In re Smith, Bankruptcy No. 94-10275.

Citation178 BR 946
Decision Date06 March 1995
Docket NumberBankruptcy No. 94-10275.
CourtUnited States Bankruptcy Courts. Second Circuit. U.S. Bankruptcy Court —District of Vermont
PartiesIn re C. Richard SMITH and Linda R. Smith, Debtors-in-Possession.

C.D. Hickey, St. Johnsbury, VT, for Community Nat. Bank (Bank).

G. Glinka, Cabot, VT, for C. Richard Smith and Linda R. Smith (Debtors).

Amended Memorandum of Decision on Appropriate Interest Rate to an Oversecured Creditor in a Chapter 12 Family Farmer Case

FRANCIS G. CONRAD, Bankruptcy Judge.

This contested matter is before1 us on Bank's objection to the interest rate Chapter 12 Debtors propose to pay on Bank's oversecured claim. We hold that neither of the two rates advanced by the contending parties appropriately compensate2 Bank for the estate's detention of the property securing Bank's claim. We also came up empty handed after rummaging through the burgeoning literature and caselaw, searching for a theory or formula that would adequately account for the nature of the conflicting interests at stake and result in an interest rate that fairly compensates the oversecured creditor. Not only are the approaches we reviewed arbitrary, and unfair to one side or the other, but many are simply too hard to use, clogging up the Court's calendar and diverting the parties' resources. We are persuaded that much of the debate over appropriate interest rates is based on assumptions that don't stand up under scrutiny, and fails to focus on the interests at stake. Our hope is that by sketching out some of our concerns in broad strokes in this Memorandum of Decision, discussion and debate will become focused more narrowly on the fundamental issues at stake whenever interest is awarded to a secured creditor. Pending that dialogue within the bankruptcy community, however, our limited holding is that a Chapter 12 Plan must pay interest on the claim of an oversecured creditor at the rate prevailing on U.S. Treasury instruments of the same or similar term at the date of confirmation.

FACTS

The facts are simple. Debtors filed a Chapter 12 petition on May 2, 1994. Debtors' first Plan of Reorganization, proposed to pay Bank's claim with interest at a 7.0% annual rate, amortized over 25 years. Full payment would be due in 10 years. Bank was to retain its lien on Debtors' farm, primary home, cattle, equipment, and crops. Bank is oversecured because the aggregate value of its collateral exceeds the amount Debtors owe Bank. All objections to Debtors' Plan were resolved at the confirmation hearing, except for Bank's objection to the proposed interest rate. That objection was set down for an evidentiary hearing.

Prior to the evidentiary hearing, Debtors located an articulate expert and obtained discovery from Bank about Bank's cost of capital, which appeared to be low. Thus armed, Debtors squeezed Bank's legal and financial udders, amending their plan to lower the proposed rate of interest from 7.0% to 6.0%. At the evidentiary hearing, Debtors' expert provided one of the most interesting testimonials about interest rates this Court has ever received into evidence. The expert testified quite convincingly that Bank's cost of capital was 4.46 percent over the last five years, and 3.39 percent over the last year. The evidence was that Bank's cost of capital is higher than the cost to most other Vermont banks, though we were not told how much higher. One of Bank's witnesses essentially confirmed the testimony of Debtors' expert about Bank's costs. To this cost of capital, Debtor gratuitously added a 1.54 percent increase to reach its proffered 6% interest rate. No factual evidence was offered to support the 1.54 percent. In the words of Debtors' counsel, the increase was offered to ensure confirmation.

Although we found Debtors' expert to be credible and engaging, much of his testimony simply wasn't about interest rates. Rather, he testified about Bank's cost of capital and how Bank recovers overhead, credit risk, interest risk and profit. As we will explain later, except for interest risk, Bank is entitled to none of these components in bankruptcy. Moreover, we fail to understand why a federal system of bankruptcy intended to equitably apportion debtors' limited assets3 should calculate interest to oversecured creditors based on the creditors' own lending efficiency. Such a system would penalize efficient performers with low costs of capital and reward less efficient lenders with high costs of capital.

