On March 1, 2013, the Court of Appeals for the Fifth Circuit held in In re Texas Grand Prairie Hotel Realty ("Texas Hotel") that a bankruptcy court did not err when it confirmed a "cramdown" chapter 11 plan that proposed to pay a dissenting secured lender interest calculated at the national prime rate plus 1.75%, which resulted in an effective annual rate of 5%.1 Notably, the lender in Texas Hotel stipulated that the "prime plus" formula for cramdown interest established by a plurality of the Supreme Court in the chapter 13 case Till v. SCS Credit Corp. would apply.2 As a result, the lender did not argue that the right methodology to calculate its interest rate should be a "market rate" approach in chapter 11 cases where an "efficient market" for exit financing exists (as alluded to as proper in Footnote 14 of the Till decision). Based on the lender's stated agreement to the "prime plus" methodology, the Fifth Circuit concluded that the bankruptcy court committed no reversible error even though, under the Till methodology, the risk adjustment to the prime rate established by Till is nothing more than a "smallish number picked out of a hat."3
While the Fifth Circuit's decision may be perceived as further endorsement of Till's "prime plus" formula, that endorsement is qualified by the lender's decision to stipulate to that formula in lieu of pursuing a "market rate" approach based on Footnote 14 of Till. Secured lenders may be relieved to know that nothing in the Texas Hotel decision precludes them from arguing for a "market rate" approach in future chapter 11 cases, if an efficient market for such loans exists. Indeed, the Fifth Circuit reaffirmed its prior rulings that bankruptcy courts enjoy "some latitude" in determining the appropriate method for calculating a cramdown interest rate in chapter 11 cases.4 Texas Hotel, therefore, cautions secured lenders that if they accede in a chapter 11 case to the "prime plus" formula established by the Supreme Court in Till, they may be forced to accept a below-market rate. However, the court was clear that in the absence of an efficient market, Till would govern in bankruptcy cases filed in the Fifth Circuit—which is comprised of Texas, Louisiana and Mississippi.
II. Factual Background
In 2007, Texas Grand Prairie Hotel Realty, Texas Austin Hotel Realty, Texas Houston Hotel Realty, and Texas San Antonio Hotel Realty (the "Debtors") borrowed $49 million from the lender (the "Lender") to purchase four hotels in Texas. The loan was secured by the hotel properties and substantially all of the Debtors' other assets.
In 2009, the Debtors were unable to make required payments to the Lender and commenced chapter 11 cases in the Northern District of Texas Bankruptcy Court. During the chapter 11 cases, the Debtors proposed a plan of reorganization (the "Plan") that valued the Lender's secured claim at approximately $39 million. The Plan further proposed to pay the Lender's secured claim over a period of ten years, with interest accruing at 5%, a rate that was 1.75% above the prime lending rate in effect at the time the Bankruptcy Court considered confirmation of the Plan.
Notably, the parties agreed that the rate of interest used in the Plan should be calculated by adding some "plus factor"—or risk adjustment—to the prime rate based on Till. Both parties also agreed that the applicable prime rate was 3.25%. The Lender rejected the Plan, however, on the basis that the Debtors' 1.75% risk adjustment to the prime rate was too low. Therefore, to confirm the chapter 11 plan over the Lender's dissent, the Debtors' needed to satisfy the Bankruptcy Code's "cramdown" provisions in section 1129(b).
III. Legal Background
Section 1129(b)(2)(A)(i)(II) of the Bankruptcy Code provides that for a Bankruptcy Court to confirm a plan over a secured creditor's objection if the plan proposes to pay the creditor deferred payments, the total of the payments discounted to present value after applying an appropriate interest rate (the "Cramdown Rate") must equal the allowed amount of the secured claim.5 Although section 1129(b) requires a Bankruptcy Court to calculate the present value of the secured claim, it does not specify the method or rate that should be used for that calculation. Rather, the Bankruptcy Code provides that the provisions of the chapter 11 plan must be "fair and equitable" and not "discriminate unfairly."6
In Till v. SCS Credit Corp., the Supreme Court opined about the method to calculate the appropriate Cramdown Rate in the context of a chapter 13 case.7 In Till, the Court evaluated a variety of methods and, in a plurality opinion, determined that a "prime-plus" or "formula-rate" method was the appropriate means to calculate the Cramdown Rate under chapter 13.8 Using this approach, the baseline for the Cramdown Rate is set at the national prime interest rate with adjustments to account for the risk of nonpayment posed by dealing with a party that is bankrupt.9 The Court did not decide the proper scale for the risk adjustment but observed that other courts have approved risk adjustments of between 1% and 3%.10
Notably, the Till decision did not specifically apply to chapter 11 cases, though the relevant statutory language applicable in chapter 13 cases like Till is similar to the statutory language applicable in chapter 11 cases. In what has become the oft-cited "Footnote 14" of the Till decision, the Court observed that "there is no free market of willing cramdown lenders" in the chapter 13 context.11 However, the availability of debtor-in-possession financing caused the Court to state that "the same is not true in the Chapter 11 context."12 Accordingly, the Court noted that "when picking a cramdown rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce."13 Though, for a variety of reasons, it is difficult to determine how relevant this footnote is to a chapter 11 case.
