IN RE WALKABOUT CREEK LIMITED DIVIDEND HOUSING ASSOCIATION LIMITED PARTNERSHIP, et al.
Case No. 09-00632
UNITED STATES BANKRUPTCY COURT FOR THE DISTRICT OF COLUMBIA
November 10, 2011
S. Martin Teel, Jr., U.S. Bankruptcy Judge
Chapter 11; Jointly Administered
S. Martin Teel, Jr.
U.S. Bankruptcy Judge
The document below is hereby signed. Dated: November 10, 2011.
MEMORANDUM DECISION
This addresses the reorganization plans submitted by the debtors, Walkabout Creek Limited Dividend Housing Association Limited Partnership (“Walkabout I“) and Walkabout Creek II Limited Dividend Housing Association Limited Partnership (“Walkabout II“). This constitutes the court‘s findings of fact and conclusions of law regarding whether those plans can be confirmed. For the reasons set forth below, I will deny confirmation.
The debtors are affiliated partnerships and the owners of adjacent residential apartment complexes in Dexter, Michigan. Walkabout I‘s complex consists of 100 units; Walkabout II‘s
The debtors commenced their cases on July 21, 2009, when they filed voluntary petitions for relief under Chapter 11 of the
I
First, MSHDA argues that the court should deny confirmation because the plans violate the absolute priority rule of
All surplus cash, as defined by the MSHDA Regulatory Agreement would be deposited as follows: 50% into the Replacement Reserve Account and 50% would remain in the Operating Account at the end of the fiscal year per the annual audit determination for the first three years. Any distributions from the Operating Account would be subject to the provisions of the Regulatory Agreement.
Section 5.5, in turn, provides:
Repayment of prior advances from the Partners as Unsecured Creditors would be permitted during the first three years subject to the terms of the existing Regulatory Agreement between the Debtor and MSHDA. No payment of Limited Dividend distributions would be permitted during the first three years subsequent to Plan Confirmation.
These provisions, MSHDA contends, violate the absolute priority rule by allowing a distribution to the debtors’ equity holders without MSHDA getting paid in full. Regardless of whether these provisions of the plan actually allow for such a distribution, MSHDA‘s reliance on
II
Second, MSHDA argues that the court should deny confirmation because each debtor has not met the cramdown requirements of
Under
As to the appropriate interest rate under
Under the coerced funds rate, courts “treat any deferred payment of an obligation under a plan as a coerced loan and the rate of return with respect to such loan must correspond to the rate that would be charged or obtained by the creditor making a loan to a third party with similar terms, duration, collateral and risk.” In re American Homepatient, Inc., 420 F.3d 559, 565 (6th Cir. 2005) (citations omitted). Moreover, in determining the appropriate interest rate, courts “consider evidence about the market for comparable loans to similar (though nonbankrupt) debtors.” Till, 541 U.S. at 477. The Till Court, however,
The Court likewise rejected the presumptive contract rate approach. Under the presumptive contract rate approach, the court simply presumes that the original rate at which the creditor loaned the funds is the appropriate rate, but can revise the rate on the motion of either party. Id. at 492 (Scalia, J., dissenting). The Court decided against this approach because it “produces absurd results, entitling inefficient, poorly managed lenders with lower profit margins to obtain higher cramdown rates than well managed, better capitalized lenders” and “because the approach relies heavily on a creditor‘s prior dealings with the debtor, similarly situated creditors may end up with vastly different cramdown rates.” Id. at 478 (internal quotation marks omitted).
Finally, the Court also rejected the cost of funds approach. Under this method, “courts focus on the characteristics of the creditor, and its ability to obtain the capital needed to lend.”
Having rejected the three methods outlined above, the Till Court settled on the formula approach. Under the formula approach, a court is to look to the national prime rate available to a creditworthy commercial borrower and adjust it upward to account for the greater default risk presented by debtor in bankruptcy. Id. at 479. The Court stated that “[t]he appropriate size of that risk adjustment depends, of course, on such factors as the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan.” Id. The Court opted for this prime-plus approach because the prime rate was readily determinable, presented lower evidentiary
Although Till is clear that bankruptcy courts should apply the formula approach in the Chapter 13 cramdown context, the Court is less clear on how courts should go about determining the relevant cramdown rate in Chapter 11 cases. At one point, the Court noted that it was “likely that Congress intended bankruptcy judges and trustees to follow essentially the same approach when choosing an appropriate interest rate under any of [the cramdown] provisions.” Id. at 474. In a footnote, however, the Court at least partially undercut this clear statement:
This fact helps to explain why there is no readily apparent Chapter 13 “cram down market rate of interest“: Because every cramdown loan is imposed by a court over the objection of the secured creditor, there is no free market of willing cramdown lenders. Interestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. . . . Thus, when picking a cramdown rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce. In the Chapter 13 context, by contrast, the absence of any such market obligates courts to look to first principles and ask only what rate will fairly compensate a creditor for its exposure.
