MPM Ruling Unwisely Endorses Till in Chapter 11

On August 26, Judge Drain, who sits in the White Plains courthouse in the Southern District of New York, delivered a surprising bench ruling confirming a plan of reorganization for the Momentive Performance Materials group of debtors ("MPM").   His rulings covered a number of issues, including interpretation of an inter-creditor agreement and denial of a make-whole premium to senior secured creditors, each of which was resolved against the senior secured creditors.  But probably the most explosive ruling, because it is not confined to the language of a particular contract, but, rather, presented as an interpretation of section 1129(B)(2)(A) of the Bankruptcy Code, was his expansive, almost literal, application of the Till plurality opinion to "cram up" the senior secured creditors with a below-market piece of 7-year paper.  

Judge Drain's analysis is noteworthy for four reasons.  First, the vast majority of Till-in-chapter-11 cases involve single-asset-real-estate or closely analogous fact patterns, in which the case is nothing more than a simple two-party dispute between the owner of the asset, who controls and dictates strategy to the debtor, and the mortgage holder, and there are no other significant creditor groups.  Rarely has any chapter 11 case involving a corporate group of debtors with multiple large creditor constituencies presented a Till litigation. 

Second, and a related point obviously, this is the first time a judge sitting in one of the main forums for complex chapter 11 cases has endorsed Till-in-chapter-11.  So it portends potential significance for future cases.  Judge Drain is a well-respected bankruptcy judge who practiced in an elite New York firm and his background will certainly give the analysis in his ruling more weight as a practical matter than a similar decision from a financially less-sophisticated judge or district (that said, Judge Drain has been known for a tendency to push the envelope in favor of junior constituencies -- see, e.g., the victory of the second lien bidder in the Westpoint Stevens 363 case (reversed on appeal at the District Court level, which reversal was then vacated by the Second Circuit on the ground the appeal had been moot under section 363(m)), or his decision in MacMenamin's Grill, that the safe harbor of 546(e) did not apply to private stock transactions (a distinctly minority view later rejected by the Second Circuit in Enron Creditors Recovery Corp v. Alfa).  

Third, his endorsement of Till conflicts with the decision of his fellow SDNY Judge Gerber in the DBSD case, who rejected, albeit with little explanation, a Till approach in the chapter 11 cramdown context.  As one of the creditor briefs (I forget which, sorry) summarizes the law in the Circuit: "There are four published Second Circuit decisions citing Till. Of those four decisions, only DBSD involved a corporate debtor and facts similar to this case and in that case Judge Gerber determined that Till was of limited value and that the market rate had to be considered. See DBSD, 419 B.R. at 209. The other three decisions in the Second Circuit all involved a single-asset real estate debtor and are thus inapposite to a complex chapter 11 case for the reasons set forth herein. Even so, two of those three decisions considered whether there was an efficient market before applying Till’s formula. See Mercury Capital Corp. v. Milford Conn. Assocs., L.P., 354 B.R. 1, 12 (D. Conn. 2006) (remanding confirmation order for determination of whether there was an efficient market for the debtor’s cramdown loan); In re 20 Bayard Views, LLC, 445 B.R. 83, 107-08 (Bankr. E.D.N.Y. 2011) (considering whether there was an efficient market before applying Till); but see In re Lilo Props., LLC, Case No. 10-11303, 2011 Bankr. LEXIS 4407 at *6 (Bankr. D. Vt. Nov. 4, 2011) (applying the Till formula without a discussion of whether there was an efficient market)."  Oddly (given that on the other issues his ruling cites decisions authored by Judge Gerber), Judge Drain ignored the DBSD conflict in his ruling, invoking instead bankruptcy court opinions from Vermont and EDNY.  

