The Bankruptcy Code provides that a debtor may confirm a plan over the objection of a class of creditors (i.e. cramdown) subject to, among other requirements, that the plan provides “fair and equitable” treatment of secured claims. Pursuant to Section 1129(b)(2)(A) of the Bankruptcy Code, “fair and equitable” treatment of secured claims can be achieved if: (i) the claimant retains its liens and receives deferred cash payments totaling its allowed claim; (ii) the claimant’s collateral is sold with liens attaching to the proceeds of sale; or (iii) the claimant receives the indubitable equivalent of its secured claim. 11 U.S.C. §1129(B)(2)(a)(i)-(iii).
Under Section 1129(b)(2)(A)(i)(II) of the Bankruptcy Code, deferred cash payments due a creditor must equal “a value, as of the effective date of the plan, of at least the value of the creditor’s interest in the estates interest in” the collateral. This provision requires that the plan pay the “present value” of the secured claim. In re Fisher, 29 B.R. 542, 543 (Bankr.D.Kan.1983), defined present value in the following manner:
[present value is not] a legal concept, but rather it is a term of art in the financial community. It simply means that a dollar received today is worth more than a dollar to be received in the future. To compensate the creditor for not receiving its money today, the debtor is charged an additional amount of money. The charge is based on a rate of interest called a “discount rate.” The discount rate is used to calculate how much the creditor should be paid so it will have the same amount of money in the future as it would have had if it did not have to wait to be paid.
Section 1129(b)(2)(A)(i)(II) does not specify how bankruptcy courts should calculate the cramdown interest rate. One of the Code’s few clues is found in Section 1129(b)(2)(A)(iii) of the Bankruptcy Code. That section states that a plan may be confirmed over the objection of a secured creditor if the plan affords the creditor the “indubitable equivalent” of its claim.
The Supreme Court in Till v. SCS Credit Corp., 541 U.S. 465 (2004) dealt with this issue in the context of a Chapter 13 plan. Till evaluated the four widely used methods of calculating the cramdown interest rate (coerced loan, presumptive contract rate, formula rate, and cost of funds approaches) and found that, in the context of a Chapter 13 case, all but the formula rate approach suffered from serious flaws:
These considerations lead us to reject the coerced loan, presumptive contract rate, and cost of funds approaches. Each of these approaches is complicated, imposes significant evidentiary costs, and aims to make each individual creditor whole rather than to ensure the debtor’s payments have the required present value. 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. Id. at 477.
The plurality then identified the only factors it viewed as relevant in properly ensuring that the sum of deferred payments equals present value: (i) the time-value of money; (ii) inflation; and (iii) the risk of non-payment. The Court endorsed the use of the formula approach. Under this approach, the bankruptcy court:
Begins by looking to the national prime rate, reported daily in the press, which reflects the financial market’s estimate of the amount a commercial bank should charge a creditworthy commercial borrower to compensate for the opportunity costs of the loan, the risk of inflation, and the relatively slight risk of default. Because bankrupt debtors typically pose a greater risk of nonpayment than solvent commercial borrowers, the approach then requires a bankruptcy court to adjust the prime rate accordingly.
Id. at 478-79.
However, while the plurality in Till is clear that the formula approach is the method to be used in Chapter 13 cases, the opinion is less clear about cases under the Chapter 11. On the one hand, the plurality noted that “the Bankruptcy Code includes numerous provisions that, like the [Chapter 13] cram down provisions, require a court to discoun[t] . . . [a] stream of deferred payments back to the[ir] present dollar value to ensure that a creditor receives at least the value of its claim. Id. at 474. It further commented that “[w]e think it likely that Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate under any of these provisions.” Id. But then, in a footnote, the plurality stated that “there is no readily apparent Chapter 13 ‘cram down market rate of interest’”, noting however, that:
[i]nterestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. Thus, when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce. In the Chapter 13 context, by contrast, the absence of any such market obligates courts to look to first principles and ask only what rate will fairly compensate a creditor for its exposure.
