To confirm a chapter 11 plan over the objection of a secured creditor, the bankruptcy court must find that the plan treats the secured creditor fairly and equitably by, among other things, providing deferred cash payments with a pre' sent value of at least the amount of the secured portion of the claim. This "present value" requirement is generally understood to mean that the debtor must pay interest on deferred amounts at a rate equal to an appropriate discount rate. While there is some variation in the approaches courts use, most strive to identify the prevailing market rate for similar loans and then adjust (usually upward) to offset plan-related risks.
We believe that the prevailing approaches are misguided. For one thing, the interest rates these approaches generate fail to properly balance risk and return. More broadly, by focusing solely on interest as a means of compensating and protecting crammed-down secured creditors, they blind courts to other measures that can provide fairer and more efficient risk-offsets. To achieve these ends, we advocate for redesigning the framework courts currently use. To do so, we examine the economic risks that are inherent in the secured commercial lending relationship, both in and out of bankruptcy. Drawing from this understanding, a new and more rational approach emerges that will not only protect crammed-down secured creditors but will do so without unduly threatening plan feasibility or unfairly disadvantaging other creditors. Our findings are relevant not only to cramdowns but might also contribute to a deeper understanding of secured-creditor entitlements in a broader sense.
TABLE OF CONTENTS Introduction I. A Hypothetical Case II. Background: Risks Faced by Secured Creditors A. Fraud and Credit Risks B. Time Value of Money and Inflation Risk C. Collateral Risk D. Prepayment Risk E. Investment Opportunity Risk III. Analysis: Chapter 11 Secured-Creditor Cramdown Plans A. Secured-Creditor Cramdown Plans: Basic Elements 1. Cash Payments 2. Present Value 3. Fixed Rate 4. Feasibility B. Early Legislative and Judicial History of the Fair-and-Equitable Requirement C. The Circuit Court Search for a Market Rate D. The Supreme Court's Decision in Till 1. Factual Background & Proceedings in the Lower Courts 2. Three Supreme Court Opinions a. The Plurality Opinion b. The Concurring Opinion c. The Dissenting Opinion 3. What is Tills Precedential Value, if Any? E. Circuit Court Cases After Till F. Recent Reform Proposals IV. Discussion: A Better Approach to Secured-creditor Risk Protection A. The Crammed-Down Secured Creditor's Increased Risks. B. The Limitations of Interest Payments for Controlling Risk C. Setting the Base Rate D. Addressing the Collateral Risk E. Addressing Lost Opportunity Costs, Transaction Costs, and Other Relevant Factors F. Summary of the Proposed Approach V. Conclusion INTRODUCTION
When a bankruptcy court confirms (or "crams down") (1) a chapter 11 (2) plan of reorganization over the objection of a secured creditor, it must find, among other things, that the plan complies with the Bankruptcy Code's requirement that the creditor receive "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." (3) Essentially, the court must find that the plan payments have a present value as of the effective date, using an appropriate discount rate, of at least the amount of the secured claim. Plans generally satisfy this requirement by providing that the deferred principal amount will bear interest at a rate equal to the discount rate.
Unfortunately, the Bankruptcy Code gives no statutory guidance for choosing or evaluating a discount or interest rate for cram-down purposes. (4) Over the years, secured creditors have pointed out the many risks they face under cramdown plans and have pushed for higher interest rates to compensate for the added risk. In seeking to identify an appropriate rate, courts have come to varying and inconsistent conclusions, leaving this body of case law in disarray. For instance, some courts conclude that a plan rate should not compensate for lost profit or the creditor's costs with respect to the loan; (5) other courts adopt a contrary stance, authorizing rates that clearly include these components. (6)
The Supreme Court had an opportunity to bring clarity to this area of law in 2004 when it decided Till v. SCS Credit Corp. (7) While Till was a consumer bankruptcy case presenting the question of the appropriate rate under a chapter 13 plan, the cram-down requirements in chapter 13 are very similar to those in chapter 11. Thus, many hoped that this decision would provide cohesive guidance for all reorganization cases.
