© 2013 The Texas Lawbook.
By Greg Hesse and Eric Flynn
Hunton & Williams
Borrowers and lenders should take note of the Fifth Circuit’s decision as it may significantly impact the decision on which methodology to use when evaluating the options on how to treat debt in a chapter 11 plan or reorganization.
Case Background
In 2007, Texas Grand Prairie Hotel Realty, LLC, Texas Austin Hotel Realty, LLC, Texas Houston Hotel Realty, LLC, and Texas San Antonio Hotel Realty, LLC (collectively, “Debtors”) obtained a $49,000,000 loan (the “Loan”) from Morgan Stanley Mortgage Capital, Inc., to acquire and renovate four hotel properties in Texas. To secure repayment, Morgan Stanley — not a party to this case — took a security interest in the hotel properties and in substantially all of the Debtors’ other assets. Subsequently, Wells Fargo Bank N.A. (“Wells Fargo”) was named trustee for the trust (the “Lender”) that eventually acquired the Loan.
Unable to repay the Loan at maturity, the Debtors filed for Chapter 11 protection and proposed a plan of reorganization. When the Lender voted against the plan, the Debtors sought to confirm the plan over the Lenders objection pursuant to 11 U.S.C. § 1129(b). The plan valued the Lender’s secured claim at roughly $39,080,000 based on the Lender’s appraisal. Under the plan, the Debtors proposed to pay off the Lender’s secured claim over ten years utilizing a twenty year amortization with interest at 5%. The Lender objected to the proposed treatment on the basis that the interest rate was too low.
Bankruptcy Court Decision
At the confirmation hearing, the Lender object to, among other things, the 5% interest rate proposed to be paid on its secured claim. Both parties stipulated that the applicable interest rate should be determined by applying the “prime-plus” formula endorsed by a plurality of the Supreme Court in Till. However, the parties’ experts disagreed on the application of that formula: the Debtors’ expert testified that Till supported a 5% rate, while the Lender’s expert insisted that Till mandated a rate of at least 8.8%.
The Till decision arose in the context of a contested Chapter 13 plan process, but has been applied by numerous courts in the Chapter 11 context. Under the Till formula method, a bankruptcy court should begin its cramdown rate analysis with the national prime rate — the rate charged by banks to creditworthy commercial borrowers — and then add a supplemental “risk adjustment” to account for “such factors as the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan.” Though the plurality “d[id] not decide the proper scale for the risk adjustment,” it observed that “other courts have generally approved adjustments of 1% to 3%.” Till v. SCS Credit Corp., 541 U.S. 465, 474-476, 480 (2004).
In arriving at his recommended 5% rate, the Debtor’s expert began his analysis by quoting the prime rate at 3.25%. He then proceeded to assess a risk adjustment by evaluating the factors enumerated by the Till plurality: looking to “the circumstances of the [D]ebtors’ estate, the nature of the security, and the duration and feasibility of the plan.” The Debtor’s expert concluded that the Debtors’ hotel properties were well maintained and excellently managed, that the Debtors’ owners were committed to the business, that the Debtors’ revenues exceeded their projections in the months prior to the hearing, that the Lender’s collateral was stable or appreciating, and that the Debtors’ proposed plan would be tight but feasible. On the basis of these findings, the Debtor’s expert assessed the risk of default “just to the left of the middle of the risk scale.” As Till had suggested that risk adjustments generally fall between 1% and 3%, the Debtor’s expert reasoned that a 1.75% risk adjustment would be appropriate.
The Lender’s expert, corroborated virtually all of the Debtor’s expert findings with respect to Debtors’ properties, management, ownership, and projected earnings. The Lender’s expert also agreed that the applicable prime rate was 3.25%. However, the Lender’s expert devoted the vast majority of his analysis to determining the rate of interest that the market would charge to finance an amount of principal equal to the cramdown loan. Because the Lender’s expert concluded that there was no market for single, secured loans comparable to the “forced loan” contemplated under the plan, he calculated the market rate by taking the weighted average of the interest rates the market would charge for a multi-tiered exit financing package comprised of senior debt, mezzanine debt, and equity resulting in a “blended” market rate of 9.3%. To bring his “market influenced” analysis within the form of Till’s prime-plus method, the Debtor’s expert purported to “utilize the [3.25%] Prime Rate as the Base Rate,” making an upward “adjustment” of 6.05% to account for “the nature of the security interest.” This calculation equaled the 9.3% blended market rate. The Debtor’s expert then adjusted the blended rate in accordance with the remaining Till factors, making a downward adjustment of 1.5% to account for the sterling “circumstances of the bankruptcy estate” and an upward adjustment of 1% to account for the plan’s tight feasibility. Ultimately, the Lender’s expert concluded that the Lender was entitled to an interest rate of 8.8%.
