‘Prime-Plus’ approach adopted in cramdowns

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The U.S. Supreme Court on May 17 rejected the “coerced loan” approach to the cramdown provision in Chapter 13 bankruptcies, which presumes that a secured creditor be paid interest at the rate that it would obtain if making a new loan to a similarly situated debtor.

In doing so, the court reversed a decision of the Seventh Circuit, In re Till, 301 F.3d 583 (7th Cir.2002).

Sub-Prime Loan

Lee and Amy Till filed for bankruptcy protection under Chapter 13, and one secured creditor, SCS Credit Corporation, objected to confirmation of the plan.

SCS held a security interest in an automobile owned by the Tills amounting to $4,894.89, although the car was only valued at $4,000. SCS is a sub-prime lender, servicing borrowers with credit histories too poor to qualify for prime-rate auto loans. The interest rate on the Tills’ loan was 21 percent.

The Tills’ plan invoked the “cramdown” provision of Chapter 13 — 11 U.S.C. 1325(a)(5)(B). Under the cramdown provision, a bankruptcy plan will be confirmed over the objection of a secured creditor if the creditor retains its lien on the collateral, and the creditor receives payments over the course of the plan that are equivalent to the value of the collateral on the plan’s effective date.

Under the Tills’ reorganization plan, the interest rate on SCS’ secured claim was 9.5 percent. This rate was set using the “prime-plus” or “formula” rate, which augments the prime rate of 8 percent by 1.5 percent to account for the risk of nonpayment.

SCS submitted that the rate should be 21 percent, the interest rate it would earn if SCS foreclosed on the vehicle, sold it, and then reinvested the proceeds in another sub-prime auto loan.

Witnesses for SCS testified that they charged 21 percent interest on all of its loans because borrowers like the Tills are poor credit risks.

The bankruptcy court confirmed the Tills’ plan, setting an interest rate of 9.5 percent. The district court reversed, holding that SCS was entitled to 21 percent interest.

The Tills appealed, but the Seventh Circuit affirmed in a decision written by Judge Kenneth F. Ripple and joined by Judge Daniel A. Manion. Judge Ilana D. Rovner dissented.

The Supreme Court accepted review, and reversed in a plurality opinion written by Justice John Paul Stevens and joined by three other justices. Justice Clarence Thomas concurred, and four justices dissented.

“While full compensation can be attained either by low-risk plans and low interest rates, or by high-risk plans and high interest rates, it cannot be attained by high-risk plans and low interest rates.” Justice Antonin Scalia in dissent

The Statute

11 U.S.C. 1325(a) provides, in relevant part, that the court shall confirm a plan if —

“(5) with respect to each allowed secured claim provided for by the plan…

(B)(i) the plan provides that the holder of such claim retain the lien securing such 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…”

Four Approaches

The Court found that the Code gives no guidance as to which of the four proposed approaches for setting interest rates was intended by Congress when it adopted the cramdown provision — the formula rate, the coerced loan rate, the presumptive contract rate, or the cost of funds rate.

The court found three considerations to guide it in selecting one of the approaches: (1) Congress intended that courts use an approach that is familiar in the financial community and minimizes the need for expensive evidentiary proceedings; (2) Chapter 13 expressly authorizes a bankruptcy court to modify the rights of creditors; and (3) from a creditor’s point of view, the cramdown provision mandates an objective, rather than a subjective, inquiry.

The court concluded, “These considerations lead us to reject the coerced loan, presumptive contract rate, and cost of funds approaches. Each of these approaches is complicated, imposes significant evidentiary costs, and aims to make each individual creditor whole rather than to ensure the debtor’s payments have the required present value.”

The court noted that the coerced loan approach requires courts to consider evidence about the market for comparable loans to similar (though nonbankrupt) debtors — an inquiry the court called “far removed from such courts’ usual task of evaluating debtors’ financial circumstances and the feasibility of their debt adjustment plans.”

The court also found, “the approach overcompensates creditors because the
market lending rate must be high enough to cover factors, like lenders’ transaction costs and overall profits, that are no longer relevant in the context of court-administered and court-supervised cram down loans.”

