Matt Oakey

A recent Supreme Court decision offers guidance to bankruptcy courts on the interest rate that must be paid to a dissenting secured creditor in a Chapter 13 bankruptcy case (individual wage earner case). The decision also has implications for secured creditors in business bankruptcies filed under Chapter 11 of the Bankruptcy Code.

On May 17, 2004, the Supreme Court issued its opinion in Till v. SCS Credit Corp., 124 S. Ct. 1951 (2004). In Till, the Court considered which of four interest rate approaches best effectuated the language of the "cram down" provisions of Chapter 13 of the Bankruptcy Code which require that, "the value, as of the effective date of the plan, of property to be distributed under the plan on account of such claims is not less than the allowed amount of such claim." 11 U.S.C. § 1325(a)(5)(B)(ii) (2004). A "cram down" plan is one method by which a debtor's proposed debt adjustment plan can be approved by the a court under Chapter 13. The plan is called a cram down because it can be approved over a creditor's objections if certain conditions are met.

Five of the nine justices on the Court, utilizing two different rationales, voted to reverse the judgment of the lower court which favored the "presumptive contract rate" approach, in which the original contract rate serves as the presumptive cram down interest rate, and either the creditor or debtor can challenge that rate with evidence that a higher or lower rate should apply. Four of these five justices favored the "formula rate," calculated as the national prime rate adjusted by some amount to account for the risk of nonpayment posed by borrowers in Chapter 13 bankruptcy. The fifth justice argued that the statute requires no risk compensation at all, but agreed that the presumptive contract rate was too high. The remaining four justices on the Court dissented, and argued in favor of the presumptive contract rate. The Court's decision is significant because, although it dealt with a Chapter 13 bankruptcy, it may offer guidance as to how courts will address the identical cram down provisions in Chapter 11 of the Bankruptcy Code.

FACTS

In October 1998, Lee and Amy Till purchased a used truck and financed $6,395 of the purchase at a 21% interest rate, for a total indebtedness of $8,285.24. SCS Credit Corp. ("SCS") took an assignment of this financing from the original seller, Instant Auto Finance. By October 1999, the Tills were in default on their payments to SCS and filed a joint petition for relief under Chapter 13 of the Bankruptcy Code. At this time, the parties agreed that the truck securing SCS's claim was worth $4,000, and this was the limit of SCS's secured claim.

Under the Tills' proposed debt adjustment plan they would make installment payments, and pay interest on the secured portion of SCS's claim at 9.5% per year. This rate was the result of the formula rate approach: adjusting the national prime rate (then approximately 8%) to account for the risk of nonpayment posed by borrowers in their financial position. SCS objected to this rate, and argued that it was entitled to 21% per year. SCS argued that this was the rate it could obtain if it could foreclose on the truck and reinvest the proceeds in loans of equivalent duration and risk as the original loan to the Tills, and that other lenders in the "subprime" market would charge that rate. This rate was describes as the "coerced" or "forced" loan rate because the secured creditor is forced to continue to extend credit with risk under the terms of the approved debt adjustment plan.

As the dispute moved through the judicial system four different approaches to the cram down rate were endorsed. The Bankruptcy Court ruled for the Tills and the formula rate. On appeal, the District Court agreed with SCS that the coerced loan rate was appropriate. On appeal from the District Court, the majority of the Seventh Circuit Court of Appeals ruled that the presumptive contract rate--similar to, but slightly different from the coerced loan rate--was appropriate. The Court of Appeals dissent suggested a "cost of funds" approach, which asks what it would cost the creditor to obtain the cash equivalent of the collateral from an alternative source.

THE SUPREME COURT'S DECISION

The Supreme Court needed to resolve which of the four interest rate approaches--the formula rate, the coerced loan rate, the presumptive contract rate, or the cost of funds rate--best effectuated Congress' intent that a Chapter 13 cram down plan ensure that the property distributed to a secured creditor over the life of the plan have a total "value, as of the effective date of the plan," that equals or exceeds the value of the creditor's secured claim.

Although the cram down statute mentions nothing about interest rates, the Court addressed the appropriate cram down rate issue in the context of an installment payment plan. In a scenario where the cram down plan calls for a lump sum payment, it is generally easy to determine whether the property distributed under the plan has value equaling or exceeding the secured claim. However, where a cram down plan calls for installment payments, this determination is less clear because money received in the future is worth less to the creditor than money received in the present. Hence, the need to choose an interest rate that sufficiently compensates the creditor for the risks associated with future payments.

