By Jeff Krieger
In 1999, Lee and Amy Till, a married couple residing in Kokomo, Indiana, stopped making payments on $4,800 owed on a 1991 Chevrolet S-10 pickup truck - a vehicle they had purchased the year before. They had made a down payment of $300, and their biweekly payments were to be just under $122, made to the Instant Auto loan company. Beset by creditors, the Tills then filed a Chapter 13 (personal) bankruptcy petition and plan, and proposed to pay 9.5 percent interest on the remaining balance of their truck loan, not the contract rate of 21 percent.
It is hard to imagine that a bankruptcy of such modest circumstances would come to fundamentally impact large commercial real estate transactions a decade later, and yet it has.
So, back to the Tills and their battle with their lender. Each side drew upon trade-group or public-interest lawyers to help wage the battle. This was "the case that could" - the struggle over the Tills' 1991 pickup truck played out not only through federal bankruptcy court, but then through the federal district court and Seventh Circuit Court of Appeals, before going all the way to the United States Supreme Court.
In 2004, in a mixed decision that is being parsed to this day - even obscure footnotes are cited - the nation's highest court issued guidance as to how a federal bankruptcy court could and perhaps should substitute a new interest rate on a secured loan to a bankrupt debtor. The new rate could or should be pegged to the current national prime rate plus an upward adjustment, and not to the current note rate, or other market or formula rates. The Tills prevailed and were allowed to pay interest at 9.5 percent.
What happened to the Tills' auto-finance company could happen to holders of more than $100 billion of distressed commercial mortgages in the United States, thanks to this largely unheralded (outside of the bankruptcy community) 2004 Supreme Court decision.
The impact of Till v. SCS Credit Corporation (2004), what is now called the Till decision, or simply Till, has been percolating through the nation's bankruptcy and circuit courts ever since, and gaining broad acceptance not only in Chapter 13 cases but also in Chapter 11 cases. And that means the Till decision applies to real estate - even big commercial real estate.
The Till decision recognizes principle (and not always principal) before size. What is good for a (small) goose is good for a (large) gander, or so the courts have ruled.
The Till decision is on its way to becoming one of the most historic and fundamental decisions to apply to bankruptcy since the U.S. bankruptcy statutes were first written, or at least since the extensive bankruptcy reforms of 1978. Indeed, prominent bankruptcy attorneys have said that the Till decision appears to have stalled or reversed a longstanding trend in which Chapter 11 had evolved into more of an effective creditor remedy than a source of debtor relief.
Debtors and creditors should be aware that the tides have again turned in Chapter 1 1 cases, and in the long struggle between creditor demands and the needs of the insolvent, it is agents of "debtor relief" that now may be getting an upper hand.
Buying distressed mortgages
The law moves slowly, and often with unintended consequences, as many in the community of distressed mortgage and real estate investors are now finding out.
Given the sizable and inherent risks, investors in distressed debt on troubled commercial properties usually are looking to buy at reduced prices and execute a timely exit strategy at relatively higher prices. Distressed investors often expect to be paid under the terms of the loan (perhaps with some workouts) or to foreclose and sell the property for what the market will bear, perhaps after a renovation and repositioning. It is a high-risk, high-energy business that often requires infusions of capital and intensive management after the bad loan has been acquired.
But now, those who are taking the uncertain risk of buying distressed mortgages in the tens or even hundreds of millions of dollars - and that includes the "loan to own" investors - are finding that bankrupt debtors are leaning on Till to hold on to properties and plead in court for adjusted, lower mortgage payments - rates that reflect current historic lows.
Being saddled with so-so mortgage yields for many years into the future is not the exit strategy distressed investors had in mind. Instead of selling repositioned real estate into an improving market, many distressed debt investors are finding they are faced with holding on to mortgages with rates of interest fixed at lower-than original contract rates.
The Till decision
At the heart of the 2004 Supreme Court ruling are interest rates: What is the appropriate rate of interest that should be applied to loans extended to bankrupt debtors? A layman might think that the terms of a real estate loan cannot be changed over the lender's objections or that if the borrower, especially a real estate borrower, cannot pay creditors in a timely fashion, then foreclosure is likely. But those sentiments could be misplaced.
Under Till, a bankruptcy court can approve a change in the current contract (mortgage) interest rate, if the creditor would still be repaid principal and not suffer a loss. The court recognizes the "present value" concept of money, and requires that secured creditors receive fair compensation, with consideration of present value, under Chapter 1 1 reorganization plans. But the twist in the Till decision is this: The U.S. Supreme Court tells us that present value should be computed by using the national prime rate and then generally adding between 1 percent and 3 percent interest to compensate for circumstance and risk.
So, in current markets, under guidance of the Till decision, a debtor can reduce a contractual interest rate to (generally) between 4.25 percent and 6.25 percent. It should be noted that the prime rate is the interest rate charged by commercial banks to their most credit worthy customers.
Moreover, debtors can ask for and have approved an interest rate that is tied to the nation's prime rate even as they cram down reluctant secured creditors ("cram down" is admittedly inelegant legalese that means creditors are contesting the plan, but are being forced along). So, creditors can oppose the debtor's plan and ask for contract rates or penalty rates, but will be forced by the court to abide by prime-plus rates.
Of course, by now any real estate expert reading this is ahead of the game. The reality now is that with the prime rate at near-record lows, a Chapter 1 1 bankruptcy approved appropriate rate of interest rate could be a few percentage points or more below the original contract or penalty rate. And the debtors will be able to hold on to their property as long as they meet the new, lower mortgage payments. The debtors are indeed debtors in possession.