Last, the MPM reasoning departs from the main line of post-Till cases, which follow the American Homepatient line of reasoning that a court should look first to whether the relevant loan market is "efficient" and then, only if the answer is no, apply the Till formulaic approach.  Instead, Judge Drain applies the Till plurality approach in virtually undiluted fashion, as if it were settled law, rejecting the reference to the "rate an efficient market might produce" in footnote 14, and modifying the formula approach only to change the base on which the interest rate payable by the debtor was calculated to substitute a  "comparable Treasury" base for the "prime rate" base in the Till formula, in part because the pre-petition senior secured debt carried a fixed rate to begin with.

The Judge offers a remarkable twist on footnote 14, which I analyzed in this post.  Noting that Collier's and others have criticized the footnote for naively confounding DIP loans with exit financing, Judge Drain adopts their criticism, but uses it oddly, not as a means to discount Till as a chapter 11 precedent, but solely to discredit the footnote's reference to markets, leaving chapter 11 a non-market environment!  "In addition, there clearly was some form of market in the Till case. The market, in fact, had a lot of data behind it with regard to subprime auto loans. Nevertheless, the court referred to it as not a perfect market, when discussing those types of loans, for which Justice Scalia somewhat berated the plurality. But that fact, that the court again referred to a perfect market, underscores the notion that it wasn't really markets that was driving the court's analysis"

I have not seen this analysis in other post-Till cases.  As a description of Till, it is actually wrong; as I noted in my earlier posts, the interest rate in Till was the usury rate in Indiana, not a rate that moved up or down as the prime rate or LIBOR-based rates do.  That was why the creditor in TIll advocated for the "presumptive contract" approach, not the "coerced loan" approach, a change in tactics that the Supreme Court noted at the outset of argument, and it led to a key colloquy with Justice Breyer that, in my opinion, ensured he voted for the debtor, because he recognized that, under the creditor's approach, the rate would not change post-confirmation, even though the debtor had supposedly been rehabilitated, and that, in his mind, denied the debtor the benefit the statute was meant to provide. And most obviously, from a real world perspective, the leveraged loan market in 2014 is a lot more competitively priced than the subprime auto loan market has ever been.

As I put up 12 posts on Till-in-chapter 11 back in January, going through Till's facts, the briefs, the oral argument, the plurality opinion and the concurrence of Justice Thomas, as well as the post-Till application of the plurality opinion in some chapter 11 cases and offered evidence of the efficiency of the commercial loan markets, I think this is a subject where I might add some value.  So, although I always enjoyed practicing alongside the Judge when he was in private practice and in front of him since he took the bench,  I am going to briefly explain why this aspect of his decision in MPM is not well founded.

Like all opinions extending Till to chapter 11, Judge Drain observes that the language of 1129(b)(2)(A)(i) is identical to the language in 1325(a)(5)(B)(ii), the section at issue in Till, and further that the plurality opinion said that courts should take "essentially the same approach"  to the two sections.  As I explained earlier this year, that is a correct observation, but it does not necessarily mean quite what the advocates of Till-in-chapter-11 take it to mean.

 

First of all, the remark "essentially the same" obviously leaves room for differences between the two, depending on how strictly you read "essentially" and how you characterize the Till opinion (I show in my January posts, summarized below, that it is chapter-13-specific, which implies that the correlative section in chapter 11 should be interpreted in the context of chapter 11).  One vital fact overlooked by pretty much every analysis of the two sections is that the chapter 11 appearance of the wording appears in a clause subordinate to the well-developed phrase "fair and equitable", while the chapter 13 section contains no mention of "fair and equitable".  Fairly plainly, I think, this signals that Congress intended the chapter 11 version to be interpreted in the same vein as then-existing "fair and equitable" precedents, while its omission of the phrase from the chapter 13 context perhaps affords more leeway to plans and judges.  So the most informed way to understand the "essentially the same approach" remark is that the endorsed approach is chapter-focused; one interprets the language in 11 in the context of the entire chapter and interprets the language in 13 in the context of that chapter.

Second, the remark appears right at the beginning of the legal analysis  and appears to be utterly prefatory, as it is not followed by any development of what the "approach" had been in chapter 11.

