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Tuesday, July 30, 2013

The Real Defect in Eminent Domain Attacks on Residential Mortgages

The New York Times carries a front-page article on Richmond CA's plans to use its eminent domain power to confiscate underwater mortgages from the current mortgage holder and restructure them in lesser amounts that leave the homeowner with a bit of equity.  Unfortunately, the article completely misses the main legal problem with the city's plan, which is that it conflicts with the Contracts Clause ("No State shall ... pass any ... Law impairing the Obligation of Contracts"), and the Bankruptcy Clause ("To establish ... uniform Laws on the subject of Bankruptcies throughout the United States") of Article I of the U.S. Constitution.   Notwithstanding the use of the "eminent domain" terminology, the law amounts to nothing more than a retroactive discharge of private debt.  Early, foundational Supreme Court cases, that remain good law, make it clear that states (and by extension, their municipalities, which have no greater power than their state) cannot discharge a debt that existed before the legislation was passed (Ogden v. Saunders; Sturges v. Crowninshield )  It should be noted that these cases arose, and the Court's opinions only speak to a situation, when there was no federal bankruptcy law in force).  As for case law from an era where federal bankruptcy legislation was in effect, see Pobreslo v. Jos. M. Boyd Co., 287 U.S.518 (1933) (federal law pre-empts discharge provisions of Wisconsin law governing assignments for the benefit of creditors);  International Shoe Co. v. Pinkus, 278 U.S. 261 (1929)("A state is without power to make or enforce any law governing bankruptcies that impairs the obligation of contracts or extends to persons or property outside its jurisdiction or conflicts with the national bankruptcy laws."); Stellwagen v. Clum 245 U.S. 605 (1918)(any state law that effects a discharge from debts is "suspended" when federal bankruptcy legislation is in effect).

I think that law is pretty clear and not much in doubt.  One could, but does not need to, go into the modern law on pre-emption principles, but I don't think that is necessary when there is such specific and substantial case law on point. The only issue is whether the use of "eminent domain" to restructure debts avoids this line of cases.  I think to conclude that it does is to elevate form over substance, generally a disfavored approach in modern times.  The only thing this law would do is relieve a resident from paying a debt in full, which is clearly a discharge in function if not in words. But also the Contracts clause is quite broadly worded (if not always interpreted that way): this is clearly a law that impairs a contract.  There is no "eminent domain" exception to the Contracts Clause; it picks up all kinds of laws.

And one has to think about, as any Supreme Court argument would dwell on, what are the ramifications for other types of debt if this were permitted to stand.  A municipality could pass a further law applying eminent domain to credit card debt, to stimulate purchases from local retailers.  Or a law taking medical debts, because "it's the right thing to do", and so on. There would be no reason left for citizens to file for chapter 7 or 13 to obtain relief from their debt.  And that would frustrate a long-standing, widely used and quite substantive federal law, and thus should be pre-empted. 

Monday, July 15, 2013

As Anyone Who Knows Securities Law Knows, Barry Ritholtz Does Not Know Securities Law ...

When I opened The AmLaw Litigation Daily today, I saw a link to an article about the Fabrice Tourre trial, which I have written about earlier.  The article brought to my attention a post by Barry Ritholtz about the lawsuit, which I found to be a remarkable combination of arrogance and ignorance about the legal issues therein discussed.  Ritholtz's website describes him as a cum laude graduate of Cardozo Law School and a member of its Law Review, who left the practice of law after a few years to go into "finance" by which I think he means managing money in the stock market. He is now the "CEO and Director of .. an online quantitative research firm" and writes about the market and financial issues on his blog and elsewhere.  He may be good at that line of business, I don't know.  As for his legal insights or lack thereof, well, the Model Rules of Professional Conduct and the ABA call on attorneys to "consider it part of his or her fundamental professional responsibility to further the public’s understanding of the rule of law and the American system of justice."  This post is intended to fulfill that responsibility by correcting the public record as to what the applicable law is.

Ritholtz's post is a screed about supposed errors in a column by Andrew Ross Sorkin in the New York Times' "DealBook" that identified numerous instances of the SEC seeking to exclude information from Tourre's jury, and noted the irony of an exclusionary agenda in a suit about full disclosure.  Ritholtz describes the article as "terrible media coverage"; "the awful media story of the day"; ""botched ... coverage"; "reek[ing]of defense attorney spin, expertly flacked"; "paydirt in ... gullibility"; "laughabl[e]"; "completely erroneous"; "nonsense"; "slipshod"; and "one-sided and erroneous in the extreme". I wonder if this is how they teach legal writing at Cardozo -- the highest possible ratio of epithets and adjectives to substantive analysis as possible?  You can see why someone who writes like that would have grown frustrated with the practice of law, where you have to back up claims like that with, you know, evidence and authority.

