Stites & Harbison, PLLC

In Money in the "Till," an article appearing in Issue No. 10, October 2004, of the Norton Bankruptcy Law Advisor, we discussed the secured creditor's response to cram down in chapter 11 cases under 11 U.S.C. § 1129(b)(2)(A) in light of Till v. SCS Credit Corp., 541 U.S. 465, 124 S.Ct. 1951, L.Ed. 2d 787 (2004).  We discussed, among other things, that: (i) there is an argument that Till does not apply to chapter 11 cases; (ii) the secured creditor may or may not want Till to apply in chapter 11 depending on the alternative legal methodology used by the court to establish an interest rate; and (iii) the legal methodology articulated by the court used for establishing an interest rate may or may not make a real difference in the outcome.  On August 16, 2005, the Sixth Circuit Court of Appeals issued In re American Homepatient, Inc., 420 F.3d 559, 2005 U.S. App. LEXIS 17203 (2005), which is the first circuit court opinion to address the application of Till to chapter 11 cases.

Till was a chapter 13 case interpreting 11 U.S.C. § 1325(a)(5), in which a plurality of the United States Supreme Court rejected the "presumptive rate" analysis of the Seventh Circuit and called for a "formula approach" under which the court begins with a prime rate of interest and then potentially adjusts upward, with the burden of proof being on the creditor to demonstrate risk factors justifying an upward adjustment.

The Supreme Court was Delphic on the issue of whether Till applies to chapter 11.  It said:

"We think it likely that Congress intended bankruptcy judges and trustees to allow essentially the same approach when choosing  an appropriate interest rate under any of these provisions [citing, among other sections, § 1129(b)(2)(A)]."

Till, 124 S.Ct. at 1959.

And it said:

"Because every cram down loan is imposed by a court over the objection of the secured creditor, there is no free market of willing cram down lenders [in a chapter 13]. Interestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. See, e.g., Balmoral Financial Corporation, http://www.balmoral.com/bdip.htm (all Internet materials as visited Mar. 4, 2004, and available in Clerk of Court's case file)(advertising debtor in possession lending); Debtor in Possession Financing: 1st National Assistance Finance Association DIP division, http://www.loanmallusa.com/dip.htm (offering "to tailor a financing program . .  to your business needs and . .   to work closely with your bankruptcy counsel"). Thus when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce. In the chapter 13 context, by contrast, the absence of any such market obligates courts to look to first principles and ask only what rate will fairly compensate a creditor for its exposure."

Id. at 1960, n. 14.

The background of American Homepatient is important to an understanding of the decision.  Both the bankruptcy and district court decisions occurred before Till was decided.  In American Homepatient, the lending group had in 2001 committed to extend the debtor in excess of $250 million in secured credit at prime plus 2.75% as long as the debt exceeded four times EBITDA, for an effective rate of about 6.5%.  American Homepatient, 298 B.R. at 159.  When the lenders refused to extend the maturity in 2002, the debtor filed bankruptcy. 298 B.R. at 160.  The debtor proposed a plan of reorganization under which the claims of the lenders were bifurcated into secured and unsecured debt, with the secured debt to receive interest at 350 basis points over the six year Treasury Note, contending that this rate was consistent with the "coerced loan theory" and "based upon the rate of return to the Lenders prior to bankruptcy."  298 B.R. at 179.  The lenders (foreshadowing footnote 14 in Till) argued that, because there was a market for this type of loan, the interest rate should be set at market, with a blended rate based on three components of the loan: senior secured, mezzanine, and equity. 298 B.R. at 182.  Although the opinion does not expressly characterize it as such, the lenders' approach appeared to be a "cost of funds” approach," which was discussed and rejected by the bankruptcy court. 298 B.R. at 182.  The bankruptcy court accepted the debtor's proposal and set the rate at approximately 6.8%.  The bankruptcy court characterized its approach as the "coerced loan" approach, relying on Memphis Bank & Trust Co. v. Whitman, 692 F.2d 427 (6th Cir. 1982) and Household Auto. Fin. Corp. v. Burden (In re Kidd), 315 F.3d 671 (6th Cir. 2003). Unlike the "coerced loan" approach in cases such as GMAC v. Jones, 999 F.2d 63 (3rd Cir. 1993), the bankruptcy court did not use "loan specific rates" but instead "more generally applicable rates." 298 B.R. at 184.

The lenders appealed, the district court affirmed, and the lenders then had at least one problem in the Sixth Circuit: the Sixth Circuit's endorsement of a "coerced loan" approach in In re Kidd, supra, using generally applicable rates instead of loan specific rates.  The lenders' argument for a blended rate was supported by the "coerced loan" approach as articulated in GMAC v. Jones, supra, and by the "cost of funds" approach discussed but not adopted in GMAC v. Valenti, supra, neither of which appeared to be the law of the Sixth Circuit after In re Kidd, especially if one assumes that the interest rate analysis in Kidd, a chapter 13 case, is applicable to chapter 11 cases (which many, including the author of this article, would argue is a troubling and dubious assumption).

So the lenders arrived at the Sixth Circuit, but the game changed on May 17, 2004, when the Supreme Court issued Till.  Footnote 14 in Till was the potential answer to the lenders' prayers because of its suggestion that one could use an efficient market for the loan in order to set a rate under § 1129(b).  Presumably, if footnote 14 ruled, then Till became the friend, not the enemy, of the secured creditor in chapter 11, because the "coerced loan" approach as applied by the Sixth Circuit prior to Till allowed 21% sub-prime car loans to be crammed down at 10.3%. Kidd, 315 F.3d 671.

But what would the Sixth Circuit do with footnote 14?

