Under the reorganization bankruptcies—Chapter 13, 12, and 11— the debtor can pay for most secured property by paying the present value of the collateral rather than the whole debt in a procedure often called a cramdown, (or cram down) because the terms of the repayment is forced on the creditor, or crammed down its throat.
In a cramdown, the debtor pays the present value of the collateral, which is the creditor's allowed secured claim, during the pendency of the bankruptcy. The present value of the collateral is simply what it was worth on the bankruptcy filing date, but since the debtor is paying that value over time, the amount is increased by an interest rate to compensate the creditor for waiting for the payment. It is the same as getting a loan and paying back the loan over time at a stipulated interest rate.
Loans That Cannot Be Crammed Down
However, there are 3 notable exceptions of loans for property that cannot be crammed down under Chapter 13:
- home mortgages, (also applies under Chapter 11)
- If the creditor has a purchase money security interest in the property (where the creditor lent the money specifically so that the debtor could buy the property):
- loans for motor vehicles that were purchased for personal use within 910 days (about 2.5 years) of the bankruptcy filing date,
- or loans for any other property purchased within 1 year of the filing date.
For these properties, the debtor must pay the full amount of the debt to keep the property. In fact, the debtor must pay more than the full debt, because under Chapter 13, the debtor must send the payments to the trustee, who then subtracts her commission and distributes the rest to the creditors.
A Debtor Might Save More Money Under Chapter 11 Than Chapter 13
A debtor who has valuable secured property that cannot be crammed down under Chapter 13 may do better under Chapter 11. Although the filing fee for Chapter 11 is significantly higher than Chapter 13, there is usually no trustee in a Chapter 11 case, so no commission must be paid. Hence, the debtor saves money in 2 ways:
- by being able to cram down property that couldn't be crammed down under Chapter 13 and probably pay a lower interest rate than the contract rate for the loan;
- by saving on the trustee's commission.
The debtor would have to compare this savings with the $1,000 filing fee of Chapter 11 and the $10,000 - $30,000 that an attorney would probably charge for an individual debtor.
Home mortgages aren't subject to cramdown because it allows more money available for mortgages at a lower interest rate than would otherwise be available if creditors had to take the risk of getting less for its property in a cramdown. During 2008 and 2009, there was much debate in Congress on whether to allow cramdowns for mortgages, since there were many foreclosures occurring that was driving down property values and forcing people out of their homes. As of this writing, the discussions continue. However, arrearages on the mortgage can be paid over time if the debtor can otherwise continue paying the mortgage.
The 910-day rule, listed in a hanging paragraph in §1325(a), for motor vehicles was enacted in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) to prevent people who were planning or considering bankruptcy from buying vehicles so that they could simply pay the value of the collateral rather than the full debt.
Calculating the Cramdown
For property subject to cramdowns, there are 2 variables that must be determined:
- the present value of the collateral,
- and the interest rate to charge.
Both of these variables are often litigated and a payment plan cannot be confirmed until these variables are settled, but if the debtor doesn't like the payment terms, he can always surrender the collateral to the secured creditor, removing it as an obstacle to confirmation.
There are several standards for determining the value of collateral. Liquidation value is what the creditor would receive in a foreclosure. Replacement value is what a retail merchant would charge for property of similar condition and age. §506(a), stipulates that the value of the collateral will be partly determined by its proposed disposition or use. However, for personal property of an individual debtor in Chapter 7 or 13, §506(a)(2) of the Bankruptcy Code stipulates that the replacement value of the collateral as of the petition date should be used and that sales or marketing costs cannot be deducted from the replacement value.
So if the debtor decides to retain the property, then replacement value is the relevant value. The bankruptcy court will determine the replacement value of the collateral, but whether it is the retail value, wholesale value, or any value in between will depend on whether the debtor is an individual or business and on the type of property. However, the full retail value may not be used since the debtor, by retaining the property, receives no warranties or any reconditioning of the property that is typically received when purchasing from a retailer.
Most valuations of collateral worth are settled by negotiation between the creditor and the debtor. Although the 2005 amendments to the Bankruptcy Code have favored the creditor, the debtor still has negotiating power in that he can always surrender the collateral to the creditor, thereby giving the creditor only the foreclosure value of the property.
Whatever the value of the collateral that is determined, that will be the creditor's allowed secured claim. However, the present value of the allowed secured claim depends on the interest rate, which is the next variable that must be determined for a cramdown.
Since the creditor will only be receiving full payment over the time that the debtor pays it off, which is usually over the span of the bankruptcy, the creditor is entitled to an interest rate on the value of the allowed secured claim. In essence, the present value of the debtor's payments must equal the value of the collateral, so the payments must be discounted by an interest rate that will equal the allowed secured claim. Once the interest rate is determined, then:
Total Amount Paid by Debtor = Allowed Secured Claim × (1 + r)n
where r = annual interest rate and n = number of years payments are made.
This is equivalent to calculating the future value of a bank deposit with the amount of the allowed secured claim that is earning the annual interest rate compounded annually. Obviously, the higher the interest rate, the more the debtor must pay to the creditor.
Generally, lenders earn interest on their loans to compensate them for the opportunity cost of using the funds some other way, for inflation, and for the risk of default. The courts have used 4 methods of determining what the interest rate should be:
- coerced loan,
- presumptive contract rate,
- and cost of funds.
The formula method (aka prime plus) uses the current prime rate plus an additional percentage. The courts generally add 1% to 3%, but allows the creditor to prove that a higher percentage is more apt. Since the prime rate already compensates for opportunity cost and for inflation according to the market's view of those factors, the additional percentage is added to compensate the creditor for the greater risk of default by the debtor, since the prime rate is only available to the most creditworthy corporations.
The presumptive contract rate method simply uses the interest rate specified in the original contract, but allowing the debtor a chance to prove that it should lower.
The coerced loan method considers what the creditor could earn if it were allowed to immediately foreclose on the property, then invest the proceeds by lending it out with the same risk and duration as the cramdown payments.
The cost of funds method considers what it would cost the creditor to borrow the amount of money equal to its allowed secured claim, since if it could borrow the money, then it would be in the same position as it would be if it had received its full payment right away. However, this method does not consider the limitations of the creditor to borrow money, since the greater its debt, the more interest it would have to pay. This method has the least support with the courts and is rarely used because this approach depends on the creditworthiness of the creditor rather than the debtor.
In bankruptcy, there is another risk that must be considered when determining the interest rate, and that is the ability of the debtor to pay the installments. While it has often been argued that higher interest rates are necessary to compensate the creditor for the increased risk of default with less creditworthy debtors, it also increases the likelihood that those debtors will, indeed, default. Hence, the most prudent interest rate should be high enough to compensate the creditor for the risk but low enough that the debtor will be likely to complete the payment plan.
Which method will yield the lowest interest rate will depend on the contract rate and on the market rate at the time of the bankruptcy. Under Chapter 13 and 12, only the debtor may submit a payment plan for confirmation, and, thus, can pick which method yields the lowest interest rate, but the creditor may argue for a higher value. Under Chapter 11, the debtor has the 1st chance to submit a payment plan for confirmation, but if the debtor fails to submit a plan within 120 days or a confirmed plan within 180 days, or a trustee is appointed for the case, then other parties in interest may submit a payment plan, and choose the method to determine the interest rate.