Following Till, courts have frequently faced the issue as to whether and how to apply Till's rationale in cases under chapter 11 with varying results. For example, in In re American HomePatient—which is the only other decision by a Circuit Court to have considered the application of Till in a chapter 11 cramdown context—the Sixth Circuit declined "to blindly adopt Till's endorsement of the formula approach" in a chapter 11 case.14 The Sixth Circuit referenced Footnote 14 as providing a guiding principle to consider what rate an efficient market would produce if such a market existed. The Sixth Circuit ultimately affirmed the bankruptcy court's decision to fix the Cramdown Rate at the rate for a six-year Treasury Bill, plus 350 basis points, or an effective annual rate of 6.785%. The Sixth Circuit ruled that this rate was appropriate under the circumstances in light of the bankruptcy court's determination that an "efficient market" existed.15
Thus, the Sixth Circuit in American HomePatient held that bankruptcy courts should apply a two-step analysis to determine the Cramdown Rate in a chapter 11 case. First, a court should assess whether an efficient market exists; and, if it does, the court should apply the market rate. Second, if no efficient market exists, the court should apply the prime-plus formula articulated in Till.16 Since the Sixth Circuit's ruling, a majority of courts have reached similar conclusions regarding Till's application in the chapter 11 context and will apply a two-step analysis that first looks to whether an efficient market exists before applying Till's prime-plus formula.17
IV. Proceedings in the Bankruptcy Court and District Court
The confirmation hearing in Texas Hotel boiled down to a battle of the experts over the appropriate Cramdown Rate under section 1129(b). The Debtors' expert testified, among other things, that the Lender's collateral was stable or appreciating in value, that the properties were well managed and in good condition, and that the Debtors' Plan was feasible. The Debtors' expert concluded that the Debtors' risk of default was slightly "left of the middle of the risk scale," referring to the 1-3% risk adjustment that the Till decision said was typical.18 Consequently, the expert reasoned that a 1.75% risk adjustment was reasonable. This, plus the prime rate, amounted to an effective Cramdown Rate of 5% annual interest.
Although the Lender's expert agreed with the Debtors' expert regarding the quality of the Debtors' business and properties, he attempted to introduce a "market influenced" analysis within the Till framework.19 To that end, the Lender's expert opined that the Cramdown Rate should be the prime rate adjusted by the rate of interest the market would charge for a loan of this type. In his view, a single loan would have been unattainable in these circumstances. As a result, he opined that if the Debtors sought financing similar to the note being offered to the Lenders in the Plan, the market would likely offer financing in three tranches, which would yield a weighted-average interest rate of 9.3%. The Lender's expert used this "blended" rate as his starting point (rather than the prime rate) and made adjustments he thought were required by the Till analysis, including a downward adjustment to account for the high quality of the Debtors' business and assets, and an upward adjustment to account for the "tight feasibility" of the Plan.20 Ultimately, he concluded that the appropriate Cramdown Rate was 8.8%.
The Bankruptcy Court concluded that the Debtors' expert properly interpreted and applied Till. In doing so, the Bankruptcy Court found that the Lender's expert offered opinions that were inconsistent with Till because, rather than adjusting the national prime rate, he was actually determining "the portion of a loan [that] would be financeable, and then . . . work[ed] from there."21 In the Bankruptcy Court's view, there was no support for this analysis in Till and, in fact, it was much closer to the "forced loan" approach that the Till plurality rejected.22
Accordingly, the Bankruptcy Court confirmed the Plan over the Lender's objection and applied a 5% Cramdown Rate. That decision was appealed to the District Court for the Northern District of Texas, which affirmed. The Lenders subsequently appealed the decision to the Fifth Circuit.
V. The Fifth Circuit's Decision
After quickly considering, and rejecting, (1) the Debtors' argument that the appeal should be dismissed as equitably moot and (2) an evidentiary objection by the Lender, the Fifth Circuit turned to the merits of the Cramdown Rate applied by the Bankruptcy Court.