Id. at 476 n.14.
Therefore, Till suggests that “when picking a cram down rate in a Chapter 11 case, it might make sense to ask what an efficient market would produce.” Id. at 477. Arguably, therefore, if there is an efficient market in a Chapter 11 case, the market rate should be applied. Where no efficient market exists for a Chapter 11 debtor, the bankruptcy court will need to use some other methodology. See, American HomePatient, Inc., 420 F.3d 559, 567 (6th Cir.2006).
(i) Market Rate Approach:
In In re Valencia Flour Mills, Ltd., 348 B.R. 573 (Bankr.D.N.M.2006), the court, without citing to Till, held that §1129(b)(2)(A) entitled the secured creditor to receive payments equal to the present value of its claims “determined based on the market rate of interest.” Id. at 577. The court cited to Hardzog v. Federal Land Bank of Wichita (In re Hardzog), 901 F.2d 858 (10th Cir.1990) for the proposition that the appropriate rate of interest was the “market” rate. In this case, based on the evidence before the court, it found that an interest rate of 6.5% would satisfy the requirements of §1129(b)(2)(A).
In In re Winn-Dixie Stores, Inc., 356 B.R. 239 (Bankr.M.D.Fla.2006), the court determined under the facts of that case, an efficient market for exit financing did exist. As evidence of that market, it pointed out the fact that the debtors shopped $720 million in post-petition financing, which was secured by all of the debtor’s assets. The debtors’ search resulted in 14 proposals among competing lending institutions for a loan that would be junior to the liens of certain pre-existing creditors. The result of that process was an interest rate of LIBOR plus 150 points.
Based on Till, In re Brice Road Developments, L.L.C., 392 B.R. 274, 280 (6th Cir.BAP 2008) held that where an “efficient market” exists, the market rate should be applied, and where no “efficient market” exists, the formula approach should be employed. The court then rejected a rate calculated from a “composite rate,” which is calculated by blending rates from senior secured debt, mezzanine debt and equity. Explaining its rejection of this methodology, the court quoted In re Am. HomePatient, Inc., 420 F.3d at 568-69 as follows:
The Lenders’ argument that the debtor could not obtain a “new loan” in the market place so highly leveraged might be so, but in actuality no new loan is being made here at all. Instead, the court is sanctioning the workout between the debtor and the Lenders. New funds are not being advanced without the consent of the claimants.
Indeed, the only type of debt contemplated by American’s reorganization plan was senior secured debt. The inclusion of other types of financing – mezzanine debt and equity – is a pure hypothetical suggested by the lenders.
The bankruptcy court found that the proposed interest rate of 6% was appropriate, stating that this rate “was within the range of rates in an efficient market for a long-term loan secured by a first mortgage on multi-family real estate with a long useful life, of the size of the Debtor’s loan held by GE Credit.”. Id. at 280.
Matter of MPM Silicones, L.L.C., 874 F.3d 787 (2nd Cir.2017) held that the market rate approach was appropriate when an efficient market for financing exists. Quoting In re American HomePatient, Inc., 420 F.3d 559, 568 (6th Cir.2005), the court adopted a two-part process for selecting an interest rate in Chapter 11 cramdowns:
[T]he market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.
Id. at 800.
In applying this rule, the court noted that other courts have held that markets for financing are ‘efficient’ where, for example, “they offer a loan with a term, size, and collateral comparable to the forced loan contemplated under the cramdown plan.” Id. at 800 (citing to In re Texas Grand Prairie Hotel Realty, L.L.C., 710 F.3d 324, 337 (5th Cir.2013)).