Rejecting the presumptive contract rate approach, the court found it “improperly focuses on the creditor’s potential use of the proceeds of a foreclosure sale.” In addition, it requires the debtor to obtain information about the creditor’s costs of overhead, financial circumstances, and lending practices to rebut the presumptive contract rate.

The court also found it produces absurd results by entitling “inefficient, poorly managed lenders” to obtain higher rates than “well managed, better capitalized lenders.”

The court also found that, under the approach, “similarly situated creditors may end up with vastly different cram down rates.”

The court also rejected the cost of funds approach, as mistakenly focussing on the creditworthiness of the creditor, rather than the debtor. In addition, it imposes a significant evidentiary burden, and permits a “financially unsound, fly-by-night lender” to obtain a higher rate of interest than a creditworthy one.

Formula Approach

In contrast, the court found the formula approach suffers from none of these defects.

The court found, “Taking its cue from ordinary lending practices, the approach begins by looking to the national prime rate, reported daily in the press, which 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. Because bankrupt debtors typically pose a greater risk of nonpayment than solvent commercial borrowers, the approach then requires a bankruptcy court to adjust the prime rate accordingly.”

The court added, “The appropriate size of that risk adjustment depends, of course, on such factors as the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan. The court must therefore hold a hearing at which the debtor and any creditors may present evidence about the appropriate risk adjustment. Some of this evidence will be included in the debtor’s bankruptcy filings, however, so the debtor and creditors may not incur significant additional expense.”

In addition, by starting from a concededly low estimate and adjusting upwards, the approach places the evidentiary burden on creditors, who are more likely than debtors to have ready access to information about the market.

Finally, the court noted that the factors relevant to the adjustment “fall squarely within the bankruptcy court’s area of expertise.”

The court found that it need not determine the proper scale for the risk adjustment, but noted that lower courts generally have approved adjustments of 1 percent to 3 percent.

Accordingly, the court reversed the Seventh Circuit, and remanded with instructions to further remand the case to the bankruptcy court.

The Concurrence

Justice Thomas wrote separately from the plurality, finding that it ignored the text of the statute, “in an apparent rush to ensure that secured creditors are not undercompensated.”

Thomas concluded that the statute only requires that the creditor receive the present value of its claim, and need not reflect any upward adjustment for the risk of nonpayment.

Thomas acknowledged that use of the prime rate may systematically undercompensate secured creditors, and that this may be “problematic as a matter of policy,” but found this “raises no problem as a matter of statutory interpretation.” Thus, even the prime rate of 8 percent would be sufficient.

Because the 9.5 percent interest rate sufficiently compensates the creditor, however, Thomas agreed with the plurality that the Seventh Circuit’s decision must be reversed.

The Dissent

Justice Scalia dissented, in an opinion joined by Chief Justice William H. Rehnquist, and Justices Sandra Day O’Connor and Anthony M. Kennedy, arguing that the prime-plus rate systematically undercompensates creditors for the true risk of default, and arguing in favor of using the contract rate — the rate at which the creditor actually loaned funds to the debtor — as a presumption that the bankruptcy court could revise on motion of either party.

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Calling that rate “generally a good indicator of actual risk,” the dissent concluded that disputes would be infrequent, and the rate would provide a “quick and reasonably accurate standard.”

The dissent found that the contract-rate approach makes two reasonable assumptions: that sub-prime lending markets are competitive and therefore largely efficient; and that the expected costs of default in Chapter 13 are normally no less than those at the time of len
ding.

The dissenters wrote, “While full compensation can be attained either by low-risk plans and low interest rates, or by high-risk plans and high interest rates, it cannot be attained by high-risk plans and low interest rates, which, absent cause to anticipate a change in confirmation practices, is precisely what the formula approach would yield (emphasis in original).”

Rejecting the plurality’s objection that the contract rate may treat similarly situated creditors differently, the dissent noted that it is only a presumption, and observed, “if two creditors charged different rates solely because they lent to the debtor at different times, the judge could average the rates or use the more recent one.”

Calling the 1.5 percent addition to the prime rate “impossible to view … as anything other than a smallish number picked out of a hat,” the dissent called it “obviously wrong — not just off by a couple percent, but probably by roughly an order of magnitude.”

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David Ziemer can be reached by email.