 

Third, neither in the Till opinion nor in its oral argument and briefs was there any discussion of what either section meant, only how the chapter 13 version of it was to be practically applied.   For example, the Solicitor General's brief in Till, which clearly served as a source for much of the plurality opinion's reasoning, states quite emphatically: "Disputes over present value and discount rates concern how courts should calculate that equivalence. Language quoted from Sections 361(3) and 1129(b)(2)(A)(i) does not in any way answer that question."  (Emphasis added).

  

So, for me, it is difficult to give much weight to the plurality's  remark that the two sections require essentially the same approach when the remark was neither preceded nor followed by any significant exposition of what either section meant.  Rather, the remark is better seen as an effort -- naive or disingenuous, the reader may pick -- on the part of the justices in the plurality to portray their approach as consistent with prior law, not as a departure therefrom.  I tend to go with the "naive" version -- I don't think they were trying to rewrite the historic standard that secured creditors have to get full value; I think they believed they were adopting a pragmatic approximation of that standard that was appropriate for the unique characteristics of chapter 13 cases.

As I explained,  and as anyone who goes back and reads the opinion critically and examines the oral argument and briefs can confirm, the Till decision is not in the slightest based on a textual analysis of the words of the statute, but is entirely driven by chapter-13-specific concerns about ease of administration and pragmatic allocation of the burden of trial when one party, the debtor, is unable to pay for adequate representation.  (Plus, the usury context noted above, that appears to have influenced Justice Breyer)   So I don't think it's reasonable to infer that the Court was establishing chapter 11 policy, and indeed, it would have been a ridiculous step to do so in a case where the subject was not presented in the grant of cert or the briefing.

I think this point really needs to be emphasized.  At the time the Bankruptcy Code was enacted in 1978, the leading cases on cramdown strongly protected the secured creditor's right to be compensated for any alteration the chapter 11 plan might work in its right to payment in full,  so long as the collateral value was there.  Even an extension of maturity was a basis to receive value.  Go back and read the exposition I laid out in January of the leading case on a creditor's rights in the face of cramdown at the time the Code was adopted, Consolidated Rock Products, to confirm that.  There is no sign in the Code, nor in the legislative history leading up to it, that Congress intended to depart from the concept of full recovery, in economic substance, on the secured claim when it enacted the Code in 1978.  And in Till, there was absolutely no contention in the briefs or oral argument that 1129(b) authorized delivery of secured debt having a present value less than a 100% recovery on the secured claim.   So it is extremely implausible -- one has to be almost to believe in a secret conspiracy of some kind -- to contend in the face of such widespread silence that 1129(b) changed the law to authorize delivery of secured debt with a present value less than 100 cents of the secured claim.  How did this come to pass with no discussion of any kind by anyone in any branch of government?  There is no answer, of course.  Yet here we are with numerous lower courts adopting such a view based on some dictum in a plurality opinion.  That sort of shallow thinking is the reason I wrote the posts on Till earlier this year, and why I write this one.

Judge Drain's ruling goes on to note, correctly of course, that the plurality opinion rejected a "coerced loan" or "forced loan" approach, and infers that he is required to do the same.   Unfortunately, that is a superficial line of reasoning.  One ought to look at the reasons why the plurality rejected that approach.  When one does so, one will see that the reasons are mainly unique to chapter 13 and not applicable to large, complex chapter 11s.  Judge Drain fails to look at those reasons (he says at one point in his ruling that he will come back to them later but unfortunately does not), and this, I think, is why he goes astray in his analysis.

Here are all two of the reasons the plurality opinion gives for not adopting the "coerced loan" approach:

"For example, the coerced loan approach requires bankruptcy courts to consider evidence about the market for comparable loans to similar (though nonbankrupt) debtors, an inquiry far removed from such courts’ usual task of evaluating debtors’ financial circumstances and the feasibility of their debt adjustment plans. In addition, the approach overcompensates creditors because the market lending rate must be high enough to cover factors, like lenders’ transaction costs and overall profits, that are no longer relevant in the context of court-administered and court-supervised cram down loans."

