Recommended Change Not Needed for Chapter 11 Cramdown Rates
The Myth of Efficient Market Cramdown Rate
In December 2014, the American Bankruptcy Institute issued its Final Report and Recommendations of the Commission to Study the Reform of Chapter 11. The Commission was comprised of 22 professionals. The group included attorneys, academics, financial advisers, and a former bankruptcy judge. After over two years of work, the Commission made more than 200 recommendations to enhance the Chapter 11 process and provide a more efficient, less costly path for smaller businesses seeking bankruptcy. In this article, Dr. Needham discusses the origin of the Commissionâs purpose, the recommendations and the impact of the U.S. Supreme Courtâs Till decision, and the infamous footnote 14 on cramdown rates.
In December 2014, the American Bankruptcy Institute issued its Final Report and Recommendations of the Commission to Study the Reform of Chapter 11. The commission was comprised of 22 professionals. The group included attorneys, academics, financial advisers, and a former bankruptcy judge.Â After over two years of work, the commission made more than 200 recommendations to enhance the Chapter 11 process and provide a more efficient less costly path for smaller businesses seeking bankruptcy.Â 
One of the commissionâs recommendations is a change in how cramdown interest rates are determined. âThe Commissionâs recommendation rejects applying the Till formula to chapter 11 cases and adopts a general market-based approach. The Commission believes this approach best satisfies the purpose of section 1129(b)(2)(A)(i). Specifically, the Commission concluded that a bankruptcy court should set the cramdown interest rate based on the cost of capital for similar debt issued to companies comparable to the debtor as a reorganized entity. If however, a market rate cannot be determined for a particular debtor, the court should use a risk-adjusted rate that reflects the actual risk posed in the case of reorganized debtor, considering factors such as the debtorâs industry, projections, leverage, revised capital structure and plan obligations.â 
The commissionâs recommendation appears to be addressing footnote 14 in the Till decision. In that footnote, Justice Stevens wrote, âThe fact helps to explain why there is no apparent Chapter 13 âcramdown market rate of interest.â Because every cramdown loan is imposed by a court over the objection of the secured creditor, there is no free market of willing cramdown lenders. Interestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. [examples omitted] Thus, when picking a cramdown rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce.â 
This article reviews court opinions regarding footnote 14, the current status of the market based approach in the courts, and why this recommendation will do little to change the way financial experts address cramdown interest rate matters in Chapter 11 cases. It looks at this recommendation not from a legal perspective, but from the view of the financial expert working in Chapter 11 cramdown matters.
Till Footnote 14
Several courts have addressed footnote 14 and its relationship to determining cramdown interest rates in Chapter 11 matters. They, in general, do not support applying footnote 14. It appears the commission has rejected the logic of the courts and market reality in making this recommendation.
Footnote 14 of the Till decision stated that an internet search showed several debtor-in-possession lenders (DIP) willing to make loans to a bankrupt company. From the rates charged by DIP lenders, a cramdown market interest rate could be construed and applied to debts to be paid over time after a business moves out of bankruptcy.
DIP lending takes place while a business is operating under Chapter 11 protection. It is not funding provided to a business that has emerged from bankruptcy. The commissionâs recommendation talks about determining the interest rate âbased on the cost of capital for similar debt issued to companies comparable to the debtor as a reorganized entity.âÂ DIP lending is not the source for that information.
Judge Lynn in his opinion in Village at Camp Bowie noted âThe Supreme Court pointed to several internet sites for the proposition that such a market exists. See Till, 51, U.S. at 476 n. 14. As of July 26, 2011, the web addresses for those sites are no longer active. Based on the description of those sites in footnote 14 of the Till opinion, they appear to offer debtor-in-possession financing rather than financing for a debtor exiting Chapter 11. These websites are therefore inapplicable to the facts in this case.â
Judge Drain goes even further in his Momentive opinion. âI believe no case has suggested that a DIP loan rate should be used as the rate for a cramdown present value calculation. The criticism is found in 7 Collier on Bankruptcy [cite omitted] where the editors state, âThe problem with this suggestion â i.e. footnote 14âs reference to DIP loans ââ is that the relevant market for involuntary loans in Chapter 11 may be just as illusory as in Chapter 13.â
Seeking an Efficient Market
Having disproved the use of DIP financing rates for determining cramdown interest rates, a court seeking a market based approach must determine what a lender charge on loans to similar borrowers with similar financial data. The Fifth Circuit Court of Appeals has noted, âWhile courts often acknowledge that Tillâs footnote 14 appears to endorse a âmarket rateâ approach under Chapter 11 if an âefficient marketâ for a loan substantially identical to the cramdown loan exist, courts almost invariable conclude that such markets are absent.â 
The reason no âefficient marketâ exists is because of the financial condition of the debtor as it emerges from Chapter 11. Although hopefully a stronger firm, it is usually highly leveraged. In many cases, the businessâ debt forced it into bankruptcy. Secured debt may run from 90 percent to 100 percent of the value of the underlying collateral. Even when emerging from bankruptcy, these ratios may remain high.
