We have received many calls lately asking how bankruptcy can help during the financial crisis triggered by the the Covid-19 virus outbreak. As everyone knows, recent months have seen unprecedented events disrupt the normal patterns of life all across the globe in the wake of the pandemic. This turbulence has left many of us feeling apprehensive, uneasy, and insecure. It has also caused a great deal of financial hardship for both businesses and individuals. Many people are out of work, or have seen their incomes go down dramatically.
The “means test” Form 122A in a Chapter 7 bankruptcy case is surrounded by myth, flawed perceptions, and misinformation. For many people it can be a scary prospect. You hear a lot of conflicting talk in the media about the means test, and everyone seems to have an opinion about one thing or another. Some people say it means one thing, and some people say it means something else. A book says one thing, a website says another. Everyone’s an expert, right? Wrong.
Adversary proceedings objecting to the discharge of certain debts sometimes arise in the context of bankruptcy cases. One such type of adversary proceeding, one based on “fraud or defalcation while acting in a fiduciary capacity,” is based on Section 523(a)(4) of the Bankruptcy Code. But to prevail under this section requires that certain conditions must exist. A recent case illustrated how such conditions may in fact exist. The case was a 10th Circuit B.A.P. case, NM-12-017, Hawks Holding LLC v. Kalinowski, decided in 2012.
In 2008, Hawks Holdings, LLC (“Hawks”) contracted with K2 Construction Company, LLC (“K2”) to build three homes on property Hawks owned near Santa Fe, New Mexico, for a contract price of more than $3.6 million. K2 was formed in 2007 as a New Mexico limited liability company, and held a general contractor’s license issued under the New Mexico Construction Industries Licensing Act (the “Contractors Act”). K2 neither completed the construction 1 called for by the Hawks contract, nor paid all of the subcontractors and material suppliers that had contributed to the project.
A Ninth Circuit B.A.P. case from 2012 addressed an issue in a Chapter 11 “single asset” real estate case where the debtor sought to confirm its plan over the objection of an undersecured lender. The case was In Re Loop 76 v. Wells Fargo Bank, na (465 B.R. 525 (9th Cir. B.A.P. 2012)). The key issue in the case was whether the bankruptcy court could consider a “third party” source of payment (in this case, a guarantor), when deciding whether unsecured claims are substantially similar under 11 U.S.C. §1122(a). Basically, the debtor wanted a large unsecured claim (a guarantor claim on a secured debt) to be classified separately from other unsecured creditors, so that the anticipated “no” vote on confirmation would not taint the acceptance of the plan by the other unsecured creditor class.
Often in real estate cases there are very large unsecured claims, possibly arising out of deficiency claims. If such a deficiency claim were placed in the same class as the other general unsecured creditors, it might negate the acceptance of that class. However, if such a debt were placed in a separate class, it might give the debtor more flexibility in confirming a plan over the objection of the creditor.
Loop 76 was a commercial real estate developer which had obtained a commercial loan of about $23 million from Wells Fargo Bank. The loan was secured against an office complex. There were also personal guarantees for the loan, signed by the principals of Loop 76. Loop 76 eventually defaulted on the loan, due to the collapse of the real estate market in 2008-2010. A Chapter 11 petition was eventually filed by Loop 76. Since the property in question was only worth about $17 million, there was a large deficiency claim held by Wells Fargo. The proposed plan attempted to classify the deficiency claim separately from the other unsecured creditors.
Wells Fargo objected to this treatment, believing that they should be lumped in with all the other unsecured creditors. They were, according to Wells Fargo, “substantially similar” to the other unsecured creditors such that separate classification was not justified. The attempt to create a separate class was, argued the creditor, nothing more than an attempt to “gerrymander” acceptance of the plan by needlessly creating a separate class of creditor. Wells Fargo also continued to pursue the guarantors of the real estate loan in state court.
