Cramdown Interest Rates Under Chapter 11: A Valuation Expert’s Perspective
Cramdown Interest Rates Under Chapter 11: A Valuation Expert’s Perspective
Under the provisions of the U.S. Bankruptcy Code (the “Code”), a plan of reorganization may be confirmed over the objection of creditors (the so-called “cramdown”) provided that certain conditions are satisfied. Regarding secured claims, reorganization plans may include the issuance of a secured interest-bearing note to a creditor that provides for deferred payments over a specified time horizon rather than a single payment as of the effective date of the plan.
Under §1129(b) of chapter 11, reorganization plans must ensure that “each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property.” In other words, §1129(b) requires that creditors receive deferred cash payments that have both a nominal value and a present value at least equal to the value of the claim. Typically, it is a relatively simple calculation to determine whether the sum of the nominal values of the deferred cash payments is equivalent to the value of the claim. It is a more difficult task to determine whether the sum of the present values of those same cash payments is also equivalent to the value of the claim.
In order to calculate the present value of deferred cash payments, it is necessary to estimate and apply an interest rate (typically referred to as a “discount rate” by valuation analysts) that properly reflects the economic characteristics (e.g., investment risk, duration, time value of money, etc.) of the deferred cash payments during their expected time horizon. In cramdown situations, this interest rate should be estimated – to the extent possible – using market evidence of relevant interest rates and investment rates of return on comparable assets or businesses. For the purposes of this article, I refer to this interest rate as the “cramdown rate.”
When the cramdown rate has been properly estimated and applied, the value of the deferred cash payments will be equivalent to the value of the claim. The Code provides no specific guidance regarding how the cramdown rate should be determined. Over the years, bankruptcy courts have accepted a variety of methods for determining cramdown rates and this disparate treatment has resulted in more than a fair amount of controversy and litigation.
In 2004, the Supreme Court addressed the cramdown rate issue for chapter 13 matters in Till v. SCS Credit Corp.2 and adopted the so-called “formula approach.” It is important to remember that Till was a chapter 13 matter involving a consumer loan of $4,895 secured by a used automobile with a market value of $4,000. When writing the Till opinion, Justice Stevens stated the following:
To qualify for court approval under chapter 13 of the Bankruptcy Code, an individual debtor’s proposed debt adjustment plan must accommodate each allowed, secured creditor in one of three ways: 1) by obtaining the creditor’s acceptance of the plan; 2) by surrendering the property securing the claim; or 3) by providing the creditor both a lien securing the claim and a promise of future property distributions (such as deferred cash payments) whose total “value, as of the effective date of the plan…is not less than the allowed amount of such claim.”
When using the formula approach as described in Till (the “Till Method”), the analyst starts with the prime rate that lenders typically charge on consumer-type loans to creditworthy customers and then adjusts this rate for certain factors including, but not limited to, the circumstances of the debtor, the nature of the proposed note, and the duration and feasibility of the reorganization plan. This cramdown rate is then proposed as the appropriate interest rate for the newly issued note to the creditor. When the cramdown rate is consistent with appropriate market interest rates for the subject assets, the value of the deferred cash payments will be equivalent to the value of the claim.
In Till, it appears the Supreme Court was attempting to establish an efficient and cost-effective means to estimate the cramdown rate for chapter 13 matters so that creditors, debtors, and bankruptcy courts could avoid expensive and time-consuming evidentiary hearings over this issue. Given the financial limitations and asset characteristics of many chapter 13 matters, it appears the Court felt that lengthy evidentiary hearings on cramdown rates are financially questionable and potentially not a good use of time for the bankruptcy court.
In Till, the scale of adjustments to the prime rate was not under consideration but the Supreme Court, citing In re Valenti3, made note that “other courts have generally approved adjustments of 1% to 3%.” (Similar to Till, Valenti involved a chapter 13 matter and a used automobile with an estimated value of $6,700.) In the wake of the Till decision, certain analysts and attorneys became convinced that the Supreme Court had determined that the appropriate adjustment to the prime rate in the formula approach is somewhere between 1% and 3%. A careful reading of Till indicates that the Court made no such pronouncement and further stated that bankruptcy courts should “select a rate high enough to compensate the creditor for its risk but not so high as to doom the plan.”
