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Friday, January 3, 2014

A Deep Dive into Till v. SCS Credit Corp -- Part VI: "Essentially the Same Approach" for Chapter 11, and a Comparison to Precedents in Business Reorganization Cases

I’ve devoted most  of  my analysis so far into trying to persuade the reader that the plurality opinion in Till was chapter 13-specific and does not provide substantial support for the use of the “prime-plus” formula in chapter 11s.  In this post, I will focus on the passages in Till -- other than footnote 14, which I will go over separately in the next post -- that have been invoked to application of the “prime plus” formula to cram-ups under section 1129(b)(2)(A).  These passages are dicta, of course, but that is not a bar to the reasoning, just a caution.
Early in Section II of the plurality opinion, the first section of legal analysis, after conceding the “Bankruptcy Code gives little guidance”, the four justices observe that the Bankruptcy Code “includes numerous provisions that, like the cram down provision, require a court to ‘discount a stream of deferred payments back to … present dollar value,’” (citations omitted).  The opinion drops a footnote here that references, inter alia, § 1129(b)(2)(A).  Then, the opinion continues, “We think it likely that Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate under any of these provisions.”  From these words, one could conclude that the plurality was intending the “prime plus” formula they were about to endorse in 13's should apply as well in 11's.[1] 
However, I hear something different in this language.  Because it's placed at the very beginning of the opinion's discussion of the law, it likely is more a preface to a line of reasoning than the conclusion that follows from that reasoning.  I think the plurality was merely trying to say that it believed the “prime plus” approach it was about to endorse was “essentially the same approach” as pre-existing law under chapter 11, not a major departure from it, and any  deviation from prior precedent was only a pragmatic reformulation of the prior law to reflect the administrative challenges of chapter 13.  Hence the qualifier ,"essentially" which I take to singal "we're doing something a little different here, not a lot".  The Court has said on numerous occasions (e.g., Dewsnup) that, when interpreting the Bankruptcy Code, they will presume, absent evidence to the contrary, that Congress did not intend to depart from well-established practice under the prior law.  I think the "essentially the same approach" passage is just a different way of making the same point.
And I think, at a high level of generality (i.e., setting aside for the moment the "highest feasible present value" passage discussed in the last post), that is a defensible perspective.  While Congress made one major change to prior practice regarding the “fair and equitable” standard in the Bankruptcy Code, by enabling the standard to be bypassed if a class consents to its treatment by the margins established by section 1126, there is no evidence that Congress intended to change the substance of the standard when the class dissents and the standard has to be applied.  Thus, since our focus is on the use of Till in chapter 11, we should continue to  look at the Court's prior precedents in the business reorganization context to see what Congress intended to incorporate into the “fair and equitable” test in chapter 11, which the plurality implies they continue to view as operative. 

I don't propose to take up the reader's time by going over well-plowed ground, since there are many articles that cover the topic broadly (a brief and clear history of those cases can be found in this article by Pamela Foohey, a professor of law at the University of Illinois).  Instead, I will confine my analysis to a short, but in-depth look at the last of the Supreme Court’s major pre-Code opinions on the subject of compensating creditors for the restructuring of their contract rights, Consolidated Rock Products v. Dubois, which I think is the most relevant precedent.

Consolidated Rock Products was a holding company, with two operating subsidiaries, Union and Consumers, each of which had separate debt issues outstanding.  Today we would call those issues “structurally senior” to the parent’s creditors, although the parent had no bank or capital market debt, just preferred and common.  The subs had substantial net intercompany claims against the parent.  All three were in a jointly administered reorganization case under § 77(B). The plan confirmed by the district court awarded the subs’ bondholders a package of new bonds, preferred and warrants to buy common stock, and allowed the parent’s stockholders to retain all the common on the reorganized company.  It also ignored, and wiped out without analysis, the intercompany claims, and extinguished as well the unpaid pre-petition interest on the subs’ bonds without consideration.

The Court granted cert because of “the importance in the administration of the reorganization provisions of the Act of certain principles” presented by the case, and reversed, by way of an opinion authored by Justice Douglas, certainly no friend of the moneyed interests.