Eight of the justices opined that the interest rate must compensate the creditor for the risk of future payments. The four justices in favor of the formula approach--the plurality--contended that the rate should be set lower, and adjusted up to account for risk. The burden to prove any increased risk would fall on the creditor. The dissent, in favor of the presumptive contract rate, argued for the higher contract rate. The debtor would then have the burden of proving that the rate should be reduced.

The ninth justice did not believe that the interest rate chosen must compensate the creditor for risk of future payments. Justice Thomas concurred with the plurality that the Seventh Circuit's ruling should be reversed because the presumptive contract rate overcompensated the creditor. However, he argued that the plain language of the statute did not require any compensation for risk of non-payment.

Three considerations guided the plurality in favor of the formula rate approach. First, the plurality noted that numerous provisions of the Bankruptcy Code require courts to discount future payments to present value (including the Chapter 11 cram down provision found at 11 U.S.C. § 1129(a)(7)(A)(ii)), and that Congress would want the courts to approach all of the provisions similarly, by a method familiar to the financial community that minimizes expensive evidentiary proceedings. Second, the plurality noted that courts can, and should, modify creditors' rights to take into account intervening changes in circumstances. Specifically, the plurality noted that because a Chapter 13 debtor's estate is court supervised, the debtor's risk of default is lower than it was prior to the debtor entering into a plan. Third, the plurality noted that the cram down plan is objective, not subjective, with respect to creditors. This means that the plan is not concerned with matching the pre-bankruptcy terms of each creditor's agreements. Instead the plan seeks to treat similarly situated creditors similarly, and to ensure that an objective economic analysis would show the creditors are adequately compensated.

With these three considerations in mind, the plurality found numerous problems with the three discarded approaches. The coerced loan approach required bankruptcy courts to make determinations about the market for loans to those in similar, but non-bankrupt, situations to the debtor. This is outside the courts' expertise. Further, according to the plurality, this method likely overcompensates the creditor because the coerced rate takes into account transactions costs and overall profits that are not relevant in the bankruptcy proceedings. The coerced loan approach also focuses on the irrelevant factor of the creditor's potential use of the proceeds of a foreclosure sale. The plurality found that the presumptive contract rate approach suffers from similar shortcomings. This approach also places an undue evidentiary burden on the debtor to produce evidence to persuade the court to lower the presumed contract rate. Finally, the plurality rejected the cost of funds approach because it wrongly focuses on the creditworthiness of the creditor instead of the debtor, and also places an undue evidentiary burden on a debtor seeking to rebut the creditor's alleged cost of borrowing.

The plurality found that the formula approach has none of these problems and is a straightforward, familiar, and objective inquiry that best effectuates the statutory language of 11 U.S.C. § 1325(a)(5)(B)(ii). The prime rate is an easily ascertainable starting point, and starting at a lower point and adjusting up (as opposed to starting high and adjusting down as with the presumptive contract rate) properly places the evidentiary burden on the creditor. Additionally, the formula approach does not improperly focus on the creditor's situation, or the prior dealings of the creditor and debtor. Finally, the plurality rejected the dissent's arguments that the formula approach would systemically undercompensate creditors, and that the presumptive contract rate was more appropriate because the free market set the rate.

TILL'S POTENTIAL IMPACT ON CHAPTER 11 BANKRUPTCY CASES

Till rejected the presumptive contract rate, and the plurality supported the formula rate approach in the context of a Chapter 13 bankruptcy proceeding. However, Till's approach could guide courts addressing cram down rates in Chapter 11 business bankruptcy proceedings as well. Chapter 11 contains cram down language that is identical to that used in Chapter 13. The plurality noted that 11 U.S.C. § 1129(a)(7)(A)(ii) requires payment of property whose "value, as of the effective date of the plan" equals or exceeds the value of the creditor's plan. Additionally, the plurality also thought it likely that Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate under any of the similar provisions in the Bankruptcy Code. The plurality explicitly did not address the issue of what the proper scale of risk adjustment should be, but did note that most courts have generally approved risk adjustments of 1% to 3%.

However, there is some language that could hint that Till might not guide cram down rates in Chapter 11 cases. In a footnote, the plurality observed that there is no free market that sets cram down rates in Chapter 13, but that the same is not true in Chapter 11. In Chapter 11, there are numerous lenders that advertise financing for Chapter 11 debtors in possession. This observation may suggest that a market rate, and not the formula approach, may serve as a base cram down rate in Chapter 11 cases.

Nevertheless, Till is significant because it gives definition to the cram down provisions of Chapter 13, and may guide courts and trustees in Chapter 11 cases as well. Till rejects the presumptive contract rate, and the plurality supports the formula rate as the appropriate cram down rate.

*This article was written with the assistance of Timothy F. Berger