The bankruptcy court, weighing the issues, ruled against Wells Fargo. Examining the history and intent of Section 1122(a) and Section 1129(a)(10), the court found that Wells Fargo had an alternate source of repayment, what it called a “third party” repayment source. Such a creditor is different from a creditor who has no such alternate source of repayment. Wells Fargo could provide no evidence that the guarantors themselves were insolvent or that they were no longer pursuing the guarantors. Thus, the court found that there was a legitimate basis for putting Wells’s deficiency claim in its own class.
Wells Fargo appealed the decision to the 9th Circuit B.A.P. The B.A.P. affirmed, noting that Wells had a third-party repayment source, unlike any of the other general unsecured creditors. Thus, there was a compelling reason to put it in its own class. Having a guarantor was a situation that no other unsecured creditor had. A court can consider third party sources of repayment, the B.A.P. held, when trying to decide if unsecured claims are substantially similar under Section 1122(a).
Furthermore, it caught the B.A.P.’s attention that, if Wells’s claim were placed in the same class as all the other unsecured creditors, it would have dwarfed all the other unsecured claims, since it was such a large dollar amount. It would have controlled the class and have been able to veto the acceptance of the proposed plan. In the interests of fairness, it made sense to put Wells’s claim in its own class, segregated from the other unsecured claims. The Bankruptcy Code permits the creation of separate voting classes of creditors, provided that there is a rational basis for it and the claims are not “substantially similar.” Not surprisingly, this issue can become a litigated one, if voting on plan confirmation turns on the acceptance or rejection of such a class.
The past few years have seen an increase in the number of bankruptcy cases filed for dentists and doctors. The reasons are not difficult to comprehend. As average household incomes decline in the economic environment currently existing, expenditures on health tend to decline as well. All but the most necessary procedures are postponed or forgotten. A concurrent rise in operating costs (insurance especially, but also in medication) contributes to the stress of operation. Changing regulations, the confusion sown by new laws, and reduced payments from Medicare and Medicaid reimbursements have not helped matters.
In the United States, medical and dental care providers are essentially run as for-profit businesses. Doctors, dentists, labs, hospitals, and clinics are also run as businesses in most situations. Yet, like many professionals (accountants, attorneys, architects, engineers, etc.), physicians and dentists usually are not trained in school how to run or market a business. At Phillips & Thomas, we have also represented physicians and dentists who have experienced very serious and unexpected events that have contributed to their business troubles.
Like all situations where small businesses are in distress, the most important thing is to take action quickly to address problem areas. We have found, from our experience in representing professionals, that moving quickly to address debt and reorganization issues is absolutely critical. Doctors and dentists face special issues that are not seen in other types of small business debtors. A Chapter 11 filing can do the following:
- Stop certain actions of regulatory agencies that may be seeking to investigate or close down a practice
- Enable the debtor to break out of leases, contracts, or agreements that are weighing on the business
- Stop all creditor calls, harassment, or collection activity
- Enable a greatly-needed “breathing space” for the filing of a plan of reorganization
- Stop the actions of creditors who may be trying to repossess medical equipment or dental equipment
- Stop the actions of tax authorities who may be trying to file tax liens or garnishments for the alleged non-payment of sales tax, withholding tax, or income tax
The key thing is that the filing of a Chapter 11 reorganization will enable a dentist or doctor to continue to do what he or she loves, and also provide a way to continue to operate the business as a going concern. In a Chapter 11 case, the debtor is a “debtor-in-possession” which means that he or she remains in charge of the operation of the business. No one will step into your shoes and try to interfere with how you run your practice. In a debtor-in-possession scenario, no trustee is appointed. You, the owner of the business, retain the rights, duties, and obligations of a “trustee” in dealing with your property and operating the business.
Essentially, you become your own “trustee.” You can obtain new loans and new credit while you are in a bankruptcy. You have the option of assuming, rejecting, or assigning leases or executory contracts that may exist. Our list of articles on this website dealing with Chapter 11 is very detailed and wide-ranging, and can be found by clicking on the tab on the right side of the home page of this site, under “Chapter 11 Bankruptcy In Kansas City.”
