by Todd Garan, Esq.

AldridgePite, LLP *

USFN Member: (AK, CA, FL, GA, HI, ID, NY, OR, UT, WA)

For the third time this year, on September 21, the Federal Reserve increased the federal prime rate by three-quarters of a percent to 6.25%.^[1]  Further, the Federal Reserve signaled additional increases are likely until inflation subsides. With each rate increase, an opportunity arises to seek a higher interest rate in Chapter 11 and Chapter 13 Bankruptcy Plans for secured creditors faced with a potential “cramdown.” This article will focus on the impact of rate increases on the formula prescribed by In re Till,^[2] addressing risk factors posed by the debtor and/or the collateral itself, and case strategy for obtaining a higher interest rate in bankruptcy cases as the Federal Reserve continues to raise the prime rate.

I.                The Till Formula and why Bankruptcy Courts Rely Upon it?

In the Chapter 11 context, §1129(b)(2)(A)(i)(II) requires a debtor's plan to provide the secured creditor with “deferred payments” having a "present value" in the full amount of the creditor's secured claim.^[3]   The same rationale applies to secured claims in the Chapter 13 context.^[4]  See, 11 U.S.C. § 1325(a)(5)(B)(ii).

Given the applicability of the present value analysis to secured claims under both Chapter 11 and Chapter 13 plans of reorganization, most courts’ interest rate methodology starts with a review of the Supreme Court's plurality decision in Till v. SCS Credit Corp., 541 U.S. 465 (2004). In Till, the Supreme Court adopted a two-part “prime-plus” formula for determining the proper interest rate a debtor should pay on a creditor’s secured claim that complies with the “cramdown” provisions of the Bankruptcy Code Till v. SCS Credit Corp., 541 U.S. 465, (2004). The Supreme Court in Till stated that:

“the approach begins by looking to the national prime rate, reported daily in the press, which reflects 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. Because bankrupt debtors typically pose a greater risk of nonpayment than solvent commercial borrowers, the approach then requires a bankruptcy court to adjust the prime rate accordingly. The appropriate size of that risk adjustment depends, of course, on such factors as the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan.”^[5]

In proposing this method, the Court in Till was motivated primarily by what it viewed as the method’s simplicity and objectivity.^[6] First, the method minimizes the need for costly evidentiary hearings, as the prime rate is reported daily, and as “many of the factors relevant to the [risk] adjustment fall squarely within the bankruptcy court’s area of expertise.”^[7] Second, the approach varies only in “the state of financial markets, the circumstances of the bankruptcy estate, and the characteristics of the loan” instead of inquiring into a particular creditor’s cost of funds or prior contractual relations with the debtor.^[8]  Third, while courts often acknowledge that Till’s infamous Footnote 14 appeared to endorse a “market rate” approach for Chapter 11s if an “efficient market” for a loan substantially identical to the cramdown loan exists, courts almost invariably conclude that such markets are lacking.^[9]

Thus, the prime-plus formula is particularly helpful in Chapter 13 cases, but also in individual Chapter 11 cases, where the majority of the loans in question are residential, including 1 to 4 unit properties. A creditor can utilize what evidence is readily available in the bankruptcy case to help bolster, or further elaborate on the risk factors to adjust the prime rate upwards to appropriately compensate a creditor for the risk associated with the debtor’s proposed Chapter 11 or Chapter 13 Plan of reorganization, serving to minimize costly experts, or lengthy evidentiary hearings. This is something all parties can appreciate, given the forum.

II.             Who Has The Burden of Proof?

In discussing the “prime-plus” interest rate calculation, the Till Court went on to explain that in starting from a concededly low estimate and adjusting upward, the evidentiary burden is placed squarely on the creditors, who are likely to have readier access to any information absent from the debtor's filing.^[10] Thus, it is up to the creditor to argue how and why the proposed interest rate should be increased above the prime rate for any additional risks.

III.           Determining the Federal Prime Rate

Fortunately, ascertaining the federal prime rate for purposes of a bankruptcy proceeding is straightforward and cost effective as this information is readily available through well-known public sources, including the internet. As a result, the federal prime rate may be subject to judicial notice,and is capable of accurate and ready determination by resort to reliable sources.^[11]  As of September 21, 2022, the Federal Prime rate was 6.25%.^[12] The chart below outlines the federal prime rate adjustments since March 2020:

Notably, because the prime rate is readily available, a creditor can quickly review a debtor’s Chapter 11 or Chapter 13 Plan of reorganization to determine if the cramdown rate is below the current federal prime rate. If so, the plan is likely unconfirmable, and a creditor may proceed with a plan objection without a full analysis of the debtor’s perceived “risk factors.”  However, a creditor seeking an interest rate above the prime rate will need to proceed with the “plus” portion of the Till formula through an examination of “risk factors.”

IV.           Evidence Available in the Bankruptcy Case to Assist the Risk Factor Analysis

As discussed above, the burden of proof for adjusting the proposed cramdown rate lies with the creditor. In other words, once the appropriate prime rate is determined, the burden falls on the creditor to convince the court risk factors warrant a rate adjustment above the prime rate. The key is to use the most cost effective means available to help build up the risk factors and achieve a more fair and appropriate interest rate for the secured claim. Creditors may utilize what evidence is already available in the bankruptcy case to avoid the need for additional expert testimony and attendant costs. So, where can a creditor find this information?

