court saw it, “the Bankruptcy Code includes numerous provisions that, like the [chapter 13] cram down provision, require a court to ‘discoun[t] … [a] stream of deferred payments back to the[ir] present dollar value,’ … to ensure that a creditor receives at least the value of its claim. We think 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.” 124 S. Ct. 1951, 1958-59, 158 L. Ed. 2d 787, 797.
In Till, the Supreme Court through Justices Stevens, Souter, Ginsberg and Breyer held that the national prime rate should be the presumptive starting point for bankruptcy courts to consider and that risk adjustments should be made from that starting point depending upon four factors: “…the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan.” Justice Thomas, concurring in the judgment, opined that the plain meaning of Section 1325(a)(5)(B)(ii) of the Bankruptcy Code does not require any risk adjustment whatsoever during the course of the plan, and would have approved a riskless rate (prime rate) which at that time was 8%.
Thus, the plurality opinion in Till holds that a formula approach based upon the prime rate of interest best carries out the intentions of Congress for those sections which require discounting to present value. Further, footnote 10 in the Till decision makes explicit reference to various sections of the Bankruptcy Code in Chapter 11 and 12 cases that deal with discounting to present value: “11 U.S.C. §§ 1129(a)(7)(B), 1129(a)(9)(B)(i), 1129(a)(9)(C), 1129(b)(2)(A)(ii), 1129(b)(2)(B)(i), 1129(b)(2)(C)(i), 1173(a)(2), 1225(a)(4), 1225(a)(5)(B)(ii), 1228(b)(2), 1325(a)(4), 1228(b)(2) (same).” The Court clearly indicated what it perceived to be a reasonable methodology in arriving at an appropriate cramdown rate of interest:
“[T]he formula approach entails a straightforward, familiar, and objective inquiry, and minimizes the need for potentially costly additional evidentiary proceedings. Moreover, the resulting “prime-plus” rate of interest depends only on the state of financial markets, the circumstances of the bankruptcy estate, and the characteristics of the loan, not on the creditor’s circumstances or its prior interactions with the debtor. For these reasons, the prime-plus or formula rate best comports with the purposes of the Bankruptcy Code.” 124 S. Ct. 1951, 1961-62, 158 L. Ed. 2d 787, 800.
There have been many subsequent reported cases thThe traditional response before the current financial meltdown to what a potential Chapter 11 Debtor could expect in a successful cram-down plan of reorganization (assuming that all of the very technical hurdles were successfully navigated) was: “Market rate of interest, seven year term, and some principal amortization.” Extending a matured or defaulted loan for seven years with some amortization of principal was in and of itself very understandable, but establishing a market rate of interest was always the litigation flashpoint. Experts would clash on what the marketplace would demand for the placement of a forced loan, with the interest rate often times the same or higher than the existing interest rate on the troubled loan. With the collapse of the commercial finance marketplace in 2008, the landscape forever changed, to the clear benefit of borrowers in the context of what a Chapter 11 case can accomplish.at have cited Till with approval in the Chapter 11 context even before the collapse of the commercial lending market in the third quarter of 2008. See, In re American Homepatient, Inc., 420 F. 3d 559, 567-569 (6th Cir. 2005) (Affirms confirmation of Chapter 11 Plan wherein the formula approach of the Bankruptcy Judge after carefully evaluating expert testimony. Where no efficient market exists for a chapter 11 debtor, the bankruptcy court should employ the formula approach. The Lenders wanted 12.16% and the Bankruptcy Court approved a 6.785% rate based upon the interest rate on a six-year Treasury note plus a risk adjustment factor of 3.5%); In re Cantwell, 336 B.R. 688 (Bankr. D. N.J. 2006) (Use Till formula approach in Chapter 11 case when no evidence of an “efficient market” to immediately refinance the Debtors’ mortgages). See also, In re Prussia Associates, 322 B.R. 572, 589 (Bankr. E. D. Pa 2005) (In a Chapter 11 case, “other things being equal, the formula approach should be followed in Chapter 11 just as in Chapter 13.” The bankruptcy court approved an interest rate based upon the prime rate of interest and a risk premium of 1.5%, but denied confirmation with leave granted to the debtor to file an amended plan to address other concerns of the court).
When there is an inefficient credit market for commercial loans the formula approach articulated in Till for the determination of an appropriate bankruptcy interest rate should be utilized. The predictable result is a loan with the prime rate of interest as its baseline, with the four risk factors analyzed by the experts to arrive at an appropriate bankruptcy rate of interest: a rate of interest that takes into consideration the risk factors pertaining to (i) the circumstances of the estate, (ii) the nature of the collateral, (iii) the reasonable certainty (probability) of the feasibility of the Plan, and (iv) the Plan’s multi-year duration. If the final interest rate in the Till case, involving a depreciating truck, only resulted in a 1.5% upward adjustment from prime, it is not unreasonable for a debtor to have an expectation that it could, in the commercial context, obtain a similar bankruptcy interest rate.
With the national prime rate being at an historical low, there currently is a window of opportunity for borrowers to restructure existing loans in the cram-down context at a favorable fixed rate predicated upon the prime rate as the initial benchmark plus an upward risk adjustment, for at least seven years along with some principal amortization. Although this is a minor adjustment to the prior conventional wisdom on the interest rate issue, the cram-down should be viewed as the ultimate borrower’s salvation in these troubled times because the actual interest rate will end up being advantageously low.
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