The Role of Profit in Valuing Chapter 11 Cramdown Paper

Judge Drain's recent bench ruling in the Momentive Performance confirmation hearing rests primarily  on the proposition that profit has "no place" in calculating the interest rate payable to secured creditors under a plan satisfies the standards of section 1129(b)(2)(A)(i).   His ruling invokes two chapter 13 cases, In re Valenti in the 2d Circuit and the plurality opinion in Till v SCS Credit Corp., and treats them as binding in chapter 11 as well.  I have written at length about the reason why the second part of that reasoning is wrong, that Till was entirely chapter 13-specific.  Now I want to write about the first part, the substantive claim that profit has "no place" in valuing cramdown paper.  As I did in my deep dive into Till, I have gone back to the opinions the Supreme Court issued in the 1940s affirming the absolute priority rule in chapter X and railroad reorganization cases, on the twin premises that (1) they embody the law as it existed when chapter 11 was drafted to replace them, and (2) the absence of any legislative evidence that Congress meant to overrule those cases when it enacted chapter 11 means those cases are still good law for chapter 11 purposes.  Neither Till nor Valenti cite any legislative history in support of their reasoning that profit has "no place" in cramdown paper valuation, just lower court cases.

As younger readers may not be aware, let me first note that the Bankruptcy Reform Act made some changes to the role of the fair and equitable standard and the absolute priority rule in confirming plans of reorganization, but those were largely procedural.  The principal change was to empower classes protected by the standard/rule to override it by acceptance of the plan, meaning that the standard/rule only came into play for a non-accepting class; the effect of this was to eliminate the ability of dissenters within the accepting class to invoke the standard/rule -- they were remitted only to the protection of the best interests standard.  Secondarily, the role of the SEC (or, in the case of railroad reorganizations, the ICC) to pass muster on the substantive economics of the plan, among other things, was eliminated in favor of allowing the parties in interest to bargain toward a consensus against the backdrop of the applicability of the standard/rule. 

But those were procedural changes.  I think it is quite evident that the substantive standard/rule was not weakened in the slightest from the "full compensation" mandate in cases like Consolidated Rock Products and the cases I will review in this post. Indeed, in his contemporaneous explanation of the then-new cramdown matrix, Ken Klee, the "author of the Bankruptcy Code" (because he was the staff member of the House Judiciary Committee that took the lead in writing the Bankruptcy Reform Act of 1978) stated that the new Code would afford additional "protection for secured claims that is not provided under present law. "  See "All You Ever Wanted to Know About Cramdown Under the New Bankruptcy Code"53 American Bankruptcy Law Journal 133, 143 (1979).  Elsewhere in the article (page 158), Klee wrote, "The discount rate [used in computing the present value of a stream of deferred cash payments on a secured claim] is equivalent to the rate of interest that would be paid on an obligation of the debtor considering a  market rate of interest that reflects the risk of the debtor's business." (Emphasis added).  In a companion article, Ron Trost, a member of the National Bankruptcy Conference that was deeply involved in the 1970s reform project, wrote: "In the usual chapter 11 case either secured creditors will consent to the plan or the business will not be able to be reorganized."  Trost, Business Reorganizations Under Chapter 11 of the New Bankruptcy Code" 34 Business Lawyer 1309, 1335 n. 182 (1979)  (Parenthetical observation: keep that in mind when you hear someone argue that the Code as enacted in 1978 struck a purported balance between debtor and creditor that has somehow shifted over time in favor of the secured creditor; that's just not true).

The Bankruptcy Reform Act of 1978's changes to prior law reflected a broader trend in the legislation of that decade toward deregulation, which was seen in the airline deregulation legislation and changes President Carter made in the makeup of regulatory agencies; motor carrier (trucking) deregulation; and railroad deregulation, and initial aspects of banking deregulation.  All of those laws reduced heavy-handed regulation by New Deal government agencies (the CAB, ICC, etc.) in favor of increased respect for market forces.  One of the intellectual drivers of the trend was now-Justice Stephen Breyer, who was then a protege of Senator Ted Kennedy, who sponsored several of the deregulating bills  Breyer said at the time:

 

"Efforts, both here and abroad, to have people guess what the market

would produce if it were free to create a price are so very different in

their result from what the market does produce when it is free that it

becomes a kind of parody of a free market situation." 

 

Quoted in Andrew Crain, "Ford, Carter and Deregulation in the 1970s", 5 Journal on Communication and High-Tech Law 413, 425 (2007). In the case of the era's bankruptcy reform, there were many alternative approaches debated throughout the decade, but it was clearly the consensus outcome that the SEC's role was virtually eliminated, and a more laissez-faire environment arose in which the parties were encouraged to reach privately negotiated resolutions within parameters set by the substantive provisions of section 1129.