The real-world aspect not really anticipated by the Supreme Court in Till is that distressed real estate investors do not buy distressed mortgages merely to have the present value of their investments protected. They make high-risk investments to seek higher returns than those of passive investors in safe loans.
The impact of the Till decision would be significant even in times of economic stability, but in the current economic environment, with so many commercial mortgages coming into bankruptcy court, the impact can and has been dramatic.
The Supreme Court had its reasons
This is not to say that the Supreme Court's Till decision was without merit. Prior to 2004, and even thereafter, but before the Till decision became broadly accepted in Chapter 1 1 cases, there were various methods - some would say a bewildering array of methods - approved by bankruptcy courts for determining appropriate interest rates on debtor's secured obligations. In truth, before Till, the wide variety of approaches to determining the appropriate rate of interest may not have reflected well on our judicial system or bankruptcy court. There were "presumptive" contract rates, something called "coerced loan" rates, and "market" rates.
The Tills had stumbled into a messy landscape, cluttered with various bankruptcy court decisions from circuit to circuit. Before the Till decision, bankruptcy courts relied on debtor- and creditor-provided market analyses of the "prevailing market rate for a loan of a term equal to the payout period, with due consideration of the quality of the security and the risk of subsequent default" (in re Monnier Bros., 1985).
Naturally, those market analyses were often subjective and contradictory, and required the hiring of credentialed experts, all carefully manipulated through an already expensive bankruptcy process. For example, experts are often deposed, requiring even further documentation and evidence - and expenses.
Before Till, bankruptcy court experts wryly noted that among reported cases one could find authority to support almost any method of calculating the appropriate rate. In contested Chapter 1 1 bankruptcy cases, the old adage "know thy judge" became paramount.
Indeed, before the Till decision, the Seventh Circuit Court had ruled that creditor Instant Auto (and its successor, SCS Credit Corporation) might be entitled to the original contract rate of 21 percent interest on its loan to the Tills, while the district court and bankruptcy court had approved two different methods of calculating the appropriate rate of interest for the auto loan.
In deciding to go to a strict formula or prime-plus approach, the Supreme Court wrote in the Till decision 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. For these reasons, the prime-plus or formula rate best comports with the purposes of the bankruptcy code."
The Supreme Court also tipped its hat to clarity and resolution, stating that the prime-rate-plus approach was "straightforward, familiar and objective . . . and minimize[d] . . . costly additional evidentiary proceedings." But in Till, the Supreme Court hinted that the purpose of bankruptcy law is not strict adherence to the contractual rights of creditors (though secured creditors are supposed to be protected from losses of principal, if there is sufficient collateral), but to get the bankrupt party back on its feet through an approved plan that adheres to uniform standards.
The Till decision even involves lofty constitutional issues. Though overlooked today among laymen and even some lawyers, the right to petition for bankruptcy is enshrined in the Constitution, as is the right of citizens (and corporations and businesses) to "uniform laws on the subject of bankruptcies throughout the United States," as expressed in Article 1, Section 8, Clause 4 of the U.S. Constitution.
The constitutional framers thus determined that bankruptcy should be a federal process and uniform - somewhat remarkable, given the power of state governments and rabid regional pride of that era. The framers may have wanted to avoid the debtor's prisons and like institutions of Great Britain, but unlike other issues of the day, there is a near-complete lack of written record on the intent of the framers in this regard. Constitutional scholars have lamented that the odd-duck bankruptcy clause appears nearly out of thin air, and was inserted into the document late in the famed Philadelphia Constitutional Convention of 1787, and without much discussion, if any.
Some have noted that many founders were farmers and landowners, and thus were often deeply in debt. George Washington, for example, experienced debt problems related to tobacco growing, and Thomas Jefferson died never having extinguished large debts.
James Madison did fleetingly address the issue of bankruptcy in The Federalist Papers No. 42, writing, "The power of establishing uniform laws of bankruptcy is so intimately connected with the regulation of commerce, and will prevent so many frauds where the parties or their property may lie or be removed into different states, that the expediency of it seems not likely to be drawn into question." Madison was also, like Washington, a land-owning tobacco farmer who borrowed heavily to bring crop to market.
Needless to say, current-day holders of contracts and distressed mortgages may not appreciate the finer points of constitutional history and law. The rub for many distressed investors in today's real estate market - and with today's record-low interest rates - is that the Till decision allows debtors to propose a bankruptcy plan that imposes on a lender an interest rate that may be percentage points below the contract rate, and perhaps many percentage points below default rates.
However, distressed real estate investors often buy mortgages precisely because they offer good contractual yields, backed by sufficient collateral (in comparison to the purchase price of the distressed mortgage), and because foreclosure (due to lack of timely debtor payments) is a possibility. Indeed, the Till decision is especially worrisome for investors who have purchased commercial mortgages with a loan-to-own agenda - debtors will have more leverage to avoid foreclosure.
Two lessons of the Till decision are: 1) distressed debt investors beware - you may find that the bankruptcy court is no friend of yours; and 2) banks or other owners of bad mortgages may find buyers prepared to offer even less than in the past.
The expected surge of distressed mortgages embedded in commercial mortgage-backed securities (CMBS) will also likely bring about many applications of the Till decision, rearranging the fortunes of distressed mortgage investors and debtors accordingly.
The relationship between law and distressed real estate investors is always evolving, and you never know when an 8-year-old case involving a $4,800 pickup truck will impact a $75 million real estate investment.
*As published in Mortgage Banking