Id. at 476 n.14 (second emphasis added). Keying off this language, the Sixth Circuit has developed an approach to determining cramdown rates in Chapter 11 cases.
In Bank of Montreal v. Official Committee of Unsecured Creditors (In re American Homepatient, Inc.), 420 F.3d 559 (6th Cir.
B.
Under the American Homepatient test, the threshold issue, then, is whether an efficient debtor-in-possession financing market exists for multi-family residential projects. In this regard, two pieces of evidence are relevant.
- MSHDA‘s Evidence. MSHDA presented evidence at the hearing that the cost to issue bonds on the market to finance the re-amortization of the debtors’ loans is 5.25%. Assuming without deciding that the market onto which MSHDA sells its bonds is efficient, this would still not provide the court with the relevant cramdown rate.
The record does not show the character of the bonds MSHDA issues. The 5.25% rate could be a general obligation of MSHDA or, alternatively, could be only collateralized by the underlying mortgages (or payment streams stemming from those mortgages), neither of which alternative represents the efficient rate for debtor-in-possession financing for multi-family residential developments.
Alternatively, even if the MSHDA bonds were collateralized only by the underlying mortgages, and therefore more likely the efficient rate for multi-family residential mortgages, 5.25% only represents the coupon rate of the bonds, and not the yield, which would provide a more accurate picture of the efficient rate: the public might buy the bonds at a discount or at a premium, and the resultant actual yield would be different from the coupon rate.1
Even if the coupon rate is collateralized only by the underlying mortgages, and the court were presented with evidence of the yield rate on the MSHDA bonds, that rate would still not represent the efficient rate for debtor-in-possession financing on multi-family residential projects because that rate would represent a blended, diversified rate of all the MSHDA projects
For these reasons, the mere fact that MSHDA would offer bonds at 5.25% does not establish an efficient market rate for multi-family residential projects.
- The Debtors’ Evidence. The debtors presented expert testimony at the hearing regarding interest rates offered by state housing finance agencies and HUD/FHA mortgage insurance programs. Two of the rates presented were for a proposed MSHDA refinancing of a 152-unit project in Kentwood, Michigan and for a proposed MSHDA construction financing on a 147-unit elderly housing project located in Royal Oak, Michigan. Additionally, the debtors presented rates from FHA-insured loans in Michigan and Virginia and the current rates offered by Freddie Mac and Fannie Mae.
The last three loans do not represent the market under which these debtors would seek financing and, accordingly, are irrelevant to my analysis. The debtors’ properties, its expert admits, would not meet the current underwriting standards for either Freddie Mac or Fannie Mae loans, and, accordingly, these
Moreover, although closer to the mark, the two MSHDA loans presented by the debtors’ expert likewise also fail to establish the efficient market lending rate for multi-family residential project mortgages. First, the first-mortgage interest rate of 6.75% does not represent the efficient rate because it merely represents the coupon rate of 5.25% plus the 1.5% allowed by the Internal Revenue Service for the bond to remain tax exempt. For the reason stated above, basing the rate off the 5.25% coupon rate is problematic because that rate could either represent MSHDA‘s creditworthiness or would otherwise be inefficient because it is not the yield rate. Second, the expert‘s evidence of the actual effective rate of the two MSHDA loans also fails to establish the market because it takes into account “soft” second mortgages with reduced or no interest, section 1602 funds with no
C.
Having found an absence of evidence that an efficient market exists, I turn to the formula approach adopted by the Court in Till. In Till, the plurality opinion held that bankruptcy courts should take the prime lending rate published in newspapers daily and then add a risk factor. The Court noted that generally bankruptcy courts employing the formula approach have added a risk adjustment of between 1-3%.
1. The Starting Interest Rate
Here, though, I do not believe the prime rate is the appropriate starting point. The prime rate represents “[t]he interest rate that a commercial bank holds out as its lowest rate for a short-term loan to its most creditworthy borrowers.”
Unlike a prime rate, however, a 30-year treasury yield does not include the average adjustment made by lenders in arriving at a prime rate for the costs of administering the loan. In other words, it is appropriate to take into account the costs of administering a loan that as an objective matter it would be expected a creditor would incur in administering a hypothetical loan of this character. A loan of this character is not the equivalent of a Treasury bond where minimal costs of administration are required because the payments come in like clockwork, and there is no need for periodic inspection of the debtor‘s property to assure that it is being kept in sound condition. Nor is it the equivalent of a short-term prime loan where the costs of monitoring performance are minimal in comparison to a loan secured by a large multi-family apartment building. Accordingly, the 4.24% figure is actually too low as a starting point.