 

It's implausible in my estimation that a law passed in that era dealing with commercial financial situations was intended to eliminate market and profit considerations from judicial analysis, especially given that the reform act was the subject of years of legislative revision, debate and study through three Congresses before it was passed and such a contrarian perspectie does not manifest itself in the legislative history.

In addition to those contemporary insights into the intent behind the Bankruptcy Reform Act of 1978, it is very instructive to turn back to the 1940s, to see not just what the law was, but what section 1129(b)(2)(A) really means today.    Perhaps the reader has already read my re-visiting of Consolidated Rock Products from1940.  In this post, I will explain how RFC v. Denver & Rio Grande WesternRailroad Co., 328 U.S. 495 (1946) and its companion case Insurance Group Committee v. Denver &Rio Grande Western Railroad Co., 329 U.S. 607 (1947) establish the following proposition:  because a secured creditor class is entitled to "full compensation" for any alteration of its rights by a reorganization plan, if it is necessary to achieve full compensation that the creditor class make a profit, then profit must be afforded the creditor to satisfy the fair and equitable standard.   This proposition of course, negates the converse, that profit has "no place" in cramdown treatments.   Of course, a debtor can always pay off the creditor in cash at confirmation, or reach a consensual bargain with the creditor, and obviate analysis of the topic.  But the creditor class cannot be forced to take back paper priced below par just because a higher rate would enable a profit to occur.  (Note, this is slightly different than saying the paper must actually trade at a market value of 100 per cent.   Courts are not infallible and the other creditors were not legally obligated to insulate the creditor against market fluctuations.  It is clear from the pre-Code cases that no court was applying the rule that strictly.  What they were requiring, though, was a good-faith, well-reasoned valuation, backed by specific evidence, and not an off-the-rack formula, that led to the conclusion that, more likely than not, the secured creditor would hold something worth 100 cents of its claim upon confirmation). 

The Facts of the Case

As the two Denver & Rio Grande Railroad cases are over 70 years old, they use a number of unfamiliar terms and references that make reading the opinions more laborious than modern opinions. Yet the effort pays off as the underlying plan issues turn out to bear a close resemblance to those presented by many modern chapter 11 cases. 

The railroad filed its petition for reorganization in 1935.  Its capital structure was complex, as was typical of the railroad reorganizations of the era, principally because various branches and subsystems and asset classes had been separately financed from one another and from the system as a whole.  So while various creditors thus had first liens on parts of the system, there was another layer of secured debt, the General Mortgage Bonds, that had blanket, but junior, liens on the system as a whole.  There were other layers of creditors and equity holders, but on the valuation that the ICC and the district court adopted, there was no value for anyone below the two classes of secured debt, and the other stakeholders were eliminated under the plan.  So this was quite analogous to many cases we see today: first lien holders and second lien holders battling over the enterprise value, with everybody else out of the money.  

Based on the aforementioned ICC and court approved valuation, the plan provided that the first liens would get a package of secured debt instruments and new stock amounting to 90% of the reorganized debtor's equity, while the second liens would receive only the remaining 10% of the equity.

The Proceedings Below

The plan was proposed on the basis of an effective date of January 1, 1943.  It cleared the ICC in June of that year, and was confirmed by the district court in June 1944 after creditor voting.  The first liens voted in favor and the second liens (General Mortgage Bonds) voted against the plan.  Several appeals were taken from confirmation, principally arguing that the valuation and consequently the treatment of creditors had failed to account for the "excess war profits" the railroad would reap after the effective date, 90% of which would, per the plan, flow to the first lien holders through the common stock stake awarded them under the plan.  For present purposes, the fact that the case turned on the awarding of "profits" to first lien holders makes the case highly relevant to Till-in-chapter-11 analysis, as exemplified in Momentive Performance.   

The circuit court of appeals agreed with the appellants, whereupon the secured creditors brought the case to the Supreme Court.  The appellate court had ruled that the secured creditors were over-compensated by the debtor's plan as approved by the ICC and the district court:  "The senior bondholders were paid in full.  They received all the new securities and most of the common stock.  Ninety percent of the General Mortgage Bonds were wiped out, . They received only a small amount of the common stock, ten per cent of their total claim.  ... We think any plan which fails to take this [buildup of huge retained earnings during WW2] into account and gives the Senior Bondholders their claims in full by substantially delivering the road to them, and gives them the surplus cash actually on hand and further enables them to receive in addition the excess war profits which are reasonably sure to come, is inherently inequitable and unfair, so long as there are class of creditors whose claims are not fully satisfied."  (Emphasis added)

The first liens argued to the Court that " The circuit court defeats the private right of creditors to full satisfaction of their claims.  The senior creditors are entitled to realizable value in the full amount of their bonds before the general mortgage bonds are entitled to anything. (Citing the then recent Supreme Court opinions  Case v. Los Angeles Lumber; Consolidated Rock Products; Ecker v. Western Pacific; and Group of Inst'l Investors. v. Chicago, Milwaukee & St. Paul Ry Co.)"