From our experience, these are the typical issues that affect physicians and dentists:
- Physical damage or problems with physical premises (fire, accident, etc.);
- Student loan debts are generally much larger than the average debtor. Interest rates can be changed, monthly payments can be changed, and if certain conditions are met, actions can be taken to seek the complete discharge of these debts.
- Data loss from computer network crashes or file management issues that cause a drop in revenue;
- Divorce or dissolution proceedings;
- Increased operating costs (medications or supplies) that affect the bottom line;
- Equipment issues (problems with dental equipment or physician equipment or action by a lienholder);
- Dealing with the large and often collateralized (with business equipment) loans that are typically found in doctors’ or dentists’ offices;
- With dentists or physicians, there can be ethical or professional conduct issues that can relate to client files and ethical obligations for ongoing patients;
- Dealing with the state regulatory agencies or state licensing authorities. State regulatory agencies and licensing bureaus typically do not have a sophisticated knowledge of bankruptcy reorganizations and a debtor’s rights under it. In some cases, these regulatory agencies overreach or fail to understand a debtor’s rights. It is important to have an attorney who knows how to deal with these agencies. At Phillips & Thomas, we have experience in this area.
Bankruptcy reorganizations for doctors, medical clinics, health care providers, and dentists have special issues that are not found in other types of cases. Depending on the goals and situation of the business or individual, it may be necessary to consider all of the relevant chapters of the Bankruptcy Code to see which chapter is appropriate for the situation (Chapter 7, 13, or 11). Again, we can’t stress enough the importance of getting guidance and advice at the earliest stages of difficulty.
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Restaurants and associated food service businesses are a big part of the local economy in the metropolitan Kansas City area. With the downturn in the economy, more restaurants, food service businesses, and commodity suppliers and vendors (especially produce) are finding themselves with thin profit margins. We have found from our experience that business owners should know all of their legal options well before financial troubles begin to press upon them. Running a restaurant is not easy even in the best of times, and we understand that. Phillips & Thomas LLC has worked with restaurant and food services businesses for many years, and is very familiar with the issues and challenges facing them.
Circumstances can change very quickly in the restaurant and food service business. The traffic of customers can evaporate or be diverted, suppliers can default on their obligations, tax issues can arise, employee problems can surface, ownership or managerial disputes can develop, or physical issues with the premises (fire, theft, damages) can happen. All of these changes require a rational, realistic response that takes into account the goals of the business and the economic management of the problem.
We have stated this principle before in other articles on this blog, and we will repeat it again: identifying and dealing with a problem quickly is vastly preferable to delay. In most situations, one’s options are widest at the beginning of a problem; those options can get narrower the longer the issue is delayed. Stated another way: in the food service business, get help quickly as soon as bad things happen. Communication is critical.
There are different types of bankruptcy options available to restaurants or food services businesses: Chapter 7, Chapter 13, or Chapter 11. Each of these options has its own merits, and is useful in different circumstances. Chapter 7 cases are liquidation cases, in the sense that a business would be “wound up” under the control of a Chapter 7 trustee. On the filing of a Chapter 7 case, the business premises would come under the control of the Trustee, who would then decide how to handle the inventory, equipment, and other issues. The operation of a business by a Chapter 7 trustee is complicated and involves many “moving parts”: dealing with landlords and leases, dealing with employees, dealing with customers or clients, and dealing with inventory and assets. It is important to consult with an attorney to go through all of these issues. Do not assume that you, the business owner, can diagnose or evaluate these issues yourself.
Chapter 13 cases can only be filed by individuals, but they are often filed in a business context where the individual is a sole proprietor, or has signed personally for the business’s debts and needs some way to reorganize those. It also often happens that a business owner is saddled with payroll or withholding taxes from the operation of a business, and needs some way to deal with those as well. Again, it is important to consult with an attorney to understand all the nuances and options available.
Chapter 11 cases can be filed by individuals or businesses for a variety of reasons. Under Chapter 11, the affairs of the business can be reorganized (or liquidated, in some situations) in such a way as to allow the business to get back to a position of profitability. We have a large number of articles on Chapter 11 cases here; if you go to the right side of your screen, you can click on the tab that says “Chapter 11 Bankruptcy”, and find numerous topics of relevance to Chapter 11 cases.