(ii) Contract Rate:
In In re Good, 413 B.R. 552 (Bankr.E.D.Tex.2009) the court dealt with a debtor that was solvent, and a lender that was oversecured. Based on these facts, the court concluded that the lender was entitled to its contract rate of interest, and given that the debtor defaulted pre-petition, its default rate of interest, in this case 15%. The court noted that “[p]ayment of interest to RMR at the contractual default rate would not reduce the payment that any other secured or unsecured creditor is entitled to receive under the plan. While payment of the default rate of interest would involve a significant amount of money, such payment would simply reduce the $85,000,000 in equity available to Good at the conclusion of the plan in four years.” In In re SJT Ventures, LLC, 441 B.R. 248 (Bankr.N.D.Tex.2010), the court found Good’s analysis faulty. Good relied upon In re Dow Corning Corp., 244 B.R. 678, 695 (Bankr.E.D.Mich.1999) for its ruling. Yet Dow Corning involved a dispute about the interest rate to be assessed during the pendency of the bankruptcy, pursuant to Section 506(b) of the Bankruptcy Code, not post-confirmation interest on payments going forward.
(iii) Formula Approach:
In In re American Trailer and Storage, Inc., 419 B.R. 412 (Bankr.W.D.Mo.2009), the court took its cue from the language contained in footnote no.14 of Till, which suggested that in Chapter 11 cases, it might make sense to consider whether there is an efficient market, but if there is not, the formula approach was proper and provided an objective calculation of the cramdown rate of interest. Id. at 436. In this case, the court found no evidence of an efficient market. In fact, given the great recession, the court found it to be “the worst market that” it had seen. There simply was no willing market of cramdown lenders, “other than the hard money type of lenders” for Chapter 11 loans of the type that was at issue in this case. Id. at 438.
Telling debtors that the only way to pay creditors the present value of their claim is to submit to vulture lenders, who lay in wait, charging sky high interest rates, just waiting for the debtor to default so they can swoop in and liquidate the collateral, is akin to holding that no Chapter 11 cramdown is feasible.
* * * *
Hard money lenders, charging upwards of 12% to 18%, generally are not going to be appropriate options for debtors in bankruptcy. Not only does such an interest rate give the lender a windfall, but it flies in the fact of what Congress intended when it drafted §1129(b)(2)(A)(i)(I) and (II), which is to give lenders the time value of their money.
Id. at 438.
In applying the formula approach, the court began by observing that the base rate should be determined by the national prime rate as set forth in the Wall Street Journal. This rate should be determined as of the date of confirmation to satisfy the requirement that the secured creditor receives the present value of its claim as of the effective date of the plan. Here, that rate was 3.25%. The court then considered the “risk factors,” including (i) the debtor’s ability to pay under the plan, (ii) the collateral coverage, and (iii) the ability to maintain that collateral coverage throughout the plan.
Here, the court found that the debtor’s projections were realistic and had historical support. It noted that the debtor had not missed a single debt service payment and had paid all postpetition expenses without the need to seek additional outside financing. Further, the debtor’s management was well respected. Personal guaranties were offered which provided further assurance that the company would be motivated to make its payments and reorganize successfully. Collateral coverage and maintenance were not factors. In fact the plan provided the lender with protection by including a provision which specifically stated that the debtor must maintain the fair market value of the lender’s collateral at a certain level or the lender would have the right to declare a default and pursue its remedies as set forth in the plan.
The court noted that the payout period was 5 years which did justify a higher interest rate. The plan also included a balloon payment, which although the court found did not render the plan infeasible, did increase the risk associated with potential default, therefore, it would increase the interest to compensate for the risk associated with the balloon component of the plan. Altogether, the court found that a 5.50% rate of interest appropriately accounted for the risks associated with the plan. Id. at 440.
