Presentation on theme: "The cram down rule 3 ways to confirm a plan as to secured Cr: (see 1325(a)(5) (chapter 13); 1129(b)(2)(A) (chapter 11) 1. Sec Cr agrees to the plan 2."— Presentation transcript:
The cram down rule 3 ways to confirm a plan as to secured Cr: (see 1325(a)(5) (chapter 13); 1129(b)(2)(A) (chapter 11) 1. Sec Cr agrees to the plan 2. surrender collateral to Sec Cr 3. CRAM DOWN: Dr keeps the collateral, lien remains, & pays off Cr over time Principal: “allowed secured claim” Interest – discount payments to “present value”
Cram down payments – the statute “the value, as of the effective date of the plan, of property to be distributed under the plan on account of such claim is not less than the allowed amount of such claim ” See, e.g., 1325(a)(5)(B)(ii)
“Allowed amount of such claim” This is the principal amount of the claim Goes to the VALUE & EXTENT of secured claim itself 506(a) Rash If were paying sec cr off in single lump sum on effective date of plan, how much have to pay? E.g., do Elray and Jean Rash have to pay principal amount to Associates of $41K, $31K, or something in between? Amy & Lee Till have to pay principal of $4,000 to keep truck
“ as of the effective date of the plan” Means that the stream of payments made over the life of the plan must be discounted to present value What was that payment stream worth “as of the effective date of the plan”?
1 st principle of finance The “first basic principle of finance” is that “ a dollar today is worth more than a dollar tomorrow
Example Assume Lee & Mary Till pay $4000 TODAY (March 9, 2010) to SCS Credit SCS then goes out and loans $4000 to another subprime truck buyer, at 18% interest/annum See next slide – this is not an exaggeration So on March 9, 2011, SCS would have right to $4720 Thus, if Tills paid SCS $4,000 on March 8, 2011, rather than in 2010, SCS is indisputably worse off – Because, amazingly, $4720 > $4000
“interest” The economic measure of the first basic principle of finance – that a dollar today is worth more than a dollar tomorrow – is of course INTEREST “INTEREST” is the price of money It is the compensation a borrower must pay for the use of money over time Borrower must repay: The principal amount borrowed PLUS the interest charge
“present value” & discount rate When looking at the current economic value – today -- of money that is to be received at some date in the future, you simply apply the appropriate interest rate to discount from the future amount The value today is called present value And the interest rate you use to discount back is called the discount rate
“no interest” plan? Could Tills pay SCS the $4,000 over the 3-year life of the plan by paying 36 installments = $4,000/36 each? (would be $111.11 a month) i.e., TOTAL $ paid = $4,000
Present value < Total $ paid If discount rate were 18%, and Tills were to make 36 monthly payments of $111.11, for a total of $4,000, the present value of that stream of 36 payments is just $3,073 – far less than the $4,000 that SCS is entitled to
Even SCOTUS knows this Thus, as the Supreme Court observed in another case, “When a claim is paid off pursuant to a stream of future payments, a creditor receives the ‘present value’ of its claim only if the total amount of the deferred payments includes the amount of the underlying claim plus an appropriate amount of interest to compensate the creditor for the decreased value of the claim caused by the delayed payments.” Rake v. Wade, 508 U.S. 464, 472 n.8 (1993).
The Big Issue: What IS the “appropriate amount of interest” One of the single most difficult, debated, and litigated questions under the Bankruptcy Code has been how to determine the “appropriate amount of interest” in a cram down plan. Saying that “interest” must be paid to compensate for delay in payment is non-controversial; what is controversial is deciding what the interest rate should be
Why the interest rate matters Consider the facts in Till to see why the interest rate matters Tills proposed an interest rate of 9.5% on the 36 monthly payments for the $4,000 principal SCS argues it was entitled to the contract rate – 21% If Tills paid at 9.5% for 36 months, but “appropriate” rate = 21%, then the present value (PV) = ~ $3,400 Far less than the required $4,000 PV
What comprises “interest”? Interest rates are comprised of several components. As Justice Stevens explained in Till: 541 U.S. at 474 “A debtor's promise of future payments is worth less than an immediate payment of the same total amount because 1. the creditor cannot use the money right away 2. inflation may cause the value of the dollar to decline before the debtor pays, and 3. there is always some risk of nonpayment.”