The Perishable Agricultural Commodities Act (PACA).
We do need to spend some time here talking about PACA. Restaurant owners, food sellers, produce suppliers, commodity suppliers, and other vendors should be aware of the existence and implications of this federal law. We have dealt PACA litigation in a variety of food service contexts, and can say that it is one of the most underappreciated and misunderstood issues that can arise in the context of restaurant and food service supplier bankruptcy cases. What is PACA? Over seventy years ago, Congress decided that sellers of farm products were at risk from buyers. Buyers had the right to reject shipment of produce from sellers, and in declining price markets, often these rejections were done to get out of inconvenient contracts. Sellers often had to spend a lot of money and travel great distances to try to sell their produce. Since agricultural commodities are perishable and easily spoil, this was seriously hurting sellers.
In order to regulate this type of interstate commerce, then, Congress in 1930 passed the Perishable Agricultural Commodities Act (PACA). The purpose of the law, as stated above, was to protect sellers from unscrupulous buyers. The US Department of Agriculture had the right to intervene when a buyer failed to honor a promise to pay for commodities. It also prevented brokers from making fraudulent charges, shippers from reneging on agreements, and a few other things. PACA was amended in 1984 in a significant way.
The 1984 amendment to PACA provided for the creation of a “trust” for the “benefit of all unpaid suppliers or sellers of such commodities until full payment of the sums owning in connection with such transactions has been received…” What happened, in effect, was that Congress created a new statutory remedy for the seller of perishable agricultural commodities to a possible debtor in bankruptcy. Basically, a seller now became something much more than an ordinary unsecured creditor. A trust was created by operation of law, and savvy sellers could now use this fact to argue for the creation of a “superpriority trust” within a bankruptcy case.
PACA litigation is complex. At issue are often the following questions:
- Does PACA even apply to the transaction in question?
- What is the definition of a “perishable agricultural commodity”?
- Is my restaurant covered under PACA?
- Will I be held responsible for the creation and maintenance of a “trust”?
- What is in a PACA trust? That is, what constitutes its “res”?
The bottom line is that restaurant owners, food suppliers, vendors, and other parties in the commodity chain are often unaware of PACA and its implications. The possible existence of a trust has important implications in a bankruptcy case, since the holder of an alleged trust may seek to file an adversary proceeding under 11 U.S.C. Sect. 523(a)(4) to have the debt declared non-dischargeable. Alternatively, such a creditor may seek to claim super-priority status in any reorganization plan under Chapter 11 or 13. If you are a restaurant owner or a dealer or handler of commodities in any way, please feel free to consult with us to discuss these issues.
With the increasing interdependence of international trade, it is reasonable to expect that cross-border insolvency proceedings will become more common. It is not too difficult to imagine a time in the future when cases that span at least one international border become routine. According to federal law, a “foreign proceeding” means “judicial or administrative proceedings in a foreign country…under a law relating to insolvency or adjustment of a debt in which proceeding the [debtor’s assets and business] are subject to control or supervision by a foreign court for the purpose of reorganization or liquidation.” 11 U.S.C. §101(23). Obviously, such proceedings present many complex issues involving choice of law, locating of property, equal treatment of creditors, and various other issues.