This means that the capital structure (debt to equity) of the business is not acceptable to traditional lenders. The businessâ cash flow is impaired due to the repayment schedule for the restructured debt.Â The debtorâs success depends on meeting the projected income and cash flow analyses filed with the court which assumed business success after emerging from bankruptcy. Finally, the reorganized firm will have to deal with the âtaintâ of bankruptcy as it moves forward.
These issues create a situation unacceptable for traditional lenders. Even when similar financial data are provided by a similar, non-bankrupt debtor to a traditional lender, that lenderâs credit committee will find it difficult to approve a loan or bundle of loans (working capital and fixed assets) comparable to the debt being restructured for long=-term payment.
The Fifth Circuit Court of Appeals has addressed this very issue. âIn the present case, Ferrell [financial expert for the creditor] himself acknowledged that âthereâs no one in this market today that would loan to the debtors â one to one loan to value ratio, 39 million dollars, secured by these properties.â While Ferrell concluded that exit financing could be cobbled together through a combination of senior debt, mezzanine debt, and equity financing, courts including the Sixth Circuit have rejected the argument that existence of such a tiered financing establishes âefficient markets,â observing that it bears no resemblance to the single, secured loan contemplated under a cramdown plan.â
Current Process vs. Commissionâs Recommendation
Many bankruptcy courts currently apply a two=step method for assessing cramdown interest rates. The first step is to determine that no efficient market exists for this type of loan. This process can be seen in Judge Lynnâs Village at Camp Bowie I, LP opinion. âFaced with various approaches to establishing a cramdown interest rate, the Court settled on a formula approach though it suggested in a chapter 11 case there might be an efficient market that would establish a proper rate for cramdown. In the case at bar, both French and Needham testified that no efficient market provides loans of the sort required from Western by Debtor. [cite omitted] The court, therefore, will use a formula approach for arriving at a correct interest rate.â  
This two-step process seems logical. While it is unlikely an efficient market exists that provides an applicable interest rate for most cramdown situations, the efficient market should be researched to inform the court that such loans do not exist. Of course should such loans exist, it seems the court may ask why these lenders have not been contacted to provide replacement funding for the contested debt. If the potential lender is contacted and after review decides to not offer a replacement loan, the debtor can argue no efficient market exists. If the potential lender makes a loan offer, the debtor may borrow funds from this new lender. This removes the need for a cramdown hearing for this particular creditor class and allows the debtor to move forward without a creditor who has been forced into this relationship.
As noted by the Fifth Circuit Court of Appeals, most courts have found that an efficient market does not exist for these restructured loans. In the Momentive opinion, Judge Drain goes further suggesting that an âefficient marketâ will never exist and therefore courts should move straight to the formula approach.
âI conclude that such a two-step method, generally speaking, misinterprets Till and Valenti and the purpose of section 1129(b)(2)(A)(i)(II) of the Code based on the clear guidance of those precedents.
Further, as noted by the Fifth Circuit in In re Texas Grand Prairie Hotel Realty, LLC [cite omitted] the first step of the two-step approach is almost, if not always, a dead end. As that decision observed, the vast majority of cases have ultimately applied a Till prime-plus approach or a base rate-plus approach to Chapter 11 cramdown rate, either having spent considerable time determining that there is no efficient market or simply by moving the base-rate formula in the first instance.â 
Since Till, attorneys, experts, and courts have been seeking ways to address the differences between addressing cramdown interest rates for individuals in Chapter 13 and corporations in Chapter 11.  Some attorneys and experts have latched onto footnote 14 to suggest an efficient market rate should be applied in Chapter 11 cramdown matters. As have been noted by bankruptcy courts, courts of appeal, and financial sources, such efficient markets seldom, if ever, exist.
The ABIâs commission has recommended that a market based rate approach be used in Chapter 11 cramdown matters. The interest rate would be based on the cost of capital for similar debt issued to companies comparable to the debtor as a reorganized entity. If a market rate cannot be found, the commission recommends a formula approach be followed. This rate would be a risk-adjusted rate that reflects the actual risk posed in the case.
Rather than a new idea, the commissionâs recommendation sounds like the two=step process currently employed by many bankruptcy courts. It puts more emphasis on the market based rate. Because of the nature and structure of this debt, it is unlikely efficient markets will be found.Â With no efficient market, experts will then use the formula approach to determine a cramdown rate. The court will then adjust the rate based on testimony.
