What is the Appropriate "Market Rate" in Valuing a Creditor’s Claims
in Individual Reorganization Plans?
Charles M. Sprinkle
New bankruptcy laws will force more individual debtors into reorganization plans. As a result, the techniques courts use to value creditors’ claims will become more important. This paper examines the methods used by courts in determining the present value of deferred cash payments under a Chapter 13 individual reorganization plan. Courts generally agree that the discount rate applied should reflect the market rate. These courts diverge, however, as to how this market rate should be determined, adopting either a "coerced loan" method or a "formula" method. This paper analyzes each of these methods in turn and concludes that the formula approach—with some refinement—will produce the most uniform and certain standard for determining current market value.
Bankruptcy reform was in the air as the wheels of the 107th Congress began to turn. Proposed legislation overhauling the Bankruptcy Code has passed through the U.S. House and Senate and the details are being worked out. If enacted, these changes will require that more individual debtors enter into a reorganization plan rather than simply liquidate their assets in a Chapter 7 ("straight") bankruptcy. As a result, the techniques courts use to value creditors’ claims will face new, heightened scrutiny.
The courts, however, may not be ready. In this paper, I will argue that the bankruptcy courts and broader federal judiciary have not adopted a clear, appropriate standard for valuing creditors’ claims in Chapter 13 cases when these claims take the form of deferred cash payments under a reorganization plan. In such a case, courts must determine the present value of these cash payments. The methods the courts use to make this determination, however, vary. I will analyze these methods in light of the policy of the Bankruptcy Code and the role the courts should play in making these valuation judgments.
For an individual reorganization plan to be confirmed, "the value, as of the effective date of the plan, of property to be distributed under the plan on account of each allowed unsecured claim is not less than the amount that would be paid on such claim if the estate of the debtor were liquidated under Chapter 7 of this title." This provision, sometimes called the "Best Interest Test," means that each creditor under the plan of reorganization is entitled to receive property with a present value at least equal to the amount the creditor would receive if the debtor’s assets were liquidated. The same rule is set out for secured creditors in section 1325(a)(5)(B)(ii), except that the comparison is not to the amount that would be received in liquidation, but the value of the underlying collateral.
- Current Methods of Valuing Creditors’ Claims in Chapter 13.
The courts have adopted rules for determining value of collateral allowed as a secured claim, and these are murky enough. But the plan will often take the form of a stream of deferred cash payments. The court must then determine an appropriate interest or discount rate so that the present value of those cash payments is equal to the amount of the creditors’ claim (either collateral value or liquidation value). On this point, the federal circuit courts generally agree as to the first step: the appropriate interest rate is the "market rate." The Seventh Circuit Court of Appeals has explained that "market rates of interest measure the real risks of nonpayment and the costs of collection (including the costs of foreclosure and bankruptcy proceedings); it is to these market rates, rather than lawyers’ speculations about business operations, that judges must turn." Here, however, the courts encounter a fork in the valuation path, adopting different approaches to just what a "market" rate of interest should be in Chapter 13. The two primary methods of determining market rate are the "coerced loan" method and "formula" method. I will examine each in turn.
A number of courts have adopted a method of calculating present value in bankruptcy comprised of two component factors. First the court will determine a risk-free rate of return—usually the rate for treasury securities—for a comparable payment period. The court will then make an adjustment to this risk-free rate to account for the increased risk associated with repayment by the individual debtor involved. This method has been dubbed the "formula approach." The method is based on the assumption that treasury securities are an accurate proxy for the real rate and expected inflation rate aspects of time value of money.
- Methodology 1: Chapter 13 Plan as "Coerced Loan"
An unsecured creditor with a claim against a debtor in Chapter 13, will have no say as to whether a plan for reorganization is confirmed by the bankruptcy court. Likewise, a secured creditor with a claim can be forced to accept the plan provided certain steps are followed. Courts in some circuits have viewed the involuntariness of creditor cooperation in this plan for debt payment as a key factor for consideration when discerning an appropriate market rate of interest. These courts thus approach the individual reorganization plan as simply a new loan (or at least a modified one) that the creditor is forced to extend the debtor. The correct interest rate, therefore, is the rate to which the parties had originally agreed or the rate that would be appropriate for a similar type of loan.