The first of those criticisms is obviously chapter-13-specific with its reference to “debt-adjustment plans”:  the four justices were saying that chapter 13 proceedings don’t involve evidence about market rates. 

Whether that is true or not of chapter 13, it’s obviously not true of chapter 11 cases, where bankruptcy judges hear evidence of market comps all the time, in contexts from lift – stay appraisals to solvency determination in avoidance actions to cram-downs at confirmation.   I cannot think of a determination of value in chapter 11 that does not involve some evidence about market value.  For example, to cite the most pertinent example, when parties present to the judge their estimates of a debtor's reorganization value, the most common method is the DCF, or discounted cash flow method, in which the debtor's projected net cash flow for several post-reorganized years is discounted to present value, and the typical discounting rate is the WACC, or weighted average cost of capital, in which all the inputs are determined by arrived at by referring to market rates, whether they be rates specific to the debtor, or to similar companies, or to broad swaths of the market.  And that's how you get to the asset side of the post-reorganization balance sheet.  That quantifying the liability side would be done by excluding market evidence is utterly incoherent.   Like all chapter 11 judges, Judge Drain sits through testimony market value testimony repeatedly, so it's not very convincing to then adopt  a line of reasoning that "considering evidence about the market" is "far-removed" from his "usual task".  That is the usual task of bankruptcy judges in commercial bankruptcies!  Honestly, the Till plurality was comprised of four men and women with no experience in private commercial practice, finance, or chapter 11; they were just ignorant of how chapter 11 worked, and those who are expert in it should be correcting that ignorance, not perpetuating it.  

The second factor identified by the plurality is vaguely worded, but in my judgment, based on the topics that were addressed in briefing and oral argument, its reference to “court-supervised cram-down loans” is a reference to the role of the chapter 13 trustee in collecting and disbursing payments from debtors under confirmed chapter 13 plans, a mechanism that is inapplicable to chapter 11s; performance under chapter 11 plans, post-emergence, is generally free of court supervision.  A chapter 11 debtor is considered reorganized, and gets a discharge, the day it comes out of 11; the chapter 13 debtor is discharged and rehabilitated only when s/he completes the payments under the plan. Also, under section 1322(d), a chapter 13 plan cannot extend payments beyond five years from the date of confirmation, a creditor protection not found in chapter 11.  These are all vital differences that need to be recognized when contemplating Till-in chapter-11 disputes.  The two chapters do not work the same way.  Even though the text of one section in one chapter resembles the text of another section in another chapter, the two chapters are not the same.   And of course it is the statute as a whole, not the phrase in isolation, that a court is charged with interpreting.  

Chapter 11 courts need to recognize this, instead of just superficially thinking that the plurality ruling reaches chapter 11 cases.   The only justification the plurality offers for its bald contention that the "coerced loan" approach should be rejected -- because "transaction costs" and "profits" are allegedly "no longer relevant" to cramdown paper -- rests on what they call the chapter-13-specific  "context of court-administered and court-supervised cramdown loans".  Thus, the whole point appears, as a matter of logic, not to carry over to chapter 11.  There is zero logic in Till that makes the "coerced loan" approach inappropriate in chapter 11.  The right way to interpret 1129(b)(2)(A)(i) is in the context of the rest of chapter 11, not by latching onto a plurality opinion from a case that interprets partially similar wording in the context of chapter 13.  Unfortunately, Judge Drain fails to read the plurality opinion this closely and simply concludes that cramdown rates must be evaluated on a not-for-profit basis.   

