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 7^th 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 7^th 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 (7^th 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 7^th Circuit.

The 7^th 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. 

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[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.

Three Thoughts on Tribune's Announced Plan to Split into Two, Six Months After Emergence

Tribune announced this week that it will split into two companies, one centered on publishing and one with everything else, following in some respects the leads of News Corp and Time Warner, and conceivably others I haven't heard about.  The decision is pretty well known so I won't bother to link to any of the numerous stories about it.  It triggered three thoughts that I felt worth mentioning.

First thought:

Moving up almost $2 on the announcement,Tribune's stock is now up more than 30% since it emerged from chapter 11 about six months ago (and about 20% in the last month, although it must be noted that a week before the spin announcement, TRBAA also agreed to buy 19 more TV stations, entirely financed with debt, which analysts believe will be highly accretive).  This illustrates a point I discussed in a post about a month ago, that post-emergence performance of the equity of reorganized companies tends to belie enterprise valuations and recovery estimates that disclosure statement usually contain; generally, disclosure statement valuations are lower than where the market values the reorganized company 6 & 12 months after emergence; thus, recovery estimates keyed to those pre-emergence valuations are similarly lower than creditors actually receive if they hold on to the equity for a modest time after emergence.

In the case of TRBAA, the disclosure statement valuation was prepared in March and April 2012.  It projected an equity market cap as of 12/31/12, the assumed (and actual) effctive date, of $4.536B (see docket 11355, Ex C).  Today, Bloomberg tells me TRBAA's equity market cap is $5,273B, up about $700 million from the estimate that was used to estimate recoveries in the disclosure statement.  So actual recoveries, which were estimated to run from 33.6 to 70% should likewise be understood to have been higher than estimated (exactly how much higher is hard to say because no class received purely equity.

Second Thought:

I remembered reading a couple of decent investment theses on TRBAA back in January when it came out, so I went back and checked them out to see how they compared to what actually happened.  One was on the Distressed Debt Investing site, which I subscribe to.  The author's bottom line was the stock was fairly valued at $49 upon emergence, based on multiples of 4.5x, 6.25x and 11x for respectively, TRBAA's publishing, broadcast and Food Network lines of business, and no value for its real estate on the basis that it was all used in the business and not separately saleable, but did note that, with slightly higher multiples and assigning independent value to the RE, a case could be made for a $60 price, which is where it was before the announcement. Also, the author did identify the possibility to "spin off the newsprint assets to help revalue the core broadcasting business higher.  I believe they should be allowed to do a tax free spin of the newsprint assets" (by newsprint, I assume he meant the newspaper publishing business and not the manufacture of newsprint per se).  So, although his bottom-line conclusion that the stock was fairly valued at $49 proved to be conservative, certainly it was an reasonably accurate analysis up to that point.

The other investment thesis came from Meryl Witmer, who often recommends post-emergence equity, in Barron's, which I also subscribe to.  Her thesis was in some respects the opposite of the Distressed Debt Investing analysis, as it didn't reference a spin of publishing (in fact, she predicted a sale of publishing, which, as the Distressed Debt Investing analysis anticipated, and as this week's news reports confirm, would have been terribly tax-inefficient)  but even so she was much more bullish and pretty much nailed the stock price move. Since Barron's is a gated site, this link may not work, but I will pull out the paragraph with the highlights:

"We estimate Tribune will have about $6 a share of free cash flow in 2013, of which 40 cents is excess depreciation and amortization over capital spending. The Food Network and other assets contribute $2 of the $6. The publishing and broadcast segments earn $4 of free cash flow, and we value them at nine times after-tax cash flow, or $36 a share. That is a conservative number. The split is about one-third publishing and two-thirds broadcasting. Then we add $20 to $25 for the Food Network and another $7 to $8 for CareerBuilder and some other online assets and real estate. We deduct a couple of dollars for pension liabilities, and get a low-end target price of $60 a share. The retransmission payments that Tribune might garner from negotiations with cable providers could add a dollar to earnings over time, which would add $10 or more to the value of the stock. The turnaround at WGN is difficult to value, but given management's track record, it could be worth at least $10 a share. Add it all up, and we get a range of $60 to $80 a share, plus free cash generated in the interim, which adds another $6 a share per year. We see the stock at $90 in three years."

Interesting that they both saw a case for $60/share, only for one it was the high-side and for the other it was the low-side.  The stock closed at $64 and change today. Even before the announcement of the spin, Imperial Capital had put out a research note raising their target price from $70 to $76 based on what they perceive to be the accretive quality of the broadcasting acquisition. (NB: I do not have any position in TRBAA as I generally avoid "old media" stocks, and I have no view on whether any of the bullish outlooks will prove out. I just read and write about value investing out of intellectual curiosity.  But bravo to those who got this right.)