In SPCP Group v. Cypress Creek Assisted Living, 434 B.R. 650 (M.D.Fla.2010) the court stated that based on Till, the court must first determine whether an efficient market exists for exit financing. If an efficient market exists, then the rate produced by that market would be the rate that should be used. If an efficient market does not exist, then the court should use the formula approach espoused in Till. Id. at 654. Here, the court held that an efficient market for exit financing did not exist, regardless of the particular risks associated with this loan. It then approved the formula approach adopted by the bankruptcy court:
Adjustment within the range of 1 percent to 3 percent has been approved in the past. Accordingly, this Court finds no error in the bankruptcy court’s arrival at the 5.25 percent interest based on 3.25 prime, as supported by the testimony of Mr. Healy, and a 2 percent adjust factor to accommodate the difference between a solvent commercial borrower and a reorganized debtor with a plan.
Id. at 660.
In In re SJT Ventures, LLC, 441 B.R. 248 (Bankr.N.D.Tex.2010), the court dealt with a debtor who was solvent, and a secured creditor who was oversecured. However, unlike the court in Good, the court here ruled that this fact was not outcome determinative. The court noted that upon confirmation of a plan, a new bargain is made, albeit not at arms length but under the cramdown provisions of the Code. These provisions simply require that a creditor receive the “present value” of his secured claim for a cramdown confirmation to succeed, i.e., “there is nothing in the Bankruptcy Code to suggest that this value should change with the debtor’s level of financial solvency, or to require that the present value pay the creditor a contractual profit margin.” Id. at 252-53.
Confirming a plan of reorganization of debt over the objections of a secured creditor requires simply that the secured creditor receive the full value of his secured claim as of the effective date of the plan. This value, however, is divorced from the specific terms of the original contract, and is instead predicated upon an objective economic assessment.
Id. at 255.
As with Brice Road and SPCP Group, the court in SJT Ventures held that first it needed to determine whether an “established and efficient market” with respect to oversecured claims existed. Where such a market exists, it offers “useful guidance for a court’s determination of the present value of a secured interest.” Id. Such a market, however, only provides “useful guidance.” The court specifically noted that “[t]he plain language of the Till opinion does not appear to require a court to consider and implement an efficient market rate if one exists, but rather suggest that it ‘might make sense to look at the market rate for reference.” Id.
The court employed the “formula ordinarily used by the market to derive the appropriate interest rate.” Employing such a “market formula” would achieve the underlying purpose espoused in Till of ensuring that secured creditors are compensated for the “time value of their money and the risk of default” by way of an objective assessment, while at the same time employing the on-the-ground insight of an effective market, where it exists. Id. In this case, the court was dealing with a $1.9 million claim, which was proposed to be amortized over 30 years, with a 5 year balloon. The loan was secured by real estate worth $2.2 million, providing a debt-to-value ratio of 82%. The court held that the “market formula” began by establishing the “risk-free” rate, which it held would be the daily 5-year Treasury Bill rate, adding a standard spread of 3% based on a debt-to-value of 65% to 70%. It then added an additional percentage value based on economic risk factors, including the non-market loan-to-value ratio. The debtor’s expert testified that that this additional rate would be a 50% increase in spread points, or 150 points. So the rate approved by the court was 6.35%.
In In re SW Boston Hotel Venture, LLC, 460 B.R. 38 (Bankr.D.Mass.2011), the court also noted the need to follow a two-step process, i.e., first inquire whether there exists an efficient market for cramdown financing, and if so, apply the market rate; or if no efficient market exists, follow the formula approach adopted in Till. In determining whether there is an efficient market for a cramdown loan, a court must analyze the terms of the restructured debt, the type of collateral, the duration of the loan, and the amount of the loan. Id. at 54. The court further stated that “[a] market analysis by experts should be performed to ascertain whether the type of loan that the debtor is proposing in a plan can be obtained or whether an efficient market is lacking.” Id.
Under the facts of this case, the court found that a market for exit financing of the type of loan proposed by the debtors did not exist. Id. at 55. In reaching this opinion, the court noted the “unprecedented negative market conditions for financing in the present economy,” as well as the nature and type of the cramdown loan proposed under the plan, the amount due the secured lender, the characteristics of the loan (in particular, the rapid amortization which occurred during the case and which was projected to continue, and the proposed terms, especially the quarterly minimum payments. Id. 55-56.