Ritholtz explains Sorkin's column with the following: "As anyone who understands security law knows, prosecutors are extemely [sic] limited about what they can say in public about an active litigation (Rights of the accused and all that). This allows clever defense lawyers to find gullible journalists to dupe with a one sided set of ridiculous accusations, knowing full well that the SEC cannot respond."

Well, as anyone who understands criminal law knows, there is no "prosecutor" in a civil case and the "rights of the accused and all that" (in, I think, the Bill of Rights?) aren't available in a civil case where there is no "accused".  And SEC v. Tourre is a civil case.

Also, as anyone who reads media coverage of judicial proceedings knows, the prosecution is by far more likely to leak details about the case to the media at the pretrial stage, in the hope of pressuring defendants or sometimes just to embellish the prosecutor's image for future career or electoral accomplishments. As one such example, counsel to the parents of Jon Benet Ramsey wrote: "Outrageous falsehoods were leaked to the media by authorities in an effort to break the Ramseys and force their prosecution. Compelling evidence of the Ramseys’ innocence was, by contrast, kept under wraps by the authorities."

But, in any case, Sorkin's column isn't about "a one-sided set of ridiculous accusations" and the SEC isn't "limited about what it can say publicly" concerning them; Sorkin just reports what the two sides are disputing in court - "in public"!.

Claiming that Sorkin "does not understand Security law of 10b-5 [sic]", Ritholtz states "there is a rich history of 10b-5 prosecution, the statute is specific, the case law well settled, and the evidentiary standards are well known." Drawing on, apparently, his understanding of that well-settled case law, Ritholtz informs us that "The prosecution doesn’t even have to show the salesman knew (or should have known) he was being deceptive. There is no mens rea (guilty mind) component; there is no need to prove actual deception on the buyer; what the buyer knew or should have known is irrelevant."  He goes on to assert (his bold and italics): "All a prosecutor has to demonstrate is that the sales pitch was deceptive, and that deception was material."  Although Ritholtz contends, "When ever I wrote something up, I try to show how I reach my conclusion.", Ritholtz actually does not analyze any particular dispute mentioned in Sorkin's column or explain how his legal insights would lead to a victory for the SEC.  He just quotes 10b-5 and declares "End of story, next case please."

Well, Ritholtz is obviously wrong "as anyone who understands security law knows".  Beyond materiality and deception, the SEC has to show "scienter", which is generally held to be satisfied by a showing of recklessness about the disclosure or lack thereof.  See, Aaron v. SEC, 446 U.S. 680, 691 (1980); see also Allan Horwich, "An Inquiry Into The Perception of Materiality as an Element of Scienter Under SEC Rule 10b-5" (2011) at n.3.  Tourre's state of mind is actually at the heart of the case. So when Sorkin recounts that "The government has argued that Mr. Tourre is part of a 'scheme' to defraud investors, but the government has not charged anyone else. The S.E.C. insists that jurors not be told that."  that is relevant to the scienter requirement:  the SEC (apparently) doesn't have a great deal of direct evidence of scienter, so they (apparently) are trying to establish scienter-by-association, by painting him as part of a "scheme"; so it's relevant for the defense to point out to the jury that, three years after the suit against Tourre was filed, no other members of the "scheme" have been identified, and that may be something the jury would like to know when evaluating the allegation of a "scheme".  It just goes to the strength of the allegation the government chose to make.

Other items Sorkin says the SEC is trying to exclude are generally relevant to the materiality of the alleged deception. In an action under Rule 10b-5, a fact is material if “there is a substantial likelihood that a reasonable [investor] would consider it important” in making its investment decision. An
omitted fact is material if there is “a substantial likelihood that the disclosure of the omitted fact
would have been viewed by the reasonable investor as having significantly altered the ‘total mix’
of information made available.” (Quotes from Basic, Inc. v. Levinson, 485 U.S. 224, 231-2 (1988) (quoting TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976)).  So, when Sorkin writes: "The S.E.C., for example, has sought to block any mention of news reports that Mr. Paulson was betting against the subprime mortgage market. The defense argues that the news reports are necessary to demonstrate that the institutional investors, who arguably read the news as part of their jobs, were not duped into thinking that Mr. Paulson was betting that the value of Abacus would rise, undercutting the S.E.C.’s contention that the investors were misled victims."  that information goes to materiality, because published news reports about an asset class are part of the "total mix of information" the investors are exposed to concerning that asset class.