Bank's expert was also credible. This expert testified that Bank does not ordinarily offer its customers intermediate-term, fixed-rate loans like those Debtors were proposing—6.0% interest over ten years. Rather, Bank generally offers only variable rates on intermediate-term loans. In the circumstance of a debtor similar to the Debtors in this case, and because the loan would not be guaranteed by the Farmers Home Administration, Bank would offer a Federal Home Loan Bank rate, plus 3 percent and two points. This would effectively be a rate of 11 percent.4 Although it is clear that Bank does not in fact customarily offer loans structured in the manner proposed by Debtor, Bank's evidence convinces us that the rate it proposes is a fair approximation of a market rate for similarly situated debtors. We have not been convinced, however, that a market rate should apply. Indeed, for the reasons set forth hereafter, we reject the use of a market rate for the award of interest to secured creditors.

Following the evidentiary hearing, we fixed interest to Bank at a rate of 7.29 percent, which was the prevailing Treasury rate for instruments of similar duration. We then confirmed the Plan, pending issuance of this Memorandum of Decision. The parties were directed to submit briefs appropriate to the issue at hand.

DISCUSSION

The exercise we now undertake resembles the search of Diogenes the Cynic5 for an honest man. Our search is for an honest interest rate, one that will further the goals of family farmer reorganization, while giving the oversecured creditor exactly the protection it is entitled to. To switch metaphors, like Goldilocks rummaging through the home of the three bears, we are looking for an interest rate that is not too high and not too low, but is "just right." Our hope is that such a rate will be easy to ascertain, providing certainty to the parties, and sparing Courts, creditors and debtors the expense and delay of prolonged evidentiary wrangling. We are confident there is such a rate, and that it is out there somewhere waiting to be found.

Our research has found this field well-plowed. Numerous Courts and commentators have written much on the subject6 that is germane to the award of interest in a Chapter 12 case.7 § 1225(a)(5). Most courts that have considered the issue hold, almost ecumenically, that a secured creditor is entitled to the market rate in the context of a cramdown.8 Despite near unanimity on the standard, however,

the case law with regard to an appropriate discount rate for cramdown purposes unfortunately has blossomed into a "many-colored splendor" of conflicting and sometimes indecipherable formulas as the courts have tried to implement the fact specific market analysis approach....

In re Computer Optics, Inc., 126 B.R. 664, 671 (Bkrtcy.D.N.H.1991). Often, the justification cited is the "coerced loan" theory espoused by Collier and followed by many unsuspecting courts.

It is submitted that a deferred payment of an obligation under a plan is a coerced loan and the rate of return with respect to such loan must correspond to the rate which would be charged or obtained by the creditor making a loan to a third party with similar terms, duration, collateral, and risk. It is therefore submitted that the appropriate discount rate must be determined by reference to the "market" interest rate.

5 Collier on Bankruptcy, ¶ 1129-03, p. 1129-99, 15th ed. (1994). Judge Yacos' opinion in Computer Optics blames Collier for "much of the confusion" that "has skewed analysis ever since."

Without citing any case or other authority that existed at the time, the Collier treatise in that comment took a quantum leap from the present value concept (in terms of the time value of money) into a totally different concept of a loan transaction involving fact specific risk analysis.

Computer Optics, supra, 126 B.R. at 671. We cannot improve on Judge Yacos' characterization. Simply put, Collier confused loans and claims. Id., at 671-72. As a result, judges have been functioning as commercial loan officers, economists, and financial managers in their opinions, and not as the overseers of the reorganization process.

Courts are, as we have noted above, nearly unanimous that the appropriate interest rate is the market rate for similar loans. Nevertheless, the attempt by lawyers and judges, who are generally not economists, accountants, or experts in finance, to divine the correct market rate is a grueling exercise in self-impalement on concepts taken out of context. The attempt has spawned a myriad of mutually exclusive approaches producing rates that could never be found in the market. The attempt to award interest equivalent to the market rate for similar loans is doomed to produce chaos and confusion, we believe, because it starts with legal concepts that don't apply. More specifically, the search for the correct market rate for similar loans9 is doomed for two reasons. First, there is no market for loans of this type. In most cases, a cerebral banker or lender would rather lend to a third-world country than make a prepetition loan to a borrower headed for bankruptcy. Although there is a growing market for trading claims in bankruptcy, the claims are generally traded at significant discounts, which confirms that there is in fact no market for loans equal in value to the amount of the claim. Second, these are not in fact loans, but secured claims; they arise out of loans which went bad, but they are in no sense of the word "loans." A "claim" is a "right to...

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