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Friday, January 3, 2014

A Deep Dive Into Till v. SCS Credit Corp – Part X: Lower Courts' Mistaken Application of Till to Chapter 11 Cases

It wasn’t long after the Till decision was handed down that an appellate court considered its application in chapter 11s. Till was decided while In re American Homepatient was pending in the Sixth Circuit.  The debtor had obtained confirmation some time before Till was decided on a fairly strained interpretation of the “coerced loan” theory previously endorsed by the Sixth Circuit, and could not have invoked Till below.  Rather, the lenders, as appellants, tried to argue that Till overruled the “coerced loan” approach and the circuit needed to remand to re-set the cramdown interest rate under an “efficient market” analysis consistent with footnote 14.  That the lender was arguing for Till made for a rather unusual positioning of the parties. The circuit chose to adopt what it called a “nuanced approach” that “the market rate should be applied in Chapter 11 cases where there exists an efficient market.  But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.” 

I pause to point out the irony of interpreting the plurality opinion to call on bankruptcy judges to gauge the efficiency of the credit markets – when the plurality opinion elsewhere rejected an alternative to the “prime-plus” formula because it considered investigation of “the market for comparable loans to similar (though non-bankrupt) debtors” to be “an inquiry far removed from such courts’ usual task of evaluating debtors' financial circumstances and the feasibility of their debt adjustment plans.”  As I indicated before, I think it’s ludicrous to believe that analyzing the material terms of loans is “far removed” from the usual work of a bankruptcy court, but, whether or not agrees with my opinion, it seems clear that calling on them to opine on the "economic efficiency" of those same markets is even farther removed.  

The panel concluded that the bankruptcy judge’s “coerced loan” analysis covered much the same ground as the “efficient market” approach and upheld the cramdown.  This very good case note from a law firm involved in the bankruptcy for other constituencies does a nice job of pointing out the superficiality of the bankruptcy court’s and circuit’s analyses of “the market”: they only looked generically at the regional loan market, and made no effort to compare the credit quality of the cramdown paper to the credit quality of the loan data they were using as references for pricing.  That is a constant problem throughout the Till progeny, that lower courts, consciously or out of oversight, proceed as if the only issue remaining susceptible to  “fair and equitable” examination after Till is the interest rate on the cramdown paper, completely contrary to Consolidated Rock’s holding that all changes have to be looked at and the whole loss has to be “fully compensated”.  In addition, as I will illustrate further below, the "nuanced approach" of the American Homepatient panel perversely invites debtors to degrade all the other terms of repayment so that the final package is so blatantly off-market that that they can argue there is no "efficient market" for them, and trigger Till-based pricing.

The cases applying Till in chapter 11 after American Homepatient tend to follow the same pattern.  The debtor is usually a closely held commercial real estate venture, with a simple capital structure – a mortgage and the owner’s equity.  The cram-up fight pits (1) the equity owner, usually a local businessperson, who evidently elicits sympathy from the bankruptcy judge (despite having made a stunningly bad investment decision in buying, or recapitalizing, the property in question with excessive leverage shortly before the credit crisis of 2008), acting through control of the debtor to try to hold on to the property, against (2) the secured creditor, often a secondary market buyer who has likely purchased the mortgage at a discount from the original lender and likely seeks to take over ownership of the property by defeating cram-up and then moving for lift-stay or another path to taking title.  The judge has valued the property such that there is no or only a negligible equity cushion, and there may be even be a deficiency.  (Where there is a deficiency, the secured creditor usually chooses, for some reason which eludes me, not to make the § 1111B election.)  The owner may or may not be willing to put new money in.  A small trade or similar small class is offered enough under the plan to be the accepting impaired class.  The judge has otherwise found the plan feasible on the assumption the prime-based interest rates proposed by the debtor are upheld, and the only issue in the way of confirmation is the satisfaction of the “fair and equitable” standard to cram-up the mortgage  holder. 

