Supreme Court Issues Landmark Decision on Chapter 13 Cramdown Interest Rates

by Rebecca J. Harper 1

In a major victory for consumer debtors, the Supreme Court in Till v. SCS Credit Corporation2 established the "formula approach" as the proper method for calculating the rate of interest applicable to secured claims paid by installment under chapter 13 of the Bankruptcy Code.3 The cramdown interest rate had been one of the most litigated -- and one of the most economically significant -- issues in bankruptcy reorganization.

Lower Court Rules for Subprime Lender

The Tills financed a used truck through a subprime lender, SCS Credit Corp., at a contract rate of 21%. They later filed a chapter 13 plan proposing to retain the truck and pay its $4,000.00 value at the reduced interest rate of 9.5%. The proposed 9.5% rate was arrived at under a "formula approach" which augmented the then national prime rate of 8% by a 1.5% risk premium, to account for the risk of nonpayment posed by borrowers in their financial position.

SCS objected to the proposed rate, contending that it was entitled under a "coerced loan" approach to "interest at the rate of 21%, which is the rate … it would obtain if it could foreclose on the vehicle and reinvest the proceeds in loans of equivalent duration and risk" as the original pre-petition loan.4

At an evidentiary hearing on the creditor's objection, SCS presented testimony that it uniformly charges 21% interest on "subprime" loans to borrowers with poor credit ratings. The debtors countered with testimony of an economics professor who testified that lending institutions use the "prime rate" as a "national benchmark rate" that not only accounts for the time-value of money, but is "very reasonable" given that chapter 13 plans are court supervised and required to be "financially feasible."5

The bankruptcy court approved the 9.5% rate under the "formula approach" proposed by the debtors. The district court reversed on appeal, interpreting Seventh Circuit precedent to require application of a "coerced loan" rate of 21% based upon the creditor's testimony concerning the market for subprime loans. The Seventh Circuit endorsed a modified version of the "coerced loan" approach, focusing on the interest rate that the creditor would obtain in making a "new loan in the same industry to a debtor who is similarly situated, although not in bankruptcy."6 The panel majority7 held that the pre-petition contract rate should serve as a "presumptive rate," which either party could challenge with evidence that a higher or lower rate should apply.8

Supreme Court Resolves Circuit Split

By the time the issue had found its way to the Supreme Court, some form of the "coerced loan" method had been adopted by seven of the ten Circuits to have considered the issue,9 whereas three Circuits had adopted some form of the "formula method."10 In a 4-1-4 decision (Justice Thomas concurring with the four member plurality), the Supreme Court adopted the "formula approach" and expressly rejected the other approaches.11

The Supreme Court concluded that the "coerced loan," "presumptive contract" and "cost of funds" approaches are complicated, impose significant evidentiary costs, and aim to make each creditor whole rather than to ensure that the debtors' payments have the required statutory "present value."12 In contrast, the "prime-plus" formula method entails a straightforward and objective inquiry which begins by looking at the national prime rate, and contemplates adjustment by the bankruptcy court to compensate for any greater risk of nonpayment posed by the debtor.

The Court did not decide the proper scale for the risk adjustment, but noted that courts have generally approved adjustments of 1% to 3%. The Court also provided considerable direction for determining the propriety and amount of any chapter 1313 risk adjustment, significantly limiting both the scope of the inquiry as well as a bankruptcy court's discretion to award inordinate rates of interest to secured creditors similarly situated under the chapter 13 plan.14 The Court noted that "starting from a concededly low estimate and adjusting upward places the evidentiary burden squarely on the creditors, who are likely to have readier access to … information" outside the debtors' bankruptcy filings.15

The Court further noted that the "formula approach" entails a "straightforward" and "objective" inquiry.16 Significantly, the Court noted that the "prime-plus" rate of interest depends only on the "state of financial markets, the circumstances of the bankruptcy estate, and the characteristics of the loan, not on the creditor's circumstances or its prior interactions with the debtor."17 The Court made clear that the interest rate must not include consideration of a lender's transaction costs, profits, or pre-bankruptcy status -- all of which are irrelevant in the context of court-supervised cramdown loans.18 Further, the very idea of cramdown precludes consideration of creditor choice or comparison of the benefits that could be derived by the creditor if it were permitted to foreclose -- by definition the creditor is "forced" to accept a rate that complies with the objective minimal requirements of the Code.
The Supreme Court reasoned that the rate selected should be "high enough to compensate the creditor for its risk but not so high as to doom the plan."19 In a refreshing departure from the majority of appellate court decisions on the issue, the Court recognized that "…Congress intended to create a program under which plans that qualify for confirmation have a high probability of success."20

