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Friday, January 3, 2014

A Deep Dive into Till v. SCS Credit Corp. – Part I: An Overview of the Topic and the Facts of the Case.

At the end of my post six months ago on the Texas Grand Prairie opinion from the Fifth Circuit, I indicated that I would follow up with a post about why I think a challenge to the application of Till v. SCS Credit Corp., in chapter 11 cases would have merit.  Many things intervened, including long stretches of great weather when I chose not to sit down at a PC, but this is it.  While I initially thought my post would be a brief review of the Till plurality opinion followed by a slightly longer explanation of the errors of economic analysis that bankruptcy courts have been making in their interpretation and application of the footnote from the plurality opinion that refers to “an efficient market”, as I delved into the background of the Till opinion, I found several interesting facts that, as far as I can tell, have never received the attention they deserve and so the initial idea has expanded to a much longer review that I have broken into several more digestible  segments.  Following this post, which summarizes the facts of the case, its lower court history and the state of the law as the issue came before the Court, there are:

1)  a couple of posts that take a “deep dive” into the briefs and the extremely revealing oral argument presented to the Court;

2)  an analysis of the plurality opinion, with particular attention to the way it reflects the facts and arguments that are covered below, and how, since Till is a chapter 13 case, those differ from the standard chapter 11 context; and

3)  an analysis of Justice Thomas’ concurrence, which supplied the fifth vote to overturn the 7th Circuit’s ruling in favor of the secured creditor.

Then, I focus on each of the passages in the plurality opinion that reference chapter 11 practice, and, in particular, look more closely than any prior commentator at the meaning of the term “efficient market” in footnote 14 to the plurality opinion.  

I identify a substantial amount of evidence that the loan market is sufficiently “efficient”  to satisfy even a strict reading of the plurality opinion,

Then, I show how lower courts have recurrently misunderstood the meaning of the term “efficient market” in applying Till and have also lost sight of the pre-Code precedent concerning secured creditor cram-down.  

I finish with a list of practical and strategic considerations for fashioning a case to overturn the use of Till in chapter 11 and a closing thought about the fairness of respecting market dynamics to resolve cramdown battles.

For those who don't have time to read all the posts, the first five posts focus on the Till decision itself, so readers who feel they are already familiar with it may want to skip those, although I encourage you to at least read the third post on the oral argument, which I think will bring to your attention things you do not know. The next five focus on the extension of Till to chapter 11; if you already understand the "efficient market hypothesis" in finance, you may not need to read the 8th post and if you are not in the mood for statistics about the credit markets, you may want to skip the 9th post.  The 10th post is the one where I address directly the lower court errors.

The aim of these posts is to convince the reader of two things: first, even if you think that Till was correctly decided in a chapter 13 context (and I am not going to question its result as a chapter 13 policy, although I will occasionally drop a footnote here or there containing my thoughts on that subject),  the “prime plus” method for pricing cramdown paper in chapter 13 was endorsed by the plurality solely as a pragmatic response to certain factors specific to chapter 13 that are not present in chapter 11 cram-downs.  Second, subsequent lower court decisions applying Till in chapter 11 are (a) generally misunderstanding what “an efficient market” is and (b) disregarding pre-Code Supreme Court decisions which were intended to carry over into chapter 11.

Factual Background 

Except as otherwise acknowledged,  all factual recitations in this post come from the Supreme Court opinion, the parties’ briefs in the Supreme Court, the transcript of argument before the Court, and the 7th Circuit opinion.

I’ll start with a short narrative of the Tills’ bankruptcy.  In 1998, Instant Auto Finance, a subprime auto lender, financed Indiana residents Lee and Amy Till’s purchase of a used 1991 Chevrolet S-10 pickup truck at a 21% annual interest rate, which, I learned in the course of my research, was the maximum rate chargeable under Indiana’s usury law.  The loan was for  $6,426 and their bimonthly payments were to be $122.  In 1999, by which time the Tills had reduced principal by about 25% but were in default, the Tills filed for chapter 13 relief in bankruptcy court for the Southern District of Indiana.  The parties stipulated to a $4,000 secured claim for the lender.[1]

The Tills’ plan proposed to repay the secured claim in full over 17 months  at a 9.5% interest rate, at a time when the “prime” rate was around 8%.  In the course of reading the transcript of argument before the Supreme Court, I came across counsel for the Tills informing the Court that the 1.5% premium was set by local rule, a fact not disclosed in the Supreme Court opinions; that was quite a surprise, given that the plurality would go on to declare that the “prime plus” approach provided room for individualized risk assessment.

The lender voted to reject the proposed treatment, objected to confirmation and, at the confirmation hearing, showed through two fact witnesses that it “uniformly” charged 21% on loans of similar credit quality and purpose, and further that such a rate was the prevailing industry rate for car loans to credits like the Tills (none of which was surprising, given 21% was the usury ceiling).