1 st component: Inflation the most fundamental and non-controversial component of interest is the second one stated by Justice Stevens – compensation for inflation. In periods of positive inflation, money becomes less valuable over time interest compensates those who forego present receipt and enjoyment of money for the devaluation of that money expected to occur over time.
Inflation, cont. For example, ignoring everything else, if inflation is 3% per annum, for the value of $100 one year from now to be equal to $100 today, the future recipient would have to be paid 3% (i.e., $3) in addition to the $100 to be paid in one year. All approaches that courts have used to fix a cram down interest rate include compensation for inflation
2 nd component: Opportunity cost interest rates also reflect the basic economic concept of opportunity cost Devoting any resource – including money – to any particular use necessarily means foregoing all other possible uses A creditor who is denied the immediate use and enjoyment of money through a cram down plan thus must be compensated for that lost opportunity cost. This is the first of the three components identified by Justice Stevens (“the creditor cannot use the money right away”).
Opportunity cost, cont. In measuring the foregone return from other possible uses of money, at a minimum one could always invest money in U.S. Treasury obligations, which are considered “risk free”. The interest rate on U.S. Treasury obligations is known as the “ risk-free rate ” this rate contains (1) compensation for inflation and (2) so- called “pure” interest – compensation for the time value of money -- and nothing else. Again, all approaches for calculating a cram down interest rate agree that at the very least, the creditor must receive the “risk-free” rate.
3 rd component: Risk of default While Justice Thomas concurring in Till advocated the use of the risk-free rate, the other 8 Justices all agreed that the risk-free rate was not enough The reason they rejected the risk-free rate is that it does not fully capture the opportunity cost of most uses of money, as virtually all uses of money of course are not risk free. Interest rates above the risk-free rate, thus, contain an additional measure of compensation – a “risk premium” – to account for the risk inherent in the future receipts of money
Risk, cont. This is the third component of interest Justice Stevens identified: “ there is always some risk of nonpayment ”.
Back to hypo Earlier we posited a hypo where SCS was paid the $4,000 the Tills owed them on the effective date of the plan, and then re-lent that $4,000 to another subprime borrower, and we concluded that in a year SCS would have a right to $4720 (at 18%) But of course there’s also a very substantial possibility that SCS wouldn’t collect a dime from those borrowers, b/c they’d just default – this is the RISK Which of course is why SCS would charge them 18%!
Warren Buffet, not subprime Assume instead that SCS made a $4,000 car loan to Warren Buffet. Would it charge Buffet 18% interest? Of course not! And WHY? Because they’d have almost no worry at all that he wouldn’t repay Instead Buffet would be charged a much, much lower interest rate – probably the “prime rate” or something close to it
“Prime Rate” The plurality in Till defined the prime rate as “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.” As of March 2010, the prime rate = 3.25%
Sliding scale of risk And then, for everyone along the default risk scale, from Warren Buffet (LOW RISK) to subprime borrower (HIGH RISK), the financial markets adjust the interest rate based precisely on the default risk assessment Recall slide 8, which showed that as FICO credit scores went down (i.e., greater risk of default), interest rates went up: FICO 720 = 6% FICO 620 = 12% FICO 520 = 18%
2 nd principle of finance second principle is that “[a] safe dollar is worth more than a risky one.” And this 2 nd principle is directly reflected in the cost of money, i.e., in the interest rate
Counterfactual problem By definition the bankruptcy judge has to resolve a counterfactual: what is the appropriate interest rate to compensate a secured creditor for the economic risks it suffers because it is not allowed to foreclose on a loan, but instead is forced to wait for full payment? The crammed down secured creditor is not actually making a loan to the debtor via cram down – it is simply not being permitted to collect immediately on a loan it made in the past – but the court must hypothesize as if the creditor were making a loan.
The competing approaches “ Formula” [Plurality Till] Start with the prime rate, then add a “plus” premium for the added risk of default for this debtor. Typically courts use a presumptive across-the-board “plus” (e.g., range of 1% to 3%) and then allow the creditor to try to prove more. this method is sometimes called “prime plus.”