This troubles me for three additional reasons, which might be called policy reasons, as opposed to the statutory interpretation and case law interpretation fallacies I have just laid out.  First, at the highest conceptual level, profit, like price or cost, is information, and information is what makes a judgment valid.  Excluding information because it is unreliable is one thing; excluding it as a matter of substantive law strikes me as deeply contrary to basic modern Western notions of how decisions are arrived at and justice is delivered fairly.   Second, it results in a bizarre and inconceivable subsidy of companies emerging from chapter 11 versus their solvent competitors, in that the latter, obviously, have to borrow at market rates which include a profit component, while the newly emerged debtor is apparently, according to the Till-in-chapter-11 dogma, entitled as a matter of law to cheaper borrowing costs.  As I wrote in criticizing Justice Thomas's concurrence in Till  (which, the reader may be forgiven for not recalling, opined that, once a bankruptcy judge made an affirmative feasibility finding, the secured creditor was entitled to receive nothing more than the risk-free rate on the repayment paper (because every bankruptcy judge is apparently always right when s/he makes a financial evaluation and we citizens are just so lucky they have chosen to deploy their talents on the bench, not running banks and hedge funds where they of course would make billions of dollars with such omniscience)): 

"Justice Thomas’s interpretation also leads to nonsensical outcomes in the real world that Congress cannot have intended.  If no debtor under a confirmed plan can be compelled to pay more than a risk-free rate, then all debtors wind up paying less than the most creditworthy citizens, the most creditworthy businesses and pretty much all state and local governments, even less than members of Congress and justices on the Supreme Court probably pay on their mortgages! 

"Were his interpretation extended to the chapter 11 context,  companies in chapter 11 would be entitled to turn all their debt into 30-year interest-only bonds with interest at the rate the U.S. Treasury pays on its 30–year bonds.  What a huge financing advantage it would give them over their competitors – for decades!  And, as a consequence, they would be much more likely to reduce their debt as little as possible in the reorganization, since it would be the cheapest kind of capital possible.  It is hard to believe Congress thought the public interest would be served by a reorganization process that reduced corporate debt as lightly as possible.  One also wonders why Congress bothered to provide for disclosure and voting by secured creditors in chapter 11, if a non-consensual approach was only capable of producing a risk-free rate.  Finally, since the Bankruptcy Code does not require insolvency as a prerequisite for filing an 11 or proposing a plan, this kind of interpretation would invite companies to resort frequently and  liberally to chapter 11 just to re-price their debt downward in a falling rate environment.  It is absurd to think that these outcomes were intended by Congress." 

Albeit to a lesser degree, Judge Drain's approach is susceptible to the same criticisms.  MPM gets to carry debt far cheaper than the market believes it deserves.  The debtor had procured stand-by exit financing to take out the secured creditors, and its rates -- fairly obvious and persuasive evidence of the debtors' credit risk  -- were set at LIBOR plus 400 bps, in the case of the first lien, and LIBOR plus 600 bps in the case of the layered one-and-a-half lien.   Those rates were over 100 bps higher than the rates the Judge approved, meaning the debtors saved millions of dollars each year by going with the cramdown paper.  That is a huge subsidy for them vis-a-vis their competitors once they emerge. I find it inconceivable that Congress intended such a systematic subsidy for reorganized debtors.  The Judge simply swept that evidence aside with his reasoning that market rates were not relevant because they contained elements of profit.   

Last, forcing senior secured creditors to systematically provide such a subsidy upends the policy of the Code that chapter 11 is supposed to induce negotiated, consensual outcomes.  If a debtor knows as a matter of legal certainty that it can impose a below-market rate on a senior secured creditor, why would it ever choose not to?  It would be financially irrational to do otherwise, and only some sort of corruption or incompetence would explain not doing so.  Specifically, why would it ever refinance the creditor, which would necessarily require going into the market and incurring higher debt service post-emergence?  Debtors would never provide for unimpairment, unless the secured creditor's collateral were sold during the case.  By the same token, why would a debtor negotiate new payout terms with the creditor, except over how much of a haircut the creditor would take:  "I can give you 96 cents on the dollar now, or I can give you paper worth 95 cents under Till, which would you rather have?"  That's all the negotiation you'll see one year. Maybe the next year, the figures are 93 and 92, depending on where interest rates go.  You can't imagine senior secured paper ever getting 100 cents on the dollar again, except, as I said before, in the sale of collateral context.  