First, the Court decided that the intercompany claim was a claim against the parent and thus was entitled, by dint of the absolute priority rule, to receive any value of the parent’s estate, for the benefit of their own creditors, before the parent’s stockholders could retain any equity.

Secondly, or alternatively, the Court said, even if the intercompany claims were not valid because corporate formalities had not been respected or assets had been commingled, still the subsidiary’s creditors were senior to the parent’s stockholders on a consolidated basis, and entitled to application of the absolute priority rule that equity receives nothing until the creditors are “made whole”.

Then, the Court articulated additional problems with the plan. I’ll skip over the first – apportionment of the reorganized company’s value between the respective subsidiaries’ bondholders, which is not relevant here – to focus on the second, which is the more well-known and more relevant portion of the opinion.  In that portion, Justice Douglas faulted the reorganization court for its failure to “value the whole enterprise by a capitalization of prospective earnings”.  Quoting a Holmes opinion from an earlier era, he wrote: “'the commercial value of property consists in the expectation of income from it.’” So here we see the Court, in its last pre-Code opinion on the “fair and equitable” standard, linking “value” in the “fair and equitable” context with “expectation of income”, which -- contrary to Justice Thomas's concurrence -- implies a risk-adjusted discount rate, not a risk-free one.

This inference is reinforced by the rest of the paragraph:

Since its application requires a prediction as to what will occur in the future, an estimate, as distinguished from mathematical certitude, is all that can be made. But that estimate must be based on an informed judgment which embraces all facts relevant to future earning capacity and hence to present worth, including, of course, the nature and condition of the properties, the past earnings record, and all circumstances which indicate whether or not that record is a reliable criterion of future performance. A sum of values based on physical factors and assigned to separate units of the property without regard to the earning capacity of the whole enterprise is plainly inadequate.

In the first two sentences, the Court uses the words “prediction”. “estimate”, and “informed judgment”, all of which entail much more than a mechanical application of a risk-free rate or a pre-ordained formula or a highly constrained range of rates to a promised stream of payments; in particular, in the phrase “all circumstances which indicate whether or not that record is a reliable criterion of future performance” the reference to “all circumstances” clearly takes the court out of the realm of anything mechanical.  So too the phrase “whether or not”, contrasted with the notion of “mathematical certitude,” which is dismissed as impossible, plainly indicates that there is uncertainty and thus risk that the court is expected to take into account.[2]

In its next section, Justice Douglas's opinion delivered an even stronger message that bears directly on the contemporary use of Till in chapter 11 cases.  He observed, first, that “The bondholders for the principal amount of their 6% bonds receive an equal face amount of new 5% income bonds and preferred stock, while the preferred stockholders receive new common stock” (emphasis added). 
But, the Court held, “the bondholders have not been made whole.  They have received an inferior grade of securities, inferior in the sense that the interest rate has been reduced, a contingent return has been substituted for a fixed one, the maturities have been in part extended and in part eliminated by the substitution of preferred stock, and their former strategic position has been weakened. Those lost rights are of value. Full compensatory provision must be made for the entire bundle of rights which the creditors surrender.” (Emphasis added again).

This mandate is being overlooked in the application of Till in chapter 11 cases.  What the courts using Till to cramdown secured debt have been doing is just what the Supreme Court said, in Consolidated Rock, failed the absolute priority test, in particular extending maturities, and tinkering with interest rates to make plans feasible. The Court said that those steps make a secured creditor less than whole and cannot pass muster under the rule; the creditors’ rights “are not recognized, in cases where stockholders are participating in the plan, if creditors are given only a face amount of inferior securities equal to the face amount of their claims”. 