Competing approaches, cont. “ Coerced Loan ” “The creditor 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.” this leaves the secured creditor as well off under the cram down plan as if it had been paid in full in cash at confirmation, because it then could have gone out and made a similar market loan with the foreclosure proceeds – e.g., this is like my hypo in slide 7
Competing approaches, cont. Presumptive contract [Dissent Till] The basic theory is the same as for “coerced loan,” only difference is that the actual contract rate between the debtor and secured creditor on the loan at issue establishes presumptively the market rate for the “coerced loan.” Adjustments up or (more likely) down then can be made upon proof by the creditor or debtor
Competing approaches, cont. “ Cost of funds” The focus is on what it would cost the creditor to borrow an amount of money equal to the allowed secured claim (i.e., the “cost of funds” to the creditor) the idea is that the creditor in theory could use the borrowed money to make itself whole.
Cost of funds rejected by 8 Justices major problems: (1) assumes that crammed down creditor has unlimited borrowing capacity and that forcing a creditor to draw on its supply of credit is costless, both of which are demonstrably false (2) practical difficulty for a court to identify the particular creditor’s cost of funds is daunting (3) ignores the core reason a cram down interest rate is necessary, which is that there is a positive risk that this debtor might default. “mistakenly focuses on the creditworthiness of the creditor rather than the debtor.” (Stevens, J., plurality).
The fight is over how to assess risk The judicial fight over cram down interest rates has focused on the risk component Eight Justices agreed in Till that: (1) the cram down interest rate must fully compensate the creditor for the risk of default by the debtor and (2) fixing that rate necessitates an inquiry into the market for interest rates in light of the specific risks posed by this debtor. Where they parted ways was over how best to approach the question
COULD use an actual market test This is the “coerced loan” theory Asks: what is the market rate for a loan of similar duration and risk? if actual, live lending markets were to develop for financing cram down loans, then there would be no need for judicial intervention at all, because the actual market – rather than the hypothetical market imagined by the judge – could be consulted
Dueling rules of thumb The plurality favored starting with the prime rate – which is admittedly too low for a bankrupt debtor – and adjusting up, with the “plus” measuring the extra risk of default by this debtor The dissent preferred starting with the actual contract rate between these parties, and possibly adjusting down, if the actual risk had changed.
Start low or high? Contract rate Prime “plus” Prime
In THEORY could end up same “if all relevant information about the debtor's circumstances, the creditor's circumstances, the nature of the collateral, and the market for comparable loans were equally available to both debtor and creditor, then in theory the formula and presumptive contract rate approaches would yield the same final interest rate.”
Plurality vs dissent “Thus, we principally differ with the dissent not over what final rate courts should adopt but over which party (creditor or debtor) should bear the burden of rebutting the presumptive rate (prime or contract, respectively).”
Theory vs reality Sounds good, but, as the characters in “Arrested Development” were wont to say – “come on”! This is just balderdash If calculating the “plus” factor were taken seriously by the bankruptcy courts, and they actually tried to compute the likely risk of default for the debtor, then there would be little reason for a secured creditor to complain about the formula method the Till plurality is surely correct that creditors have access to much of the relevant information
“plus” is NOT a real risk assessment The problem is that the “plus” is not a real adjustment Because proof is difficult and time is short, courts routinely use a presumptive “plus” rate, normally somewhere between 1 % and 3%. Justice Scalia saw this; looking at the lack of an evidentiary record supporting the 1.5 % “plus” number used in Till, he quipped – probably correctly – that “it is impossible to view the 1.5% figure as anything other than a smallish number picked out of a hat.”
Till proves “plus” is b.s. The Tills are a perfect case in point: in the real world, since they were very bad credit risks, they could only qualify for a subprime rate – 21%, in the actual case. Yet they confirmed a “formula” based plan of 9.5 percent. How? Through the use of two presumptions – 8% for the prime rate, and another 1.5 % for the “plus – coupled with a disinclination in the bankruptcy court to adjust any further, despite the obvious evidence that the Tills were far worse credit risks than a 9.5 % rate would warrant.
Systematic undercompensation This is the real complaint the Till dissent had; Justice Scalia stated, “I believe that, in practice, this approach will systematically undercompensate secured creditors for the true risks of default.” When a 21% debtor can get a 9.5 % cramdown rate, it is hard to argue the “undercompensation” point.
