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Weathering the Storm: Bankruptcy Court Permits Minimal Artificial Impairment and Applies Investment Band Approach to Determine the Cram-Down Rate Under Till
Ian T. Peck, Stephen M. Pezanosky, Jarom Yates
Bankruptcy Judge Michael Lynn of the Northern District of Texas recently issued a noteworthy opinion in In re Village at Camp Bowie I, L.P. that addresses two important Chapter 11 confirmation issues. Judge Lynn determined that a plan that artificially impaired a class of claims in order to meet the requirements of section 1129(a)(10) had not been proposed in bad faith and did not violate the requirements of section 1129(a). In his ruling, Judge Lynn also applied the Supreme Court’s cram-down “interest”1 rate teachings in Till v. SCS Credit Corporation and approved an expert’s use of the “investment band” method for determining the appropriate rate of return for a secured lender.
The Debtor’s primary asset was a mixed-use development property (the “Property”) in Fort Worth, Texas. In addition to an equity investment of $10 million, the Debtor financed the property through bank loans in excess of $30 million. After certain modifications, default, and subsequent forbearance agreements, the Debtor’s lender sold its position at a discount to Western Real Estate Equities, LLC (“Western”) after the expiration of the final forbearance period. Western posted the Property for foreclosure, and the Debtor filed for relief under Chapter 11.
Western admitted that it had acquired its claim in order to acquire the Property rather than negotiate a consensual Chapter 11 plan and filed a motion to lift the automatic stay. After a six-day hearing, the court denied the stay motion, noting that there was a small amount of equity in the Property above Western’s lien.2
After denying the motion to lift the stay, the Debtor filed a cram-down plan of reorganization (the “Plan”) that contemplated a new equity infusion of $1.5 million by the Debtor’s equity holders. The Plan identified only two classes of claims: (1) Western’s secured claim of approximately $32 million and (2) general unsecured claims of approximately $60,000. Under the Plan, Western was to receive a new five-year cram-down note that would provide for interest-only payments for the first three years at an interest rate of 5.83 percent, followed by two years of payments of principal and interest, amortized over thirty years, with the remaining balance to be paid in full at the end of the five-year period.
Because Western was impaired, and opposed confirmation of the Plan, the Debtor had to create an impaired accepting class to satisfy the confirmation requirements of section 1129(a)(10). To achieve this result, the Debtor proposed to pay general unsecured creditors in three equal monthly installments beginning on the effective date, despite the Debtor’s ability to pay such claims in full on the effective date.
Western objected to the Plan arguing, inter alia, that (1) the Plan had impermissibly artificially impaired the class of general unsecured creditors and (2) the proposed interest rate would not provide Western with the present value of its claim as required by section 1129(b).
Although the general unsecured creditors were to be paid in full, the court concluded that they were impaired because they were being paid over time and that “meaningful impairment” was not required.
Noting that the good faith requirement of section 1129(a)(3) requires that the Plan must be “proposed with the legitimate and honest purpose to reorganize and has a reasonable hope of success,” the court determined that “[t]here [was] no question” that the Plan met that standard because the Debtor proposed the Plan “with an honest intent that its debt be restructured” and the plan was feasible and was therefore likely to succeed.
Judge Lynn also considered the “totality of circumstances surrounding establishment of a Chapter 11 plan” and focused primarily on the motive of the Debtor in artificially impairing the general unsecured creditors and the motive of Western in objecting to the Plan. Western asserted that the Debtor’s motive for artificially impairing the general unsecured creditors was to preserve equity and that such motive was improper. The court rejected this assertion as the basis for a finding of bad faith, noting that because the Bankruptcy Code contemplates the protection of both creditors and equity holders, a debtor may not be faulted for its concern for equity holders. The court then turned the tables and considered Western’s motive in the case, emphasizing that Western would receive the full value of its claim under the Plan. The court noted that, while Western’s true objective to acquire the Property was neither illegal nor immoral, its motive could be considered when determining the good faith of the Debtor, and that the only option available to the Debtor for protecting equity interests was to artificially impair the general unsecured creditors.
Although artificial impairment should not generally be encouraged, “[w]here a fair and equitable restructuring may be accomplished only through artificial impairment, it should not be prohibited.” (emphasis added). Recognizing that the value available to equity would be erased if artificial impairment was not permitted, Judge Lynn endorsed the Debtor’s ability to utilize artificial impairment for strategic purposes under the facts of the case.