Sorkin also reports that the parties battled over the defense's ability to introduce evidence that the SEC's star witness was the subject of an SEC investigation in an unrelated matter which the SEC dropped just a couple weeks before trial.  The evidence goes to a star witness's bias and credibility when she alleged she was deceived, as the SEC wanted, so sneering (inaccurately) about the elements of a 10b-5 action is irrelevant to the admissibility of evidence about a witness's bias and credibility on an issue even Ritholtz puts at the heart of the case.

In some respects, the SEC's positions smack of desperation.  Their decision to target a relatively junior deal guy has always seemed perverse to me.  There seems to be no "smoking gun" and Tourre is a relatively young person who hasn't made tens of millions of dollars and thus cuts an even more sympathetic figure than the senior people at other firms who prevailed against the SEC in other enforcement actions. And the SEC already collected $550,000,000 from Goldman on the same lawsuit.  They really ought to have dropped the case against Tourre and declared victory. By not doing so, they painted themselves into a "win-or-die" corner and are pulling out all the stops not to be embarrassed again.  I feel sorry for Tourre and hope he prevails at trial.

That concludes my public service announcement which has hopefully added to the public understanding of the law.  As Barry Ritholtz once wrote, "End of story, next case please".

Thursday, July 11, 2013

Three Thoughts on Tribune's Announced Plan to Split into Two, Six Months After Emergence

Tribune announced this week that it will split into two companies, one centered on publishing and one with everything else, following in some respects the leads of News Corp and Time Warner, and conceivably others I haven't heard about.  The decision is pretty well known so I won't bother to link to any of the numerous stories about it.  It triggered three thoughts that I felt worth mentioning.

First thought:

Moving up almost $2 on the announcement,Tribune's stock is now up more than 30% since it emerged from chapter 11 about six months ago (and about 20% in the last month, although it must be noted that a week before the spin announcement, TRBAA also agreed to buy 19 more TV stations, entirely financed with debt, which analysts believe will be highly accretive).  This illustrates a point I discussed in a post about a month ago, that post-emergence performance of the equity of reorganized companies tends to belie enterprise valuations and recovery estimates that disclosure statement usually contain; generally, disclosure statement valuations are lower than where the market values the reorganized company 6 & 12 months after emergence; thus, recovery estimates keyed to those pre-emergence valuations are similarly lower than creditors actually receive if they hold on to the equity for a modest time after emergence.

In the case of TRBAA, the disclosure statement valuation was prepared in March and April 2012.  It projected an equity market cap as of 12/31/12, the assumed (and actual) effctive date, of $4.536B (see docket 11355, Ex C).  Today, Bloomberg tells me TRBAA's equity market cap is $5,273B, up about $700 million from the estimate that was used to estimate recoveries in the disclosure statement.  So actual recoveries, which were estimated to run from 33.6 to 70% should likewise be understood to have been higher than estimated (exactly how much higher is hard to say because no class received purely equity.

Second Thought:

I remembered reading a couple of decent investment theses on TRBAA back in January when it came out, so I went back and checked them out to see how they compared to what actually happened.  One was on the Distressed Debt Investing site, which I subscribe to.  The author's bottom line was the stock was fairly valued at $49 upon emergence, based on multiples of 4.5x, 6.25x and 11x for respectively, TRBAA's publishing, broadcast and Food Network lines of business, and no value for its real estate on the basis that it was all used in the business and not separately saleable, but did note that, with slightly higher multiples and assigning independent value to the RE, a case could be made for a $60 price, which is where it was before the announcement. Also, the author did identify the possibility to "spin off the newsprint assets to help revalue the core broadcasting business higher.  I believe they should be allowed to do a tax free spin of the newsprint assets" (by newsprint, I assume he meant the newspaper publishing business and not the manufacture of newsprint per se).  So, although his bottom-line conclusion that the stock was fairly valued at $49 proved to be conservative, certainly it was an reasonably accurate analysis up to that point.