The judge takes testimony from the debtor’s and the lender’s respective experts.  The debtor’s expert testifies that nowhere in the market can one find 100% LTV commercial mortgage paper trading at par, thus there is no “efficient market” from which the judge can derive a proper interest rate.  The lender’s expert testifies that, while there may not be 100% LTV first mortgage debt trading at par, one can devise a package of senior and mezzanine securities that add up to 100% LTV and calculate the blended interest rate the debtor would likely pay on the package; however, that rate is far in excess of the rates proposed and renders the plan infeasible. The expert may or may not concede that the plan as proposed is feasible.  After taking the evidence, and sometimes after playing some role in its creation, the judge recites the paragraph from the plurality opinion in Till that identical language in different chapters of the Bankruptcy Code should be construed similarly, determines that said dicta and footnote 14 in Till instruct the court to determine whether the market for emergence paper as tailored by the debtor is an efficient market; finds as a fact that the lending market is not an “efficient market”, but rather that there has been a “market failure” (in making these findings, the court may be somewhat cavalier about who bears the burden of proof on this question, as it often seems the judges are acting as if the creditor has the burden to show the market is efficient, when in fact it is one of the propositions of the debtor’s case that the market is inefficient and thus the debtor bears the burden of proof on that point); and thus, instructed by Till, the judge accepts the “prime plus” formula in the plan for the cram–up paper; and confirms the plan.

It must be noted that none of these cases specifies in great detail what the judges are looking for in an “efficient market” or why they have not found it.  None of them writes in any depth about investigating the depth of the credit markets, the types of debt that are available, the credit quality of debtors  in the market,  the amount of primary issuance or secondary trading, or how prices react to changes in credit quality of a macro or a company-specific nature.

I will use the bankruptcy court decision in In re Castleton Plaza, a particularly egregious illustration of the paradigm, to emphasize a few of these points.[1]  The decision was reversed on appeal by the 7th Circuit on other grounds (failure to establish competitive bidding for the equity owner's new value investment, contrary to 203 N. LaSalle and Radlax).  But its handling of the Till issue should not go unreviewed. 
The debtor was a shopping center owned by one George Broadbent, who managed it through a separate management company.  The center was just one of many real estate investments Broadbent and his wife owned. It carried a mortgage, including an assignment of leases, with an initial principal amount of $9.5 million, bearing regular interest at 8.37%, default interest of "not less than 11.37%" and late charges of 5%.  The mortgage, funded in 2000, matured in September 2010.  There was no other credit support. The debtor filed on February 16, 2011, the eve of a state court foreclosure hearing, on which date the amount due to the secured creditor was approximately $10.25 million. On September 30, the court valued the collateral at $8.25 million.   The debtor had also built up $1 million of cash collateral.

The court found that "from 2006 to 2010 ... the Debtor's gross income declined every year." Although it turned up in 2011, the average through 2011 was an annual decrease of 7.6%.  Also "for some time, the Debtor has realized decreased rent rates [including] in the past several months...."  "The current vacancy rate ... exceeds 30% and is higher than any annual vacancy average over the past thirty years."  Still, there was an "apparent consensus among the expert witnesses that the property will perform significantly better at some point in the next several years and that its value will increase to reflect that."  But even the debtor's expert admitted it would not happen "until 2014 or 2015" (the hearing was in early 2012).

The court agreed that the creditor had effectively undermined the debtor's projections, but concluded that the amount of the new value contribution offset the potential shortfall.  The court concluded the plan was feasible even though "not supported by the Debtor's recent historical performance."  The new value was to come from George Broadbent's wife, who had "a personal net worth of more than ten million dollars."  It was initially set at $75,000 (less than 1% of her net worth) and then upped to $375,000 (less than 4%) after the secured creditor offered a competing bid for the new equity of $300,000; the court blocked the creditor's further $600,000 offer.  The court concluded that the wife was not an insider and thus 203 N. LaSalle did not apply.  (The appellate court of course disagreed with all of the judge's new value analysis).[2]

The plan was confirmed based on the acceptance of the trade class.  The class consisted of about $56,000 in claims, according to a motion filed by the secured creditor (docket 435).  A maintenance company and a construction company held two-thirds of the claims and each testified at the confirmation hearing that they voted to accept the 15 cent payout under the debtor's plan -- even though the secured creditor would pay them in full with interest -- because they valued "their long-term business relationship with the Broadbent Company."  (It could not have been a coincidence that they just happened to wind up with two-thirds of the claims in the class.)