A.        Debtors’ Schedules. First, a creditor may examine any risks outlined in the Debtor’s Schedules and Statements. This seems obvious, but it is equally important to understand a debtor’s bankruptcy schedules and statements are executed under oath and can be treated as admissions of fact of which a court can also take judicial notice.^[13] As such, the schedules provide useful information with an evidentiary basis about the debtor, debtor’s operating history, and information to test the veracity of debtor’s good faith intent and financial projections.

B.        Monthly Operating Reports. Second, monthly operating reports are unique to Chapter 11 Cases, including in the Subchapter V context. The filing of monthly operating reports are mandatory pursuant to the Federal Rules of Bankruptcy Procedure, associated with U.S. Trustee’s guidelines, and are often adopted through local bankruptcy court rules as well.^[14]  Operating reports are very helpful in the risk assessment process because the reports readily allow a creditor and court to view the actual and historical income and expense information for a property, including, but not limited to, property taxes, any debt payments, insurance, homeowners’ association dues, property management fees, and maintenance and repair costs over the course of the case. 

C.        Debtor’s Financial Projections. Third, debtors are often required to provide financial projections in support of a plan of reorganization, particularly in a Chapter 11, to support how a debtor will make payments under the plan to prove feasibility, a required element of plan confirmation.^[15] These projections should, though do not always, provide income and expense information on a property-by-property basis, in addition to a debtor’s personal income and expenses, and payments proposed under the plan of reorganization.

            The above information is within the “four corners” of the debtor’s bankruptcy case to provide a creditor with admissible evidence to support the risk factors below and build on the federal prime rate to appropriately compensate a creditor for risks under a proposed plan of reorganization.

V.              The Risk Factors and Putting it Altogether

In addition to the information gathered from the debtor’s bankruptcy filings, additional risk factors may be evident based on: (i) the history of the debtor; (ii) the nature of the debtor’s proposed restructuring; or (iii) the collateral itself. Generally, the appropriate size of the risk adjustment depends upon such factors as the circumstances of the debtor’s estate, the nature of the security (collateral), and the duration and feasibility of the proposed reorganization plan.  These factors may be further refined and/or expanded on by considering: (a) the quality of debtor's management; (b) the commitment of the debtor's owners; (c) the health and future prospects of the debtor's business; (d) the quality of the lender's collateral; and (e) the feasibility and duration of the plan.^[16] However, in many ways, these are merely factual refinements within the three factors initially discussed by the Till Court.

A.        The Debtor’s Pre-Bankruptcy History.  Generally, information about the debtor or debtor’s history may not factor heavily in terms of an upward risk adjustment since it assumes the debtor struggled financially to end up in bankruptcy. However, there are certain instances where evidence should be referenced to make it more of a factor or less neutral to the court. A debtor is expected to manage and perform under the proposed plan of reorganization, after all, so what has gone on before should not be completely ignored and could serve to test the veracity or even the good faith of debtor’s proposed plan of reorganization.

For example, is the debtor a repeat filer, or does the debtor have a history of filing for bankruptcy protection every few years, or defaulting on previously confirmed plans? In essence, is there a greater likelihood debtor may drag creditors through a bankruptcy case seeking the benefits of a modification, but fail to follow through in completing a plan of reorganization to term or discharge?  Accordingly, the debtor’s pre-petition history could provide grounds for an upward risk adjustment.

Another red flag involves a newly formed entity with no operating history or substantive assets beyond the real property in question versus an ongoing business with a decent operating history, cash reserves, or other substantive assets. The former is riskier because the debtor is a self-contained unit with very limited business prospects absent the real property rental income, and thus, warranting a risk adjustment upwards in the court’s risk analysis.

Thus, creditors and the court should not ignore the debtor’s pre-petition history and debtor’s historical management of the assets as the perspective can provide some argument for an upward risk adjustment.

            B.        The Nature of the Debtor’s Proposed Operations.  A creditor should examine the debtor’s plan of reorganization itself, and how all the assets and income/expense projections will be treated post-confirmation. In assessing risk, it is important to understand whether the debtor’s assets have sufficient equity to be liquidated in a time of disruption. For instance, if the debtor proposes to “cramdown” all loans to the fair market value of each asset at plan confirmation, thereby creating a portfolio of 100% loan-to-value debt, how will the debtor handle a downturn post-confirmation?  While it is true a debtor may benefit from cramdowns over time, if there is a disruption shortly after confirmation, a debtor may find it difficult to refinance or even sell certain real property that is in default with no equity. An upward market may provide some relief, while a flat or falling market would obviously pose challenges for the reorganized debtor. Thus, it is important to examine the risks of the debtor’s proposed plan of reorganization itself.

