Chapter 11 Bankruptcy

Unsecured Creditors: Risk and Cramdown Rates (Part II of II)

This is the second of a two-part article, read Part I here. In October 2017, the Second Circuit Court of Appeals handed down its decision on cramdown interest rates in the matter In re: MPM Silicones, LLC. This decision has already stirred a great deal of discussion regarding cramdown interest rates to be paid secured creditors in Chapter 11 bankruptcy matters. Numerous articles have appeared on-line discussing the impact of this decision. These articles follow in a long line of literature on cramdown hearings and secured creditors.

Conversely, little has been written about impaired unsecured creditors, their contested claims, and the interest rate to be paid on deferred cash payments to be made to satisfy those claims. This article reviews the portion of the U.S. Bankruptcy Code relating to the standards for the court to confirm a reorganization plan over the objection of an impaired class, the status of unsecured creditors, varying categorizations for unsecured creditors, and factors to consider when reviewing the repayment plan offered by the debtor. Ultimately, an argument will be made for the interest rate to be offered on deferred cash payments made to unsecured creditors.

[su_pullquote align=”right”]Resources:

Bankruptcy, Insolvency, and Restructuring

Valuation of Distressed Businesses and Plan of Reorganization

Assessing Risk in Valuing a Business

Valuation of Business, Securities, and Intangible Assets for Bankruptcy Purposes

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Liquidation and Risk

In a Chapter 11 bankruptcy matter, a secured creditor must retain the security interest (the collateral) up to the amount of its claim and be paid a series of deferred cash payments equal to the present value of collateral securing the claim as of the effective date of the reorganization plan.  Should the court deny the reorganization plan and order the liquidation of the debtor, the secured creditor will, most of the time, expect to have the collateral returned or, if the collateral is sold, receive the sale proceeds equal to the value of the claim.  In single asset real estate (SARE) Chapter 11 matters, the secured creditor may ask the court to deny confirmation and allow the creditor to foreclose on the collateral real estate to sell or manage the property as it chooses.

Unsecured creditors by the very nature of their claim do not have the protection afforded secured creditors.  Under a reorganization plan, unsecured creditors receive a stream of payments having a present value no less than what they would receive in liquidation.  As a result, if the estimated liquidation value of the bankrupt firm’s assets is less than the total unsecured claims, the unsecured creditors may be asked to accept less than full payment of their claims.  In some cases, there are no proceeds remaining for the payment of unsecured claims after payments are made to the secured creditors.  In those situations, the unsecured creditors receive nothing.

A SARE bankruptcy provides a good example.  Should the secured claim be greater than the value of the collateral and the court denies confirmation of the reorganization plan, the secured creditor will foreclose on the real estate and there may be little, if any, assets remaining in the bankrupt entity.  In this situation, unsecured creditors could expect little in the form of payment for their claims.

In many Chapter 11 bankruptcies, the cash flow of the debtor’s reorganized entity will allow for full payment of unsecured creditors over time.  In these situations, the debtor negotiates acceptable payment terms with the unsecured creditors securing their consent for the reorganization plan.  In other situations, the debtor may not offer full repayment for the unsecured claims because of cash flow constraints.  This is appropriate as long as the liquidation of the debtor’s assets would not generate sufficient proceeds to pay unsecured claims in full.

This is why unsecured creditors must remain aware of the debtor’s financial condition and ability to make payments throughout the bankruptcy process.  The mere fact that the unsecured creditor has the right under the bankruptcy code to demand full payment of its claim does not guarantee that the debtor will be able to make a full payment.

Satisfying Unsecured Claims with Deferred Cash Payments

When equity holders of a bankrupt business want to retain their interests, the debtor may offer general unsecured creditors a schedule of deferred cash payments equaling the full amount of their claim plus interest.  Any cash payments will be made from the reorganized business’ cash flow.  These unsecured claims could come from a variety of sources.  They could be related to goods and services provided to the debtor prior to bankruptcy.  It could be a deficiency claim in which a secured creditor’s claim is greater than the value of the collateral securing that claim.  Another could be from unsecured bond holders.  Or, the claim could be for some other reason such as a judgement against the debtor in a lawsuit.

To satisfy the Bankruptcy Code, the stream of payments must have a present value equal to the full amount of the unsecured claim.  This means that the stream of payments must include interest so that the total amount of payments, while greater than the amount of the claim, will have a present value as of the effective date equal to the full amount of the claim.

In circumstances where the debtor wants to retain equity interest in the reorganized firm, the debtor may offer interest on the deferred cash payments as an incentive for the unsecured creditors to accept the reorganization plan.