The other investment thesis came from Meryl Witmer, who often recommends post-emergence equity, in Barron's, which I also subscribe to.  Her thesis was in some respects the opposite of the Distressed Debt Investing analysis, as it didn't reference a spin of publishing (in fact, she predicted a sale of publishing, which, as the Distressed Debt Investing analysis anticipated, and as this week's news reports confirm, would have been terribly tax-inefficient)  but even so she was much more bullish and pretty much nailed the stock price move. Since Barron's is a gated site, this link may not work, but I will pull out the paragraph with the highlights:

"We estimate Tribune will have about $6 a share of free cash flow in 2013, of which 40 cents is excess depreciation and amortization over capital spending. The Food Network and other assets contribute $2 of the $6. The publishing and broadcast segments earn $4 of free cash flow, and we value them at nine times after-tax cash flow, or $36 a share. That is a conservative number. The split is about one-third publishing and two-thirds broadcasting. Then we add $20 to $25 for the Food Network and another $7 to $8 for CareerBuilder and some other online assets and real estate. We deduct a couple of dollars for pension liabilities, and get a low-end target price of $60 a share. The retransmission payments that Tribune might garner from negotiations with cable providers could add a dollar to earnings over time, which would add $10 or more to the value of the stock. The turnaround at WGN is difficult to value, but given management's track record, it could be worth at least $10 a share. Add it all up, and we get a range of $60 to $80 a share, plus free cash generated in the interim, which adds another $6 a share per year. We see the stock at $90 in three years."

Interesting that they both saw a case for $60/share, only for one it was the high-side and for the other it was the low-side.  The stock closed at $64 and change today. Even before the announcement of the spin, Imperial Capital had put out a research note raising their target price from $70 to $76 based on what they perceive to be the accretive quality of the broadcasting acquisition. (NB: I do not have any position in TRBAA as I generally avoid "old media" stocks, and I have no view on whether any of the bullish outlooks will prove out. I just read and write about value investing out of intellectual curiosity.  But bravo to those who got this right.)

Third Thought:

One of the main policy arguments being made by proponents of rewriting the Bankruptcy Code is that the original intent of chapter 11 has been perverted by distressed debt investors and senior secured creditors to become a crass "financial and takeover play" where cases are rushed through to confirmation or liquidation by these heartless institutions just looking for a quick buck, depriving poor corporate debtors of the chance to use the "tools" of chapter 11 to fix their business under court protection in a more "thoughtful" manner.

Well, obviously, Tribune puts the lie to that myth as well.  Tribune was in chapter 11 for over 4 years.  That's more than enough time to use the "tools" provided by the bankruptcy code in a "thoughtful" manner.  So when does it make the strategic decisions to double down on broadcasting and split up into two businesses?  During those 4 years?  Um, no.  Six months after emergence.  Its chapter 11 process was principally spent fighting about who would bear how much of the loss that came from the over-leveraged Zell buyout.  It didn't need any more time in chapter 11.  What it needed was to get out of chapter 11, and turn off the professional fees associated with litigious bankruptcies.  Then it could fix its business, the way solvent companies somehow manage to do without resort to the tools of the bankruptcy code.

Bankruptcy is a good environment for addressing balance sheet mistakes and legacy liabilities, but the legalistic environment -- with every party in interest having a statutory right to object to management decisions, numerous constituencies billing the estate (effectively the fulcrum creditors) for legal and FA advisors reviewing those decisions, and all decisions being passed on by a judge who does not likely have industry experience to evaluate them independently -- is nowhere near as conducive to operational and strategic boldness and creativity as is commonly supposed.  More often, the better path by far is to get out of chapter, simplify the number of constituencies management has to think about, get the balance sheet right so the company has the capacity to make long-term decisions again, and get on with life as a rehabilitated company.

Tuesday, July 9, 2013

Pension and Other Post-Retirement Obligations Dominate the Balance Sheet at AK Steel

Over the weekend, Barron’s ran this chart with one of its writers’ columns:

In Over Their Heads

These companies have pension liabilities that equal or exceed their market value. Below, each firm's liability as a percentage of market cap.

AK Steel                                 917%

Unisys                                    562

Resolute Forest Products        516

United States Steel                 439

Exelis                                     228

Navistar International             196

Alcoa                                    179

Goodyear Tire and Rubber    174

Huntington Ingalls Indus         174

General Motors                     173

RR Donnelley & Sons           171

J.C. Penney                          148

Northrop Grumman              142

Lockheed Martin                  133

Delta Air Lines                     132

Sears Holdings                     118

Raytheon                             116

Allegheny Technologies        105

Textron                                100

Boeing                                 100

Market capitalization data as of July 5, 2013. Liabilities data as of Fiscal Year End 2012. Sources: J.P. Morgan Asset Management, Bloomberg, company reports.