Next the court followed the “formula approach” espoused in Till. Here, the court noted that the national prime rate was 3.25%. The debtor’s expert opined that one percentage point must be added to the cramdown loan for risk, considering the circumstances of the estates, the nature and value of the collateral, the term of the plan, and the feasibility of the plan. The expert noted the commitment to the project of the debtors’ principals and management, their development of another project and, most importantly, the accomplishments of the debtors broker in selling unites during the pendency of the case and substantially meeting projections. The expert evaluated the collateral available to satisfy the lender’s claim and concluded that the loan to value ratio would be 66% as of the proposed effective date of the plan. Id. at 57.
In In re Pamplico Highway Development, LLC, 468 B.R. 783 (Bankr.D.S.C.2012), the court stated that the market rate should be applied in Chapter 11 cases where there exists an efficient market. Absent such a market, the formula approach should be used. Id. at 792-93. Here, the court determined based on testimony from witnesses with experience and knowledge regarding real estate financing, that such financing was unavailable to the debtor “because the loan proposed under the Plan has a loan to value ratio of 100% and Debtor’s creditworthiness is less than favorable due to its prior default on the First Citizens loans and its bankruptcy filing.” Id. at 793.
The court therefore, followed the formula approach. Here, the debtor proposed an interest rate of 5.50% per annum. The debtor’s witness testified that she added a risk premium of 2.25% to the prime rate published in the Wall Street Journal of 3.25% to arrive at a Plan rate of 5.50%. She also noted that the estate had made significant improvements since the petition date, including the addition of a new tenant and the conversion of a nonperforming location into one with a steady monthly rental income. The debtor had also been able to increase its profitability by cutting costs and changing the menu of its restaurants. Further, the businesses were in grow neighborhoods, were relatively new constructions, were in good locations and had below average risk. Finally, the court concluded as follows:
Considering that the general consensus among courts is that a one to three percent adjustment to the prime rate is appropriate, with a 1.00% adjustment representing the low risk debtor and a 3.00% adjustment representing a high risk debtor, a risk adjustment of more than 3.00% would appear to be inappropriate under the circumstances that Mr. Fowler testified show “below average risk.”
Id. at 794-95.
In In re Texas Grand Prairie Hotel Realty, L.L.C., 710 F.3d 324 (5th Cir.2013) the court noted the conundrum caused by the Till plurality’s invitation to apply the prime-plus formula under Chapter 11, and the often acknowledged footnote 14, which appears to endorse a “market rate” approach under Chapter 11 if an “efficient market” for a loan substantially identical to the cramdown loan exists. The court stated that the Till plurality expressly rejected methodologies that “require[ ] the bankruptcy courts to consider evidence about the market for comparable loans,” noting that such approaches “ require an inquiry far removed from such courts’ usual task of evaluating debtors’ financial circumstances and the feasibility of their debt adjustment plans.” Id. at 336. It also acknowledged that the formula approach could achieve what the marketplace deemed an absurd result.
While Wells Fargo is undoubtedly correct that no willing lender would have extended credit on the terms it was forced to accept under the §1129(b) cramdown plan, this “absurd result” is the natural consequence of the prime-plus method, which sacrifices market realities in favor of simple and feasible bankruptcy reorganizations. Stated differently, while it may be “impossible to view” Robichaux’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.
Id.
Focusing on Till’s footnote 14, the court also noted that markets for exit financing are “efficient” only if they offer a loan with a term, size, and collateral comparable to the forced loan contemplated under the cramdown plan. Id. at 337. In this case, the parties acknowledged that there was no one in the market that would loan the debtor funds on a one to one loan-to-value ratio. While the objecting party concluded that exit financing could be cobbled together through a combination of senior debt, mezzanine debt, and equity financing, the court noted that it rejected the argument that the existence of such tiered financing establishes “efficient markets,” observing that it bears no resemblance to the single, secured loan contemplated under the cramdown plan. Id.