Fortunately or unfortunately, depending on your point of view, use of the Till Method has expanded beyond chapter 13 matters and is now considered when calculating cramdown rates under §1129(b). Consequently, we now observe testifying financial experts adjusting the prime rate by 1% to 3% in order to establish the cramdown rate in chapter 11 matters. As will be discussed, it is important that bankruptcy attorneys, judges and financial experts providing testimony on cramdown rates understand the elements and application of the Till Method in order to assess whether it is appropriately applied under §1129(b).
In order to assess the Till Method appropriateness, it is important to understand the nature of the prime rate used in the analysis. The prime rate is a commonly used benchmark for short-term and medium-term adjustable-rate loans such as home equity lines of credit and credit cards. This fact can have material consequences when estimating cramdown rates for chapter 11 matters. For example, adjustable rate loans are not subject to the same level of interest rate risk (generally measured as the duration of the note) as cramdown notes, which are typically fixed interest rate notes. Since interest rate risk can have a material impact on the level of market interest rates, the prime rate may materially understate the appropriate interest rate to use in a cramdown situation. Also, the prime rate is typically used to set interest rates on loans to well capitalized individuals with excellent credit ratings. This condition is not likely to be the case with a debtor who is already in bankruptcy proceedings with a reorganization plan that may involve loan-to-value ratios on the subject assets that approach 100%. In addition, the prime rate may have little relevance or application to the typical financial structure of chapter 11 assets.
To demonstrate the potential issues, let us assume we have a single asset real estate entity that owns a multi-story commercial office building in New York City. The entity is currently in chapter 11 proceedings and the debtors have put forth a plan of reorganization that the creditor has objected to because of the proposed cramdown rate. Accordingly, under §1129(b), the bankruptcy court will consider whether the deferred cash payments have both a nominal value and a present value equal to or greater than the allowed amount of the subject claim. In order to do this, the bankruptcy court will likely address the following: 1) value of the property, 2) proposed deferred cash payments, 3) duration of the proposed note, 4) feasibility of the plan, and 5) appropriate cramdown rate.
For simplicity of demonstration, let us assume that the debtor acquired the subject property five years earlier for $150 million at a loan-to-value ratio of 80%. Consequently, the principal value of the loan at origination was $120 million. During the intervening period, the debtor paid $30 million in principal payments leaving the current claim on the property at $90 million. A real estate appraiser recently appraised the market value of the property at $90 million. Consequently, the claim is fully secured by the value of the property and the reorganization plan represents a 100% loan-to-value ratio. The plan proposes a 10-year fully amortizing note at a cramdown rate of 4.75% based on a 1.5% adjustment to the current prime rate of 3.25%. The nominal value of the deferred cash payments of the plan is equal to $115 million (annual payments of $11.5 million for 10 years). Obviously, the nominal amount of the deferred cash payments exceeds the value of the claim of $90 million. Consequently, this element of the plan is compliant with the first requirement of 1129(b) in that the nominal value of the deferred cash payments must be equal to or greater than the value of the claim. The question then becomes, is the present value of the deferred cash payments equal to or greater than the value of the claim and therefore in compliance with the second requirement of 1129(b).
If appropriate market interest rates are consistent with the cramdown rate of 4.75%, the present value of the deferred cash payments will be equivalent to the value of the claim at $90 million. In other words, if the 4.75% cramdown rate is also used to discount the future cash payments of $11.5 million, the sum of the present values of those future cash payments will be equal to the value of the claim. However, if appropriate market interest rates exceed the cramdown rate, the present value of the deferred cash payments will be less than the value of the claim and the second requirement of §1129(b) will not have been met.
In order to assess whether the cramdown rate is appropriate, it is necessary to analyze market interest rates and investment rates of return for similar properties. For the purpose of this example, let us assume that current market conditions indicate that a 10-year fully amortizing loan on a commercial office building in New York City would require a 70% loan-to-value ratio with a debt interest rate based on the 10-Year U.S. Treasury rate adjusted by a 4% premium. Mezzanine debt is available for the 20% of the financing structure that lies between a 70% and 90% loan-to-value ratio. The market interest rate for mezzanine debt is based on an adjustable rate set at 8% above the prime rate. In addition, the expected rate of return on equity for similar properties is 14%. Given these market conditions, how should the bankruptcy court determine the appropriate cramdown rate?
In this example, the first step is to add the 4% premium to the 10-Year Treasury rate of 2%. The Treasury rate is used in this example rather than the prime rate because the interest rate premium of 4% is based on empirical studies that compare interest rates on actual loans to the 10-Year Treasury rate. This calculated 6% interest rate is then multiplied by the 70% loan-to-value ratio to calculate a weighted interest rate of 4.2%. The 70% loan-to-value ratio is used in this example because the empirical studies indicate that lenders set interest rates on similar properties based on a 70% loan-to-value ratio. Presumably, interest rates would be higher if the loan-to-value ratio exceeded the 70% threshold.