Struck by how large an outlier AK Steel was, I thought it would be interesting to look into it some more. 

First, I looked at its market cap over time.  Right now, AKS is a $3.25 stock.  Five years ago, back in July 2008, however, it was a $50 stock;  even in Q2 2010, it was a $25 stock.  At the earlier point, it would have had a post-retirement-to-market-cap ratio below 1:1.  At the later, it would have been around 1:1.  Now, however, it’s 9:1, according to Barron’s.  (All the other facts in this post come from, AKS’s 10-K for 2012, its Q for Q113, its year end press release and the May 2013 investor presentation on the IR page of its website).

Second, I looked at what were being counted as its pension liabilities.  AKS’s balance sheet shows an accumulated post-retirement obligation deficit of about $1.77B.  But its market cap, with 136MM shares outstanding, is about $440 million.  That is not a 9:1 ratio, so the Barron’s chart must be based on gross liabilities, ignoring the pension assets.  That doesn’t make a lot of sense to me.  So AKS’s ratio of net post-retirement obligations to equity market cap is nowhere near 9:1 but more like 4:1, a very different number.

Still, that's a lot of leverage and the $3.25 stock price signals the company has big problems going on, so (third) I  wondered what the rest of its balance sheet looked like. And it wasn’t pretty.  Here is a super-condensed version of the 12/31/12 b/s:

($ in millions)
($ in millions)
A/P & accrued liabs
A/R, net
Long-term Debt
Inventory, net of LIFO reserve
Pension & other post-retirement
Other liabs
Investments in JV’s etc
Deferred Tax and other misc intangible assets

The super-condensed balance sheet suggests AK Steel is “insolvent” on a “fair value” basis as such terms are defined  in the Bankruptcy Code:  it has total assets of $3.9B which include, however, deferred tax assets and other similarly non-marketable assets equal to roughly $0.4B  It has liabilities that would be difficult to dispute of almost $4B.. If we strip out the non-marketable intangible assets and liabilities, there is a negative net worth of about $0.5B.  (And that assumes the investments are worth book but who knows?)

Looked at as an EV multiple of EBITDA, it still appears to be balance-sheet insolvent.  EBITDA for 2012 was only $181 million and for 2011, $266 million, neither of which will support liabilities over $3B at a normal, let alone a steel industry, multiple.  EBITDA for the last quarter, although up substantially y/y, was only $67 million.  Things probably have not improved much in the quarter just ended; although they won’t announce earnings for another couple of weeks; their ASP will likely dip by 1% in 2Q13 to $1,055 per ton, the company disclosed last month. 

Fourth, I looked at its cash flow and liquidity.  Again, not pretty.As you can see from the following table, for the past three years, AK Steel has had increasing negative cash flow from operations, and increasing incurrence of debt.

Net Cash Flow from Operations
Net Cash Flow from Investing
Net Proceeds from Debt Issuance[1]

Source:  AK STEEL HOLDING CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS Years Ended December 31, 2012, 2011 and 2010 (dollars in millions)

So it looks like they have burned over half a billion cash on an operating basis in the past three years, while maintaining capital investments at an average level of a quarter-billion a year, which I assume is rational in their industry, but funding it all through debt – over $1.1B of incremental debt.  Since debt is now over $1.4B, that means, since the start of ’10, they have quadrupled their long term debt.  It would be nice if they were getting the full benefit of QE’s low interest rates, but in fact the coupons are all north of 7.5%.  Interest expense last year was about $87 million and should be around $100 million this year.  On the bright side (and this is the only bright side I can find), there are no maturities in the next three years.

The company’s investor communications lately emphasize that they have over $1 billion of liquidity, taking into account over cash on their balance sheet and about $872 million of undrawn availability under an ABL.  However, cash on the balance sheet has dropped just $50 million in the first quarter, from $227 million to $171 million.  Q2 will not show as much a drop, but only because AKS issued $30 million of new debt in June.  Also, I have not looked at the revolver to see what, if any financial conditions there are to borrowing, and if there are, whether AKS can satisfy them.   Regardless, it does seem AKS should be able to scrape through 2013 if it can keep  EBITDA in the $66 million / quarter run rate. With $171 of beginning cash, plus 4X $67, of $268 of incoming EBITDA, they can cover $100 of interest expense and a capex run-rate of 250, if they're still capex-ing at that rate, for the next 12 months or so.