The road in this area of the law has been a rocky one. Some countries (e.g., Finland, Ireland, The Netherlands) historically have not recognized foreign bankruptcy proceedings at all. Other nations take a different approach, assuming that their own proceedings should have universal applicability while denying such treatment to other nations. In the United States, Chapter 15 of the Bankruptcy Code deals with foreign bankruptcy proceedings. Chapter 15 was only recently added to the Bankruptcy Code (in 2005) with the passage of the Bankruptcy Abuse Prevention and Consumer Protection Act of that year. Chapter 15 allows proceedings for a foreign debtor to access U.S. Bankruptcy Courts. It was intended to modernize and harmonize the law of cross-border bankruptcy proceedings. Chapter 15 cases have been filed for various purposes:
- To protect the assets of a foreign creditor that may be located in the United States from actions by creditors;
- To establish orderly procedures for U.S. creditors to follow in the filing of claims actions against foreign creditors;
- To bind creditors to the terms of a restructuring plan that may have been created in a foreign jurisdiction;
- To facilitate asset sales or liquidations that may have originally arisen in a foreign proceeding;
- To permit a foreign debtor to use the cash collateral of its big creditors in the U.S.;
- To permit discovery of parties subject to U.S. Bankruptcy Court jurisdiction
Chapter 15 cases are rather unique. Debtors under Chapter 15 have a great deal of power. The filing of proofs of claims is fundamentally different from the other chapters of the Bankruptcy Code. The foreign debtor’s representative in the U.S. has many powers similar to those of a debtor in possession under Chapter 11. They may examine witnesses, sell assets, and operate the business affairs. However, they typically are restricted in undertaking avoidance actions, such as fraudulent conveyances. In addition, it is well to note that relief under Chapter 15 is limited under Section 1506 of the Bankruptcy Code. Under this section, a U.S. bankruptcy court may decide against taking action that would be “manifestly contrary to the public policy of this country.”
The trend is this area of the law is clearly towards greater internationalization and universality. A recent case from the Southern District of New York is illustrative. The case is In Re Rede Energia, S.A (14-10078, SCC). The company, Rede Energia, SA, was a Brazilian business that had a plan of reorganization that had been filed and confirmed in Brazil. At issue was the question of how (and to what extent) would Rede Energia’s reorganization plan would be recognized in the United States. Rede Energia (the debtor) was a major power company in Brazil. Its foreign administrator in the US commenced a Chapter 15 proceeding in New York. The debtor’s plan had been “crammed down” in Brazil over the objections of some creditors. The debtor sought an order from the New York bankruptcy court that would give “full faith and credit” to the Brazilian confirmed plan of reorganization.
Some of Rede’s unhappy creditors in New York argued that, under Section 1506 of the U.S. Bankruptcy Code, the Brazilian plan of reorganization was clearly violative of U.S. public policy. (Specifically, the creditors complained that the plan had three classes of unsecured creditors, which were being treated differently). But the New York bankruptcy court ruled otherwise, in a decision that will be an important precedent as these types of cases become more and more common. Under Chapter 15, the court stated, there is no requirement that the laws of a foreign nation (e.g., Brazil) be identical to those of the U.S. Rather, the issue was whether the creditors received a reasonable degree of due process and fairness in the original proceeding.
Looking at the issue this way, the New York court found that the objecting creditors in New York did in fact receive a full and fair hearing on all of their issues during the legal proceedings in Brazil. They could not now reopen these issues. Furthermore, the court held, it would not be appropriate for a U.S. court to “superimpose” its own law over those of a foreign country. Finality, and a sort of “cross-border res judicata”, were key factors in the decision. The New York court was similarly unpersuaded by the creditors’ argument that treating differently the three classes of unsecured creditors was a big problem.
On the contrary, the court noted that it does sometimes happen in bankruptcy reorganizations that similarly situated creditors are treated differently. This is so despite the fact that the Bankruptcy Code aspires to similar treatment of similarly situated creditors. Every plan of reorganization is different. Taken as a whole the Rede Energia case stands for the idea that the principles of res judicata, due process, and fairness are universal and will be given international application in Chapter 15 cross-border insolvency cases.
Phillips & Thomas is one of the few firms in the metro area that has been involved in a Chapter 15 international insolvency proceeding. Our managing partner George Thomas speaks Portuguese and travels to Brazil frequently.
Read More: Bankruptcy Appeals And The Appellate Process
Within the Chapter 11 world, a common and powerful type of Chapter 11 reorganization case is the “real estate reorganization” Chapter 11 case. These types of cases are filed by real estate management companies, by individuals who own residential or commercial real estate, by holders of “single asset” real estate projects or properties, or by entities or persons who have ownership interests in real estate.