That is just an incoherent reading of the statute as a whole.  It turns on its head a carefully crafted complex of substantive provisions such as unimpairment, and procedural provisions such as disclosure and voting, as to all of which cramdown has historically served as a backdrop or last resort, that guides constituencies to negotiated resolutions in the main and thereby reduce the amount of judicial resources needed to reorganize businesses.  Instead it makes cramdown the default rule, and negotiated outcomes aberrations, and thereby renders all the other sections of chapter 11 dealing with claim treatment mere exceptions to that rule.

A Deep Dive Into the Texas Grand Prairie Decision

In March, a panel of the Fifth Circuit issued an opinion, Wells Fargo Bank, N.A., v. Texas Grand Prairie Hotel Realty LLC,  affirming a bankruptcy court order confirmng a chapter 11 plan for four commonly controlled debtors that owned hotels in Texas.  The case has generated numerous client letters, blog posts and other commentary because it upholds the application in chapter 11 of the "prime plus" or "formula" method for determining the applicable rate of interest to cram-down secured debt under 1129(b)(2)(A) that a plurality of the Supreme Court approved for chapter 13 plans in Till v SCS Credit Corp., 541 U.S. 465 (2004).  The commentators disagree whether the opinion green-lights Till in chapter 11 cases (when the panel states “while it may be ‘impossible to view’ [debtor’s] 1.75% risk adjustment as ‘anything other than a smallish number picked out of a hat,’ the Till plurality’s formula approach — not Justice Scalia’s dissent — has become the default rule in Chapter 11 bankruptcies.”) or is actually signaling something different (when they note at the end of their opinion that it is predicated on the appellant's stipulation that Till controlled but aside from that, they “do not suggest that the prime-plus formula is the only — or even the optimal — method for calculating the Chapter 11 cramdown rate.”). 

However, bankruptcy courts in the Circuit are already interpreting the opinion as a license to apply Till in chapter 11 cramdowns over the objection of the secured creditor.  See, e.g., the May 24, 2013 decision of the bankruptcy court in Austin, In re LMR, LLC, reproduced on Weil's website). (Although LMR is another hotel owner in Texas, nothing about the reasoning of either Grand Prairie or LMR supplies any basis to think the approach is limited to that kind of debtor.  But the coincidence is remarkable that the other modern Fifth Circuit case on chapter 11 plan interest rates, In Re T-H Limited Partnership, is also a case involving an owner of multiple hotels.).  I write this post frankly to argue against that trend.  I don't think the Till approach is correct at all, but setting that aside, a deep dive into the record and briefs in Texas Grand Prairie has unearthed some facts about Texas Grand Prairie that did not make it into the Fifth Circuit opinion that I think make it a particularly bad vehicle to reach any grand conclusions about cramdown interest rates. 

In particular, from the briefs and record, I learned that the 5% interest rate crammed down on the lender compared to a 1.9% rate that would have resulted had the contract rate been reinstated (although the contract rate was a floating rate and the 5% was fixed).  Since the dissent in Till advocated a presumption in favor of the contract rate, which would then be adjusted up or down based on a variety of factors, one can see that the plurality approach probably resulted in the Texas Grand Prairie getting a higher (albeit fixed) rate than under the Till dissent's approach. 

Secondly, the lender's expert had conceded the plan was feasible, if barely so (I am puzzled as to why the objector's expert gave such an opinion; there is no requirement to have an opinion on more than one issue and, although experts cannot be controlled at the end of the day, trial counsel normally manage to keep their side's experts from volunteering opinions that are not helpful to their client's case).  That seems to me to have harmed the lender's case, because it undercut its claims about the level of risk in the plan. Even the plurality in Till says in a couple of places that plans with high risks of default ought not be confirmed and on appeal you would like to be able to argue as forcefully as possible that the plan you're challenging was one such plan.

Last, the appellant framed its challenge, not as an issue of law related to the interest rate methodology, which would be reviewed de novo, but as a challenge to the admissibility and weight to be given the debtor's expert's testimony, which of course is reviewed for abuse of discretion (it attempted to repair that mistake in its reply brief but, as one of my professional friends who later became a federal circuit judge once told me, "we don't have time to read reply briefs").  Challenging the expert's methodology is not the same as challenging the Till plurality's methodology.  I would hope that future courts considering Texas Grand Prairie as a precedent would recognize this and accordingly recognize that it did not really involve a properly framed challenge to the Till plurality's methodology and not misconstrue it as an endorsement of Till.

