Slide 2 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 Slide 3 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)
Slide 4 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 Slide 5 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? Slide 6 1 st
principle of finance The first basic principle of finance is that a
dollar today is worth more than a dollar tomorrow Slide 7 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 Slide 8 Auto interest rates? FICO SCORE APR 720-850 6.334%
690-719 7.843% 660-689 9.825% 620-659 12.782% 590-619 17.666%
500-589 18.458% See
http://www.edmunds.com/advice/finance/articles/159646/ article.html
http://www.edmunds.com/advice/finance/articles/159646/ article.html
Slide 9 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 Slide 10 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 Slide 11 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 Slide 12 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 Slide 13 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). Slide 14 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 Slide 15
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 Slide 16 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. Slide 17 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.
Slide 18 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 Slide 19 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). Slide 20 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. Slide 21 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 Slide 22 Risk,
cont. This is the third component of interest Justice Stevens
identified: there is always some risk of nonpayment . Slide 23 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
theres also a very substantial possibility that SCS wouldnt collect
a dime from those borrowers, b/c theyd just default this is the
RISK Which of course is why SCS would charge them 18%! Slide 24
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 theyd have almost no worry at all that
he wouldnt repay Instead Buffet would be charged a much, much lower
interest rate probably the prime rate or something close to it
Slide 25 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% Slide 26 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% Slide 27 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 Slide 28 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.
Slide 29 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. Slide 30 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 Slide 31 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 Slide 32 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. Slide 33 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 creditors 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). Slide 34
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 Slide 35 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 Slide 36 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. Slide 37 Start low
or high? Contract rate Prime plus Prime Slide 38 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. Slide 39 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). Slide 40 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 Slide 41 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. Slide 42 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. Slide 43 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. Slide 44 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. Slide 45 Pluralitys 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 Slide
46 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.
Slide 47 Whats 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. Slide 48 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? Slide 49
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. Slide 50 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 Slide 51 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! Slide 52 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? Slide 53
Numbers on risk dont lie Go back to slide 8, which had the auto
loan rates for debtors, based on the Drs FICO scores The upshot of
the Till decision is to give the debtors a free bump of about 200
points on their FICO score! Slide 54 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 Sopay too little interest, but on too high a principal
amountwho knows, maybe get it right! Slide 55 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 creditors objection, anything that paid creditor that
much or more. Slide 56 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 creditors 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!!