The second step in this example is to use the mezzanine rate for the 20% portion of the financing structure that lies between a 70% and 90% loan-to-value ratio. In this situation, market conditions indicate that the appropriate interest rate is set by adding an 8% premium to the prime rate of 3.25% for a total rate of 11.25%. The mezzanine rate is an adjustable rate that will float with the prime rate. Consequently, there is little interest rate risk associated with the mezzanine rate. This rate may disadvantage the creditor in a cramdown situation due to the fact that the creditor is required to accept a fixed cramdown rate over the 10-year horizon based on a 100% loan-to-value ratio. Fixed interest rate notes are subject to interest rate risk and generally require higher interest rates than adjustable rate notes. On the other hand, mezzanine capital is typically in a subordinate position and does not have the ordinary protections afforded to senior secured debt. Given the fact that this cramdown situation involves a 100% loan-to-value ratio, the entire debt balance is in a senior secured position. In this situation, the increased risk associated with the fixed cramdown rate may be offset by the reduced risk associated with the senior secured debt position. Therefore, the mezzanine debt rate may be the appropriate rate to use for this component of the financing structure. If this were the case, the 11.25% mezzanine rate would be multiplied by 20% to calculate a weighted interest rate of 2.25%.
The third step in this example is to include an analysis of the rate of return on equity of 14% for a property of this type. The rate of return on equity is an observed rate based on empirical studies of historical equity cash flow performance of similar properties. Consequently, this rate is subject to future volatility based on market conditions and risk factors. Therefore, the observed rate of return on equity inherently reflects a premium for investment return volatility that may occur in the future. Presumably, if the future rate of return on equity were fixed, the market would accept a lower rate of return. In addition, equity capital is typically subordinate to senior secured debt and mezzanine financing, which increases investment risk and is thus priced into the equity rate of return. Presumably, the market would accept a lower rate of return if equity were on an equal footing with senior secured debt regarding liquidation preference. In our example, the cramdown rate is fixed in nature and applies to 100% of the financing structure. Consequently, there is no subordinate position for any portion of the financing structure. Therefore, the debtor may be disadvantaged if required to pay the full market equity rate of return due to the fact that the cramdown rate is fixed in nature and the proposed plan is based on a 100% loan-to-value ratio. On the other hand, the equity rate of return is typically higher than interest rates on debt capital because it is the equity portion of the financing structure that disappears first when the subject property declines in value. This economic phenomenon is not cured by a fixed cramdown rate or a senior secured debt position. In our example, these factors may tend to counterbalance each other and the equity rate of return may be the appropriate rate to use for the 10% portion of the financing structure that lies between the 90% and 100% loan-to-value ratio. If this were the case, the rate of return on equity of 14% would be multiplied by 10% to calculate a weighted interest rate of 1.4%.
The final step in this example is to sum the three weighted interest rate components to calculate the appropriate cramdown rate of 7.85%. If the appropriate cramdown rate of 7.85% is applied to the deferred cash payments that were calculated using the proposed 4.75% cramdown rate, the value of the deferred cash payments declines from $90 million to $78 million. Consequently, the 4.75% cramdown rate fails the second test of §1129(b) and the proposed plan may not be confirmable. If the cramdown rate is reset to 7.85% and the deferred cash payments are recalibrated accordingly in a newly proposed plan, the value of the deferred cash payments would then be equivalent to the value of the claim and the proposed plan may then be confirmable.
In general, establishing a market-based cramdown rate in a chapter 11 matter is a more complex undertaking than simply applying somewhat qualitative adjustments to the prime rate as suggested by the Till Method. While the Till Method may be a useful framework to consider, especially in the absence of market-based empirical data, the inherent characteristics of the method may make its application in a chapter 11 matter problematic. Therefore, in situations where relevant market information related to specific interest rates and investment rates of return are available, the financial expert may want to consider alternatives to the Till Method.
Daniel R. Van Vleet, ASA
1 A version of this article first appeared in the March 2012 edition of the American Bankruptcy Institute Journal.
2 Till v. SCS Credit Corp., 541 US 465, (2004)
3 In re Valenti, 105 F. 3d 55, 64 (CA2)