Third Thought:

One of the main policy arguments being made by proponents of rewriting the Bankruptcy Code is that the original intent of chapter 11 has been perverted by distressed debt investors and senior secured creditors to become a crass "financial and takeover play" where cases are rushed through to confirmation or liquidation by these heartless institutions just looking for a quick buck, depriving poor corporate debtors of the chance to use the "tools" of chapter 11 to fix their business under court protection in a more "thoughtful" manner.

Well, obviously, Tribune puts the lie to that myth as well.  Tribune was in chapter 11 for over 4 years.  That's more than enough time to use the "tools" provided by the bankruptcy code in a "thoughtful" manner.  So when does it make the strategic decisions to double down on broadcasting and split up into two businesses?  During those 4 years?  Um, no.  Six months after emergence.  Its chapter 11 process was principally spent fighting about who would bear how much of the loss that came from the over-leveraged Zell buyout.  It didn't need any more time in chapter 11.  What it needed was to get out of chapter 11, and turn off the professional fees associated with litigious bankruptcies.  Then it could fix its business, the way solvent companies somehow manage to do without resort to the tools of the bankruptcy code.

Bankruptcy is a good environment for addressing balance sheet mistakes and legacy liabilities, but the legalistic environment -- with every party in interest having a statutory right to object to management decisions, numerous constituencies billing the estate (effectively the fulcrum creditors) for legal and FA advisors reviewing those decisions, and all decisions being passed on by a judge who does not likely have industry experience to evaluate them independently -- is nowhere near as conducive to operational and strategic boldness and creativity as is commonly supposed.  More often, the better path by far is to get out of chapter, simplify the number of constituencies management has to think about, get the balance sheet right so the company has the capacity to make long-term decisions again, and get on with life as a rehabilitated company.

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.

Equitable Mootness Ends the Charter Saga

Professor Robert Lawless at Credit Slips has a short post explaining briefly why he half-heartedly signed on to an amicus brief filed with the Supreme Court by a bunch of law professors in support of the certiorari petition in Law Debenture Trust Co. v. Charter Communications, Inc. (No. 12-847).  The Court denied the application so the Second Circuit's underlying decision stands, that Law Debenture Trust's appeal of the confirmation order in the Charter chapter 11 case was equitably moot because the plan had been substantially consummated approximately three years earlier.

The Charter POR was particularly aggressive, even unsavory, and it is unfortunate that no appellate review will ever be applied. 

Here are just a few of the alarming facets of the confirmed plan:

1) Many classes of bondholders received much less than par - according to the petition for cert, the issue petitioner represented only received 32.7% -- and voted  against the plan.

2) The plan had a $1.6B rights offering for new equity as its central feature but the price was set almost a year before the plan was confirmed and as the petition for cert says in footnote 2: "When the plan became effective, those shares immediately traded at nearly twice their acquisition price—a massive, overnight return. Compare CCI 2009 Form 10-K Annual Report F-13 (Feb. 26, 2010), and CCI S-1 Registration  Statement, at item 15 (Dec. 31, 2009), with CCI  2010 Form 10-K Annual Report 31."

3) Shareholders in general were wiped out, but the controlling shareholder, Paul Allen, was not.  Instead, he (a) was paid $200 million (ostensibly by the creditors behind the rights offering, but really at the expense of other noteholders) to cooperate with the POR, (b) allowed to retain an ownership interest in a subsidiary in order to preserve its NOL, to shelter the COD income that would arise under the POR and protect the other tax attributes, and also (c) allowed to retain a 35% voting stake in the company, to avoid (the bankruptcy court found) a "change of control" default under a credit agreement that the rights offering sponsors wanted to preserve (at the time the restructuring was negotiated, in early 09, reinstatement of the billions of bank debt was crucial to the plan  because it carried a LIBOR+250 interest rate, which was anywhere from 500 to 700 bps cheaper than market at the time; ironically, interest rates fell so much throughout 09 that the reorganized debtors replaced the facility within 5 months of emerging, and promptly removed Allen from the board.  As the cherry on his sundae, Allen and many others got broad releases and bars against lawsuits related to their stewardship of Charter and their participation in the reorganization.

4) To permit confirmation in the face of such substantial creditor rejection of the plan, the bankruptcy court took the aggressive view that, in seeking confirmation of a plan proposed by multiple debtors, only one debtor needed to satisfy the criterion of 1129(a)(10) that, where any class of creditors is impaired, at least one such class must accept the plan by the voting thresholds specified by section 1126.  (that "one accepting impaired class per plan" interpretation was wisely rejected by Judge Carey in the Tribune chapter 11; he read the section to mean "one accepting impaired class per debtor" which makes much more sense as a matter of interpreting 1129).