The legal issues surrounding leases in bankruptcy cases can depend on what type of bankruptcy is being talked about. Chapters 7, 13, and 11 each have separate rules and procedures with regard to leases. In a Chapter 7 case, the bankruptcy trustee has the option of assuming the debtor’s interest in the lease or curing any default under it. In practice, this only happens on rare occasions with commercial leases (not residential leases). Chapter 7 trustees almost never bother with residential leases, since they provide no value to the estate. In commercial lease situations where the rent provided under the lease is significantly below the market rate, or where the premises have some sort of value to the estate in a business liquidation, this type of thing is possible in theory.
In a Chapter 7 business liquidation, the trustee has the right to commandeer the premises and use them for storage or for a bankruptcy sale. Here again, this rarely happens. Even in a liquidation, it often happens that by the time the case is filed, there is little value to the estate that can be had by operating the business. In situations where Chapter 11 cases are converted to Chapter 7, or where the business has a large amount of liquidation value, this can change. When the bankruptcy petition is filed, the landlord is prevented by the automatic stay from attempting to enter the premises and repossess the inventory or equipment on the premises, even if the rent has not been paid and a state court has ordered the debtor to be evicted.
The Chapter 7 trustee can use the leased premises to store the property until it can be sold, if it has significant value for the estate. If the trustee does not assume the lease of the business, and uses the premises for storage, it may not be easy for the landlord to collect rent from the trustee. The trustee typically claims that the estate is only liable for a lower amount, or only for the period in which the trustee was actually in possession. And if there is not enough funds in the estate to pay for the expenses of administration, then the amount might not be paid. Landlords and their attorneys are often unfamiliar with the nuances of bankruptcy law and their rights under it.
They may be unpleasantly surprised to find out that their statutory landlord lien is invalid in bankruptcy. Rent arrearages that may exist at the time of the filing of the case might get treated as a general unsecured claim in the estate, which usually amounts to very little in recovery. A landlord subject to the automatic stay by the filing of a bankruptcy case cannot simply ignore it. This is true regardless whether he has received notice from the court. One of the basic purposes behind the automatic stay with regard to leases in Chapter 7 is to permit the trustee time to assess the condition of the premises and any property in it. Generally the trustee has 120 days to assume or reject a lease of nonresidential real property. The court can extend this for another 90 days if needed.
In business liquidation cases where a lease is involved, it is not always a simple matter for a landlord to collect rent during the time the trustee is in possession of the premises. In situations of nonresidential real property, the trustee has an obligation to “timely perform all the obligations of the debtor” arising under the lease, until the lease is assumed or rejected. In Re Cukierman, 265 F.3d 846 (9th Cir 2001). If the lease has significant value, it is even possible that the trustee may assume and the possibly assign or sell it. Before it can be assumed, he would have to cure any default under it, and compensate the landlord for any damages suffered by the breach of the lease.
If the property continues to be used by the trustee after the filing of the bankruptcy, it is possible that the landlord can request compensation under Section 503(b) of the Bankruptcy Code (administrative expense). The landlord would be entitled to the “reasonable value” of the use of the premises. This is not necessarily the rent amount specified in the lease agreement; in fact, it may be significantly less than this. And even if the estate can afford to pay the landlord administrative rent, claims will be based on the actual value received by the estate, not on the value that was lost by the landlord. However, the landlord may be entitled to “adequate protection” payments during the pendency of the case. As can be seen from this discussion, a landlord’s attorney will need to be aggressive and persistent if he wishes to recover anything for his client from the Chapter 7 trustee once a business liquidation is filed.
“Cramdown” is a term of art used to describe a situation in a Chapter 13 or Chapter 11 bankruptcy in which a secured creditor is being paid to the fair market value of the collateral secured by its claim, rather than the full loan balance. In a Chapter 11 plan, if the plan proposes to pay the secured claim in deferred cash payments, those payments would include post-confirmation interest at the “market rate.”