Net of the new value, the debtor's plan left "a loan-to-value ratio of approximately ninety-seven percent" and provided for repayment of the balance of the secured claim over 10 years based on a 30-year amortization schedule, which would have left a $7.329 million balloon at maturity.  The proposed interest rate was 6.25% calculated simply by adding 300 bps to the then prime rate of 3.25%.  The deficiency claim was to receive 20 quarterly payments of $.0075 (less than a penny on the dollar) adding up to a 15 cent recovery, without interest.
The court's "efficient market" analysis consisted of one sentence: "There is not an efficient market in which a loan can be obtained for more than 97% of the value of a shopping center with an occupancy rate of less than 70% ...." (I'll say).  The court then decided it was authorized to endorse the "prime plus 3" rate proposed by the debtor per Till.  For good measure, the court also decided that there was no efficient market for the debtor's new equity interests.  (I'm not making this up). 
Note how the American Homepatient formulation of footnote 14 drew the court farther away from common sense.  Instead of inferring from the fact that "there is no efficient market that would make a loan like this" that the proposed repayment terms were not fair and equitable, American Homepatient's "nuanced approach" leads the court in exactly the opposite direction, to conclude that they are fair and equitable precisely because they can't be found in an efficient market.   Under the "nuanced approach", Till is always there to establish a default fair and equitable interest rate, so debtors with more expensive debt are perversely incentivized to make the other terms of the proposed repayment as crazy as possible to ensure there are no comps in the market, and then they trigger a rate reduction under Till
The secured creditor did complain that the other terms of the loan were off-market as well, but, according to the court, framed this as an "indubitable equivalence" argument, which the court felt itself able to ignore because the debtor was not asking the court to confirm based on indubitable equivalence (§1129(b)(2)(A)(iii)), but rather the deferred cash payment avenue of § 1129(b)(2)(A)(i). The court confirmed, although it was reversed on appeal on the new value issue; I checked the creditor's appellate brief and they did make some argument on the Till analysis - not challenging Till, but arguing that the cramdown paper did not conform to the terms an "efficient market might produce."   The 7th Circuit did not reach that question.  Post-mandate, the debtor proposes essentially the same treatment of the secured claim in its revised plan, except that it has come to treat the entire claim as secured and increased the interest rate to 7%. 

Although some of the Till-in-chapter 11 cases are undoubtedly less egregious, they all tend to use Till for the same purpose, to protect local business owners from the realities of the market in which they operate and the broader capital markets, and they all suffer from the same errors. They assume – incorrectly - that (a) evidence can be found on the naked question of whether a credit “market” is “efficient” without specifying anything further and (b) to the extent they specify anything further, they erroneously assume that for an “efficient market” in loans to exist, it must necessarily contain a loan having the same characteristics as the debtor’s proposed cramdown and bearing an interest rate such that the loan is worth par. Both of those assumptions are wrong. 
First, one cannot tell whether the loan market is “efficient” per se.  One must posit other criteria about risk preferences and possibly other factors to judge its efficiency.  If a criterion specified is: “always make ultra-safe loans and never lose principal”, a market with even a low level of defaults may not be efficient even if the profits earned on the loans overall are high.   If a criterion specified is: “every borrower should always get the money it wants regardless of risk imposed on the lender”, then a market with credit approval restrictions may be inefficient.   If the criteria is, get the highest coupon possible for yield-hungry investors, then safer loans may not be efficient.  If a criterion specified is specified is “provide a reasonable variety of different types of loans – different leverage levels, different risk premiums, different maturities, for example – so that the holders of capital and the borrowers of capital can find matches as close as possible to their individual risk preferences and some amount of capital is constantly available to those seeking it”, then a market that does so may be efficient even if there are defaults or some investor is denied credit.  And which of the possible criteria make sense measured against section 1129(b)(2)(A)(i)?  Since the relevant statutory section prescribes that the secured creditor must receive "value ... equal to its ...claim" which is to say par, the criteria by which credit market efficiency is to be judged should be (1) does it have a lot of loans valued at par, and (2) assuming it does, what kind of terms do they carry?  If the debtor's proposed paper matches one set of terms that trades at par, it probably satisfies the test.  If it doesn't match any par paper in the market, it probably doesn't satisfy the statute.
By the same logic, there cannot be a "market failure" until one specifies what the market is supposed to be doing.  Is it supposed to be protecting lenders' capital against loss at all costs?  Is it supposed to be financing borrowers' projects regardless of the risk of loss?  Or is it supposed to be achieving a sustainable balance of the two interests in a timely way without excessive transaction costs?  You need to specify the objective to know if a mechanism has succeeded or failed.  Seen, in this light, the absence of a 100% LTV loan trading at par in the broader market does not inherently signal inefficiency; rather, quite obviously, it may well signal a very efficient processing of information about the creditworthiness of such loans (they aren’t very), and a very efficient reflection of  lenders’ risk preferences – that they are adamantly opposed to putting at risk the same amount of funds needed to own the property outright if they are only permitted to receive the kind of return associated with senior secured debt, which throws off only a fraction of the rewards of ownership.  If one specifies as a criterion for the efficiency of the credit markets that they “construct loans that are both sufficiently safe and profitable that, over the long term, lenders remain healthy and willing to make credit available,” then the rejection of certain loan types is perfectly consistent with that objective and thus the market may well be efficient, even though a borrower here or there may be disappointed.  If, consistent with the statutory language of 1129(b)(2)(A)(i), the test of market efficiency  is that new loans should trade at or near par, then the fact that the debtor cannot point to a loan trading at par that resembles its proposed note does not signal a market failure - as long as other new loans are trading at par.
Secondly, in assuming that the credit markets can only satisfy the “efficient market” standard if they contain debt matching the debtor’s proposed cramdown paper that is valued at par, the judges invoking Till both (a) construct an absurd definition of what a “market” is  and (b) ignore the “risk preference” component of assessing efficiency.  The fact that one cannot find a 100% LTV loan priced at par, standing alone, in credit market data tells nothing about whether the credit “market” is “efficient” unless one defines the market to consist solely of 100% LTV loans.   Nothing in Till’s footnote or in any thoughtful writing on the subject suggests that footnote 14 in the plurality opinion envisioned such a limited definition of the relevant “market”. 
 