Significant Impact on Chapter 13 Feasibility

The high court's decision represents a long-overdue end to conflicting lower court treatment of this issue that has plagued creditors' and debtors' counsel -- and bankruptcy judges -- for the past two decades. The scope of the decision is broad, applying not only to undersecured subprime loans, but to all secured claims subject to modification pursuant to 11 U.S.C. § 1322(b)(2).21

The Court's reasoning is straightforward and consistent with the structure of the Code.22 By eliminating inquiry into the parties' subjective characteristics, the decision produces a cost-efficient rule that lends itself to uniform application nationwide. The decision is ultimately true to Congressional intent of chapter 13 to provide all consumer debtors with an effective means to retain secured collateral often essential to the very livelihood of the debtor.

States Not Immune From Dischargeability Suits

Bankruptcy practitioners often view their clients as drowning in a sea of debt. Apparently, the Supreme Court had a similar image in mind when it handed consumer debtors a life preserver in their pursuit of student loan and other dischargeability determinations. Relying upon an exception previously carved out for admiralty proceedings, the Court held that a bankruptcy dischargeability suit brought against the state does not implicate a state’s Eleventh Amendment immunity from suit.23

Sink or Swim?

In Tennessee Student Assistance Corp. v. Hood, the question on which the Supreme Court granted certiorari was whether Congress had authority to abrogate state sovereign immunity under the Bankruptcy Clause of the Constitution (Article I, section 8, clause 4) when it enacted § 106(a) of the Bankruptcy Code. The Sixth Circuit ruled in Hood that a bankruptcy court could decide a student loan hardship discharge case because § 106(a) was a valid abrogation of the state’s immunity from suit.24 Since most appellate courts had read Seminole Tribe of Florida v. Florida25 as severely limiting Congress’ authority to abrogate immunity26, most observers anticipated a reversal in Hood if the Court actually decided the abrogation issue.

Fortunately for Ms. Hood and other debtors looking to have a bankruptcy judge determine their entitlement to an undue hardship discharge, the Supreme Court left the abrogation issue for another day. The Court still managed however to affirm the Court of Appeals’ judgment in a 7-2 decision.

Drawing on a distinction between in rem and in personam proceedings, the Court noted that a bankruptcy court’s jurisdiction is “premised on the debtor and his estate, and not on the creditors,” and therefore the discharge of a debt by a bankruptcy court is an in rem proceeding.27 This permitted the Court to then rely upon an earlier decision in which it had held that the Eleventh Amendment does not bar federal jurisdiction over certain in rem admiralty proceedings.28 Since the bankruptcy court’s jurisdiction is “premised on the res,” a State is bound by a discharge determination even if it elects not to participate in the bankruptcy proceeding.

Substance over Form

While the court rather easily concluded that States may be bound by judicial actions without their consent in certain in rem proceedings, it still needed to grapple with the Tennessee guaranty agency’s concern that it had been served with a summons and complaint in an adversary proceeding brought by Ms. Hood. After all, the Court has often stated that the primary purpose of the Eleventh Amendment is to prevent the “indignity” of subjecting a State to court process.29

For the majority, the Bankruptcy Rule requirement that a debtor file an adversary proceeding in order to obtain a discharge under § 523(a)(8) did not transform the substantive nature of the matter from an in rem to an in personam proceeding. A student loan dischargeability action is not like an adversary proceeding brought by a trustee to recover property from the State, such as a preference action that would clearly implicate in personam jurisdiction over the State. Rather, the court suggested that no great significance should be placed on the service of a summons and complaint in a student loan discharge case as the process is “indistinguishable in practical effect” from a motion. The Court sensibly observed that “[t]o conclude that the issuance of a summons, which is required only by the Rules, precludes Hood from exercising her statutory right to an undue hardship determination would give the Rules an impermissible effect.”30

Practice Tips

The Hood opinion makes clear that debtors may now directly bring adversary proceedings or motions against the State to obtain determinations that student loan, tax obligations or other debts owed to the State are or have been discharged. Similarly, the opinion extends to many other bankruptcy proceedings that are in rem in nature, ensuring for example that plan confirmation proceedings and lien avoidance actions are not suits against the state for immunity purposes.