The Sixth Circuit recognized the problem with the plurality opinion and quoted the inconsistent parts of the opinion, including footnote 14.  After citing several cases and articles on the issue, it stated:

"Taking all of this into account, we decline to blindly adopt Till's endorsement of the formula approach for Chapter 13 cases in the chapter 11 context.  Rather we opt to take our cue from Footnote 14 of the opinion, which offered the guiding principle what "when taking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce." [citation omitted]. This means that the market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality. This nuanced approach should obviate the concern of commentators who argue that, even in the Chapter 11 context, there are instances where no efficient market exists."

Reading to this point, and knowing that the lenders sought to demonstrate in the bankruptcy court that there was a market rate for the loan and that the market rate was based on blending three components of the financing, the reader at this point might reasonably anticipate victory for the lenders.

But the Sixth Circuit was not finished. The debtor's expert, Mr. Rosen, had testified that the applicable interest rate on the "senior" debt of similar healthcare companies was 300 basis points over LIBOR/Treasuries, with another 50 basis points tacked on for lack of amortization. 289 B.R. at 181.  The Sixth Circuit then used the "senior debt" component, which is only one of the three components of the debt (the other two being the riskier mezzanine and equity components) to affirm setting the entire rate at 6.78%. 420 F.3d at ___.  The Sixth Circuit proclaimed that what the bankruptcy court had done was to determine what an efficient market would provide. 420 F.3d at ___.  The lenders composite rate structure was rightly rejected, according to the Sixth Circuit, because it was premised on a new loan and not a workout.  The Sixth Circuit focused on the "type" of loan, i.e., "senior secured debt," because that is what the loan was called in the debtor's plan. [top of page 7].

What is disregarded in the Sixth Circuit analysis is the debt to collateral ratio, which in the market place drives the interest rate, regardless of the type of loan (healthcare, widget making, etc.)  An interest rate derived without reference to this ratio is not a market rate.  Mr. Rosen's testimony only had to do with the top piece of the loan, the most secured and least risky portion, which calls for the lowest interest rate.  That rate simply is not a market rate for the entire loan, which in any under-secured cram down scenario (such as the one in American Homepatient) will never have more than a one-to-one collateral to debt ratio.

To illustrate this scenario in very simplistic terms: Bank makes the borrower a car loan.  Borrower goes into bankruptcy. The balance of the car loan on the petition date is equal to the value of the car (one-to-one collateral to debt ratio).  Borrower goes to a lender who makes "senior secured" loans at 2% interest so long as the loan does not exceed 30% of the car value.  Is 2% a market rate for the "coerced loan" in bankruptcy as "senior secured debt" even though the debt to collateral ratio in the bankruptcy is one-to-one?  Yes, according to the Sixth Circuit analysis in American Homepatient.

In American Homepatient, the Sixth Circuit boldly pronounced that, in chapter 11 cases, under Till's footnote 14, if there is an efficient market, then that market will be used to set the rate in chapter 11.  It then did something else.  It looked at loans of a similar type ("healthcare senior secured") and affirmed a rate chosen by type, disregarding what the market would do.  What the market would do is set a rate based on the risk characteristics, including the debt to collateral ratio.  It is hard to distinguish what the Sixth Circuit did in American Homepatient from what it did in Kidd, supra. In both cases it appears that the Sixth Circuit wanted to avoid the high interest rate sought by the lender and was trying to find a legal analysis that would do so.

The three discussion points mentioned above are: (i) whether Till applies in chapter 11 cases; (ii) whether the secured creditor wants Till to apply in chapter 11; and (iii) whether the legal approach articulated by a court used for establishing an interest rate makes a real difference in the outcome.

In light of American Homepatient, in the Sixth Circuit it appears that:

    (1)    Till will be a factor in chapter 11 cases.  If it is demonstrated that there is an efficient market, then that market will be used; if not, then the "formula rate" approach will be utilized.

    (2)    If an efficient market rate is chosen without regard to the nature of the loan and instead based on a name given to the loan (e.g., "senior secured"), then the lender may well prefer the "formula rate" approach as opposed to the "efficient market" or "coerced loan" approaches, because the formula approach actually may give more weight to risk factors than the other two approaches.  It is hard to say what the court will do with the risk factors in a chapter 11, where the lender typically is faced with much more volatile collateral (e.g., cash flow vs. value of car) and a much longer pay-out period.  It is not difficult to fashion a compelling argument that 500 or 60 basis points should be added to prime for a 25 year health care loan.

    (3)    It is difficult to say whether the legal analysis is driving the decisions in these cases.  One measure would the number of cases where confirmation is denied because the interest rate is too low.  What really may drive these cases, and one factor referenced in the plurality opinion in Till, is a desire not to have confirmation denied because of the interest rate.  In Till the Supreme Court stated: "Together with the cram down provision, this requirement [formula rate approach] 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 (emphasis added)." 541 U.S. at 480.  Are there other areas of the law where the legal analysis is overtly decided by how it affects the outcome of the case?  Should lenders assume that courts will adjust the legal analysis as necessary to achieve the "right" result?  The Supreme Court has seemingly sanctioned this approach.  Maybe the honesty is refreshing, but the prospect of legal analysis that is overtly (or covertly) result-oriented is disturbing.

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(1) Stites & Harbison PLLC represented various creditors and parties in interest in the case but did not represent the Lender Group or the Debtor.

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This article has been submitted for publication in the June edition of Norton Bankruptcy Law Advisor®.

Article Co-authored by:

Robert C. Goodrich, Jr., Member, Creditors' Rights & Bankruptcy Service Group
Madison L. Martin, Associate, Creditors' Rights & Bankruptcy Service Group

Reproduced with the permission of Thomsom West; no further reproductions or uses are authorized without the express consent of Thomson West.