The parties presented no clear evidence regarding the costs of monitoring performance. Jeffrey John Sykes of MSHDA testified that if the debtors’ plans were confirmed, MSHDA would have to pay off the bonds on the existing debt. If new bonds were
whenever we enter into a bond issue, one of the key documents that‘s a part of that bond issue is what‘s called a non-arbitrage certificate and . . . what the I.R.S. is saying . . . in this non-arbitrage certificate is that you‘re not to make money.
Under the Internal Revenue Service rules regarding non-arbitrage bonds, he explained:
the spread is the amount that you can earn to cover the costs of paying for the administration of that bond issue. There‘s costs to remarketing agents, there‘s costs of staff to cover the administration of the mortgages so it‘s the I.R.S. that came to the conclusion that the one and a half is what it costs to administer one of these programs.
The costs of remarketing agents are transaction costs that Till holds are not an appropriate consideration in arriving at a
Moreover, the debtors’ plans call for payment of interest only for the first three years of the plan. Loans containing an interest only provision command a higher interest rate than loans calling for amortization of principal from the outset. This is a
Finally, the debtors’ plan call for a 35-year repayment period whereas the 4.24% figure is for a 30-year treasury bill. Obviously the inflation and risk adjustments for a 35-year loan are greater than for a 30-year loan. For this third reason, the 4.24% figure is too low as a starting point.
2. The Risk Premium Adjustment to be Added to the Starting Interest Rate
After arriving at a relatively risk-free starting interest rate, the Till plurality directs the bankruptcy court to add in a risk adjustment premium that “depends, of course, on such factors as the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan.” Till 541 U.S. at 479. The Court further goes on to direct bankruptcy courts to “hold a hearing at which the debtor and any creditors may present evidence about the appropriate risk adjustment” but also notes, importantly, that “[s]ome of this evidence will be included in the debtor‘s bankruptcy filings . . . .” Id. Moreover, at this hearing the “evidentiary burden [rests] squarely on the creditors, who are likely to have readier access to any information absent from the debtor‘s filing (such as evidence about the ‘liquidity of the collateral market‘).” Id.
(citations omitted).3
Till was a chapter 13 case involving a consumer debtor. In a chapter 11 case, a sophisticated chapter 11 debtor, in the business of operating a large multi-family apartment project, may be no less likely than a public housing authority to have ready access to information regarding an appropriate risk adjustment. In contrast to a chapter 13 consumer debtor, the debtors here, as proponents of plans addressing secured claims against large multi-family projects, arguably ought to bear the burden of proof. Nevertheless, I need not reach that issue.
In contrast to a chapter 13 case, the pendency of these debtors in bankruptcy cases does not materially lessen the risks MSHDA will face with respect to the re-written loans. The Court in Till pointed to the bankruptcy court‘s supervision of a chapter 13 plan as a reason why the risks to the lender were reduced, stating “the postbankruptcy obligor is no longer the individual debtor but the court-supervised estate, and the risk of default is thus somewhat reduced.” Till, 541 U.S. at 475 (footnote omitted). In this case, however, the debtors’ future income will not be paid (as occurs in a chapter 13 case) to a
The parties only presented limited evidence at the confirmation hearing regarding the risk of default in these reorganizations. John Freeman, the president of the managing general partner of the debtors, testified that Michigan has been particularly hard hit over the past few years by recession, with an unemployment rate of 15%. This resulted in properties experiencing more serious financial difficulties. Freeman further testified that the projects have between a 93%-98% occupancy rate and that the debtor had several critical deferred maintenance items since 2008. The debtors’ plans provide to set aside $1,000 per unit for the first three years and $500 per unit thereafter to meet ongoing capital expenditure requirements and to place one-half of the debtors’ net income into replacement reserves for the first three years of the plan. Moreover, MSHDA presented evidence through Craig Torres that the properties were
The Court in Till, 541 U.S. at 480, noted that courts following the formula approach have generally fixed the risk premium at 1% to 3%. That, of course, is just an observation devoid of any discussion of the facts of the cases in which generally such an adjustment was made. It is not even dicta, and certainly not binding precedent. The difficulty is that the Court gave little guidance as to how a risk premium number is to be arrived at after a bankruptcy judge fully considers all the factors that bear on risk. Although the Court in Till listed some factors a bankruptcy court should consider in arriving at a risk adjustment, the Court gave no explanation for how bankruptcy courts are supposed to quantify a risk adjustment after considering those factors. Although the Court observed that “many of the factors relevant to the adjustment fall squarely within the bankruptcy court‘s area of expertise,” Till,
Commercial lenders build a risk premium into their interest rates based on their experience in dealing with loans over a long period of time. In contrast, most bankruptcy judges have only limited familiarity with how often a loan goes into default based on its risk features, and even though they can arrive at a rough estimate of a percentage likelihood of default, have no training in quantifying that into a risk premium number to be added to a relatively risk-free starting point. When a bankruptcy judge picks a risk premium number, unless expert testimony regarding the components of market interest rates is presented, it may be guesswork that would not pass muster under the standards applicable to expert witnesses. That is why the coerced loan approach to fixing interest rates for present value purposes, based on what are prevailing market rates, was generally easier of application than has been the Till formula approach.