At the conclusion of the testimony of the Debtor’s expert, the Lender filed a Daubert motion seeking to strike his testimony. See, Daubert v. Merrell Dow Pharmaceuticals, Inc., 509 U.S. 579, 589 (1993). The bankruptcy court denied the challenge and adopted the Debtor’s expert testimony, finding that “the Debtor’s expert properly interpreted Till and properly applied it,” and that his “assessment of the circumstances of the estate, the nature of the security, and the feasibility of the plan . . . [were] credible and persuasive.” The court rejected the Lender’s expert testimony, finding that his expert analysis was inconsistent with Till’s prime-plus method. The court specifically found that the Lender’s expert’s method was more in the nature of a forced loan approach, which was expressly rejected by the Court in Till. Consequently, the court concluded that the appropriate risk adjustment was 1.75% and thus, that the Lender was entitled to a 5% interest rate. The bankruptcy court went on to confirm the Debtors’ plan of reorganization.
The Lender appealed to the district court, challenging the bankruptcy court’s decision to admit the Debtor’s expert testimony as well as the court’s adoption of his interest-rate analysis. The district court affirmed and the Lender appealed to the Fifth Circuit.
The Fifth Circuit’s Decision
In deciding Texas Grand Prairie, the Fifth Circuit first reaffirmed its decision in In re T-H New Orleans Ltd. P’ship, 116 F.3d 790, 800 (5th Cir. 1997) in which it expressly stated that it did not endorse any one method of determining the appropriate rate of interest in a chapter 11 proceeding. The Fifth Circuit, specifically took great pains to establish that while the Till methodology was used in this case, per the stipulation of both parties, Till was not the sole method of determining the rate of interest in contested chapter 11 proceedings in the Fifth Circuit.
Having established that there is no single approved methodology for determining the appropriate cramdown interest rate in chapter 11 proceedings, the Fifth Circuit noted that the parties stipulated that the Till methodology applied and turned to the facts in the case before it. Since the issue on appeal related to the lower court’s findings of fact, the court used the clearly erroneous standard of review.
The Fifth Circuit found that, as the plurality in Till instructed, the Debtors’ expert engaged in a holistic evaluation of the Debtors, concluding that the quality of the bankruptcy estate was sterling, that the Debtors’ revenues were exceeding projections, that the Lender’s collateral — primarily real estate — was liquid and stable or appreciating in value, and that the reorganization plan would be tight but feasible. On the basis of these findings — which were all independently verified by the Lender’s expert — the Debtors’ expert assessed a risk adjustment of 1.75% over the prime rate of interest. The Fifth Circuit noted that this risk adjustment fell squarely within the range of adjustments other bankruptcy courts have assessed in similar circumstances. The Fifth Circuit also found that the Lender’s expert predicated his 8.8% cramdown rate on the sort of forced loan analysis rejected by the Till plurality.
In reaching its conclusion, the Fifth Circuit addressed the Lender’s contention that the plurality in Till repeatedly referenced “the market for comparable loans” as “relevant” and thus, the Lender’s inclusion of the market for comparable loans in its analysis was proper. The Fifth Circuit rejected the Lender’s argument, stating that aside from the fact that the Lender took the quoted language out of context, Till expressly rejected methodologies that “require[] the bankruptcy courts to consider evidence about the market for comparable loans,” noting that such approaches “require an inquiry far removed from such courts’ usual task of evaluating debtors’ financial circumstances and the feasibility of their debt adjustment plans.” Till, 541 U.S. at 477.
The Fifth Circuit also noted that, curiously, the Lender did not try to predicate its “market influenced” blended rate calculation on the Till plurality’s Footnote 14, which suggests that a “market rate” approach should apply in Chapter 11 cases where “efficient markets” for exit financing exist. Till, 541 U.S. at 477 n.14. The Fifth Circuit noted that many courts — including the Sixth Circuit — have found Footnote 14 persuasive. See In re Am. HomePatient, Inc., 420 F.3d 559, 568 (6th Cir. 2005). Even assuming, however, that Footnote 14 has some persuasive value, it does not suggest that the bankruptcy court here committed any error. Among the courts that adhere to Footnote 14, most have held that markets for exit financing are “efficient” only if they offer a loan with a term, size, and collateral comparable to the forced loan contemplated under the plan. In re 20 Bayard Views, LLC 445 B.R. 83, 110–11 (Bankr. E.D.N.Y. 2011); In re SW Boston Hotel Venture, 460 B.R. 38, 55 (Bankr. D. Mass. 2011). In the present case, the Lender’s expert acknowledged that “there’s no one in this market today that would loan this loan to the debtors — one to one loan-to-value ratio, 39 million dollars, secured by these properties.” While the Lender’s expert concluded that exit financing could be cobbled together through a combination of senior debt, mezzanine debt, and equity financing, courts, including the Sixth Circuit have rejected the argument that the existence of such tiered financing establishes “efficient markets,” observing that it bears no resemblance to the single, secured loan contemplated under a cramdown plan.
By reason of the foregoing, the Fifth Circuit held that bankruptcy court had not committed clear error when it confirmed the Debtors’ reorganization plan which provided the Lender with a 5% discount rate. Accordingly, the Fifth Circuit affirmed the district court’s affirmation of the bankruptcy court’s decision.
Conclusion
The Fifth Circuit’s decision in Texas Grand Prairie is instructive for debtors and creditors on the way in which Till will be applied when determining the appropriate interest rate, when Till is applied at all. Texas Grand Prairie is further notable for the Fifth Circuit’s continued determination that it leave the decision on whether to apply Till in chapter 11 proceedings to the discretion of the bankruptcy courts.
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