At the same time, there are some aspects of the case that might have been litigated differently to produce a different result.   As alluded to above, the Fifth Circuit opinion says that "Both parties stipulated that the applicable rate should be determined by applying the “prime-plus” formula endorsed by a plurality of the Supreme Court in Till...."  But the odd thing is that I don't see any reference in any of the briefs to such a stipulation.  What I do see is a very strained interpretation of Till by the creditor-appellant that may have confused the panel and contributed to the decision in the debtor's favor. 

The appellant's brief makes a chest-thumping proclamation that Till requires "objective analysis" of "market evidence" and "ordinary lending practices" in formulating an interest rate.  So, in that sense, the creditor-appellant is definitely saying that Till governs and maybe that is what the opinion means by a stipulation.  But the appellant has Till all wrong.  Its brief makes virtually no mention of the "prime plus" formula.  While I wish Till had said what the appellant claimed it said, because that is what the law should be, Till's plurality opinion explicitly rejects incorporating market evidence, stating in the first paragraph of Section III of that opinion:

"For example, the coerced loan approach requires bankruptcy courts to consider

evidence about the market for comparable loans to similar (though nonbankrupt) debtors an inquiry far removed from such courts usual task of evaluating debtors financial circumstances and the feasibility of their debt adjustment plans. In addition, the approach overcompensates creditors because the market lending rate must be high enough to cover factors, like lenders’ transaction costs and overall profits, that are no longer relevant in the context of court-administered and court-supervised cramdown loans." (Emphasis added)

Now, if the plurality had adopted the "coerced loan" approach, the appellant in Texas Grand Prairie would have been correct that the Court wanted bankruptcy courts to look at the loan market.  But they rejected it, obviously; that was the approach endorsed by the Seventh Circuit opinion overturned by Till. So the appellant was just off the mark in how it presented the key legal argument to the panel.  (Appellant's reply brief tried to correct for that, but see quote above for the value of reply briefs in fixing your mistakes.)  The Fifth Circuit opinion quite clearly spells all this out. 

The wrong-headed appellate approach is too bad because the case contained some decent facts for the appellant, had it framed them differently.  Among the key facts that would have supported a different strategy, I found these in the briefs:

1.   Although the circuit court opinion only refers to the appellant's secured claim of $39 million, which was equal to the value of the collateral, its allowed claim was $51 million, so it had a general unsecured claim of roughly $12 million that was lumped in with the general unsecureds in a class that was also crammed down with periodic payments eover 5 years equal to 25-30% of the claim.  So, one might wonder, how did the plan get confirmed if both the mortgage and unsecured claims were crammed down.  Apparently, there were two small secured claims (property tax and a vendor with a deposit) that were classified separately and called "impaired" because the plan provided them to be paid in full ten business days after the effective date of the plan, on account of which treatment they voted to accept, giving the debtor accepting impaired classes.  There is no indication in the briefs that appellant either raised an objection to the artificial impairment, or preserved it for appeal.  Notwithstanding the Circuit's recent Camp Bowie decision, I don't understand how that could have gone uncontested in 2010.  Also, while I have not done the math, I cannot quite understand why the lender chose not to make an 1111B election on these facts because the economics seem to favor keeping that extra $12 million as a secured balloon payment getting some interest, even if it reduces the interest rate on the $39 million portion of the claim somewhat.  Perhaps it was to keep the general unsecured class from voting to accept, but what does that matter if you're not going to object to the artificial impairment of the other secureds?