Such an approach was employed by the Sixth Circuit in Memphis Bank & Trust Co. v. Whitman. In that case, a bankruptcy court found that the interest to be allowed for repayment of a secured claim should not be related to the contract rate agreed upon between the debtor and secured party. Rather, it found that the interest should be the value of the collateral plus interest on that amount at a 10% rate. But why 10%? The bankruptcy court left that a mystery.
Circuit Judge Merrit decided that reorganization plans were not the place for random numbers. His opinion stated that:
Rather than tying the interest rate to an arbitrary ten per cent rate, the Bankruptcy court’s solution, or some other arbitrary rate, we hold that in the absence of special circumstances bankruptcy courts should use the current market rate of interest used for similar loans in the region. Bankruptcy courts are generally familiar with the current conventional rates on various types of consumer loans. And where parties dispute the question, proof can be easily adduced.
In General Motors Acceptance Corp. v. Jones, the Third Circuit agreed with the Sixth Circuit that "in effect the law requires the creditor to make a new loan in the amount of the value of the collateral rather than repossess it, and the creditor is entitled to interest on his loan." The court conceded that the "coerced loan" in a Chapter 13 plan could not be the "precise equivalent of a new loan." In many cases, the costs of the plan will be less than that of a loan (e.g., the bankruptcy trustee will perform many of the debt servicing functions—collection, distribution, monitoring—that would have otherwise fallen on the creditor). On the other hand, certain aspects of coerced loans present increased costs to the secured creditor (e.g., the fact that in the bankruptcy context there will rarely be an equity cushion to compensate for asset depreciation—especially important when the collateral is an automobile). The court concluded that these variable costs to the creditor will often balance each other out, making the coerced loan rate a rough, but fair approximation of the market rate.
The court in General Motors, however, goes beyond adopting and adding gloss to the coerced loan approach—concluding that "it would be consistent with the statutory objective and would reduce litigation expenses if we imposed an additional rule in this area." That rule: a presumption in all Chapter 13 cases that the contract rate of interest that the creditor had earlier agreed to is the appropriate rate of interest unless either the debtor or creditor comes forward with "persuasive evidence" that the rate should be otherwise.
The Fourth Circuit has also followed the coerced loan approach, but tentatively so. In United Carolina Bank v. Hall, the court rejected the district court calculation of a 10% interest rate in which it had added a 1.5% risk component to an 8.5% prime rate component. It too largely agreed with Memphis Bank that the court should rather look to the market of similar loans in the region to set the rate. The court was concerned, however, that in setting the market rate secured creditors should not be put in a better position than they would have been had the debtor’s collateral been returned. It noted that in lieu of undertaking the reorganization plan the creditor would have borne the expense of repossessing and liquidating the collateral. Therefore, the court reasoned, that in determining the market rate with respect to secured creditors, the court was obligated to look not only to rates the creditor received on similar loans made in the area but also the expenses incurred in obtaining those loans. The court concluded that the best means to prevent such a "windfall" to creditors would be to cap any interest rate used in the "cram down situation at the contract amount to which the secured creditor had originally agreed."
To summarize: The "coerced loan" approach in determining the market rate has garnered broad approval. The courts are attracted to the fact that it is a rule with a rationale—dispelling the impression widely held that when it comes to numbers many jurists are willing to abandon the revealing light of logic in favor of the masking fog of arbitrariness. As shown in the discussion in the following section, however, some courts find that what seems at first random and illogical actually furthers some important objectives in this area of law.
- Methodology 2: The "Formula" Approach to the Market Rate
One of the most recent and probably most notable applications of the formula approach was by the Second Circuit in General Motors Acceptance Corp. v. Valenti. In the case, the debtors had financed the purchase of a car with General Motors Acceptance Corporation (GMAC) on an installment contract. The next year they filed a Chapter 13 bankruptcy. Instead of returning the car to GMAC, their plan proposed that they be permitted to keep it and make installment payments at an interest rate of 8%. GMAC was not pleased and objected. The bankruptcy court, however, took little heed and set the cram-down interest rate at 9%—ultimately confirming the debtor’s plan (without issuing an opinion).
The district court affirmed the bankruptcy court’s confirmation, finding the appropriate discount rate "is not the rate being charged by GMAC for similar loans ["coerced loan" approach], rather, it is the rate paid by GMAC for the funds it borrows." It concluded that the bankruptcy court’s valuation was in accord with that guideline.