I’ll use the stock market as an example to make this clear.  If a share of a stock -  say, Facebook -  is trading consistently in the $50 vicinity, and an investor comes along and says, “you know, I really want to own Facebook but I think a share of Facebook is really only worth $25", is the stock market "inefficient" - such that the government should step in and “fix” the "market failure"  for that buyer by forcing someone to sell him a share of Facebook at $25 - or is the buyer’s view simply “off-market” such that the failure is his and not "the market's"?   Go back to the supply-demand curve from Microeconomics 101 in the earlier post:  The individual buyer is just at a different place on the demand curve than the intersection with the supply curve or equilibrium point; that is not a "market failure."   I would hope that the reader would see that the right answers are: “we need to look at the market as a whole” to determine whether it is efficient and not give weight to one participant’s particular risk and price preference. That "did the debtor get what it wants” approach also conflicts with the “objectivity” the plurality opinion sought to impose on these determinations.[3] 
Extending the principle to commercial bankruptcies, we can go back to Castleton Plaza, which was worth roughly $8.25 million.  The financial markets can offer numerous ways to finance a CRE property worth $8.25 million.  There are all kinds of debt/equity combinations that add up to $8.25 million -- 70/30; 80/20; etc. - and they have varying prices associated with them.  There are even more leveraged blends of senior and mezzanine debt available at certain times in the markets.   The secured creditor in Castleton, like the one in Texas Grand Prarie, put on expert testimony about the ability to raise the full value of the property through an 80/20 blend of senior and mezzanine debt that resulted, in added cost to the debtor of 100-200 bps.  So the markets for financing CRE are actually very efficient: they will supply the capital needed to finance 100% of a property's value in various forms and at varying rates of return consistent with the varying risk.  That is efficient.  Stated conversely, there is no principle in the definition of efficient markets in finance that ex ante rules out combinations of securities as an efficient means of matching capital providers and capital seekers. 
What the debtor can't get is 97-100% LTV debt financing at interest rates that leave the owner in possession and reaping the upside over the value of the property without sharing some of that return with the external investors to compensate them for the risk of loss.. But that is perfectly consistent with an efficient market outcome.  No one would think that a market in which the seller of a damaged car receives less money than the seller of a well-maintained car is inefficient.  An efficient market reacts to information about quality and prices it differently.  Moreover, an efficient market does not care who owns a parcel; it is agnostic, or indifferent, about the identity of either the owner or the financing party – no one’s price is privileged, everyone is a market taker in the efficient market environment.  This is a fundamental point misunderstood by the judges who have been applying Till to impose below market paper on secured creditors.
 
It’s also not correct to focus narrowly on the “exit loan market” either, as footnote 14 might be interpreted to have suggested.  The day after the chapter 11 plan is substantially consummated and the cramdown paper is issued, it gets valued, marketed, etc.,  like any other loan on the lender’s books.  It does not go into a special “exit loan” basket and stay there, carried at face value, until it is paid off.  Nor does it mean a thing to the market that a bankruptcy judge has found the plan feasible or fair and equitable;  the judge’s findings of fact are not preclusive on market participants who were non-parties to the proceeding..  It’s just another loan with an interest rate, interest coverage, collateral package, covenant package and other underwriting facets, and thousands of secondary loan market participants will form a view on its value, which will be expressed through their bids, just like any other loan in the market.  Under GAAP, if the loan is held by a lender other than a regulated bank and not for sale, it will have to be valued by reference to the market, whether that is a Level I, II or III valuation; if it is held by a regulated bank, it will likely be scrutinized by bank examiners for credit quality and is subject to being criticized, reserved against, or having additional capital dedicated to it under risk-based capital regulations.