Further, it is crucial to thoroughly review and scrutinize a debtor’s financial projections and overall substantive cash flow under the plan, including the net cash flow of each real property asset. Are there substantive cash reserves available after the payment of administrative claims following confirmation of the plan? Is the debtor expected to operate at a negative cash flow for any substantive period post-confirmation, or does it appear any of the real property assets will fail to generate sufficient net income after expenses? Are there expenses that are patently missing from the debtor’s projections, or are those expenses overly simplistic?  Indeed, while the overall plan may appear feasible on its face, it may be that certain real property assets are in fact problematic, requiring debtor to compensate by reallocating funds. In such a scenario, courts should consider the risks of default as to the subject property, and other assets as well.  This in turn could lead to a cascading effect in the debtor’s performance under the plan, particularly where debtor is not able to quickly liquidate or refinance assets to deal with defaults or disruptions. It is worthwhile to note these issues for the court based upon evidence already before it, as it serves to provide a reality check on debtor’s plan projections overall.

C.        The Collateral Itself.  Arguably, the property itself is one of the most important factors for the court to consider in assessing risk adjustment above the federal prime rate. A rental property may be inherently riskier than a debtor’s residence, which makes sense because in a time of distress or disruption, a debtor is more likely to use income from other sources, including the rental property, to pay the mortgage on a home than the rental property obligations. Similarly, a debtor will be less likely to dip into personal net income to cover the expenses for that rental property when there is a disruption in the rental income stream, thereby shifting the expenses and risk to the creditor. Some of this risk may be mitigated depending upon the type of rental property in question. For example, a 1 to 4 unit property with multiple tenants may fare better in terms of handling income disruptions due to a vacancy, unlike a single-family residence with only one tenant. At the same time, multi-unit properties can be more costly given common area expenses and maintenance, so thorough verification of expense information is very important.

In addition, the occupancy status and vacancy rate of the property should be examined as risk factors. Will the real property be occupied and generate rental income by the effective date of the plan?  If not, debtor would invariably have to either forgo meeting such projected expenses post-confirmation for a period, thereby creating a deficit, or pull funds from elsewhere to cover any shortfall, which may make debtor’s ability to perform under the plan generally, or other real property obligations, more precarious.

Similarly, creditors should scrutinize the specific property projections against historical income and expense information in the monthly operating reports or schedules to ensure all regular and ongoing expenses are considered, along with a sufficient cushion for disruptions, vacancy and/or repairs for the property. If the debtor’s current projections only consider the mortgage payment, taxes, and insurance, with little to no net income, this is largely a red flag, and suggests the debtor’s projections are far too simplistic and will not be able to handle any disruptions. This is certainly a notable risk adjustment.

A less common example that would give rise to an upward risk adjustment, but an important one, is whether the property or collateral requires repairs before it can become habitable and generate income to meet the debtor’s proposed expenses under a plan. If the debtor’s financial projections do not allow for, or anticipate how those repairs will be made, and/or when the repairs would be completed, then any chance of the debtor being able to meet those projections by the effective date is likely illusory, at best, given funds from elsewhere under the plan would need to be utilized.

Accordingly, while the burden of proof to establish cause for a rate adjustment falls on creditors, many reorganizations present ample evidence and perceived risk factors to justify a higher interest rate above the federal prime rate.

VI.           Final Outlook: The Increasing Federal Prime Rate Should Be Utilized To Compensate for Risk and Provide Creditors with Leverage

As the Federal Reserve continues to raise the base prime rate, creditors seeking a higher cramdown interest rate should closely monitor for upcoming rate increases. It may be wise to postpone any stipulated agreement regarding the appropriate market rate until closer to the confirmation date if the Federal Reserve has signaled an intent to raise rates in the near future.  Further, each rate increase presents a creditor with increased leverage in plan negotiations and an opportunity to negotiate more favorable plan terms.

 Further, by utilizing the risk factors discussed above, and the information readily available to the court in the debtor’s bankruptcy case, creditors may bring these risks to the court’s attention easily and thereby present an opportunity to obtain a 1- to 3-point increase above the federal prime rate to compensate the creditor more appropriately for the anticipated risks.  For example, if the prime rate is currently at 6.25%, it is possible for a creditor to obtain a rate of 6.50% to 10.50% by utilizing evidence that is already before the court.

            In addition to compensating for risk under a debtor’s plan, there is a secondary benefit.  If the court agrees with a creditor’s analysis, then a debtor must rework the proposed financial projections at the adjusted interest rate. If this occurs, a debtor may conclude retention of the collateral provides more of a burden than a financial benefit, which may result in the court blocking confirmation, or a stipulated surrender of the collateral.  At the very least, it makes the debtor more amenable to a creditor’s preferred stipulated claim treatment terms. Likewise, a debtor may be forced to convert or dismiss a case if the appropriate interest rate adversely affects the feasibility of the proposed plan. Again, higher interest rates result in increased creditor leverage. Something most creditors prefer, particularly in the Chapter 11 context.

            Thus, by using trending increases to the federal prime rate to recalculate the Till formula, and by utilizing the evidence within the debtor’s bankruptcy case to support upward rate adjustments due to perceived risk factors, creditors can obtain more favorable loan terms under the debtor’s proposed plan of reorganization, or block a cramdown or reorganization altogether.

Copyright @2022

Fall 2022 USFN Report