For example, when both Justice Thomas and the dissenter in the Seventh Circuit contended that the risk of default was already priced in to the loan when made and thus the lender was not entitled to any risk adjustment in the reorganization, that clearly contradicts Consolidated Rock’s holding.  The maturity of the debt in Till, as in many of the chapter 11 cases applying it, was extended as part of the cramdown.
Consolidated Rock teaches that the “fair and equitable” rule requires that the creditor be “compensated” for the extension.  A risk–free rate cannot provide any compensation for an extension of maturity when the initial contract rate was above the risk-free rate to begin with. This 1943 article by an analyst at the SEC, which played a much larger role in reorganizations then, confirms that Consolidated Rock was contemporaneously so interpreted, to require a risk-adjusted capitalization rate.

So, too, when the plurality in Till went off on the “highest feasible present value” tangent, they subordinated the “fair and equitable” standard to the goal of helping debtors reorganize and thus departed significantly from prior business reorganization precedent.  Whether that is defensible in the 13 context as a pragmatic matter, I don't propose to dwell on.[3]

It’s also critical to recognize that the Court in Consolidated Rock was talking about more factors than just an interest rate.  They are talking about maturity, collateral, “strategic position” (which I take to be a reference to the absolute priority of debt over equity and a blessing by the Court of the often-discomfiting effect that has on equity owners' wishes) and the whole package of contract rights “lost” in the restructuring.  This essential aspect of the fair and equitable analysis has been forsaken in the application of Till in chapter 11.   Courts today seem to be acting as if, because Till dealt just with an interest rate, the only “fair and equitable” inquiry is "what is the interest rate?"  Consolidated Rock makes clear the whole package of terms has to be analyzed and all impairments of the original bargain have to be compensated.  Nothing in Till addresses the treatment of other issues, nor does anything in a consumer case like Till suggest that the more complex analysis required by Consolidated Rock has been thrown out the window. 

Justice Douglas ends the paragraph by affirming that the “fair and equitable” rule emanates not just from dry statutory language, but equity: “The plan then comes within judicial denunciation because it does not recognize the creditors' 'equitable right to be preferred to stockholders against the full value of all property belonging to the debtor corporation'” (Emphases in this paragraph added).

I want to expand a little on that last point, that the absolute priority rule is equity-driven.  It is constantly overlooked in corporate reorganizations that the equity holders have taken on debt through the corporation, yet are privileged by corporate law to be immune from liability for any deficiency in creditors’ recovery against the corporate assets. Bankruptcy, of course, is an environment where such a deficiency tends to manifest itself. The tradeoff for the shareholders’ privilege has always been that the creditors’ claims have priority over those assets against the shareholders’ equity in them.  The absolute priority principle merely continues that priority in bankruptcy, just as the shareholders’ privilege from being held to account to the creditors for their losses continues.  Undercutting one side of that tradeoff -- the absolute priority principle -- is not, as some have mistakenly contended, a salutary “balancing of the interests of debtors and creditors”.  Rather, it disrupts the balance – the shareholders hold on to their immunity from liability for unsatisfied corporate debts, while being permitted to appropriate some of the value that would otherwise be dedicated to the creditors’ claims.  Although chapter 11 permits such a re-balancing on a consensual basis, it does not, and should not, impose one on a non-consensual basis. That is neither balance nor equity.

[1]           One could also conclude that the reference to bankruptcy courts "choosing an appropriate interest rate" for cramdown paper provides additional evidence that the justices in the plurality lacked a strong understanding of the process of plan formulation and confirmation and of the respective roles of plan proponents, who are the ones who actually "choose" a rate to propose, and bankruptcy judges, who decide if the proposed treatment of the affected claim satisfies the statute's standards.  Although I think that is fairly plausible, as none of those justices seem to have any prior experience with reorganization cases, the interest rate question still needs to be tackled, so the analysis has to go beyond just saying, "well, they just didn't have a strong grasp of reorganization practice" and needs to explain what the reorganization practice is.

[2]           In the third and last sentence, the Court clearly rejects a valuation of merely tabulating static “property” values, and clearly holds that the fair and equitable analysis is to be based on a “going concern” valuation.

[3]           As I indicated in my fourth post, fn.3, I think there are better reference rates than the prime rate for used car loans that may actually work to chapter 13 debtors' benefit.