If the debtor seeks more than a discharge or some other in rem determination, such as an order to enforce the automatic stay, discharge injunction, or turnover requirements, there can also be little doubt after Hood that the bankruptcy court’s in personam jurisdiction against the State will be invoked and that an Eleventh Amendment immunity defense will be asserted by the State. At least until the Court ultimately decides the abrogation issue, debtors may still obtain such relief under the Ex Parte Young31 doctrine, which permits suits for prospective declaratory and injunctive relief against state officers to prevent them from violating federal law. 32

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1 Thanks to Rebecca J. Harper of the UAW-Daimler Chrysler Legal Services Plan, Marion, Indiana, for preparing this article. Ms. Harper is the attorney for the Tills and represented them throughout the proceedings, which included briefing and arguing the matter before the Supreme Court.
2 124 S.Ct. 1951 (2004).
3 Pursuant to 11 U.S.C. § 1325(a)(5)(B)(ii), allowed secured claimants who have not accepted different treatment under the plan must receive a present value equal to the allowed amount of the secured claim (i.e., the value of collateral to be retained). Bankruptcy Code provisions governing chapter 11 business reorganizations and chapter 12 farm reorganizations contain similar cramdown language requiring payment of property whose "value, as of the effective date of the plan," equals or exceeds the value of the creditor's claim.
4 124 S.Ct. at 1957.
5 Id..
6 In re Till, 301 F.3d 583 (7th Cir. 2002).
7 In dissent, Judge Rovner argued that the "coerced loan" or "presumptive contract" rate overcompensates creditors, and advocated either a "formula approach," or a "cost of funds approach" based upon the cost to the creditor to obtain the cash equivalent of the collateral from an alternate source. 301 F.3d at 593-99.
8 The Seventh Circuit majority placed the initial burden upon the debtor by concluding that, "…if a debtor proposes a plan with a rate less than the contract rate, it would be appropriate for a bankruptcy court to require the debtor to come forward with … evidence that the creditor's current rate is less than the contract rate." 301 F.3d at 593, quoting GMAC v. Jones, 999 F.2d 63, 70-71 (3d Cir. 1993).
9 See Matter of Southern States Motor Inns, Inc., 709 F.2d 647 (11th Cir. 1983), cert. den., 465 U.S. 1022 (1984), United States v. Arnold, 878 F.2d 925 (6th Cir. 1989), In re Hardzog, 901 F.2d 858 (10th Cir. 1990), GMAC v. Jones, 999 F.2d 63 (3d Cir. 1993), United Carolina Bank v. Hall, 993 F.2d 1126 (4th Cir. 1993), In re Smithwick, 121 F.3d 211 (5th Cir. 1997), cert. den., 523 U.S. 1074 (1998). See also In re Kidd, 315 F.3d 671 (6th Cir. 2003) for a recent variation on the traditional "coerced loan" approach.
10 See United States v. Doud, 869 F.2d 1144 (8th Cir. 1989), In re Fowler, 903 F.2d 694 (9th Cir. 1990), In re Valenti, 105 F.3d 55 (2d Cir. 1997) [abrogated on other grounds by Associates Commercial Corp. v. Rash, 520 U.S. 953 (1997)].
11 124 S.Ct. at 1960-65. Justice Stevens, joined by Justice Souter, Justice Ginsburg and Justice Breyer, concluded that the prime-plus or formula rate "best comports with the purposes of the Bankruptcy Code." 124 S.Ct. 1954-55, 1962. In a separate concurring opinion, Justice Thomas concluded that the clear text of the statute does not require a debtor-specific risk adjustment. Because the 9.5% rate is higher than the risk-free rate, Justice Thomas concluded that the 9.5% rate proposed by the debtors sufficiently compensated the creditor for delay in receipt of payment. Id. at 1965-68. Justice Scalia, with whom Chief Justice Rehnquist, Justice O'Connor and Justice Kennedy joined, dissented. Id. at 1968-78
12 Furthermore, the Court noted that the "presumptive contract" approach adopted by the Seventh Circuit produces "absurd results." Id. at 1960.
13 The Court found it "likely that Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate" under any other chapter 13, chapter 12 or chapter 11 provisions containing similar "value, as of the effective date of the plan" language. 124 S.Ct. at 1958-59.