The only other glimmer of hope  is that AKS’ very heavy pension funding burden is projected to moderate by 2016 (when, btw, their ABL expires). In 2013-15, they project to spend nearly $740 million in pension and OPEB payments   At least that is down from the last three years, which took about  $860 million out of them.  I believe those payments are already deducted above the line in AKS’s EBITDA calculations.

So far the market is financing them and not panicking.    Their senior unsecured debt is rated B1/BB-, so relatively high up on the high-yield credit ladder.   The outlook is “solidly negative” however, in S&P’s view, so a downgrade could come at some point, and, frankly, the rating seems a little high to me  for the balance sheet.  The unsecured debt is quoted in the high 80’s, so not in distressed territory.  Its equity cap of $440 million probably reflects more of a long-term call option on the business if steel prices go up, given the current negative book net worth, leveraging off the fact there are no debt maturities for the next few years.  But given the cash flow projection I estimated in the preceding paragraph, how long-term is that call option really?  It might be as little as a year.  My guess is everyone is playing it a quarter or two at a time, hoping for steel prices to turn up again (good luck, last week's Economist carries a story titled "Steel: An Inferno of Unprofitability").  If they don’t do so by year-end, however, then sometime in 2014, notwithstanding the absence of  fixed debt maturities, AKS may find itself with liquidity challenges that will force it to start to access its revolver or find longer-term capital (at what will probably be a very steep price), because revolver banks very much don't like revolvers being drawn to provide permanent capital.  Otherwise they will face a restructuring or a sale to, likely, a foreign buyer sometime after 1H14..

[1]  Proceeds of debt incurrence, minus debt repayments & debt issuance costs

Tuesday, July 2, 2013

A Deep Dive Into the Texas Grand Prairie Decision

In March, a panel of the Fifth Circuit issued an opinion, Wells Fargo Bank, N.A., v. Texas Grand Prairie Hotel Realty LLC,  affirming a bankruptcy court order confirmng a chapter 11 plan for four commonly controlled debtors that owned hotels in Texas.  The case has generated numerous client letters, blog posts and other commentary because it upholds the application in chapter 11 of the "prime plus" or "formula" method for determining the applicable rate of interest to cram-down secured debt under 1129(b)(2)(A) that a plurality of the Supreme Court approved for chapter 13 plans in Till v SCS Credit Corp., 541 U.S. 465 (2004).  The commentators disagree whether the opinion green-lights Till in chapter 11 cases (when the panel states “while it may be ‘impossible to view’ [debtor’s] 1.75% risk adjustment as ‘anything other than a smallish number picked out of a hat,’ the Till plurality’s formula approach — not Justice Scalia’s dissent — has become the default rule in Chapter 11 bankruptcies.”) or is actually signaling something different (when they note at the end of their opinion that it is predicated on the appellant's stipulation that Till controlled but aside from that, they “do not suggest that the prime-plus formula is the only — or even the optimal — method for calculating the Chapter 11 cramdown rate.”). 

However, bankruptcy courts in the Circuit are already interpreting the opinion as a license to apply Till in chapter 11 cramdowns over the objection of the secured creditor.  See, e.g., the May 24, 2013 decision of the bankruptcy court in Austin, In re LMR, LLC, reproduced on Weil's website). (Although LMR is another hotel owner in Texas, nothing about the reasoning of either Grand Prairie or LMR supplies any basis to think the approach is limited to that kind of debtor.  But the coincidence is remarkable that the other modern Fifth Circuit case on chapter 11 plan interest rates, In Re T-H Limited Partnership, is also a case involving an owner of multiple hotels.).  I write this post frankly to argue against that trend.  I don't think the Till approach is correct at all, but setting that aside, a deep dive into the record and briefs in Texas Grand Prairie has unearthed some facts about Texas Grand Prairie that did not make it into the Fifth Circuit opinion that I think make it a particularly bad vehicle to reach any grand conclusions about cramdown interest rates. 

In particular, from the briefs and record, I learned that the 5% interest rate crammed down on the lender compared to a 1.9% rate that would have resulted had the contract rate been reinstated (although the contract rate was a floating rate and the 5% was fixed).  Since the dissent in Till advocated a presumption in favor of the contract rate, which would then be adjusted up or down based on a variety of factors, one can see that the plurality approach probably resulted in the Texas Grand Prairie getting a higher (albeit fixed) rate than under the Till dissent's approach. 