The commission has recommended that when the formula approach is used that the risk consideration should include the debtorâs industry, projections, leverage, revised capital structure, and plan obligations. These factors are generally encompassed in Tillâs directive. âThe appropriate size of that risk adjustment depends, of course, on such factors as the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan.â
The Fifth Circuit added the following. âWithin that [Till] range, courts typically select a rate on the basis of a holistic assessment of the risk of the debtorâs default on its restructured obligations, evaluating factors including the quality of the debtorâs management, the commitment of the debtorâs owners, the health and future prospects of the debtorâs business, the quality of the lenderâs collateral, and the feasibility and duration of the plan.â 
Chapter 11 bankruptcy can be a complex and expensive process without contested hearings. When a creditor opposes the reorganization plan, the court needs to address the creditorâs concerns along with the reasonableness of the debtorâs chances of being successful as a reorganized entity. When the differences are over the repayment of debt, its terms and interest rate, the current two=step process has provided satisfactory results.
In the more than ten years since Till, court cases have shown that seldom is there an efficient market for Chapter 11 cramdown matters. Courts and experts have devised many ways of assessing the risk involved. The process is not perfect; however, it is part of the system that works.
In dealing with cramdown interest rates, debtors, creditors, and the courts should head the words of the Till decision.
â[A] court may not approve a plan unless, after considering all creditorsâ objections and receiving the advice of the trustee, the judge is persuaded that âthe debtor will be able to make all payments under the plan and comply with the plan.â [cite omitted] Together with the cramdown provision, this requirement obligates the court to select a rate high enough to compensate the creditor for its risk but not so high as to doom the plan. If the court determines that the likelihood of default is so high as to necessitate an âeye-poppingâ interest rate, [cite omitted] the plan probably should not be confirmed.â
A courtâs ruling on the appropriate cramdown interest rate is a somewhat Solomon like decision. It must provide for risk and the time value of money so that the creditor receives the present value of the debt over time.
At the same time, the bankruptcy process must provide debtors with a reasonable opportunity to reorganize and continue in business. This unusual situation is not what is commonly found in the efficient market between borrowers and lenders. The current two-step process allows the court to confirm that no efficient market exists before moving to the formula approach to assess the interest rate. If an efficient market does not exist, then the commissionâs recommendation becomes much ado about nothing. There are problems with the Chapter 11 process that need to be addressed. And, changes in policy and procedures need to be made. The process financial experts and the courts use to determine cramdown interest rates is not one of them.
 Overview and Analysis of Select Provisions of the ABI Chapter 11 Reform Commission Final Report and Recommendations, Orrick Restructuring Group, page II
 Ibid, page 5
Till v SCS Credit Corp., 541 U.S. 465 (2004), 476, n. 14
 In re: Village at Camp Bowie I, LP, 452 B.R. 702, 713 n. 24; 2011 Bankr. LEXIS 3033; 55 Bankr. Ct. Dec 84, (Bankr. N.D. Tex, 2011)
 In re: MPM Silicones, LLC, 2014 Bankr. LEXIS 3926, *80, (Bankr. S.D. N.Y. 2014)
 In re: Texas Grand Prairie Hotel Realty, LLC, 710 F.3d; 2013 U.S. App. LEXIS 4514, *19-20; 57 Bankr. Ct. Dec. 177
 In re: Texas Grand Prairie Hotel Realty, LLC, 710 F.3d; 2013 U.S. App. LEXIS 4514, *32-33; 57 Bankr. Ct. Dec. 177
In re: Village at Camp Bowie I, LP, 452 B.R. 702, 712-713; 2011 Bankr. LEXIS 3033; 55 Bankr. Ct. Dec. 84, (Bankr. N.D. Tex, 2011)
 The author of this article is the Needham mentioned in the opinion. I was retained by the debtor to offer an opinion on cramdown interest rates.
 In re: MPM Silicones, LLC, 2014 Bankr. LEXIS 3926, *86, (Bankr. S.D. N.Y. 2014)
 Till is a Chapter 13 bankruptcy case. Many courts have found it informative and directive in applying the formula approach for determining cramdown interest rates in Chapter 11 cases.
 Till v SCS Credit Corp., 541 U.S. 465 (2004), 479
 In re: Texas Grand Prairie Hotel Realty, LLC, 710 F.3d; 2013 U.S. App. LEXIS 4514, *20; 57 Bankr. Ct. Dec. 177
 Till v SCS Credit Corp., 541 U.S. 465 (2004), 480-481
Allyn Needham, Ph.D., CEA, is a principal at Shipp, Needham & Durham, LLC (Fort Worth, Texas). For the past 17 years, he has worked in the area of litigation support. Prior to that, he worked more than 20 years in the area of banking and risk management. Dr. Needham has also been an Adjunct Professor of Economics at Texas Christian University and Weatherford College. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy and business valuation. Dr. Needham can be reached at firstname.lastname@example.org and 817-348-0213.