As an initial matter, the Fifth Circuit considered the Lender's contention that the decision below should be reviewed de novo rather than for clear error. In the Lender's view, the Bankruptcy Court's methodology for calculating the Cramdown Rate was a question of law because "Till is 'controlling authority' that requires bankruptcy courts to apply the prime-plus formula to calculate the Chapter 11 cramdown rate"23 The Fifth Circuit rejected this argument and, in doing so, reaffirmed a prior holding that "'[declined] to establish a particular formula for determining an appropriate cramdown interest rate' under Chapter 11. . . ."24 In reaffirming this holding, the Fifth Circuit reiterated that it would be imprudent to "tie the hands of lower courts as they make the factual determination involved in establishing the appropriate interest rate."25 The Fifth Circuit further reasoned that Till failed to compel a different result because it was distinguishable as a case under chapter 13 of the Bankruptcy Code and was of limited precedential value even in chapter 13 cases because of the splintered opinion that was reached by the Supreme Court.26 In other words, the Fifth Circuit rejected the automatic application of Till's presumptive "prime-plus" approach to all chapter 11 cases.
The Fifth Circuit then turned to whether the Bankruptcy Court committed clear error by adopting a 5% Cramdown Rate under section 1129(b) of the Bankruptcy Code. The court noted that the parties had stipulated to using Till's "prime plus" methodology. Although the court acknowledged that the "prime plus" methodology was motivated primarily by "simplicity and objectivity"—and risks systematically undercompensating creditors by applying a risk adjustment that is nothing more than a "smallish number picked out of a hat"—the court found that courts applying the Till formula in chapter 11 have "generally hewed to the plurality's suggested range of 1% to 3%."27 Moreover, the Fifth Circuit agreed that the Debtors' expert engaged in an "uncontroversial application of the Till plurality's formula method."28 Indeed, the court found that the proffered risk adjustment fell squarely within the range of adjustments other bankruptcy courts have assessed in similar cases.29
The Fifth Circuit was unpersuaded by the Lender's arguments that the 5% Cramdown Rate produced an "absurd result" because the market was charging rates in excess of 5% on smaller loans with better collateral. In rejecting the Lender's arguments, the court noted that this "absurd result" was the natural consequence of the "prime plus" method the Lender stipulated would apply in this case. The Fifth Circuit noted that the Lender had made no attempt in the proceedings below to argue in favor of a market rate in reliance on Footnote 14 of Till, "which suggests that a 'market rate' approach should apply in Chapter 11 cases where 'efficient markets' for exit financing exist."30 Moreover, the court noted that the evidence introduced by the Lender would not satisfy Footnote 14's requirement for an "efficient market" because (a) the multi-tranche debt/equity financing analysis of the market rate used by the Lender's expert to calculate his Cramdown Rate indicated that an efficient market for this financing did not exist, and (b) the expert admitted that no debt financing could be obtained for the entire amount of the loans at issue.31
Importantly, the lenders in American HomePatient introduced similar evidence that the market would require tranches of senior debt, mezzanine debt, and equity to support their arguments for a higher Cramdown Rate. As in Texas Home, those arguments were unsuccessful because the Sixth Circuit concluded that a composite rate deduced from hypothetical tranches of new financing is irrelevant where no new funds are being advanced.32 Thus, both Circuit Courts that have been presented with lender arguments based on a composite rate derived from multi-tranche debt/equity financing have rejected those arguments.
At bottom, the Fifth Circuit concluded that the Cramdown Rate adopted by the Bankruptcy Court was consistent with the "prime plus" methodology adopted in Till and with the vast majority of decisions that have applied Till in chapter 11 cases. Further, and "perhaps most importantly," the court noted that the "prime plus" approach was accepted as governing by the Debtors and the Lender. For these reasons, the Fifth Circuit found that the Bankruptcy Court did not commit clear error and the decision was affirmed. Nevertheless, the Fifth Circuit stated that it was not suggesting that "the prime-plus formula is the only—or even the optimal—method for calculating the Chapter 11 cramdown rate."33
The Fifth Circuit's decision in Texas Hotel sends a clear warning to secured creditors seeking to object to a proposed Cramdown Rate: don't limit yourself to the "prime-plus" formula from Till or you will likely be forced to accept an interest rate calculated by taking the national prime rate and adding a "smallish number picked out of hat." Fortunately for secured lenders, Texas Hotel also sends a clear message that Till's presumptive "prime-plus" approach is neither the only—nor necessarily the optimal—method for determining the Cramdown Rate in chapter 11 cases. Based on the Fifth Circuit's invitation to use other methodologies, secured creditors should consider arguing for application of a market-based rate, especially in the context of corporate restructurings where the need for simplicity (which drove the Supreme Court's decision in the Till chapter 13 case) is arguably less compelling than the need for just compensation. However—and perhaps this is the clearest "take-away" from the only two Circuit Court (the Fifth and Sixth Circuits) decisions on point—the argument that the Cramdown Rate should be high because equity financing would be required in the marketplace for a loan of this size likely will not prevail because both Circuit Courts have found that the need to resort to such financing is indicative of the lack of an efficient market for the type of financing at issue.