14 The Supreme Court directed that bankruptcy courts aim to "treat similarly situated creditors similarly…." 124 S.Ct. at 1960. This is important because in a typical chapter 13 case in which allowed secured claimants are paid concurrently by wage assignment, the burden of proof is placed squarely upon the individual creditor who seeks to obtain a rate of interest outside the norm for similarly situated creditors.
15 124 S.Ct. at 1961.
16 The Court determined that the "formula approach" should limit the additional evidence required and minimize the cost of evidentiary proceedings. 124 S.Ct. at 1961. The anticipated reduction of evidentiary costs follows from the Court's characterization of the cramdown interest rate as an "objective" inquiry that precludes consideration of the subjective pre-petition creditor-debtor characteristics that complicated application of the "coerced loan" approach.
17 124 S.Ct. at 1961.
18 Interestingly, the Court responded to one of the dissent’s arguments in support of the presumed contract rate by noting that “several considerations suggest that the subprime market is not, in fact, perfectly competitive” and that used vehicles are often sold by “tie-in transactions” in which the “terms of financing are dictated by the seller.” 124 S.Ct. at 1962.
19 124 S.Ct. at at 1962. This too is a significant limiting factor, since, if the plan cannot pay the risk premium demanded by the creditor, the debtor may now assert that the risk premium is too high as a matter of law. The Court's analysis thus provides a decisive means for debtor challenge to the propriety and amount of the risk premium -- and an important safeguard against creditor abuse.
20 124 S.Ct. at 1963.
21 For instance, the Court's decision encompasses noncontractual claims such as statutory IRS allowed secured claims, as well as oversecured claims not secured solely by real property that constitutes the debtor's principal residence.
22 The decision commands a return to debtors of the right of contractual modification under § 1322(b)(2) which had been effectively eliminated by the majority of Circuit Court decisions by placing an unrealistic burden upon debtors who sought to modify a creditor's contractual interest rate. By recognizing that "there is no readily apparent Chapter 13 'cram down market rate of interest,'" 124 S.Ct. 1960, n.14, the decision effectively eliminates the "market rate" misnomer that had been improperly engrafted onto the statute by lower courts, thereby limiting Chapter 13 access and impeding successful reorganization based upon the outrageous demands of creditor-specific "markets."
23 Tennessee Student Assistance Corp. v. Hood, 124 S.Ct. 1905 (2004).
24 In re Hood, 319 F.3d 755 (6th Cir. 2003).
25 517 U.S. 44 (1996).
26 E.g., Nelson v. La Crosse County Dist. Atty., 301 F.3d 820 (7th Cir. 2002); In re Sacred Heart Hospital of Norristown, 133 F.3d 237 (3d Cir. 1997); Matter of Estate of Fernandez, 123 F.3d 241 (5th Cir. 1997); In re Creative Goldsmiths of Washington,119 F.3d 1140 (4th Cir. 1997).
27 Hood, 124 S.Ct. 1910.
28 California v. Deep Sea Research, Inc., 523 U.S. 491 (1998).
29 See Alden v. Maine, 527 U.S. 706 (1999); Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996).
30 Hood, 124 S.Ct. 1914. On this point, the Court cited to 28 U.S.C. § 2075 ("[The Bankruptcy Rules] shall not abridge, enlarge, or modify any substantive right").
31 209 U.S. 123 (1908). See also Alden v. Maine, 527 U.S. 706, 756-57 (1999); Idaho v. Coeur d’Alene Tribe of Idaho, 521 U.S. 261, 276-77 (1997); Seminole Tribe of Florida v. Florida, 517 U.S. 44, 48 (1996).
32 To invoke the Young doctrine, the party seeking enforcement of federal law must establish the following two elements. First, the party must allege that a state official is acting in violation of federal law. See Pennhurst State School & Hosp. v. Halderman, 465 U.S. 89, 106 (1984). Second, the relief sought must be prospective in that the party must seek to enjoin future violations of federal law rather than obtain monetary compensation or other retrospective relief for past violations. Green v. Mansour, 474 U.S. 64, 68, (1985); Quern v. Jordan, 440 U.S. 332, 346-49 (1979).