The Supreme Court's Opinion

In a 7-1 ruling, the Supreme Court reversed the circuit, reinstated the confirmation of the plan, and justified the award of "profits" to the first lien holders as necessary to achieve "full compensation" under the fair and equitable standard.

The Court said: "junior claims can receive nothing until the senior claims receive securities of a worth or value equal to their indebtedness.  The [General Mortgage Bonds] are definitely junior [to the holders of liens on discrete systems within the overall railroad].  The Commission did not make a finding that the cash value of the securities awarded the senior claims as of the effective date of the plan equalled [sic] the face of the claims. It did, however, carefully state its reasons for concluding that compensation 'flowing under the plan to the various classes of bondholders for the rights surrendered by them' was adequate in the light of the full priority rule.  For those classes, other than the Junior Generals, that received common stock, the Commission said that the possibility of 'unlimited dividends on common stock' was a factor in offsetting loss of position. Thus it is clear that when the Commission made its allocations it had definitely in mind that one thing that gave the senior creditors compensation for the admission of junior claimants to participation in securities before the seniors obtained full cash payment was their chance to share in the unlimited dividends that might be earned and paid on the common stock to have a part in the 'lush years'."   328 U.S. at 517-18.

In a section of the opinion titled "Cash and War Earnings", the Court noted that the ICC had justified the plan's departure from full cash equivalency by the fact that the senior secured bondholders would receive 90% of the common stock and thereby participate in the "excess war profits".  "The error of the Circuit Court lies in its assumption that the senior bondholders were paid in full by the securities allotted to them without also accepting the determination of the Commission ... as of January 1, 1943, [that] all subsequent earnings were a part also of the common stock  that was awarded the senior bondholders."  328 U.S. at 523-24.

In other words, it was the profit component, conveyed through the common stock distributed  to the first liens, that saved the plan from failing the fair and equitable test!  "[T]hrough these common stock advantages the [secured creditors] may be compensated for their loss of payment in full in cash." Id. at 525.

A Second Bite at the First Liens' Apple

After the Court issued its opinion, the railroad debtor went back to its reorganization court for permission to abandon its confirmed plan in favor of one that gave better treatment to the junior constituencies.  It argued changed circumstances, in particular that, due to the "radical lowering of money rates for the indefinite future", the interest payable to the secured creditors under the plan as confirmed was just too damn high.    Once again, the district court rejected the attempt, but the circuit court stayed the lower court's order to consummate the plan.   The first liens took the matter before the Supreme Court again.  

In Insurance Group Committee v. Denver & R.G.W.R. Co., 329 US 607 (1947), the Court, again with only one dissenter, vacated the appellate court's ruling and reinstated the district court's order.  The Court confirmed its holding from the prior year: "To justify the change of position of creditors from fully secured to partially secured, creditors were given opportunities to participate in profits through common stock ownership with a change at larger earnings than the Commission's forecast anticipated. We held the priority rule was satisfied by this type of allocation." 329 U.S. at 617 (emphasis added). 

Regarding the allegedly excessive interest rate on the debt instruments issued to the first liens, the Court said: " As none of the authorized securities is alleged by the debtor to have shown values much above par, the chosen rates of return have not proven to be excessive."  Id. at 615.   Supporting that statement, the Court footnoted a table taken from Moody's that showed the first lien bonds included in the package of debt and equity issued to the first liens had traded in the 102.89-103.82 range during 1945 and 46, although they had traded below 90 during 1947, and the package as a whole was not precisely valued by the Court:  "The debtor has made no allegation ... that the existing cash value of the securities allotted any creditor has ever aggregated the amount of the creditor's claim against  the debtor. ... Until it can be contended with some show of reasonableness that the creditor[senior creditors[ have received more in value than the face of their claims, the debtor's insistence on a re-examination of the plan is without substantial support [citing Northern Pacific Railway v Boyd and Group of Institutional Investors].  ... the debtor [fails] to allege any actual sales or value of the securities which would show that the creditor have received through the allotted securities payments on their claims in excess of their face...." 

Clearly the Court found market values relevant, not as the sole determinant of the "fair and equitable" analysis, but as a very relevant component  thereof.   And the Court clearly reaffirmed the crucial role of profits in satisfying the fair and equitable standard.  As these cases has never been questioned in subsequent Supreme Court opinions, or in the legislative revisions of the bankruptcy law since then, these principles remain good law in the chapter 11 context.