Although Till is now more than eight years old, the Texas Hotel decision provides much-needed guidance to bankruptcy practitioners and judges on the precise contours of that seminal Supreme Court case. When Till was first decided, a number of bankruptcy pundits predicted an avalanche of chapter 11 cramdown cases using the Till precedent to restructure secured debt at absurdly low rates.
One would have thought that Till would be especially useful in the first-lien and second-lien cases that became so prevalent in the past six years, with the often undersecured second-lien lenders seeking to convert their debt to equity as part of a strategy to cramdown the first-lien lenders with a low "prime-plus" rate. But these predictions never materialized for reasons that have nothing to do with Till. Perhaps the frequency of cross-ownership between first- and second-lien debt issued by the same debtor made this "scorched-earth" approach less appealing to the holders of that debt. Moreover, this scorched-earth approach only works if the debtor—which typically controls the content of the plan of reorganization through exclusivity—has an appetite for a highly contested confirmation process. Most of them don't, choosing instead to adopt a strategy that facilitates the quickest and least expensive exit from chapter 11. And conventional wisdom remains that it is easier to confirm a plan with the support of the most senior class rather than the support of a junior class. Only time will tell whether the Texas Hotel decision encourages new contested confirmation proceedings by clarifying Till.
1 See Wells Fargo Bank Nat'l Ass'n v. Tex. Grand Prairie Hotel Realty, L.L.C. (In re Grand Prairie Hotel Realty, L.L.C.), No. 11-11109, 2013 U.S. App. LEXIS 4514, at *33 (5th Cir. March 1, 2013).
2 541 U.S. 465, 479-81 (2004).
3 Texas Hotel, 2013 U.S. App. LEXIS 4514, at *29-*30.
4 Id. at *13-*14, n.32.
5 See 11 U.S.C. § 1129(b)(2)(A)(i)(II).
6 Id. at § 1129(b)(1).
7 541 U.S. 465.
8 Id. at 471-80.
9 Id. at 478-80.
10 Id. at 480.
11 Id. at 476 n.14.
14 420 F.3d 559, 568 (6th Cir. 2005).
15 See id. at 566.
16 Id. at 568.
17 Gary W. Marsh & Matthew M. Weiss, Chapter 11 Interest Rates After Till, 84 AM. BANKR. L.J. 209, 213 (2010) (surveying cases); see also In re 20 Bayard Views, LLC, 445 B.R. 83, 107-09 (Bankr. E.D.N.Y. 2011) (same); In re Nw. Timberline Enters. Inc., 348 B.R. 412, 432 (Bankr. N.D. Tex. 2006) ("[R]ather than mechanically apply the formula approach in Chapter 11, one might have plenty of evidence of what an available market rate is for a similar loan to the Chapter 11 debtor at issue, since there is a universe of lenders who regularly make exit loans to Chapter 11 debtors."); In re Prussia Assocs., 322 B.R. 572, 588-89 (Bankr. E.D. Pa. 2005) ("The Supreme Court's dicta implies that the Bankruptcy Court in such circumstances (i.e., efficient markets) should exercise discretion in evaluating an appropriate cramdown interest rate by considering the availability of market financing.").
18 Texas Hotel, 2013 U.S. App. LEXIS 4514, at *23.
19 Id. at *24-*25.
21 Id. at *26.
23 Id. at *11-*12.
24 Id. at *12 (quoting In re T-H New Orleans Ltd. P'ship, 116 F.3d 790, 800 (5th Cir. 1997)).
26 Id. at *13-*14.
27 Id. at *18-*20 (citations omitted).
28 Id. at *27.
30 Id. at *30.
31 Id. at *32-*33.
32 In re American HomePatient, 420 F.3d at 568-69.
33 Texas Hotel, 2013 U.S. App. LEXIS 4514, at *33.
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