Market rates of interest include a built-in component for profit, and profit is necessarily part of the value that a lender hopes to achieve in lending. When, via cramdown, a lender is denied any profit, that deprives the lender of the value it could
In addition, Till viewed transaction costs as a component of market rates of interest that ought not be included in a present value calculation under the
Necessarily, under the Till formula approach, a bankruptcy judge might look to the real world of market rates and attempt to divine what part of market rates represents a risk premium component, but market rates of interest are not nicely broken down in the Wall Street Journal as to their various components
3. Arriving at a Final Figure Under the Till Formula Approach
Here, the debtor has attempted to depart from the formula approach and to seek to fix the plans’ interest rate based on prevailing market rates of interest, which would usually result in a higher rate of interest than the Till formula approach. The record contains evidence of market rates of interest, but such evidence is generally of federally insured mortgages in which the
D.
The foregoing analysis is unaltered by the debtors’ argument, which I reject, that the proposed interest rate under their plans is effectively higher than the face amount. At the trial, the debtors presented evidence showing that by reason of being required by the Regulatory Agreement to rent some of the units at below-market rents, the debtor would effectively be
III
Finally, MSHDA argues that the court should deny confirmation under
As evidence of feasibility, the debtor prepared 10-year projected budgets for the properties. The budgets began with 2010 baseline income and expense figures, which the debtors derived from actual 2009 expenses and incomes. The debtors then carried these numbers out over a 10-year period, assuming no revenue growth in years 1-3 and 1% per year growth in years 4-10, and assuming a 2% per year increase in expenses over the period.4 Furthermore, the projected budget included replacement reserve funding of $1,000 per year per unit for years 1 through 3, and $500 per year per unit for years 4 through 10 and projected mortgage expenses over the period, with years 1 through 3 being interest only and years 4 through 10 with payments of interest and principal on the mortgage over an amortization period of 35 years at 5%. As I stated above, however, 5% is too low. That necessarily results in less funds being available for capital
There are several relevant pieces of evidence that bear on whether the amounts that would be available for capital expenditures using a 5.24% cramdown rate of interest (or the amounts that would be available even using the 5% cramdown rate of interest proposed by the debtor) are sufficient to meet the debtors’ capital expenditure requirements over the course of the plan.
First, the debtors’ interest rate expert, Donald Marshall, stated in his report that “Contributions to replacement reserves of $1,000 per unit per annum for the first 3 years and $500 per unit per annum thereafter are appropriate for funding ongoing capital improvements for a property of this character.” I give little weight to this testimony, however, as Marshall is only an expert in interest rates, not replacement reserves, and, in any event, Marshall had never visited the properties to determine whether these properties might require more than the standard contributions to replacement reserves.
Second, the president of the debtors’ managing member, John Freeman, testified that he believed that “going forward with the projected contributions to the replacement reserve and the projected debt service coverage that we will have sufficient funds to operate and maintain these properties for the
Finally, Steve Lathom, an employee in MSHDA‘s multi-family finance area, also testified that he ran projections based on the debtors’ submission to MSHDA of its 2010 projected budget for capital needs and other expenditures. The result of these
Ultimately, however, my decision comes down to burdens of proof. The burden of demonstrating feasibility under
IV
An order follows denying confirmation of the debtors’ plans.
[Signed and dated above.]
Copies to: Recipients of e-notice.
Notes
[Footnotes omitted.]a court choosing a cramdown interest rate need not consider the creditor‘s individual circumstances, such as its prebankruptcy dealings with the debtor or the alternative loans it could make if permitted to foreclose. Rather, the court should aim to treat similarly situated creditors similarly, and to ensure that an objective economic analysis would suggest the debtor‘s interest payments will adequately compensate all such creditors for the time value of their money and the risk of default.