In this case the debtors proposed a plan of reorganization for four hotel properties. The plan was rejected by the mortgage lender (Wells Fargo), so they sought to cramdown the plan under Section 1129(b) of the Bankruptcy Code. The plan valued Wells Fargo’s secured claim at ~$39 million and proposed to pay off the loan over 10 years with interest accruing at 5% (1.75% over prime). The bankruptcy court confirmed the plan; the district court affirmed; and Wells Fargo appealed to the 5th Circuit.
As a threshold matter, the court considered whether the appeal was equitably moot. In a bankruptcy appeal, equitable mootness can be established if (1) the plan is not stayed, (2) there has been substantial consummation of the plan, and (3) the relief requested would affect either rights of third parties or the success of the plan. Wells Fargo conceded the first two points. So the question turned on the effect of the requested relief.
The debtors contended that granting relief on appeal could result in a “cataclysmic unwinding” of the plan. However, the court noted that it had an option to grant partial relief, and the debtors did not present credible evidence that this would lead to unwinding the plan. So, the court concluded that the appeal could proceed.
In order to support cramdown of the plan, the deferred cash payments to Wells Fargo had to have a value at least equal to its secured claim (which is set equal to the value of the collateral securing the claim under Section 506(a) of the Bankruptcy Code). The value of the deferred payments is determined by discounting to present value using an appropriate interest rate.
In determining the proper cramdown rate, both sides appeared to start with the “prime-plus” formula adopted by a plurality of the Supreme Court in Till v. SCS Credit Corp., 541 U.S. 465, 124 S. Ct. 1951, 158 L. Ed. 2d 787 (2004). While asserting that Till had limited precedential effect given that it was a splintered decision in a chapter 13 context, the 5th Circuit generally endorsed the plurality approach of using a national prime rate as supplemented by a “risk adjustment.” The 5th Circuit also cited with approval the observation in Till that courts have generally approved adjustments of 1% to 3%.
According to Till, the primary advantage of the prime-plus approach is its simplicity and objectivity. The “coerced loan, presumptive contract rate, and cost of funds approaches” were rejected because each is “complicated, imposes significant evidentiary costs, and aims to make each individual creditor whole rather than to insure the debtor’s payments have the required present value.”
Although the plurality suggested the same approach would be appropriate for a chapter 11 case, in footnote 14 they noted that a “market rate” approach might be suitable in a chapter 11 if there were “efficient markets” for exit financing. Notwithstanding this invitation, most courts have followed the prime-plus approach in the chapter 11 context.
Both parties also agreed that the prime rate was 3.25%. However, the debtor’s expert chose an adjustment of 1.75%, leading to a rate of 5%; while the Wells Fargo expert chose a series of adjustments, which led to a rate of 8.8%.
The debtors’ expert considered various factors regarding the stability of the project and the feasibility of the plan to suggest that the risk of default was “just to the left of the middle of the risk scale,” leading to a risk adjustment factor of 1.75%.
The Wells Fargo expert used an approach that took into account market conditions. Since there was no market for single loans comparable to the forced loan under the plan, he calculated a rate by taking the weighted average of a package consisting of senior debt, mezzanine debt, and equity, resulting in a blended market rate of 9.3%. To bring this within the prime-plus methodology, he characterized this result as prime with an upward adjustment of 6.05% based on the nature of the security. Adding a further downward adjustment of 1.5% for the circumstances of the estate, and an upward adjustment to account for the plan’s tight feasibility, resulted in a rate of 8.8%.
The 5th Circuit agreed with the bankruptcy court that the debtors’ expert followed the Till approach, while the Wells Fargo expert based his rate on a form of coerced loan analysis, which had been rejected by Till.
Wells Fargo complained that the Till approach produced an absurd result because market rates for smaller over‑collateralized loans to comparable hotel owners were in excess of 5%. The court simply observed (footnotes omitted):
[T]his “absurd result” is the natural consequence of the prime-plus method, which sacrifices market realities in favor of simple and feasible bankruptcy reorganizations. Stated differently, while it may be “impossible to view” [the debtors’ experts] 1.75% risk adjustment as “anything other than a smallish number picked out of a hat,” [a quote from Justice Scalia’s dissent in Till], the Till plurality’s formula approach – not Justice Scalia’s dissent – has become the default rule in chapter 11 bankruptcies.”
While concluding that the cramdown rate approved by the bankruptcy court was not clearly erroneous, the court hastened to add that it was not suggesting that the prime-plus formula was the only “or even the optimal” method for calculating a rate.
It can be difficult to understand an analysis that leads to a risk adjustment to a prime rate in the 1% to 3% range for a loan that is effectively 100% loan to value with a borrower that has been in financial difficulty.
Regardless, it is clear that under the prime-plus approach a lender should not expect the proposed cramdown rate to have any relationship to the market rate that it would charge under similar circumstances.
Vicki R. Harding, Esq.