For secured claims, interest is added to the deferred cash payments to allow for the time value of money and risks related to the repayment period.  This interest allows the creditor to receive the present value of its claim.[1]  Many financial experts and attorneys look to the U.S. Supreme Court’s Till decision for guidance in determining cramdown interest rates.[2]  However, Till discusses approaches for determining the cramdown interest rate for a secured claim in Chapter 13.  Many courts have found it informative and directive for cramdown matters for secured claims in Chapter 11, but it does not address some of the primary issues in dealing with the payment of a claim with no security.[3]

There is little literature or case decisions providing guidance in determining the appropriate interest rate for unsecured claims.  Many may argue that unsecured creditors should receive interest at rates equal to or greater than those being paid to the secured creditors to compensate them for the additional risk associated with their stream of payments.  This is because the unsecured creditors have no collateral on which to secure their claim, foreclose, and sell for its value.  They would claim that the risk of default is greater because of this lack of security.

However, it can as easily be argued that unsecured creditors should only be paid for the time value of money.  This is because in many cases, liquidation of the debtor would leave them with payments less than their claim or no payment at all.  Conversely, the cash flow of the debtor will enable it to make the deferred payments; therefore, limiting the risk to the unsecured creditors.

The question posed in this article is, “When evaluating the circumstances of unsecured creditors, where is the risk?”

Consider:

1. The unsecured creditor has no security; therefore, should the debtor be liquidated, the unsecured creditor is low in priority to receive an allocation of the proceeds from the sale.
2. Should the debtor have sufficient cash flow and net asset value for the repayment of the claims, the unsecured creditor has a right to receive payment in cash or property for the full value of its claim as of the effective date of the plan.

Therefore,

“What risk does the unsecured creditor incur when a schedule of payments is offered instead of receiving nothing or a very limited amount from the proceeds of the debtor’s liquidated assets and the payments will pay in full the unsecured claim from the debtor’s projected cash flow that the court has found sufficient?”

Prior to the bankruptcy, many of these unsecured creditors provided goods and services to the debtor.  As a part of that agreement, the unsecured creditors agreed, in principal, to be paid out of the cash flow of the business.  The debtor has now offered to make a series of deferred cash payments out of its future cash flow to satisfy this claim.  If the court finds the reorganization plan feasible, then the risk for repayment from the future cash flow stream does not seem to be greater than the risk when the goods and services were provided.  The creditor’s payments may take longer than originally anticipated, but the risk appears to be at the same level as prior to the bankruptcy.

For other unsecured creditors, those having a deficiency claim or holding a judgement against the debtor, paying the full amount of the deficiency or award in a lump sum would be detrimental to the ongoing operation of the business.  Being paid over time protects the unsecured claimant by offering the best option for being paid in full.

For these unsecured creditors with large claims, the risk to them is similar to the risk for the general unsecured creditors.  As an example, the trier of fact may award an amount to a plaintiff (who, under a Chapter 11 bankruptcy filing, becomes an unsecured creditor).  With the conclusion of the trial or the appellant process where the verdict is upheld, the plaintiff anticipates receiving the full value of the award in a lump sum payment.  This is not unlike the unsecured creditors who provided goods and/or services to the debtor expecting to be fully paid according to the terms of their invoice.  Under the reorganization plan, the unsecured creditor has become impaired because the debtor wants to change the terms of their agreement.  The debtor wants to pay the claim over time through a series of deferred payments.  Even if the unsecured creditor calls for liquation of the debtor, under most circumstances, there is no certainty that liquidation would provide for full payment of the litigant’s unsecured claim.

When a debtor offers this form of payment in its reorganization plan, it is because the debtor wants to remain in business and retain its equity interests.  Therefore, rather than only offering the full value of the claim, the debtor may offer to pay interest on the claim to entice the impaired unsecured creditor to vote in favor of the plan.

Because these payments are to be made over time, the feasibility of the reorganization plan is foremost in assessing whether to accept or reject the plan.  If the debtor will be able to make the payments, the unsecured creditor will have only the standard risk that occurs in daily business transactions.  If the debtor’s projections show limited cash flow and potential problems with payment, the creditor’s risk may be greater.  But, with its priority in line to receive payments, forcing the debtor into liquidation may not provide a better opportunity for payment of the unsecured claim.

Because of this, it appears the time value of money provides for the appropriate interest rate.  This rate would be equal to the risk-free rate for the offered repayment period.  This interest rate would provide for the present value of an unsecured claim when paid in a series of deferred payments.