The Second Circuit disagreed—vacating and remanding the case for recalculation of the district court’s determination of the interest rate. It held that the formula method should be applied: instructing that the "market rate of interest . . . should be fixed at the rate on a United States Treasury instrument with a maturity equivalent to the repayment schedule under the debtor’s reorganization plan." The court added that "[b]ecause the rate on a treasury bond is virtually risk-free, the . . . interest rate should also include a premium to reflect the risk to the creditor in receiving deferred payments under the reorganization plan"—the second component of the formula approach. It embraced this method because "it is easy to apply, it is objective, and it will lead to uniform results. In addition, the treasury rate is responsive to market conditions."
Just as notable, however, is the Second Circuit’s express rejection of the coerced loan approach and the reasoning it offers as support:
David Epstein, a bankruptcy scholar and practitioner (and, not insignificantly, the lawyer who argued the General Motors case before the Second Circuit), has argued that the last two sentences of the quoted language seem inconsistent. He suggests that if GMAC had received the value of its allowed claim immediately, "it would have used the funds it received to arrange a new loan to some third party. GMAC’s return from that new loan would reflect not only GMAC’s cost of funds but also its other costs and risks and profit." Epstein concludes, therefore, that the court’s admonition not to "put the creditor in the same position that it would have been in had it arranged a ‘new’ loan" is contrary to the reality of what the court suggests is the very purpose of the statute. We believe that courts adopting the "forced loan" approach misapprehend the "present value" function of the interest rate. The objective of § 1325(a)(5)(B)(ii) is to put the creditor in the same economic position that it would have been in had it received the value of its allowed claim immediately. The purpose is not to put the creditor in the same position that it would have been in had it arranged a "new" loan.
Epstein’s economic argument is sound, but his assumptions as to what the court means by "new loan," may be more tenuous. Is it a "new loan" to a third party as Epstein assumes? Or does the court mean to say a "new loan" to the insolvent debtor at hand? Based on a review of the forced loan approach (as discussed above), I think the court intended the latter interpretation. The crux of the forced loan approach is the potential interest premium that may be added because of a particular debtor’s circumstances—circumstances which have presumably deteriorated since the time of the initial loan since the individual is now in Chapter 13.
It is this margin—between the interest originally agreed upon by the debtor and creditor and the interest rate that the creditor would charge to extend credit to the debtor under her new, present (distressed) circumstances—where the Second Circuit finds the potential inequity of the forced loan approach. If the creditor is able to collect a new, higher interest rate under the reorganization plan than it would have collected had the debtor met its original obligation, then indeed the creditor has profited from the reorganization. More bluntly, one might say that the creditor is a profiteer of the debtor’s misfortune!
Though Epstein may have interpreted the court’s words contrary to its intent, he makes an important point by exposing an ambiguity in that language. When shades of meaning can mean differences of conceivably vast sums of money, nothing less than total precision of words will suffice.
With respect to the method for determining a current market rate, should a debtor or creditor who anticipates a claim being made subject to a reorganization plan simply accept that there is disagreement among the courts and seek out the applicable law in their jurisdiction? This result does not seem appropriate. The situation presented is more than just a question of which of two plausible methods will get the involved parties to the same desired result. Instead, the different approaches the courts have taken leave questions as to what the appropriate goal of the statute is and what role the courts should play in reaching that result.
- Resolving the Question: What Should Debtors and Creditors Expect in Reorganization?
When debtors and creditors resort to the bankruptcy laws to resolve their debt and payment problems, what do they seek most? I am confident they are not looking to bankruptcy judges to form valuations based upon comparisons largely disconnected from reality. A articulable standard and certain result—certain, at least, based on their view of the evidence—are what parties desire. With some additional refinement, the formula approach best meets this objective.
This method is most desirable because it divides the interest rate into its certain and uncertain components. The court must then articulate its rationale distinctly for each component in the two-step process. This eliminates potential confusion when the parties in the case and subsequent litigants who look to the case for guidance try to parse what portion of the interest rate was intended as the real rate of return and what portion was intended to constitute the risk premium. The increased and regular use of the formula method would garner two hopeful results: First, the courts would become more proficient at using the method—gradually developing more advanced standards of determining the real rate and risk premium components based upon their experience. Second, as the number of courts using the method grows, standardization will naturally occur. Judges will read each others opinions, attend conferences together, and listen to the analysis of legal scholars. From this, a consensus will develop as to what factors should weigh heaviest in their approach and which should weigh least. Ultimately, these layers of refinement will produce a uniform standard that can be applied in any bankruptcy court in the nation—tailored, of course, as the facts of each case require—with confidence in its fairness and accuracy.