With all those aggressive and in some cases questionable goings-on, the case deserved appellate scrutiny.  Unfortunately for the appellant/petitioner, the Second Circuit makes it pretty hard to review confirmation orders, and imposes a presumption in favor of mootness as long as the plan has been consummated (which Charter did the day after appellant's motion for a stay pending appeal was denied).  As a result, like many other large cases with contested confirmation battles coming out of the Southern District - Adelphia, Calpine, Delta, ION Media, Journal Register, just to name a few recent reported opinions dismissing appeals from confirmation orders on grounds of equitable mootness, the legal decisions of the bankruptcy judge involving very large sums and important principles of reorganization law went unreviewed.

Although I would have liked the Court to take the case, I was not entirely surprised because the doctrine, being equitable, is hard to position as something worthy of Supreme Court intervention.  The petitioner strove to depict a "well entrenched" conflict among the circuits but, even without looking at the respondents' brief in opposition, I could tell that the depiction was exaggerated, as many of the decisions cited by petitioners were merely from district courts, not circuit courts of appeal.  The respondent did an excellent job knocking that argument down.  Also, the respondent, probably in exaggerated fashion, depicted the case as particularly unique and thus not a good vehicle for the Court to make pronouncements about the doctrine generally, harping, almost embarrassingly, on the unusual depth of the financial crisis (since confirmation took place in late 2009, I found that argument grossly overstated).

The law professors supported the application for certiorari, and the petitioners' characterization of the state of the law.  Their brief is fairly neutral on the doctrine of equitable mootness, but in writings outside of the brief, including Lawless's blog post, they plainly want to see the doctrine cut back or removed entirely.  Although I would have liked to see Charter reviewed and the lower court's holdings eliminated as precedents, I don't at all agree with their antipathy toward equitable mootness.
They argue it prevents appellate courts from reviewing and harmonizing chapter 11 doctrines.  That may be true, but it's hardly the only relevant factor.  The professors failed to balance that benefit against the practical impact on chapter 11 of diluting the equitable mootness doctrine, which I think would deter investments of fresh capital to fund emergence.  Even though I think Charter's POR was so outside the pale that it should never have been confirmed and deserved to be overturned on appeal to the extent possible. it is a case where fresh capital of $1.6 billion was infused into a grossly over-levered enterprise and that kind of investment needs to be encouraged and protected, from the perspective of the public policy behind reorganization of businesses. Weakening the doctrine to the point where potential investors shy away from investments that reorganize troubled companies strikes me as a terrible practical outcome that cannot be justified by increased doctrinal clarity.  The professors' attention to harmonizing the case law that they teach in their classrooms comes off as a classic example of "ivory tower" perspective that ignores the real world financial impact of their position.  

The best solution, it seems to me, is to have much more liberal standards to get a stay pending appeal at the district court level in large chapter 11 cases.  That would enable appellate review but protect investments of fresh capital from an intolerable risk of having carefully negotiated investments upset after the fact by appellate courts.

Camp Bowie

Sheppard Mullin's bankruptcy law blog alerted me to an interesting Fifth Circuit opinion dealing with several closely related chapter 11 plan confirmation issues. The February 26 opinion in Matter of Village at Camp Bowie, L.L.P. allowed a chapter 11 debtor to "cram up" a "new value" plan on its secured lender, holding that the plan satisfied the "one accepting class of impaired creditors" requirement of section 1129(a)(10) when the class of general unsecured creditors, which received only de minimis impairment of (full payment in 90 days without interest), voted to accept.  The Fifth Circuit is not traditionally associated with such a "pro-debtor" / anti-secured-lender stance, so I looked at the opinion closely to see if this was a major shift in its approach to chapter 11 battles.  I found that the case presented some fairly unusual  - and appealing - facts (which aren't fully captured by the Sheppard blog post) and the opinion ultimately struck me as a fairly sensible approach to those unusual facts.  But I think the fact pattern was sufficiently different from the Circuit's prior chapter 11 precedents, like Greystone and Sandy Ridge, that the decision is more sui generis than any kind of a doctrinal shift. Its facts actually resemble the Second Circuit's vote designation opinion in In re DBSD North America, Inc. more than the gerrymandering case law.