Secondly, the lender's expert had conceded the plan was feasible, if barely so (I am puzzled as to why the objector's expert gave such an opinion; there is no requirement to have an opinion on more than one issue and, although experts cannot be controlled at the end of the day, trial counsel normally manage to keep their side's experts from volunteering opinions that are not helpful to their client's case).  That seems to me to have harmed the lender's case, because it undercut its claims about the level of risk in the plan. Even the plurality in Till says in a couple of places that plans with high risks of default ought not be confirmed and on appeal you would like to be able to argue as forcefully as possible that the plan you're challenging was one such plan.

Last, the appellant framed its challenge, not as an issue of law related to the interest rate methodology, which would be reviewed de novo, but as a challenge to the admissibility and weight to be given the debtor's expert's testimony, which of course is reviewed for abuse of discretion (it attempted to repair that mistake in its reply brief but, as one of my professional friends who later became a federal circuit judge once told me, "we don't have time to read reply briefs").  Challenging the expert's methodology is not the same as challenging the Till plurality's methodology.  I would hope that future courts considering Texas Grand Prairie as a precedent would recognize this and accordingly recognize that it did not really involve a properly framed challenge to the Till plurality's methodology and not misconstrue it as an endorsement of Till.

At the same time, there are some aspects of the case that might have been litigated differently to produce a different result.   As alluded to above, the Fifth Circuit opinion says that "Both parties stipulated that the applicable rate should be determined by applying the “prime-plus” formula endorsed by a plurality of the Supreme Court in Till...."  But the odd thing is that I don't see any reference in any of the briefs to such a stipulation.  What I do see is a very strained interpretation of Till by the creditor-appellant that may have confused the panel and contributed to the decision in the debtor's favor. 

The appellant's brief makes a chest-thumping proclamation that Till requires "objective analysis" of "market evidence" and "ordinary lending practices" in formulating an interest rate.  So, in that sense, the creditor-appellant is definitely saying that Till governs and maybe that is what the opinion means by a stipulation.  But the appellant has Till all wrong.  Its brief makes virtually no mention of the "prime plus" formula.  While I wish Till had said what the appellant claimed it said, because that is what the law should be, Till's plurality opinion explicitly rejects incorporating market evidence, stating in the first paragraph of Section III of that opinion:

"For example, the coerced loan approach requires bankruptcy courts to consider
evidence about the market for comparable loans to similar (though nonbankrupt) debtors an inquiry far removed from such courts usual task of evaluating debtors financial circumstances and the feasibility of their debt adjustment plans. In addition, 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 cramdown loans." (Emphasis added)
Now, if the plurality had adopted the "coerced loan" approach, the appellant in Texas Grand Prairie would have been correct that the Court wanted bankruptcy courts to look at the loan market.  But they rejected it, obviously; that was the approach endorsed by the Seventh Circuit opinion overturned by Till. So the appellant was just off the mark in how it presented the key legal argument to the panel.  (Appellant's reply brief tried to correct for that, but see quote above for the value of reply briefs in fixing your mistakes.)  The Fifth Circuit opinion quite clearly spells all this out. 
The wrong-headed appellate approach is too bad because the case contained some decent facts for the appellant, had it framed them differently.  Among the key facts that would have supported a different strategy, I found these in the briefs:
1.   Although the circuit court opinion only refers to the appellant's secured claim of $39 million, which was equal to the value of the collateral, its allowed claim was $51 million, so it had a general unsecured claim of roughly $12 million that was lumped in with the general unsecureds in a class that was also crammed down with periodic payments eover 5 years equal to 25-30% of the claim.  So, one might wonder, how did the plan get confirmed if both the mortgage and unsecured claims were crammed down.  Apparently, there were two small secured claims (property tax and a vendor with a deposit) that were classified separately and called "impaired" because the plan provided them to be paid in full ten business days after the effective date of the plan, on account of which treatment they voted to accept, giving the debtor accepting impaired classes.  There is no indication in the briefs that appellant either raised an objection to the artificial impairment, or preserved it for appeal.  Notwithstanding the Circuit's recent Camp Bowie decision, I don't understand how that could have gone uncontested in 2010.  Also, while I have not done the math, I cannot quite understand why the lender chose not to make an 1111B election on these facts because the economics seem to favor keeping that extra $12 million as a secured balloon payment getting some interest, even if it reduces the interest rate on the $39 million portion of the claim somewhat.  Perhaps it was to keep the general unsecured class from voting to accept, but what does that matter if you're not going to object to the artificial impairment of the other secureds?
2.   The plan was, of course, a "new value" plan and the debtor conducted an "auction" of sorts for the equity that was being infused by old equity.  The person conducting the auction was the same one who testified at trial as an expert on the proper interest rate.  He did not find anyone interested in paying more for the equity than the insiders.  One reason he gave for the lack of response seems highly relevant to the cramdown issue on appeal: "the assignment was challenging because the reorganized debtors would be fully leveraged, with the lender’s secured claim encumbering the hotels at a loan-to-value ratio of 100%."  He further testified:
"And so what you’re really selling is an option, sort of an upside option. Okay? And so on a fully valued estate, is someone willing to pay more than 1.5 million dollars for the option that there’s value accretion in excess of that….