The Tills responded with expert testimony from an IUPUI  economics professor (who -- quoting from the Supreme Court opinion  -- “acknowledged that he had only limited familiarity with the subprime auto lending market”) to the effect that a fair market price of capital and the time value of money was captured by a market "prime rate" of 8% interest, and that a 1.5% risk premium should be added to cover the risk that petitioners would not make payments as required by the plan.  By a remarkable coincidence, his testimony just happened to dovetail with the rate established by local rule.  The professor further asserted that the 9.5% formula rate was “very reasonable” given that Chapter 13 plans are “supposed to be financially feasible”. Moreover, the professor noted, respondent’s exposure was fairly limited because chapter 13 plans are performed “under the supervision of the court”. The chapter 13 trustee filed comments supporting the formula rate as, among other things, “easily ascertainable, closely tied to the condition of the financial market, and independent of the financial circumstances of any particular lender.”

The bankruptcy judge chose to allow the IUPUI professor’s testimony as expert testimony, adopted its reasoning (I imagine the judge had some involvement in crafting the local rule that the professor’s testimony said was reasonable) and confirmed the plan in an unreported opinion in June 2000. 

A brief aside: paying an academic expert to deliver expert testimony is pretty unusual in chapter 13, especially where the amount in controversy was less than $1,000.[2]  So I looked further into the case to see if I could figure out how that came to be, and saw that the UAW was representing the Tills.  The UAW apparently had a legal services plan for members, and one of the Tills was a member.  In an earlier version of this post, I speculated  that the UAW had invested in the expert because of the precedential nature of the issue, but Annette Rush, one of the Tills' counsel, informed me after reading the blog that hiring the expert was done just as a matter of trial strategy in the Tills' case specifically, and I thank her for enabling me to correct the recitation of facts.

The district court reversed, in November 2000, saying the lender’s unrebutted evidence established that a subprime market existed and that the established rate for the subprime lending market was 21%, which the District Court considered the controlling inquiry under Koopmans v. Farm Credit Services Of Mid-America, 102 F.3d 874 (7th Cir. 1996)(chapter 12)(“the creditor must get the market rate of interest, at the time of the hypothetical foreclosure, for loans of equivalent duration and risk”). The District Court stayed its order pending the debtors’ appeal to the 7th Circuit.

The 7th Circuit affirmed the reversal in August 2002 on different reasoning, 2-1.  It echoed the district court in stating that a secured creditor is due the same rate it would “obtain in making a new loan in the same industry to a debtor who is similarly situated, although not in bankruptcy” and “is entitled to the rate of interest it could have obtained had it foreclosed and reinvested the proceeds in loans of equivalent duration and risk”, since nothing less would give the creditor the “indubitable equivalent” of its nonbankruptcy entitlement.”  But it went further than the district court and announced that the pre-petition, non-default contract rate was presumptive evidence of what  that rate was, adopting GMAC v. Jones, 999 F.2d 63 (3d Cir. 1993).  The “old contract rate will yield a rate sufficiently reflective of the value of the collateral at the time of the effectiveness of the plan to serve as a presumptive rate.”

The dissenter thought that the debtors’ interest rate should be whatever it would cost the lender to obtain an equal amount of money, i.e., the lender’s cost of funds, and no more.  Further, the dissenter contended that the lender had already been fully compensated for the risk of nonpayment in the interest rate initially specified (even though 75% of that loan remained unpaid and the creditor was being prohibited from exercising its contractual remedy for default).[3]

The Seventh Circuit’s decision reinforced a conflict that already existed among the circuits.  In addition to GMAC v. Jones, five other Circuits had adopted variations on the “coerced loan” approach: Matter of Southern States Motor Inns, Inc., 709 F.2d 647 (11th Cir. 1983), cert. den., 465 U.S. 1022 (1984); In re Hardzog, 901 F.2d 858 (10th Cir. 1990); United Carolina Bank v. Hall, 993 F.2d 1126 (4th Cir. 1993); In re Smithwick, 121 F.3d 211 (5th Cir. 1997), cert. den., 523 U.S. 1074 (1998); United States v. Arnold, 878 F.2d 925 (6th Cir. 1989).

In contrast, the Second, Eighth and Ninth Circuit Courts of Appeals had adopted alternative “formula” methods for discounting payments to present value, generally beginning with a relatively riskless rate, like US Treasuries, and adding a risk premium but also generally affording the trial judge discretion in computing the specific rate. See, e.g., In re Valenti, 105 F.3d 55 (2d Cir 1997) (which, much like the Till plurality, endorsed lower court decisions using a prime plus formula).

So, after several previous denials of cert, the Supreme Court chose Till as the vehicle to resolve the circuit conflict. 

[1]           The lender also received a $895 deficiency claim which was not satisfied in full, and is not relevant to my chapter 11 focus, but is worth keeping in mind to the extent one wants to think about whether the Tills’ plan was “fair and equitable” in a broader sense, especially when advocates of greater debtor relief emphasize the 21% pre-petition interest rate and the supposed profit reaped by the lender.  The lender here was not paid in full on its total claim.  I further doubt they were allowed any amount for their legal fees defending their claim.

[2]           On a $4,000 amortizing note over 17 months, the 11.5% difference in interest rates amounted to about $500 in additional payments.

[3]           In my opinion, that analysis reflected neither a sound legal analysis of a secured loan nor a basic grasp of finance in a market economy. The fact that a risk has materialized has nothing to do with whether the government can coercively re-expose the lender to a renewal of that risk or a different one, or at what price it can take away the lender's remedy for the risk materializing.