Unfortunately, the Supreme Court rendered a fractured decision. A four-justice plurality believed that the claim should bear interest at a rate determined by a "'formula approach," which involves adding a risk adjustment to the U.S. prime rate. (8) The opinion did not explain how a court should make the adjustment, noting only that courts have approved upward adjustments of one to three percentage points. A concurring opinion argued for a risk-free rate with no risk adjustment. (9) Finally, a four-justice dissent believed that the rate should be presumptively equal to the prepetition contract rate, subject to adjustment for plan-related risks. (10) Thus, the justices in both the plurality and the dissent agreed that it is appropriate for a court to make risk adjustments. Otherwise, the case provided no clear rule for chapter 13 cases, much less for chapter 11 cases.
The plurality in Till further suggested in dictum that, in a chapter 11 cramdown, a court may determine whether there is an efficient market for loans similar to the secured claim in question and use the prevailing market rate or, if no such market exists, use the formula approach. (11) The circuit courts of appeal that have addressed the issue since Till have generally followed this recommendation. (12) And, while many commentators have weighed in with criticisms and proposals for reform, they have tended to focus narrowly on the mechanics of interest-rate determination rather than on the deeper assumptions underlying the jurisprudential framework.
It is time to take a step back and consider the fundamental underpinnings of this approach, including a broader understanding of secured-creditor risk, return, and entitlement. In doing so, we believe it will reveal that the prevailing approach is inconsistent with the Bankruptcy Code and fails to properly balance risk and return. Under the present approach, courts have focused too much on a quest to find the prevailing market rate and, as a result, have ignored other essential components of the fair-and-equitable analysis. In particular, they have evaluated rates in isolation from other factors that bear on whether the plan is fair and equitable, including whether the creditor has already been compensated for risk and its costs by other means. In fact, compensation for risk may be better managed through other devices. Armed with a more sophisticated understanding of risk and return, bankruptcy courts will be able to engage in a more precise, risk-centered inquiry that the present-value analysis demands. The threshold inquiry should be whether the crammed-down secured creditors continuing lien provides adequate protection. Then, with respect to the plan interest rate, courts should begin with the yield on Treasury securities with a remaining term to maturity that is equal to the plan term. Courts should subject this base rate to upward-only adjustments, expressly identifying the relevant factors with sup porting evidence. We suggest a nonexclusive list of factors that courts might consider.
At the outset, we acknowledge that a flexible, multi-factor approach of this sort might introduce undesirable levels of uncertainty and unpredictability, but we believe that the Bankruptcy Code calls for a more principled analysis. Furthermore, the current state of the law is far from a model of certainty and predictability, much less logical consistency. Over time, as courts and litigants apply the framework to a variety of cram-down scenarios and expressly identify the reasons for adjustments, they will generate a baseline level of understanding that will help guide settlements in future cases, thereby driving down costs and inefficiencies.
Finally, it is important to note that our analysis is based on the current language of the Bankruptcy Code. Congress used a rather arcane formulation in the secured-creditor cram-down provisions. Had Congress intended to require interest at the prevailing market rate for a similar loan, at the applicable prebankruptcy contract rate or at the prime rate plus a risk adjustment, it could have said so in much simpler terms than the current statutory language. The fact that it chose not to do so must be considered in applying the statute.
Part I of this article presents a hypothetical case, highlighting some of the issues and inconsistencies in the way courts and litigants have assessed secured-creditor risks and entitlements in chapter 11. Part II introduces some of the risks faced by secured creditors in the ordinary course of their commercial lending transactions, both in and outside of bankruptcy. Part III explores the murky jurisprudence surrounding secured-creditor cramdowns and how best to compensate the secured creditors increased risk through plan interest payments. Part IV offers what we believe is a more nuanced assessment of both the ways in which the debtor's financial distress and bankruptcy amplify the secured creditor's risk, as well as the ways in which the plan may compensate for or protect against these risks. Our approach is designed to be responsive to the basic principles that have been articulated...