In his concurring Till opinion, Justice Thomas noted, “there is always some risk of nonpayment when A promises to repay a debt to B through a stream of payments over time rather than through an immediate lump sum payment.”[4]  He argues that no risk adjustment should be made when determining the interest rate.  “In most, if not all cases, where the plan proposes a stream of cash payments, the appropriate risk-free rate should suffice.”[5]

Justice Thomas states that the appropriate interest rate on these deferred payments should be the yield on U.S. Treasury securities maturing over the period of the deferred payments.  This would provide for the time value of money, but would not include an adjustment for the potential of risk of default on the deferred payment stream.  This is because the risk of receiving the payments from the firm moving out of bankruptcy appears to be no greater than the risk assumed by these unsecured creditors prior to the business’ bankruptcy.

Conclusion

Unlike secured creditors, unsecured creditors have no collateral securitizing their claim in a Chapter 11 bankruptcy.  The unsecured creditors’ hope is to be paid out of the debtor’s future cash flow or the proceeds from the liquidation of the debtor’s assets.  Being paid from the future cash flow of the debtor is not unlike the payment method proposed prior to bankruptcy.  However, the terms of that payment and even the amount to be paid may change under the reorganization plan.  These changes make the unsecured creditor impaired and allow the creditor to vote to accept or reject the debtor’s plan.

Under the bankruptcy code, an unsecured creditor may be paid as little as the liquidation value of its claim.  In some cases, this could be zero.  In bankruptcies where the debtor wants to retain its equity interests, the unsecured creditor must be paid the present value of its allowed claim.  If the reorganization plan offers to pay the unsecured claim with a series of deferred cash payments, the debtor may offer, or the creditor may demand, interest on these payments.  The interest provides an incentive for the impaired class to accept the plan.

This article has argued that, in most cases, the interest paid on unsecured claims should be at a risk-free rate.  The interest should be appropriate for the length of the payments (e.g., the yield on securities maturing in three years when a three-year payout has been offered).  This provides for the payment of the present value of the claim but does not overcompensate for the risk.  Having argued that the unsecured creditors initially agreed to be paid out of the cash flow of the business, the new repayment plan offers the same option with a different payment schedule.  And, should the court find the debtor’s plan feasible, the repayment plan provides no greater risk to the unsecured creditor’s claim than the transaction creating the claim.

Justice Thomas stated that there is always some level of risk of default when someone is paid over time rather than in a lump sum.  But even with that minimal level of default risk, he believed the risk-free rate best provided for the present value of these deferred cash payments.[6]

By applying a risk-free rate to these unsecured claims, the court clears a path for providing payments equaling the present value of the unsecured claims without creating a situation making the debtor’s reorganization plan unfeasible due to the application of eye-popping interest rates.  I believe the adoption of this consideration would fulfill the criteria and expectations set by the Bankruptcy Code and benefit both debtors and creditors in allowing an enhanced opportunity for firms seeking protection under Chapter 11 to emerge to continue in business.

I want to thank J. Robert Forshey of the law firm Forshey Prostok in Fort Worth Texas for his assistance with this article.  His knowledge and experience were greatly beneficial to my understanding of the bankruptcy code’s handling of unsecured creditors. – Dr. Needham

[1] In Re: SJT Ventures, 2010 WL 3342206 (Bkrtcy. N.D. Tex. 2010); In Re: T-H New Orleans Limited Partnership, 116 F.3d 790, (5^th Circuit 1997).

[2] Till v. SCS Credit Corp., 541 U.S. 465 (2004).

[3] In Re: Texas Grand Prairie Hotel Realty, LLC, 710 F.3d 324; 2013 U.S. App. LEXIS 4514, 57 Bankr. Ct. Dec. 177, (5^th Circuit 2013).

[4] Till, 488.

[5] Till, 487.

[6] Till, 487.

Allyn Needham, PhD, CEA, is a partner at Shipp, Needham & Durham, LLC, a Fort Worth-based litigation support consulting expert services and economic research firm. Prior to joining Shipp, Needham, & Durham, he was in the banking, finance, and insurance industries for over twenty years. As an expert, he has testified on various matters relating to commercial damages, personal damages, business bankruptcy, and business valuation. Dr. Needham has published articles in the area of financial and forensic economics and provided continuing education presentations at professional economic, vocational rehabilitation, and bar association meetings.
Dr. Needham can be contacted at (817) 348-0213, or by e-mail to aneedham@shippneedham.com.