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Friday, January 3, 2014

A Deep Dive into Till v. SCS Credit Corp – Part IV: Plurality Opinion

In this post, I aim to convince the reader that the justices signing the plurality opinion selected what they thought was a practical, pragmatic resolution for chapter 13 cases that was not meant to be exported to chapter 11’s at all, but rather reflected the specific circumstances that dominate chapter 13’s.  That approach may not even have appeared to them to be the ideal approach to implementing the statute; it may in fact have been only the second-best approach in their minds (to looking at comps in a well-functioning market), but the plurality, at least, convinced itself that it was the best practical approach available to them.

In rendering a decision, the Court split into three camps: a plurality voting to overturn the 7th Circuit, in an opinion authored by Justice Stevens and joined by Justices Breyer, Ginsberg and Souter; a 5th vote to do so from Justice Thomas who authored a separate concurrence which I analyze in the next post; and the other four justices (Kennedy, O’Connor, Rehnquist and Scalia dissenting (I will not discuss the dissent as it is not relevant to my thesis). 

In the prior recap of oral argument, I showed that the justices devoted little time to a discussion of the statute and one even wondered if the statute specified a particular method of valuing the cram-down paper at all.   True to that theme, the first six words of  the plurality opinion, following its recitation of the facts and the proceedings below, are: “The Bankruptcy Code provides little guidance ….” 

The plurality goes on to make some fairly general points that address positions taken in the Till litigation that are not particularly insightful or relevant to chapter 11: that the Bankruptcy Code authorizes modification of pre-petition debt over a creditor’s objection (which generally speaking begs the question of what kind and degree of modification) and that the cramdown rate should be set “objectively” and not “subjectively” (by which they mean the creditor’s own cost of funds  and investment practices are not relevant).  They offer four reasons why payments under a chapter 13 plan bear reduced risk of default compared to the prepetition debtor:  the bankruptcy judge has found the plan feasible; the debtor’s financial affairs have been disclosed; the “public nature of the proceedings” reduce the debtor’s ability to take on more debt and, under chapter 13, the trustee remains in place to receive all post-confirmation income and distribute it.[1] 

They offer their opinion that Congress “likely” intended courts to use “essentially the same approach when choosing an interest rate” to discounting payment streams to present value throughout the Bankruptcy Code.  That might afford some fodder for the application of the “prime plus” formula to chapter 11, although it is hedged twice by “likely” and “essentially the same”.  But then, on the very next page, they reverse field and drop footnote 14 to suggest that chapter 11 cramdowns should in fact be handled differently, by reference to “the rate an efficient market would produce. In the Chapter 13 context, by contrast, the absence of any such market obligates courts to look to first principles and ask only what rate will fairly compensate a creditor for its exposure.”  (emphasis added). These two statements are where the impetus to apply the “prime plus” formula in chapter 11s comes from so I will analyze them in more detail in a following post.  At this point, I am just summarizing the opinion. 

Ultimately, the plurality states, a bankruptcy court “should aim to treat similarly situated creditors similarly, and to ensure that an objective economic analysis would suggest the debtor’s interest payments will adequately compensate all such creditors for the time value of their money and the risk of default.”  Which is fairly broad and vague and open-ended conclusion but certainly does not imply they thought they were breaking new ground.
In Section III of the plurality opinion, the alternatives to the “prime plus” formula are eliminated for various reasons.  Few of these reasons arise in chapter 11.  The analysis begins by saying:

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 cram down loans. 

The first of those criticisms is obviously chapter 13-specific with its reference to “debt-adjustment plans”: the four justices are saying that chapter 13 proceedings don’t involve evidence about market rates; whether that is true or not of chapter 13, it’s obviously not true of chapter 11 cases, where bankruptcy judges hear evidence of market comps all the time, in contexts from lift – stay appraisals to solvency determination in avoidance actions to cram-downs at confirmation.[2]  The second is vaguely worded, but in my judgment, its reference to “court-supervised cram-down loans” is a reference to the role of the chapter 13 trustee in collecting and disbursing payments from debtors under confirmed chapter 13 plans, and thus likewise inapplicable to chapter 11s; performance under chapter 11 plans, post-emergence, is generally free of court supervision. A chapter 11 debtor is considered reorganized, and gets a discharge, the day it comes out of 11; the chapter 13 debtor is discharged and rehabilitated only when s/he completes the payments under the plan. That is a vital difference in understanding Till.

The plurality rejects the “presumptive contract rate approach” and “cost of funds” approaches because, by focusing on something other than the debtor’s proposed payment stream, they are less “objective”; also they might produce different interest rates for creditors of the same debtor, based on the creditors’ own financial condition, and finally they  impose evidentiary burdens on the chapter 13 debtor who, it goes without saying, could not generally afford to bear them and thus would be unfairly disadvantaged at trial.  Certainly the last factor is inapplicable to chapter 11’s, where debtors have squadrons of expensive professionals paid for by the estate.