Having determined that the Plan was proposed in good faith, the court considered whether the Plan was fair and equitable to Western. A plan is fair and equitable with regard to a secured creditor if it meets any of the three alternatives identified in section 1129(b)(2)(A). The Plan proposed to treat Western under the first alternative, section 1129(b)(2)(A)(i), which states that a secured lender must retain its liens and must receive “deferred cash payments. . .of a value, as of the effective date of the plan,” equal to the amount of the secured claims. To determine whether the Plan complied with section 1129(b)(2)(A)(i), the court analyzed whether the “interest” rate designated in the Plan - 5.83 percent - would result in Western receiving the present value of its secured claim.
In determining the adequacy of the proposed rate, the court looked to the Supreme Court’s decision in Till v. SCS Credit Corporation3 for guidance. Specifically, the court noted that in Till, the Supreme Court settled on a formula approach, whereby the appropriate rate of interest is determined with reference to a base rate, such as the prime rate, and adjusted to appropriately account for risk.4 Judge Lynn agreed that the formula approach was appropriate and adopted the specific methodology employed by Western’s expert.
The Western expert began with the five-year treasury bill rate as the “risk free” rate of return and then adjusted upward to account for various risk factors. The expert made an additional adjustment based on the term of the Plan which provides Western with only interest for three years. In making his risk assessment, the expert divided the cram-down note into three separate tranches, (1) a senior secured position equal to 65 percent of the collateral value, (2) a junior or mezzanine position equal to 20 percent of the collateral value, and (3) an “equity” band equal to the remaining 15 percent of the collateral value, to reflect the realities of commercial lending practices and the varied levels of risk associated with different tranches of debt in a typical financing transaction. This methodology is often referred to as the “investment band” approach.5
After separating the various tranches of risk, the expert adjusted the base rate for each tranche to account for the amount of risk appropriate for the relevant loan-to-value ratio of each tranche. The expert then calculated a blended interest rate, taking into account the percentage of debt represented by each of the three tranches. He then adjusted the rate downward to compensate for (1) the reduced risk at the junior and equity levels due to the fact that only one lender was involved and (2) the benefits of bankruptcy such as court supervision and the determination of feasibility. Ultimately, the expert identified two different interest rates based on the two different appraisal values presented by the experts at the stay hearing. The expert identified an interest rate of 6.25 percent for a Property value of $38.4 million and a rate of 7.75 percent for a Property value of $28.4 million.
While the court agreed with the Western expert’s methodology, the court disagreed with the collateral values and overall claim amount used by the expert. Judge Lynn also disagreed with the expert’s opinion as to the value of the benefits of bankruptcy, noting that “[a]s to the Debtor’s balance sheet, the effect of the Plan and the Chapter 11 case is minimal.” Finally, the court rejected the expert’s inclusion of a profit to the lender of approximately 0.85 percent, noting that no such profit was required by section 1129(b)(2)(A)(i).6
After considering all relevant factors, the court determined that the interest rate proposed under the Plan - 5.83 percent - was not sufficient to provide Western with the present value of its secured claim and that the Plan was therefore unconfirmable. The court did, however, state that if the Plan were amended to provide for an interest rate in keeping with the court’s findings, then the court would be prepared to approve confirmation of the Plan. The significance of this portion of Judge Lynn’s opinion is clear: Till’s formula approach does allow for use of the “investment band” methodology for determining an appropriate cram-down rate of return under 1129(b)(2)(A)(i). His disregard of the profit element, however, confuses the concept of adequate protection with the clear language of section 1129(b)(2)(A)(i) which requires a rate that will give the lender a value equal to its collateral. This is a fact determination driven by a market that requires a profit element in a discount rate.
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1 To be more consistent with section 1129(b)(2)(A)(i), the interest rate should be stated as the rate of return.
2 The two experts appraised the value of the Property to be $38.4 million and $28.4 million. Judge Lynn ultimately concluded that the value of the property was $34 million.
3 541 U.S. 465 (2004).
4 The Supreme Court in Till suggested that in a Chapter 11 case there might be an efficient market that could establish the proper cram-down rate. The experts for both the Debtor and Western testified that no such efficient market existed for the financing proposed in the Plan.
5 See, e.g., In re Cellular Info. Sys., 171 B.R. 926, 941-44 (Bankr. S.D.N.Y. 1994).
6 The expert had assumed that since the prime rate theoretically provides a profit to the lender, that the Supreme Court in Till approved of including a profit margin for the lender. Because the Supreme Court did not specifically address or condone the inclusion of a profit margin for the lender, the court rejected the profit adjustment.