"So as a valuation guy, I looked at it and said, you know, this seems to be fully priced…. But the universe for this type of buyer in this atypical transaction that, to me, seemed to be fully priced, I was -- I knew we had an uphill battle, and frankly, I didn’t know if we’d get any takers on the front end.”

Bizarrely, the bankruptcy judge agreed with him: "the owner of the new equity “may receive a return on its investment, but … they have put their money into a high risk investment and may receive no return".  (Emphasis added).  Of course, I look at that and say, if the equity in a 100% LTV asset has high risk of no return, then the loan must have a similarly high risk of a loss of some kind because the odds are pretty small that the losses are going to magically stop right at the debt/equity line.  And you would expect that recognition to show up in the interest rate analysis, but sadly it does not.

3.  The debtor's expert testified that average terms for loans to limited-service hotels in 2010 included a loan-to-value ratio of 58%, an interest rate of 7.9%, and a debt-coverage ratio (net operating income divided by debt service) of 1.5, none of which come close to the terms of the plan.  But he disregarded the market "because he believed that the market for hotel and hospitality loans generally was not an efficient market".  Which of course are magic words, if you want to invoke Till, as I shall discuss further below. 
Thus, he positioned himself to develop an interest rate based on the prime-plus formula.  He formulated one by determining that the obligation at issue was “just to the left of the middle of the risk scale,” which he understood to be a range of one to three percentage points above the prime rate, absent “extreme circumstances”.  Obviously the "1-3 percentage points" of risk spectrum come from dictum in Till, not finance or controlling precedent.  He testified: I used a one-to-three, which seems to be suggested in Till, and the middle of the one-to-three range [above prime] would’ve been two. The rate just to the left of that, 1.75. That’s what I chose”.  Personally, were I a judge, I would have a hard time seeing that as expert testimony, even under an abuse of discretion standard.
So somehow the "high risk" of the equity infusion became "just to the left of the middle of the risk scale" when the focus turned to the 100% LTV mortgage.  And even though the loans that are being made to better-capitalized companies were yielding 7.9% interest, the 100% LTV loan was only going to earn 5%. 
It sure seems to me there was an appellate case to be made out of those facts, although the "clear error" and "abuse of discretion" standards of review are definitely hurdles.  I can't think of any support for deeming the "risk scale" to be limited to 1-3 percentage points; that other courts have frequently (but not always - for example, the recent Camp Bowie decision in the same circuit involves a a risk adjustment over 3%) adopted risk premia within those parameters does not make such a range law, and certainly there was no factual basis in 2010 to limit the upper end to 3%.  Appellant did make those arguments, but, as I read the opinion, combining them with the position that they were inconsistent with Till may have confused the appellate panel, as they are quite slavishly consistent with Till
Given these details, I don't feel that Texas Grand Prairie is an opinion that should be interpreted aggressively in favor of debtors. There were several questionable strategic decisions by appellant, any one of which might have led to a different result.  I would say, rather, that the door remains open in the Fifth Circuit to a well-thought-out challenge to the Till plurality's method in chapter 11 cases.  Such a challenge would entail, among other things, not misunderstanding Till; not conceding its prime-plus formula governs in 11's; and not having an expert muddy the record with unhelpful opinions. It would also, I think, benefit from challenging the claims made by the Till plurality about the defects of the "coerced loan" approach, challenging the 1-3 percentage points range; challenging what "prime" rate means; and last, challenging the application of the "efficient market" reference in footnote 14 of the plurality opinion.   I will discuss these last points in a subsequent post.