Conversely, the plurality asserts in Section IV, the “prime-plus” formula “has none of these defects”. Again, note that the entire focus here is on what is practical, what is the best mechanism to approve, nothing about statutory interpretation.  The formula, they assert, takes “its cue from ordinary lending practices” because it starts with the “prime rate” which is in the newspaper every day.[3]  Once a risk adjustment factor is added, “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.”  Although this statement is so generalized it could be argued to apply to chapters 11 & 12,  the opinion cites an amicus brief filed by an organization of chapter 13 trustees, further indicating it was thought to be targeted to chapter 13 cases.

This section of the opinion closes by explicitly noting that the opinion does not approve any specific scale to be used for risk adjustment factors.  In explaining their perspective (keep in mind this is dictum in a plurality opinion), they say something which in my experience bears no relation to chapter 11 practice and thus could not have been thoughtfully intended to apply to chapter 11: that the rate on chapter 13 cramdown paper is supposed to be (a) selected by the court and (b) “high enough to compensate the creditor for its risk but not so high as to doom the plan.”   Essentially, having started at “present value” as being required by the statute, they wind up at something I would call “highest feasible present value“, i.e., “you can have as much value as we can give you and still confirm the plan”.  Whether this is right as a chapter 13 matter, I will leave to one side, but neither in practice nor in precedent does it resemble the chapter 11 context. 
As far as the judge actually selecting the cramdown rate in chapter 11, although on occasion a judge might more or less give fairly clear guidance about what s/he might approve, to move things along, I cannot recall seeing a court ever confirm a plan with language like that and specify the rate.  If a judge saw it, he or she would likely tell the debtor that it’s the debtor’s job to propose a plan and the judge’s job to review it, and then the parties would go out and cut their deal.[4]

As far as turning cramdown valuation in chapter 11 into the “highest feasible present value” approach endorsed by the plurality, that would fly in the face of the Court’s prior precedents on the subject as I will discuss in the sixth post.  In addition, the process of formulating a chapter 11 plan in the real world generally operates in a very different manner: typically, (1) financial professionals try to figure out the debtor’s projected EBITDA;  (2) then, they look at the debt levels of comparable companies and recent deals in the credit markets to determine (a) how much debt, as a multiple of the projected EBITDA, the reorganized debtor should reasonably take on; and (b) what other salient terms comparable financings are presently carrying; and then (3) they approach potential exit lenders to test their hypothesis and fine-tune the specific terms for the debtor in the dual track process of negotiating with creditors and soliciting exit financing.  In other words, the chapter 11 plan process does not start with a desired debt amount and then solve for feasibility by lowering the interest rate, as the plurality thinks chapter 13 does.  It starts with the amount available to pay debt service, then derives a feasible debt amount from that number by looking at comps that – this is important -- are solvent.  Because the comps are solvent companies by definition, there is no need for the professionals to do a big, separate feasibility analysis of the debtor’s risk of default, although one will be prepared anyway to make a record that complies with confirmation formalities.  It’s just embedded in the use of solvent comps that, if you use the same debt/EBITDA ratios and the same interest rate solvent companies have, the debt burden will invariably meet the feasibility test.  Applying the plurality’s approach in chapter 11 runs the risk, I think, not only of systematically under-compensating recipients of cramdown paper contrary to the Court’s prior precedents, but, equally important for bankruptcy policy, of systematically over-leveraging reorganized debtors’ balance sheets and thereby increasing the risk of “chapter 22s.”

Section V of the plurality opinion is  devoted to addressing issues raised by the other five justices’ views.  First, they respond to the four dissenters’[5] recommendation of the “presumptive contract rate” with an argument about the subprime lending market, which they opine, is not “perfectly competitive” in part because it is highly regulated to protect borrowers from their own “ignorance”. This section, whatever you think of its intrinsic merit[6], is further  evidence of my two main themes: (1) reference to the market is the first inquiry, even for these justices, although they have been persuaded, as footnote 14 indicates, that the market does not work for chapter 13 debtors, and (2) that the plurality opinion is driven by factors peculiar to 13s that don’t carry over to 11s. 