The market rate is a rate that the bankruptcy court considers fair in light of current market factors. In Re Hardzog, 901 F.2d 858, 860 (10th Cir. 1990); Till vs. SCS Credit Corp., 541 U.S. 465, 476 n. 14 (2004).
In the case of In Re American Homepatient, Inc., 420 F.3d 559 (6th Cir. 2005), the court determined that the Chapter 11 cram down interest rate should be market rate where there exists an efficient market; if a market does not exist, then a court should employ the “formula approach” described by the Till case for Chapter 13 cases.
Under this “formula approach”, the interest rate is set as the national prime rate adjusted to reflect risk posed by the debtor. Of course, secured creditors in a Chapter 11 or Chapter 13 case are never really going to be satisfied with this “market rate.” Several methods have been advanced by courts in determining how this “market rate” should be determined. We will describe each of these approaches.
Formula Approach. Under the so-called formula approach, as stated above, the court begins with a base rate (such as prime rate) and then adds points for “risks” posed by the debtor. The formula approach was adopted by the Second Circuit in In re Valenti, 105 F.3d 55, 64 (2nd Cir. 1997) and by the Tenth Circuit in In re Hardzog, 901 F.2d 858, 860 (10th Cir. 1990).
Cost of Funds Approach. Under this method, the rate is determined based on what interest the creditor would have to pay to borrow the funds. This approach is apparently not favored and has not been formally adopted by any circuits.
Coerced Loan Approach. There are two variations of the “coerced loan approach.” One variation is that the cram down interest rate is set as the same as the creditor would receive if it could foreclose and reinvest the proceeds in loans of equivalent duration and risk. Koopmans v. Farm Credit Servs., 102 F.3d 874, 875 (7th Cir. 1996). Another permutation on this approach is to examine the rate that the debtor would pay outside of bankruptcy to obtain a loan on terms comparable to those proposed in the Chapter 11 plan.
Presumptive Contract Rate Approach. Under this approach, the court begins with the pre-bankruptcy contract rate. This rate then creates a rebuttable presumption that either the creditor or the debtor can counter by persuasive evidence that the current rate should be different. In re Smithwick, 121 F.3d 211, 214 (5th Cir. 1997).
What is the guiding principle behind all of these approaches? Bankruptcy courts generally take the position that in reviewing reorganization and cramdown issues, it is important to balance the interest of the creditor in obtaining protection and compensation, while at the same time, setting an interest rate that is consistent with the fresh start offered by bankruptcy. There should be some consistency in approaches. Bankruptcy courts have the power to modify interest rates. There should be objective economic analysis applied, that weighs the risks of default with the fresh-start objective of bankruptcy.
Starting with the national prime rate of interest makes good sense. The “prime” rate (in the view of the Till case, cited above) is 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.” Till, 124 S. Ct. at 1960. “A bankruptcy court is then required to adjust the prime rate to account for the greater nonpayment risk that bankrupt debtors typically pose.” Id.
But how should this “risk adjustment” be determined? There are several factors that need to be weighed. The interest rate should be high enough to allow the creditor some relief, but not so high as to torpedo the plan. As discussed in Till, the following factors are normally relevant:
- Circumstances of the estate. This term is rather vague, but presumably means any factor or issue that will impact on the debtor’s ability to perform on the loan, or otherwise increase risk.
- Nature of the security. This means specific things directly related to the security. Value, depreciation characteristics, and the debtor’s use of the collateral are some of these things.
- Duration of the plan. Inflation and expected market volatility are typically factors here.
- Feasibility of the plan. This would be the projected likelihood of success, that is, the debtor’s ability to perform the terms of the plan.
Regardless of the methods used, the setting of a cramdown interest rate is important in both Chapter 13 and Chapter 11 cases. In Chapter 13 cases, the issue may not come up with as much frequency as in Chapter 11 cases.
This is because many jurisdictions already have procedures whereby “trustee’s discount rates” of interest may be used. However, even model Chapter 13 plan formats allow debtors to set their own rates. Chapter 11 cases typically allow more creativity (or freedom) in crafting interest rates that can assist in the success of a Chapter 11 plan.