In Texas Grand Prairie, the bankruptcy court determined that the cramdown interest rate would be 5% based on the prime-plus approach. This rate was based on expert testimony that the debtor’s revenues were exceeding projections, the lender’s collateral – primarily real estate – was liquid and stable or appreciating in value, and that the reorganization plan would be tight, but feasible. On this basis a risk adjustment of 1.75% over prime was accepted.
In In re Texas Star Refreshments, LLC, 494 B.R. 684 (Bankr.N.D.Tex.2013), the court dealt with the interest rate issue in the context of §1129(b)(2)(B)(i) which provides that the treatment of a dissenting unsecured class is fair and equitable if such class “receive[s] . . . on account of such claim property of a value, as of the effective date of the plan, equal to the allowed amount of such claim.” In other words, Texas Star Refreshments was dealing with unsecured claims, an obvious difference from Till. In this regard, the court stated that at first blush, an unsecured creditor should receive a higher interest rate than a secured creditor, given the risk of non-payment. It then noted that “[t]his analysis fails, however, when the relative risks of liquidation and confirmation are considered. A secured creditor’s risk may increase given a debtor’ continued use of the creditor’s collateral. An unsecured creditor’s prospects of repayment may indeed be enhanced if the debtor survives and the only other real alternative is liquidation.” Id. at 701-02.
Here, the court selected a rate of 5%, which was the state judgment rate. It noted that such a rate is based on state law and was, therefore, based on an objective standard. Id. at 702. However, the court also noted that the 5% judgment rate fell within the formula-plus rate of Till.
The Circuit [referencing Texas Grand Prairie] further noted that “[a]mong the courts that follow Till’s formula method in the Chapter 11 context, ‘risk adjustment’ calculation have generally hewed to the plurality’s suggested range of 1% to 3%.” Till approved an adjustment of 1.5%, and Texas Grand Prairie approved a risk adjustment rate of 1.75%. The rate here is 1.25% above the prime rate.
Id. at 702.
In In re Sunnyslope Housing Limited Partnership, 859 F.3d 637 (9th Cir.2017) the court followed the Formula Approach. Here, the plan provided for an interest rate of 4.4%, which was lower than the original rate on the debtor’s loan. Notwithstanding, the Ninth Circuit found no clear error in the bankruptcy court’s conclusion that this was an appropriate rate. The bankruptcy court noted that the relevant national prime rate was 3.25%. It then adjusted that rate upward to account for the risk of non-payment. The court also heard testimony that the market loan rate for similar properties was 4.18%. In setting the 4.4% rate, the bankruptcy court noted that interest rates had decreased significantly since the original loan was made. The bankruptcy court also noted that the risk to the lender had similarly decreased since then because, when the loan was made, the apartment complex had not yet been built.
In In re Charles Street African Methodist Episcopal Church of Boston, 578 B.R. 56 (Bankr.D.Mass.2017), the lender disputed the fairness and equitableness of the plan’s treatment of its secured claims, with its objections to confirmation based solely on the interest rate, 6.3% that the Church incorporates into the new promissory notes. The court first concluded there was no efficient market for church lending. It then adopted the debtor’s formula approach. In determining the appropriate risk premium to assign to the notes above the risk inherent in the prime rate, the debtor’s expert examined the church’s historical financials and its financial projections. Additionally, he considered the fact that the loan-to-value for the notes was 96%. And he noted that church bonds are generally issued at loan-to-value rations of 75% or less. Id. at 84.
The expert also analyzed the debt service coverage ratio for the notes and concluded that church would have a projected debt service coverage ratio of 1.53. He also testified that he assessed the duration of the notes in determining an appropriate interest rate under the Till formula. He testified that in addition to the risk premium he assigned, he added the spread between the rate for five-year Treasury bonds and the rate for 20 – year Treasury bonds. The difference between the 20 – year Treasury rate (2.65%) and the five-year treasury rate (1.83%) was 0.82%. The addition of this “tenor spread” compensates the lender for the passage of time, as the risks of nonpayment are already accounted for in the risk premium the expert assigned. Id. at 84-5.
