White Paper: Texas Court Decision Considers Market Interest Rates in Cramdown Interest Rate Calculation

 

Texas Court Decision Considers Market Interest Rates in Cramdown Interest Rate Calculation

On September 2, 2015 Judge Houser issued a Memorandum Opinion and Order (the “Memorandum”) which constituted the Court’s findings of fact and conclusions of law in the Couture Hotels bankruptcy.[1]  One of the topics addressed in the Court’s Memorandum is Mansa Capital, LLC’s (the “Secured Creditor”) objection to the Debtor’s expert’s methodology for calculating the cramdown interest rate (the “Cramdown Interest Rate”) under the Debtor’s plan of reorganization.

Factual Background

The Debtor retained ValueScope Director Christopher C. Lucas, CFA, CPA (the “Debtor’s Expert”) as its interest rate expert.*  The Debtor’s Expert reached his conclusion regarding the appropriate Cramdown Interest Rate on the secured claim by performing the following procedures:

  • Considered the factors which led to Debtor’s bankruptcy
  • Personally inspected the hotel pledged as the primary collateral to the Secured Creditor’s loan (the “Hotel”) and consideration of its quality
  • Reviewed the plan documents including review and recalculation of the Debtor’s five year forecast (the “Forecast”)
  • Interviewed the Debtor’s managers regarding their plans to achieve the Forecast
  • Interviewed the Director of Research and Business Analysis with the Dallas Convention and Visitors Bureau and the Director of Economic Development and Tourism for the city of Farmers Branch regarding general economic conditions in Dallas broadly and Farmers Branch specifically. These interviews also included discussion of the balance of supply and demand for hotel rooms in the Dallas area and for the area immediately surrounding the hotel pledged to the Secured Creditor as collateral
  • Reviewed hotel loan interest rates advertised by lenders who specialize in making hotel loans and interviews with those lenders

The Debtor’s Expert adjusted the observed hotel loan interest rates (the “Market Interest Rate”) to reflect the factors enumerated in Texas Grand Prairie[2], as follows:

Market Interest Rate     +/- Risk premium for debtor’s management quality

+/- Risk premium for commitment of the Debtor’s owners

+/- Risk premium for the health and future prospects of the Debtor’s business

+/- Risk premium for quality of the Debtor’s collateral

+/- Risk premium for the feasibility and duration of the Debtor’s plan

The Debtor’s Expert then took the adjusted Market Interest Rate derived above and converted it into a spread over the prime rate of interest to be consistent with the Formula Approach preferred by the Supreme Court in Till.[3]

Motion to Strike

Counsel for the Secured Creditor objected to Mr. Lucas’ testimony on the grounds that his employment of a market-based interest rate as the starting point in his analysis was inconsistent with the rulings in Till and Texas Grand Prairie.

The Court’s Conclusion

The Court noted that Texas Grand Prairie clarifies that Till is merely instructive in determining cramdown interest rates and concluded that it had legal discretion to consider other factors, including industry risk premia in its decision.  The Court also noted that Debtor’s Expert and the Secured Lender’s Expert had both relied on Till and Texas Grand Prairie in their analyses but that they had applied the cases differently.  Because the parties had not stipulated the use of a strict prime-plus formula approach, the Court concluded that it had discretion to consider additional factors to determine a proper Cramdown Interest Rate.    Based on this conclusion, the Court overruled the motion to strike Mr. Lucas’ testimony.

In Defense of the Use of Industry Risk Premia

The factors relevant to making and pricing commercial loans are commonly summarized as the “Four C’s of Credit,” which include:

  • Character – referring to the willingness of the prospective borrower to repay the loan
  • Capacity – referring to the cash flow available to repay the loan generated by the prospective borrower
  • Capital – referring to the resources (assets) available to the prospective borrower to repay the loan
  • Conditions – referring to external factors (industry conditions, etc.) which impact the prospective borrower’s ability to repay the loan

The five factors considered in Texas Grand Prairie (management quality, owner commitment to the business, health and future prospects of the debtor’s business, collateral quality and feasibility and duration of the plan of reorganization) very clearly reflect the first three C’s of Credit.  The Texas Grand Prairie factors, however, are very debtor centric and only indirectly consider external factors, such as industry conditions.  Obviously, external factors such as oil prices and economic conditions can significantly influence a debtor’s ability to repay its obligations.

Incorporating an industry risk premium provides an instructive starting point from which to consider the other adjustment factors described in Texas Grand Prairie because the debtor may now be compared to other participants in its industry rather than to a hypothetical entity that borrows at the prime rate of interest.  By incorporating an industry risk premium, cramdown interest rates can be calculated as follows:

Prime Interest Rate        +     Industry risk premium (industry market rate[4] less the prime rate)

+/- Risk premium for debtor’s management quality

+/- Risk premium for commitment of the Debtor’s owners

+/- Risk premium for the health and future prospects of the Debtor’s business

+/- Risk premium for quality of the Debtor’s collateral

+/- Risk premium for the feasibility and duration of the Debtor’s plan

In Till, the Supreme Court advocated starting with a low rate of interest (the prime rate) and adjusting upward for the additional risks presented by the facts and circumstances surrounding the debtor.  When an industry risk premium is incorporated into the analysis, both upward and downward adjustments for the additional Texas Grand Prairie factors may be appropriate because the adjustments are being made relative to other borrowers in the debtor’s industry.

Limitations on Use of Industry Risk Premia

It is important to note that incorporation of industry risk premia into cramdown interest rate analyses may not always be possible.  For example, in 2009 and 2010, lenders largely stopped making new hotel loans – thus, market rates for this industry were difficult to observe during this period.  Similarly, industry risk premium analysis may be difficult to perform for debtors operating in very small industries or if the debtor’s assets are difficult to compare to those of its competitors.

Conclusion

The Texas Grand Prairie ruling does not “tie the hands of the lower courts” by defining the methodology to determine cramdown interest rates but leaves courts with discretion to consider the facts of each case.  When industry risk premia are available, they provide insight into investors’ assessment of repayment risk associated with similar loans.  This information can be helpful to Courts in their assessment of reasonable cramdown interest rates.

[1] In re: Couture Hotel Corporation, No. 14-34874-BJH, opinion dated September 2, 2015

[2] In re: Texas Grad Prairie Hotel Realty, LLC, No., 11-11109, 2013. WL 776317 (5th Clr. March 1, 2013)

[3] Till v. SCS Credit Corp., 541 U.S. 465 (2004) (plurality)

[4] For loans of comparable terms to maturity

*ValueScope is not a licensed CPA firm.

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