It is important to recognize that this is completely consistent with how large loans to business borrowers are originally priced anyway: by referencing the yields of comparable deals as reflected in the prices in secondary trading, and then tailoring the final terms based on the reaction of the market as the arranger went out to drum up interest.

So, a proposed cram-up note – in all of its terms, not just the interest rate - should be placed in the context of the entire commercial financing marketplace, not just DIP loans or exit loans, regardless of the fact that it’s being issued under a chapter 11 plan, because that market is where and how the loan is going to be valued beginning the day after the debtor emerges and begins its life as a reorganized debtor.  That is where the creditor’s recovery will be objectively and definitively determined, not in a judicial opinion.  And that is truly consistent with the debtor’s status as having reorganized.  It is supposed to be in a position to stand on its own two feet vis a vis its competitors in the market, without ongoing court protection or subsidy.  (Especially when the equity owner, like the Broadbents in Castleton Plaza, has a net worth "more than ten million dollars", who could possibly think that the federal laws should be interpreted to subsidize their property ownership?)
What's really happening from an economic perspective when judges impose a capital structure that differs from the market's then-prevailing risk and price matrix is that the judge is distorting the market, becoming a government actor picking winners and losers, often favoring the local over the outsider, and making it less efficient.  The paper "Absolute Priority Rule Violations, Credit Rationing and Efficiency" by Professor Stanley Longhofer, currently chair of Real Estate and Finance at Wichita State, asserts that absolute priority deviations "create an impediment to efficient financial contracting". Specifically, he explains (an ungated, prior version of the paper is here) in fairly technical terms the commercially obvious point that, the greater the transfer, or perceived risk of transfer, from lender to equity in a default state, the greater the risk to the lender in making a loan in the first place. Yet, that risk cannot be reflected in a higher initial interest rate, because that would only increase the probability of the default state arising, and the transfer occurring.  A "death spiral" or "vicious circle" comes into play:  lenders choose not to make marginally riskier loans at all, and the credit markets become less efficient because the supply of credit at the margin becomes suboptimal.

This certainly matches my experience representing potential investors in distressed situations.  The first question[4] they always ask is "how can I get screwed"?  If that can't be answered to their satisfaction, they are unlikely to pursue the loan at all.   Bankruptcy practitioners see the dynamic Professor Longhofer describes when we advise potential distressed investors about the risk that a very high yielding loan will be recharacterized as equity in a bankruptcy, which takes away the risk premium and the principal to boot.  At the fringes of lending, the correlation between credit risk and credit price turns into a feedback loop and price increases inflict risk as opposed to compensating for it.  So the availability of credit is not just an infinite supply where every risk has a price and every loan can get funded at some price. 

Although bankruptcy practitioners often lose sight of this fact, bankruptcy is a small part of a much larger world of commerce, credit and contracts, so if the goal of a public law is to make the public as a whole better, off, it may be best to administer the bankruptcy laws in such a way as to do as little damage to those more widely used economic mechanisms as possible. 




[1]           I could not find a publicly available version of the bankruptcy court opinion.  It is at docket number 285, case no. 11-01444-BHL-11 at the PACER site for the Southern District of Indiana Bankruptcy Court.  The appellate decision is here.

[2]           The debtor filed a petition for cert (12-1422 at the Supreme Court) that was denied. I reviewed the bankruptcy court docket post-mandate and the travesty has continued, although it may end soon.  The court denied the creditor's motion for relief from stay, without a new valuation; the court set a date for auction of the new equity but the debtor apparently aborted it; the debtor filed two further iterations of a new value plan without competitive bidding, which even the bankruptcy court said were unconfirmable after the appellate result, and the creditor moved to dismiss, which is to be heard in January 2014. 

[3]             Yet, as a sign the US equity markets are efficient, they do offer our hypothetical investor a way to buy a      share of Facebook at $25.  That is called a call option - a call on Facebook at $25. However, the option has    a price that generally tracks the difference between the price of a share of Facebook and $25.  So there is no          great arbitrage opportunity between the two -- another sign of an efficient market. 

[4]   Technically it's the first substantive question (the first actual question usually being "do you have a conflict"?).