2.   The plan was, of course, a "new value" plan and the debtor conducted an "auction" of sorts for the equity that was being infused by old equity.  The person conducting the auction was the same one who testified at trial as an expert on the proper interest rate.  He did not find anyone interested in paying more for the equity than the insiders.  One reason he gave for the lack of response seems highly relevant to the cramdown issue on appeal: "the assignment was challenging because the reorganized debtors would be fully leveraged, with the lender’s secured claim encumbering the hotels at a loan-to-value ratio of 100%."  He further testified:

"And so what you’re really selling is an option, sort of an upside option. Okay? And so on a fully valued estate, is someone willing to pay more than 1.5 million dollars for the option that there’s value accretion in excess of that….

"So as a valuation guy, I looked at it and said, you know, this seems to be fully priced…. But the universe for this type of buyer in this atypical transaction that, to me, seemed to be fully priced, I was -- I knew we had an uphill battle, and frankly, I didn’t know if we’d get any takers on the front end.”

Bizarrely, the bankruptcy judge agreed with him: "the owner of the new equity “may receive a return on its investment, but … they have put their money into a high risk investment and may receive no return".  (Emphasis added).  Of course, I look at that and say, if the equity in a 100% LTV asset has high risk of no return, then the loan must have a similarly high risk of a loss of some kind because the odds are pretty small that the losses are going to magically stop right at the debt/equity line.  And you would expect that recognition to show up in the interest rate analysis, but sadly it does not.

3.  The debtor's expert testified that average terms for loans to limited-service hotels in 2010 included a loan-to-value ratio of 58%, an interest rate of 7.9%, and a debt-coverage ratio (net operating income divided by debt service) of 1.5, none of which come close to the terms of the plan.  But he disregarded the market "because he believed that the market for hotel and hospitality loans generally was not an efficient market".  Which of course are magic words, if you want to invoke Till, as I shall discuss further below. 

Thus, he positioned himself to develop an interest rate based on the prime-plus formula.  He formulated one by determining that the obligation at issue was “just to the left of the middle of the risk scale,” which he understood to be a range of one to three percentage points above the prime rate, absent “extreme circumstances”.  Obviously the "1-3 percentage points" of risk spectrum come from dictum in Till, not finance or controlling precedent.  He testified: “I used a one-to-three, which seems to be suggested in Till, and the middle of the one-to-three range [above prime] would’ve been two. The rate just to the left of that, 1.75. That’s what I chose”.  Personally, were I a judge, I would have a hard time seeing that as expert testimony, even under an abuse of discretion standard.

So somehow the "high risk" of the equity infusion became "just to the left of the middle of the risk scale" when the focus turned to the 100% LTV mortgage.  And even though the loans that are being made to better-capitalized companies were yielding 7.9% interest, the 100% LTV loan was only going to earn 5%. 

It sure seems to me there was an appellate case to be made out of those facts, although the "clear error" and "abuse of discretion" standards of review are definitely hurdles.  I can't think of any support for deeming the "risk scale" to be limited to 1-3 percentage points; that other courts have frequently (but not always - for example, the recent Camp Bowie decision in the same circuit involves a a risk adjustment over 3%) adopted risk premia within those parameters does not make such a range law, and certainly there was no factual basis in 2010 to limit the upper end to 3%.  Appellant did make those arguments, but, as I read the opinion, combining them with the position that they were inconsistent with Till may have confused the appellate panel, as they are quite slavishly consistent with Till. 

Given these details, I don't feel that Texas Grand Prairie is an opinion that should be interpreted aggressively in favor of debtors. There were several questionable strategic decisions by appellant, any one of which might have led to a different result.  I would say, rather, that the door remains open in the Fifth Circuit to a well-thought-out challenge to the Till plurality's method in chapter 11 cases.  Such a challenge would entail, among other things, not misunderstanding Till; not conceding its prime-plus formula governs in 11's; and not having an expert muddy the record with unhelpful opinions. It would also, I think, benefit from challenging the claims made by the Till plurality about the defects of the "coerced loan" approach, challenging the 1-3 percentage points range; challenging what "prime" rate means; and last, challenging the application of the "efficient market" reference in footnote 14 of the plurality opinion.   I will discuss these last points in a subsequent post.