The Bankruptcy Code allows a debtor to confirm—or cramdown—a reorganization plan over creditors’ objections if certain criteria are met. One requirement is that, if secured claims are to be paid over time, the secured creditors must receive cash payments with both a nominal value and a present value at least equal to their claims. This recognizes the economic reality that $100 today is worth less than $100 paid in $10 increments over 10 years.
Determining if the nominal value of a payment stream equals the face value of a claim is “attorney math,” e.g., simple addition. But to create a future payment stream with the same value as a lump sum payment today requires establishing an interest rate that reflects the characteristics of those deferred payments—e.g., investment risk, duration, time value of money, etc. If the interest rate is correct, then the discounted present value of the payment stream equals the nominal value of the claim today. Simple, right? (If you are lost, try this explanation from Math Is Fun or a refresher from the Harvard Business Review.)
But how do you come up with an appropriate interest rate? The legal brains who wrote the Bankruptcy Code provided no practical, mathematical guidance, leaving lawyers and judges to muddle through on their own, or with the help of valuation experts. Confusion and litigation ensued.
The Formula Approach
To illustrate, in 1998 an Indiana couple bought a used truck for about $6,000. They financed the purchase at a 21% interest rate, ultimately ending up in bankruptcy owing over $8,000 on an old truck worth about $4,000. The couple wanted to keep their truck and pay the lender principal plus interest at what they felt was more reasonable rate of 9.5%. But the finance company held out for 21%, which it felt was needed to compensate for the high risk loan. The fight over the truck, and the interest rate, ended up before the Supreme Court in the seminal case Till v. SCS Credit Corp.
The Supreme Court adopted a “formula approach” for coming up with an interest rate, which people also refer to as—wait for it—the Till Method. Under this approach, you build a cramdown interest rate from the ground up by starting with the prime rate and then adjusting for factors such as the debtor’s circumstances, the nature of the proposed “loan”, and the duration and feasibility of the debtor’s plan. Add that all together and, viola, you have your cramdown interest rate.
But Till leaves a lot of unanswered questions. (Why start with the prime rate and not a risk-free treasury bill, you might be wondering?) In a cliffhanger footnote, the Supreme Court itself pondered whether Till’s formula approach should be applied in the very different context of Chapter 11 cases, which often involve large commercial loans negotiated between sophisticated parties. That is an excellent question that a lot of bankruptcy professionals would like an answer to.
The Efficient Market Approach
While some cases have applied Till’s formula approach in the context of Chapter 11 cases, others have adopted a so-called “efficient market” approach. The question these courts grapple with is what interest rate lenders in the market would charge on a similar new loan. If an efficient market exists for the type of “loan” in question, in theory, you can look to the markets to tell you an appropriate interest rate that will compensate the lender for risk and the time value of money. While that is theoretically sound, one of the real world difficulties is that cramdown plans are inherently coercive, and there is no market for coerced loans.
Other Theoretical Approaches
Other approaches that are possible include a coerced loan approach, a presumptive contract approach, or a cost of funds approach. The goal of all of these methodologies is the same, e.g., to create a concrete framework for applying present value theory. For an in depth, academic discussion of all of these approaches, Northwestern University Law Review has published an excellent article.
No Easy Answers…
What is clear is that establishing a cramdown rate in a Chapter 11 case is going to be significantly more complex than simply applying a few qualitative adjustments to the prime rate or referencing some sort of “Blue Book” of cramdown interest rates. To establish an appropriate cramdown interest rate requires knowing the legal jurisdiction you are in and the latest cases on the issue, and often, involving a financial expert to support your position.