A Deep Dive into Till v. SCS Credit Corp -- Part VII: How to Understand Footnote 14

Footnote 14 in the Till plurality opinion has become the jumping-off point for the use of the "prime-plus" formula in chapter 11, and in this post, I will analyze it in detail.   To begin with, here is the footnote:

This fact helps to explain why there is no readily apparent Chapter 13 cram down market rate of interest. Because every cram down loan is imposed by a court over the objection of the secured creditor, there is no free market of willing cram down lenders. Interestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. See, e.g., Balmoral Financial Corporation, http://www.balmoral.com/bdip.htm (all Internet materials as visited Mar. 4, 2004, and available in Clerk of Court’s case file) (advertising debtor in possession lending); Debtor in Possession Financing: 1st National Assistance Finance Association DIP Division, http://www.loanmallusa.com/dip.htm (offering “to tailor a financing program . . . to your business needs and . . . to work closely with your bankruptcy counsel). Thus, when picking a cram down rate in a Chapter 11 case, it might make sense to ask what 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.

The footnote is susceptible of two readings:  The first is that given by many lower courts,  beginning with In re American Homepatient, to first look at “what rate an efficient market might produce” and then, if none is discovered, proceed with the “prime plus” formula.  But if you look closely at the footnote, you will see it says nothing about the “prime plus” formula at all.  It does not say “it might make sense first to ask what rate an efficient market might produce, and then….”  It just says, “it might make sense to look at what rate an efficient market might produce”.  Unlike the American Homepatient approach, I think the phrase “might make sense” was intended just to indicate the chapter 11 issue was being left open for future analysis, and not to impose an "efficient market" hurdle that had to be overleaped to get out of the "prime plus" formula. 

Also, notice how the footnote only contrasts chapters 11 and 13, rather than asserting resemblances between them: “the same is not true in the Chapter 11 context … In the Chapter 13 context, by contrast ….” (emphasis added).  I find it hard to discern any intention of the justices to signal in the footnote an endorsement of applying their chapter 13 approach to chapter 11 cases, when the footnote only works to distinguish them. If anything, footnote 14 is a caution not to apply the prime plus formula in chapter 11s.

I don’t believe this footnote reflects an enormous amount of thought about what should happen in chapter 11.  Others before me have noted, for instance, that the two citations of bankruptcy lending proposals are examples of DIP lending – lending to a company that has just entered chapter 11 – not exit lending that would be more analogous to a cram-down note.  The justices who subscribed to this opinion do not appear to have recognized the incongruity, which I think undermines any argument to treat this footnote as if it provided a definitive roadmap for 11’s.  The terms of DIP lending are not necessarily indicative of the terms that the borrower can wind up with once it exits chapter 11 successfully.  Generally speaking, a DIP loan would be stricter in terms of the ability to draw down, on the use of proceeds, would have greater reporting and lender oversight, would likely prohibit all other debt incurrence during its term, and finally would be of considerably shorter duration than the terms of an exit credit facility.  DIP loans have both the blessing and the curse of being extended in a judicially supervised, fishbowl environment whereas the debt of a company outside of bankruptcy is administered with no such supervision or intrusion. 

So I doubt the justices meant this footnote to suggest that DIP lending terms were probative of cram-up criteria in chapter 11.  Rather, I think it was simply an honest attempt, albeit somewhat uninformed, by  the justices signing the plurality opinion to signal that they weren’t taking a position on the applicability of the mechanical “prime-plus” formula in chapter 11’s, because that formula was not compelled by the words of the statute, but was more of a pragmatic approach to the chapter 13 environment.   I think they were taking pains to make clear that they were not making a rule that would affect chapter 11 practice and further recognizing the colloquy at oral argument concerning the existence of a market for lending in chapter 11, and leaving the door open to a future evaluation of the chapter 11 context specifically.