The coerced loan approach would make this type of development in the law difficult. As described above, nothing in that approach would require that the court deconstruct its own reasoning for the benefit of the parties and legal community. The method depends upon a hodgepodge of assumptions and, perhaps, guesswork as to what the interest rate would be for "similar loans" in the particular locality. Some courts and commentators have concluded that such a determination could be nothing more than a series of guesses. No framework exists within the method itself to encourage standardized development among the courts. Much is left to chance and lost in confusion.
New bankruptcy laws will force more individual debtors into reorganization plans. If the courts do not move to adopt a more standard and certain method of determining the current market rate of interest, Congress may take the initiative and mandate an approach. Such action could possibly strip bankruptcy courts of needed discretion in setting the most accurate rate. Better that the courts move to improve their own methods and preserve its latitude in making these decisions. The "formula approach," by breaking down into distinct components the valuation technique, provides the best framework for ensuring that law develops a more accurate and uniform method of determining the market rate of interest.
11 U.S.C. §1325(a)(4) (1996).
EPSTEIN ET AL., BANKRUPTCY 687-93 (1992).
See §506(a) (detailing what is an “allowed claim” of a secured creditor).
See Christopher Challis, Valuation in a Chapter 13 "Cram Down:" What's That Kenworth Truck Worth, Anyway?, at http://www.law.wfu.edu/courses/law&value-palmiter/Papers/1999/Challis-CramDown.htm (Spring 1999).
See In re Hollinger, Bankr. L. Rep. (CCH) 78,133 (Bankr. N.D. Fla. Feb. 4, 2000).
Koopmans v. Farm Credit Serv. Of Mid-America, ACA, 102 F.2d 874, 876 (1996).
See 11 U.S.C. §1325(a)(5)(B)(i-ii) (commonly referred to as a “cram down”).
692 F.2d 427 (1982).
Memphis Bank & Trust v. Whitman, Bankr. L. Rep. (CCH) 68,901 (6th Cir. Tenn. Nov. 4, 1982).
Memphis Bank & Trust, 692 F.2d at 431.
999 F.2d 63 (1993).
Id. at 67 (quoting Memphis Bank & Trust Co. v. Whitman, 692 F.2d 427, 429 (1992)).
Id. at 68.
See id. at 68-69.
See id. at 70.
See id. at 70-71.
993 F.2d 1126 (1993).
See id. at 1130. This method of tacking on a risk-premium to the risk-free rate is the “formula” approach discussed infra at Part I.B.
See id. at 1131.
105 F.3d 55 (1997).
Id. at 58.
General Motors Acceptance Corp. v. Valenti, 191 Bankr. 521, 521 (N.D.N.Y. 1995)
General Motors, 105 F.3d. at 59.
General Motors, 191 Bankr. at 522.
Id. Basing the discount rate on the interest rate that the creditor would have to pay to borrow capital is another approach—often termed the “cost of funds” approach—that could perhaps be included in this paper as a third methodology. My research revealed no federal circuit court that has adopted this method. For examples of cases where the approach has been used see Matter of Jordan, 130 B.R. 185, 190 (Bankr. D.N.J. 1991); Matter of Campbell, 16 B.R. 496, 497 (Bankr. N.D. Ill. 1982).
General Motors, 105 F.3d. at 64.
David G. Epstein, Don’t Go and Do Something Rash About Cram Down Interest Rates, 49 ALA. L. REV. 435, 458 (1998).
See, e.g., In re Computer Optics, Inc., 126 B.R. 664 (Bankr. D.N.H. 1991) (finding that “there is no ‘market’ in the real world for ‘similar loans’ when dealing with a reorganized entity . . . and it is not surprising that the case decisions taking such approach exhibit much conjecture and inconsistent results); Hon. John K. Pearson et al., Ending the Judicial Snipe Hunt: The Search for the Cramdown Interest Rate, 4 AM. BANKR. INST. L. REV. 35 (1996) (concluding that “in no reported case has a court concluded, based on evidence presented, that any actual market exists in which a lender makes loans to debtors under the circumstances which generally prevail in reorganization”).