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"?).
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