The expert then compared his formula result with the result using the “presumptive contract method” which entails examining the loan originally provided to the debtor and adjusting for changes in market conditions. The presumptive contract analysis performed by the debtor adjusted for both changes in market conditions and the increase in the proposed duration of the notes compared to the original loan. The expert testified that the contract rate at issuance of the original loan was 0.375% lower than the prime rate at the time of issuance. At the current prime rate of 4.25%, that would yield an implied loan rate for a five-year term under current market conditions of 3.875%. He then added the spread between the five-year BBB rate and the 20 – year BBB rate to adjust for the difference in maturity. The spread between these two rates was 1.701%, resulting in a presumptive contract rate of 5.576%. The expert used this spread to account for the difference in maturity because the BBB rate is the lowest investment grade rate. He determined it was an appropriate proxy because this rate is for debt which is investment-grade, but unsecured, and he determined that those two differences offset one another, the notes being less than investment grade but also secured. Id. at 85.
Pre-Till Cases
In In re Monnier Bros., 755 F.2d. 1336 (8th Cir.1985), the court held that the appropriate rate of interest was the contract rate. In coming to this conclusion, the court cited Colliers on Bankruptcy ¶1129, at 1129-65, which stated:
The appropriate discount rate must be determined on the basis of the rate of interest which is reasonable in light of the risks involved. Thus, in determining the discount rate, the courts must consider the prevailing market rate for a loan of equal term to the payout period, with due consideration for the quality of the security and the risk of subsequent default.
In Monnier, the contract rate was the appropriate discount rate given the fact that only twenty months had elapsed between the time the contract was made and the time the plan was confirmed. Further, the contract, like the plan, contemplated a 15 year payment term and identical security was involved. In other words, the contract rate, which was the rate agreed upon in an arms-length bargain between the businessmen, presumably reflected the prevailing costs of money, the prospects for appreciation or depreciation in the value of the security, and the risks inherent in the long-term agricultural loan involved in that case.
A second approach followed in establishing an appropriate discount rate is described in In re Villa Diablo Associates, 156 B.R. 650 (Bankr.N.D.Cal.1993). In this case, the market rate was established through the use of a formula. The formula approach begins with establishing a “base rate,” utilizing the rate on treasure obligations, the prime rate, or some other established index. Once the “base rate” is established, it is then adjusted based on several factors relating to the nature of the loan, the security and the risk of default. Among the factors considered were the following: (a) the size and term of the loan. (This factor examines the manner in which the market place structures loans in similar situations, that is, for similar types of properties without taking into consideration the power or status as a Chapter 11 debtor. Stated another way, has the debtor proposed a loan structure consistent with the practices in the market place?) (b) The quality of the security. (This factor examines the quality of the collateral for the loan not only at the present time, but prospectively during the term of the plan.) (c) The risk of default.
In Villa Diablo, the Court stated that the formula approach made particular sense where the loan sought to be rewritten in the plan of reorganization was outside normal underwriting criteria, such as a 100% loan-to-value ratio. The first approach would be difficult to follow because there would be no reliable market data for comparison period.
In re Danny Thomas Properties III Ltd. Partnership, 231 B.R. 298 (Bankr.E.D.Ark.1999), utilized the formula approach, citing U.S. v. Doud, 869 F.2d 1144 (8th Cir.1989). In this case, the debtor’s plan proposed to amortize the secured obligation over a 30-year period with a ten-year balloon. In establishing the base rate, the Court used a ten-year treasury rate which matched with the maturity date under the plan, rather than a 30-year treasury rate which matched the amortization period.
