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This article was originally published by the American Bankruptcy Institute Journal, in Volume XXXIII / January 2014 and can be accessed by ABI members at http://journal.abi.org/sites/default/files/2013/november/turnaround.pdf. Please contact the ABI at (703) 739-0800 for reprint permission.
Why Till Works
By Franklind Lea
American Bankruptcy Institute, Financial Advisors and Investment Banking Newsletter, Vol 11, Num 4 l March
Many have reviewed the U.S. Supreme Court’s Till Opinion (Till v. SCS Credit Corp.) and walked away shaking their heads in confusion. The underlying case involved a higher-risk borrower who had purchased a used truck and shortly thereafter filed for bankruptcy under chapter 13. The parties asked the Court to choose the best method to determine a cramdown interest rate. It is important to realize that the Court was not addressing an all-inclusive list of methodologies available to financial practitioners, but was choosing from four methodologies previously used by various bankruptcy courts. The case and resulting opinion were not an indictment of the mathematics of a particular interest rate methodology, but rather selected the one that the Supreme Court felt bankruptcy courts might best apply to return the present value of a creditor’s security interest in its collateral (Bankruptcy Code § 1129(b)(2)(A)(II)). From a financial perspective, there are often multiple ways to determine the cost of capital for a borrower. The simplest, at least from an intuitive perspective, is the formula approach (a/k/a the build-up rate). The question before the Supreme Court involved a relatively straightforward consumer case. For various reasons, the Court determined that creditors were in a better position to determine and support their view of the correct interest rate and so moved the burden of proof to the creditor. In most chapter 13 cases, this makes good sense. Since chapter 13 cases are consumer cases and in some manner must be workable, a simple solution, such as the formula approach, was a good result. However, there is some disagreement over whether Till should apply to more complex chapter 11 cases. In chapter 11, the situation is more balanced. Borrowers tend to be far more sophisticated and better able to provide evidence to prove their rate of interest. Simple is still good, however, and the formula approach suggested in Till continues to work. The question now for many restructuring professionals is, “Does this mean that bankruptcy courts should only use the formula approach in chapter 11 cases, and is simplest method still good in all cases?” Many sophisticated financial professionals and some courts have reasoned that other methodologies may be an acceptable way to determine the appropriate interest rate. Financial professionals have routinely used methods such as the weighted average cost of capital and the capital asset pricing model for several decades. In fact, in many investment scenarios, the presentation of a formula approach would be deemed to be too simple and less reliable than one of these other methodologies. When an investment committee at a major bank or investment firm determines the appropriate return for its investment, it does not rely solely (if at all) on the formula approach. That said, in making its decision, the committee absolutely considers the same concept that the formula utilizes: the idea of comparison. The investment committee compares the risk and potential return of the new investment to the risk and return of other investments. The committee knows its cost of funds (its unique base rate), and that as it incurs more risk, it must add to its rate. So whether the investment committee compares the rate to the Prime rate, U.S. Treasuries or some other rate, the same underlying concept of adding or subtracting for more or less risk remains. So if the formula approach works, why are so many financial professionals reluctant to use it? The answer is largely in our training. From our earliest finance and economics classes, we learned that the markets move to account for supply and demand, markets bid up or down the price of a good or service to balance the supply and demand, and those markets are generally economically efficient. By efficient, I do not mean the existence of an active market as the Supreme Court seemed to imply, but rather that investors in the market adjust their pricing based the information in the market. Ultimately, for less risk, investors demand less; for more risk, investors demand more. In the context of all of this training and market theory lies the punch line: “all the pieces of information.” To complete the formula approach, the financial professional must determine all of the risk factors and the pieces of information needed to price the risk. The Court in Till gave us four broad categories to use in this evaluation, but the list of more specific risk factors in a complex chapter 11 case is usually very long. In many cases, risk factors can be continually broken down into an infinite number of pieces, so analyzing each of these risk “sub-factors” is unrealistic, if not impossible. More importantly, the individual pieces of market data used to determine the price for each of these risk factors is often not available. So how does someone determine the rate of interest for a loan? The answer is to analyze the risk and reward in bite-size pieces. Sometimes those pieces have very definable market-driven data. In an interest rate scenario, the financial professional may be able to determine that the average loan for unanchored retail shopping centers is Prime plus 2%. This is a definable and accurate data point that infers information about risk and reward. The analyst can continue to examine other variables and make adjustments, such as its market location, age and condition, etc., to include all of the risk factors of the debtor’s plan. Financial professionals are trained to look toward known market data, so the idea of introducing error with personal subjective judgment instead hard market data should be a source of discomfort. In many cases, the risk factors may be easy to identify, but deriving the pricing of a risk factor from the market may be too expensive or time-consuming, or the data simply might not exist. The lack of available market data should force the analyst to consider the aspects of each subjective adjustment. In these cases, analysts must rely on their experience and judgment to estimate the necessary reward for the risk. Financial professionals who use methods other than the formula approach, such as the weighted average cost of capital, often must make subjective adjustments into the calculation’s inputs in order to properly use the method. In the context of chapter 13, case efficiency prevails with the formula approach. Judges routinely see the data for the many consumer cases that come before them. They make judgments and move on. It is simple, logical and efficient, and it works. In chapter 11 cases, judges must make decisions on a number of wide-ranging business types, debt structures and plan designs. Few judges have the opportunity to routinely deal with such wide-ranging data and issues. As a result, experts are called upon to help the judge identify the risk factors, to provide and interpret data, and to give opinions on subjective matters. And this is why Till works: Using Till forces the financial professional to break their opinion down into “bite-size pieces,” the validity of which can then be considered by the trier of fact.
Copyright 2014 American Bankruptcy Institute.Please contact ABI at (703) 739-0800 for reprint permission.