Next, the plurality simply reiterates its point that chapter 13 rates are supposed to be set at a rate that enhances feasibility: “In our view, however, Congress intended to create a program under which plans that qualify for confirmation have a high probability of success.”  Although I think this begs the very question as to what rate is necessary to ”qualify for confirmation” in the first place, it seems clear the plurality is reiterating its “highest feasible present value” interpretation here and there is nothing new here to discuss vis a vis chapter 11 relevance. Further, the plurality justices immediately make a muddle of their guidance by stating that “Perhaps bankruptcy judges currently confirm too many risky plans, but the solution is to confirm fewer such plans, not to set default cram down rates at absurdly high levels, thereby increasing the risk of default.”  Which is quite a “straw man” argument, as no one was suggesting courts were or should be setting “cram down rates at absurdly high levels” – the opponent of cramdown, is just saying, don’t confirm!  What’s “absurdly high” is the loan to value ratio!  Third, the plurality explains that the “presumptive contract rate’ approach may lead to stale and outdated results because circumstances may have changed since that loan was established.  This likewise has nothing to do with my thesis and so I will not discuss it further.

Last, but most definitely not least (because the plurality describes this as the area where they “principally differ with the dissent”, so future interpretation should focus on this point more than any other), the plurality again frames the issue as one of allocating the evidentiary burden:  “In our view, any information debtors have about [risk adjustment] factors is likely to be included in their bankruptcy filings, while the remaining information will be far more accessible to creditors (who  must collect information about their lending markets to remain competitive) than to individual debtors (whose only experience with those markets might be the single loan at issue in the cases.”   That point also illustrates my thesis that the plurality was thinking of “prime plus” as a practical chapter 13 solution and not as a trans-chapter interpretation of the Bankruptcy Code.  In chapter 11 cases, debtors always have access to professional advisors and experts whose fees are charged to the estate, and thus can determine prevailing rates and other terms in the lending market as easily as creditors can. There is an ample supply of published confirmation opinions out there that show this to be true.

[1]           However, they provide no citations, beyond the statute, for the proposition that these reduce risk and offer no estimate of how much of a reduction they effectuate; frankly, these unsubstantiated assertions are nothing more than makeweights.  This is one reason I think it would have made more sense for the Court to take on the issue of chapter 13 cramdown rates via a rule-making procedure, where factual assertions like these could have been tested and additional real-world input could have been gathered and studied properly.

[2]           Even in the chapter 13 context, the assertion that “evidence about the market for loans” is “far removed from [bankruptcy] courts’ usual task” is ridiculous.  Judges hear evidence about financial conditions, including lending rates, all the time in chapter 11 cases and they’re the same judges who adjudicate chapter 13 cases.  As well, when these judges adjudicate preference cases and other “usual tasks”, they have to find facts about the “ordinary course of business” of whatever businesses the debtor and the creditor happen to be in, which is a task at least as “far removed” from what these justices perceive their “usual task” to be as hearing “evidence about the market for loans”.

[3]           It is not the point of this post to criticize the Till plurality opinion as a chapter 13 matter, but I have to say, this part of the opinion shows such an incredible lack of awareness of lending practices that it warrants at least a footnote.  First, the opinion itself identifies the “prime rate” as one available to a “creditworthy commercial borrower” but then completely fails to explain why consumer credit should be priced like a commercial loan; in reality, bank loans to consumers and commercial enterprises are evaluated and priced totally differently, reported differently, etc.  I fail to understand why the plurality could not have chosen something more relevant like the “average rate for a used car loan in the local market” as the starting point. One can go to a website like to find out current “average auto loan rates” which are then broken down into new and used car rates, and add a debtor-specific adjustment from there.  That was what the Sixth Circuit had endorsed in a case virtually identical to the Tills, In re Kidd, 315 F.3d 671 (6th Cir. 2003) and appears to have all the advantages of the “prime plus” formula while also being more focused on the particular type of loan, a used car loan.
Second, as a matter of economic substance, it should be kept in mind the commercial banks which offer “prime rate” or “base rate” loans are funded primarily by federally insured deposits, which have lower rates than other lenders’ funding sources, enabling them to offer lower rates on their loans. So using banking concepts like “prime rate” or “base rate” to set cramdown rates in chapter 13 probably favors debtors vs. an average or median rate drawn by looking at the full consumer credit market.

[4]           On a couple of rare occasions, I recall seeing a debtor file a chapter 11 plans with a “placeholder” provision for a cramdown interest rate; that is, the section prescribing the proposed treatment for the claim would describe the interest rate on the take-back paper to be something like “the rate determined by the Bankruptcy Court at the Confirmation Hearing to be the rate necessary to cause the treatment herein provided to comply with the requirements of Section 1129(b)(2) of the Bankruptcy Code”.  But those were typically filed just to comply formally with an exclusivity deadline or otherwise to keep a case moving forward for some reason.  Such terms were then amended to reflect later negotiations. 

[5]           This section also discusses Justice Thomas’s concurrence which I handle in the next post.

[6]           It is intellectually maddening that the private market rate-setting mechanism is required to be “perfect,” while government intervention to set those rates is held to a standard no higher than that of being “administratively easier”.