Village at Camp Bowie is an operating commercial real estate property in Fort Worth, Texas.  Its owners acquired and improved it in 2004, investing approximately $10 million of equity and financing the rest with a typical commercial mortgage. The mortgage matured in 2008 and apparently was not re-financeable.  The mortgage lender and borrower spent approximately 2-1/2 years in a workout / modification mode.  In July 2010, the mortgage lender sold the debt to the appellant, Western Real Estate Equities, L.P., who, according to the opinion "purchased the Notes with an eue toward displacing the Village as the owner of the underlying real estate".  (The bankruptcy court opinion states that the buyer admitted this on the witness stand at confirmation and further found that the buyer "had no interest in negotiating plan treatment acceptable to it with the debtor").  The court goes on to note that Western "posted the Village for a non-judicial foreclosure immediately after acquiring the Notes".  Village filed chapter 11 to stay the foreclosure.

At the time of filing, the debtor owed a little more than $32 million on its mortgage and also owed trade creditors about $59,000.  The bankruptcy court, at some point prior to plan confirmation, found that the value of the real estate was $34 million, meaning that the mortgage was over-secured and the estate was solvent. The opinion does not contain any indication that the valuation was appealed.

The debtor proposed one new value plan that the bankruptcy court rejected. After modifications, the bankruptcy court confirmed a plan that provided for:

(1) the mortgage to be restructured as a five-year balloon with full cash pay interest using an interest rate of at least 6.4%, which, the bankruptcy court opinion reports, was about 470 bps over comparable Treasuries at the time of confirmation (the Fifth Circuit opinion quotes the rate as 5.84% but a reading of the bankruptcy court opinion shows that that court rejected the 5.84% interest rate and required the debtor increase it to "at least 6.4%" which the Fifth Circuit does not mention);

(2) the owners to infuse $1.5 million of cash; and

(3) the general unsecureds to be repaid in 90 days without interest.

The unsecureds voted to accept, but the mortgage holder voted against the plan and objected to considering  the general unsecureds as impaired for purposes of satisfying 1129(a)(10).

So the case presented someone with an oversecured note trying to take away the debtor' s equity, by voting
against a full payout plan, while the debtor's owners were willing to infuse a meaningful amount of money to hold on to their property and further to make multiple enhancements of the secured creditor's treatment under their plan to win confirmation.   I think the court was influenced by the relative sympathies the parties' objectives evoke, although it does not say so explicitly.  Just as the opinion does not show any appeal of valuation, it shows no feasibility issue being raised on appeal either.  So the case looks just like a blatant attempt by the distressed mortgage buyer to own something worth more than its claim at the prejudice of someone willing to put up real money to enable full repayment. The case resembles DBSD quite a bit in that respect: as the bankruptcy judge wrote "If any party has a questionable motive in this case, it is Western."  However, neither the bankruptcy court nor the appellate court address the case under section 1126, and presumably the debtor did not frame its confirmation case in that fashion.  

But, in gauging the precedential value of Camp Bowie, it is essential to understand these key facts.   It is thus very different from cases like Greystone and Sandy Ridge which involved an opposite fact pattern:  under-secured mortgage lenders fighting efforts by the equity to hold on to properties by writing off the lenders' deficiency claims and imposing substantial losses on them, and solving the 1129(a)(10) hurdle with clever artificial impairment.  Here, in contrast, there was an over-secured lender trying not to achieve repayment in full, but something better than that.  In Greystone and Sandy Ridge, there were unsecured deficiency claims receiving dramatically inferior treatment to the general unsecureds, whereas in Camp Bowie, there was no deficiency claim.  In each of these cases, then, the legal battles brought to the appellate level were over issues of classifying and treating the small unsecured creditor class, but the good faith objectives of the litigating parties were completely different one to the other and really, I think, drive the results in all of them. 

That said, the Fifth Circuit seems, to me, to get the 1129(a)(10) analysis right.  The delayed repayment of the general unsecureds was clearly impairment, and it clearly voted to accept.  So 1129(a)(1) was clearly satisfied as a formal matter.  The substantive inquiry into whether the amount of impairment was "good enough" or done for the right motive is better handled under 1129(a)(3)'s "good faith" test, where the varying goals of the parties involved can be assessed both more directly and more flexibly; as the above shows, those goals can differ enormously from one case to another. The court correctly observed that Greystone did not turn on 1129(a)(10) but was an 1122 classification holding, and correctly notes that other decisions prohibiting "gerrymandering" plan classes to get one accepting impaired class are not applicable because there was only one class of unsecureds (because of the unusual fact that the mortgage lender was over-secured, the debtor did not have to gerrymander unsecureds to create an accepting impaired class).

The opinion rejects a stricter reading of 1129(a)(10) from the 8th Circuit about 20 years ago, creating the potential for Supreme Court review to resolve a circuit conflict.  But, because litigants and courts can frame  this kind of dispute as an 1129(a)(3) issue, and are not required to litigate under 1129(a)(10), I don't see the circuit conflict as being significant enough to require Supreme Court involvement. But we'll see.