In re Value Recreation, Inc., 228 B.R. 692 (Bankr.D.Minn.1999) also followed the formula approach. In doing so, the court noted that present value is not properly based on rates commercially available to similarly situated borrowers for similar loans because those rates include enhancements to the risk free investments in addition to risk, most notably profit. Id. at 697, n.8. The court went on to state that:
Present value in the bankruptcy environment, however, does not include profit. It is not a subjective measure of what return the particular creditor might be able to obtain on the money if the claim were to be satisfied now. Present value of a claim is an objective measure, without regard for who the creditor is, or what particular investment markets and strategies the creditor might make use of to maximize return on investment. Id. at 697.
The court then concluded that the “present value of a claim is best arrived at by starting with the rate for a risk free investment for a term similar to the proposed loan.” Id. The rate is then enhanced to reflect the risk that the claim might not be satisfied. The risk factors that need to be considered include the nature and value of the collateral pledged; the financial ability of the debtor to make the payments; and the term of the obligation. What was not relevant, was “whether a debtor would qualify for a similar loan, or any loan, in the marketplace. Id.
Whether a debtor is presently creditworthy in the marketplace, is at best only marginally related to the prospect that an existing claim against the debtor will not be satisfied in the future. It is the risk of the claim going unsatisfied that is the appropriate focus in determining its present value, once the risk free rate has been identified. Id. at 697-98.
In In re Star Trust, 237 B.R. 827 (Bankr.M.D.Fla.1999) the court appeared to use the formula approach, noting. The court started by determining what the commercial market rates were for commercial loans with similar terms (in this case real estate loans) with 20 year amortizations and 10 year maturities. The court noted that these loans normally have between 70 and 80 percent loan to value ratios and 1.2 to 1 debt service coverage ratios.
There are a number of factors in this case which require a rate higher than the rates indicated above. The loan does not meet the 80% loan to value ratio t this time, nor does it have a 1.2 to 1 net income to debt service coverage ratio. Higher supervision costs will be involved with this loan, Additionally, an officer of the Bank testified that because of the status of the loan, the Bank has been required by regulators to establish a contingency reserve of 20 percent of the outstanding principal balance. That amount is approximately $240,000. While such a reserve may not preclude the Bank from employing the assets against which the reserve is established, the reserve is a liability on the books of the Bank and when established was a decrease in earnings. . . .Accordingly, none of the rates in the 8 percent range are appropriate. Id. at 842.
In In re Vescio, 227 B.R. 352 (Bankr.D.Vt.1998), the Court noted that the Second Circuit, pursuant to In re Valenti, 105 F.3d 55, (2nd Cir.1997), ruled that secured creditors are entitled to receive a risk premium on top of the market rate to “reflect the risk to the creditor in receiving deferred payments under their reorganization plan.” However, Vescio noted that Valenti may no longer be good law as a result of the Supreme Court decision of Associates Commercial Corp. vs. Rash, 138 L.Ed.2d 148 (1997). In Rash, the Supreme Court required that collateral be valued at its replacement valued, rather than liquidation value, to protect secured creditors from the “double-risks” that the debtor “may again default and the property may deteriorate from extended use.” Vescio noted that the Supreme Court stated that “the replacement-value standard accurately gauges the debtor’s use of the property,” while “adjustments in the interest rate…do not fully offset these risks.”
In Vescio, the Court stated that Rash implicitly modified the Second Circuit’s risk premium requirement, by requiring that risk be accounted for in the valuation of the underlying property, rather than in determination of the interest rate. State another way, if “replacement-value standard accurately gauges the debtor’s use of the property,” then adding a risk-premium to the interest rate would unlawfully prefer secured creditors, compensating them twice for the same risks. A problem, however, arises because when properties are appraised utilizing the income approach, risk causes an increase in the capitalization rate, which in turn diminishes the property’s value. Accordingly, the Vescio identified the components of the capitalization rate that dealt specifically with the inherent risks associated with the plan, and added the amount of value discount they represent back into the valuations of the property.
Matthew T. Gensburg
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