What is wagging what? Undercompensation is understandable under the formula method Start with the prime rate (8%). How likely is it that the bankruptcy court then will make an “adjustment” that almost triples the rate? Dissent: “When the risk premium is the greater part of the overall rate, the formula approach no longer depends on objective and easily ascertainable numbers. The prime rate becomes the objective tail wagging a dog of unknown size.”
Plurality’s view of the “plus”? 1 st, plurality mostly dodged the issue of the appropriateness of the “plus” 2 nd, Stevens suggested that plan feasibility test would take that into account But that test cuts the other way! A plan that pays the CR too little (and thus less) is surely MORE FEASIBLE for the Dr to perform Feasibility test does not consider whether the Cr is being adequately compensated
Thumb on the scales? motivation of plurality: court should “select a rate high enough to compensate the creditor for its risk but not so high as to doom the plan.” Interest rates, though, are supposed to compensate the creditor for risk, without taking into account how likely it is that the debtor can bear onerous payments. one senses a judicial thumb on the scales favoring plan confirmability, with the risk assessment calculus skewed to cut the debtor a break, rather than to fairly compensate the creditor.
What’s not to like about K rate? The only reasons to doubt the accuracy of the contract rate would be: (1) a belief that the market itself is not competitive, and thus the rates charged in contracts are not reflective of actual risk; (2) even if the contract rate was reflective of the market when executed, things have changed to alter the risk assessment; or (3) an assessment that there is something innately different about risks (for better or worse) in a bankruptcy reorganization case.
Not seem likely Hard to see why any of those 3 concerns are particularly likely as a systematic matter Non-competitive market? Change in risk picture for the better? Bankruptcy risks are less?
Justifying the K rate To support a presumptive contract rate, one only need agree with the dissent that “it does not strike me as plausible that creditors would prefer to lend to individuals already in bankruptcy than to those for whom bankruptcy is merely a possibility – as if Chapter 13 were widely viewed by secured creditors as some sort of godsend. … The better assumption is that bankrupt debtors are riskier than other subprime debtors – or, at the very least, not systematically less risky.”
giving it up for the K rate… Even if there were some credence in these concerns, it still would be fair to ask why the bankruptcy court could not be trusted to account for the differences and adjust downward just as the plurality was content to let bankruptcy judges start with a rate they knew to a certainty was too low – the prime rate – and adjust up Plurality said would be too hard for DR to rebut
K minus vs prime plus? If weighing the wisdom of the dissent vs plurality, also ask: whether the risk of over-compensation that would result from a “contract minus” adjustment approach would be greater than the risk of under-compensation from the “prime plus” system favored by the plurality. * When the numbers show a prime rate of 8%, a contract rate of 21%, and an “adjusted” rate of 9.5 %, the under- compensation pitch seems more plausible!
Now be honest … answer the following questions: 1. do you think that interest of 9.5 % is fair compensation for a creditor forced to accept payments from a debtor who is already in bankruptcy, on a subprime loan with an original interest rate of 21%? 2. If you were that creditor, would you be indifferent to being paid cash in full up front or being paid 9.5 % over a period of years?
Numbers on risk don’t lie Go back to slide 8, which had the auto loan rates for debtors, based on the Dr’s FICO scores The upshot of the Till decision is to give the debtors a free bump of about 200 points on their FICO score!
Do 2 wrongs make a right? Till: formula rate undercompensates Cr on interest rate Rash: replacement value overcompensates Cr on the principal (“allowed secured claim”) More than Cr itself could ever realize on foreclosure So—pay too little interest, but on too high a principal amount—who knows, maybe get it right!
Where are we now? Four Justices (Plurality) approved formula, and rejected cost of funds, risk-free, coerced loan, and presumptive contract. Four Justices (Dissent) approved presumptive contract, and rejected cost of funds, risk-free, and formula; probably amenable to coerced loan. One Justice (Concurrence) approved risk-free, and would uphold, over creditor’s objection, anything that paid creditor that much or more.
Current status, cont. eight votes against risk-free and cost of funds, so those are off the table concurrence (J. Thomas) will uphold as against the secured creditor’s objection any method that proposes to pay the creditor as much or more than risk-free – which of course means every other method still on the table, including formula, presumptive contract, and coerced loan Thus have 5 votes for ANY of formula, K, or coerced— SO DR can pick whichever it likes best!!