Notwithstanding these views, since many lower courts have since chosen to accord much greater weight to the footnote than I believe it deserves, for the balance of this post, I will take the orthodox approach to interpreting Supreme Court opinions like sacred texts and assume that every point made in the plurality opinion reflects their considered intent and move on to trying to figure out what footnote 14 in the plurality opinion meant.

            Clearly, the focus of all endeavors to apply Till's footnote 14 to chapter 11 cram ups rests on the term “efficient market”.  Thus, the question becomes, I think, “what did these 4 justices mean by an ‘efficient market’”  Note that this query may be somewhat different from asking “what is an ‘efficient market’?”  The latter is a question on which at least hundreds of thousands of pages, if not millions of pages, of academic and think-tank study have been devoted, without necessarily arriving at a consensus formulation that regularly applies in the real world.  I am not going to address the broad question in great detail for three reasons. First, although I have read several papers on the subject, I don’t claim to have the necessary level of expertise to add to the mountain of scholarly output on it.   Second, I assume the average reader of this post is not an economist but a lawyer, restructuring professional or judge; I am doing a “deep dive” into Till, not into the efficient market hypothesis. Last and most important,  one of the overarching themes of this "deep dive" into Till is that the statements the plurality made were not plucked from the ether or handed down from Mount Olympus, but tie back to specific points and concerns found in the briefs and argument.  Footnote 14 is no different.  

It can be traced back to a specific colloquies with lender’s counsel during oral argument in which two things were agreed:  a) there is a market for lending to businesses in chapter 11, and b) in the subprime auto loan market, interest rates do not change as circumstances change because of the usury laws.  As shown in the next section an efficient market is, at a minimum, one in which prices respond to new information.  But, as the colloquy at argument confirmed, rates in the subprime auto loan market failed to follow the sustained decline in interest rates generally, due to usury caps; thus the subprime auto loan market appears to be "inefficient" by definition.  I have already quoted the colloquy but it bears repeating here for emphasis, ergo:

MR. BRUNSTAD: Your Honor, the contract rate is the best evidence,

the single best evidence of the market rate.

QUESTION: Contract rate -- if there has to be a number that's wrong,

it has to be that one. … The contract rate by definition was entered into

at some significant period of time prior to the present, and the present,

by chance in this instance, is 2 years later, and we know that interest rates

fell at least 1 or 2 percent during that time.

MR. BRUNSTAD: But not for subprime –

QUESTION: So -- what?

MR. BRUNSTAD: But not for subprime loans.

QUESTION: That's impossible. The prime rate --

MR. BRUNSTAD: No, Your Honor. This is why.

QUESTION: If that's so, then the risk went up.

MR. BRUNSTAD: No, that's not correct, Your Honor, and this is why.

QUESTION: No. It isn't?

MR. BRUNSTAD: Because State law caps the maximum rate that can be paid.

QUESTION: Oh, okay. … All right, because it's a usury problem.

MR. BRUNSTAD: Correct.

And later, Mr. Brunstad told the Court, “what we're doing is we're saying there is a stream of payments to be made here and we have to figure out what it's worth. The best test for what it's worth would be what the market says. Now, the problem is, is that in chapter 11 there is a market. People do lend to chapter 11 debtors….”  To which a justice responded: “I understand. Tell me a question I don't know the answer to.”

Once we put footnote 14 in this context, it becomes clear that the plurality was saying something very simple when it referred to an "efficient market": having dropped the footnote in the first place to make clear that they weren't imposing the prime-plus formula on chapter 11s, they were perfectly willing in principle to see chapter 11s rely on market rates, yet, at the same time, they really didn't know anything about how the market for credit to companies exiting chapter 11 operated, beyond a couple of webpages someone's chambers had turned up searching the Internet, and they simply did not want to sign on to a "pig in a poke".  So someone came up with the phrase "efficient market" as a shorthand way to signify "a market that responded to changing facts better than the one before us in this case", and to preserve the flexibility to evaluate the workings of the commercial loan market in the future. I think that was the only purpose of the phrase "efficient market" in footnote 14, and it was not intended to be interpreted literally or technically.