Dealing with the Chapter 13 Bankruptcy "Cram-Down" Provision

By Keith E. Whann

Despite a booming economy, the credit worthiness of the average consumer has been on a steady decline over the past several years. In 1997, over 1.3 million people filed Chapter 7 or Chapter 13 bankruptcy petitions. Given the explosive number of new consumer bankruptcies, more and more automobile dealers are being affected by a phenomena affectionately referred to as a “cram-down.” The Chapter 13 “cram-down” provision allows debtors to retain collateral as long as they offer repayment of the “secured portion” or fair market value of the collateral in their repayment plan. The balance of the indebtedness that exceeds the fair market value of the collateral is considered to be unsecured and is placed at the lowest priority of payment. In 1997, the U.S. Supreme Court, interpreting the cram-down provision, was hailed as having ruled on the creditors’ side in the case of Associates Commercial Corp. v. Rash.

The main issue in Rash was whether the value of the equipment should be its wholesale value or its retail value. The Supreme Court held that “the value of the property (and thus the amount of the secured claim under §506(a)) is the price a willing buyer in the debtor’s trade, business or situation would pay to obtain like property from a willing seller” or “the cost the debtor would incur to obtain a like asset for the same proposed use.” Therefore, whether replacement value is the equivalent of retail value, wholesale value, or some other value depends on the type of debtor and the nature of the property. The balance owed by a debtor over the fair market value of the collateral is treated as unsecured debt.

Although many in the industry thought that the imposition of a replacement value standard in determining the value of the collateral would substantially improve the secured creditor’s position, automobile dealers have not received a significant benefit from Rash. Consider for instance the In re Jones decision rendered by the United States Bankruptcy Court for the Northern District of Illinois.

In the case of In re Jones, Money Store Auto Finance, Inc., the lienholder on the debtor’s automobile, filed a secured claim in the amount of $21,182.74, consisting of $14,053.13 in principal and $7,029.61 in interest. The debtor objected, arguing that the Money Store’s secured claim should be limited to $13,675 and that the remainder should be treated as an unsecured claim. The Court agreed with the debtor’s analysis.

According to the Court, the claim is only secured to the extent of the value of the collateral. In other words, the claim for interest is unsecured. The Court based its decision on 11 U.S.C. §506(a) which provides in relevant part that “[a]n allowed claim of a creditor secured by a lien on property in which the estate has an interest...is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property... and is an unsecured claim to the extent that the value of such creditor’s interest...is less than the amount of such allowed claim...” In addition, the Court followed the rationale set forth in Rash stating that the value of the property was the price a willing buyer in the debtor’s trade or situation would pay to obtain like property. With respect to the appropriate date for valuation purposes in a Chapter 13 cram-down, the Court held that the collateral should be valued as of the day the plan is confirmed.

In addition to determining the “value of the property” and the “appropriate time for valuation,” the Court also addressed the issue of the amount of interest that should be allowed. Pursuant to §1325(a)(5)(B), a secured creditor in a Chapter 13 case is to receive payments under the plan totaling no less than the value of its interest in the collateral as of the effective date of the plan. The Court held, however, that the value of “interest” is only in the secured value of the principal claim and a proper rate of interest to be applied thereto, but not in the contract rate of interest thereon. The court said: “The Bankruptcy Code protects the creditor’s secured interest in the property, not the creditor’s interest in profit it had hoped to make on the loan.” The Court further held that the appropriate discount rate is one that approximates the creditor’s cost of funds in its business, the rationale being that a creditor with a secured claim is not harmed if it receives interest that compensates it in full for additional interest costs incurred due to the deferral of payment. Hence, the appropriate rate for discounting a secured creditors claim to present value was the “market rate” or “prime rate” because it is the actual cost of money for a reliable borrower and it allows the market to make the necessary risk assessment.

In essence, the effect of the “cram-down” provision is threefold. First, it reduces the amount of the secured claim to the value of the property at the time the bankruptcy plan is confirmed. Second, it provides the debtor with more time to pay the loan. Third, it reduces the value of interest to the prime rate. For example, a three (3) year loan of $10,000.00 at an interest rate of 18 percent may be reduced to a claim of $6,000.00 payable over a period of six (6) years at the prime interest rate. Should the debtor decide he doesn’t want the car anymore, he can simply stop paying the trustee and abandon the plan. There is no penalty for a debtor who doesn’t live up to the terms of the bankruptcy plan.

Therefore, although the Rash case provided that a higher standard of value should apply when a debtor proposes to “cram down” the collateral in a Chapter 13 case, the practical effect of interpreting the “replacement value” has changed very little. However, the impact of the overwhelming number of bankruptcies has not escaped the attention of Congress. The 105th Congress introduced two Bills, House Bill 3150, the “Consumer, Lenders and Borrowers Accountability Act of 1998,” and Senate Bill 1301, the “Consumer Bankruptcy Reform Act of 1997” in an effort to bring about Bankruptcy Reform. Both Bills tended to favor Chapter 13 filings, but they also contained relief from the Chapter 13 cram-down provisions. Efforts by members of Congress to add the Bill in the form of an amendment to the Omnibus Spending Bill, however, were unsuccessful.

The 106th Congress continued the crusade for bankruptcy reform, however, introducing two Bills. H.R. 833, The Bankruptcy Reform Act, was identical to the Bankruptcy Bill passed by the House the previous year, and S. 625, The Bankruptcy Reform Act of 1999. Unlike last year, the consensus is that some type of Bankruptcy Reform Bill will pass this year and 18 will include provisions requiring that debtors file under Chapter 13 of the Code rather than under Chapter 7 in certain circumstances. Therefore, it is extremely important that any reform also include relief from the Chapter 13 cram-down provision.

Several industry groups formed the Coalition for Financial Responsibility and have worked diligently to obtain that relief from cram-down in the form of an amendment. Currently, retail loans generated within six months of the filing of the bankruptcy petition are exempt from cram-down in both the House and Senate Bills which have already been passed by the respective chambers of Congress. Although the cram-down relief provisions in both the House and Senate Bills as passed are uniform, there are other provisions in the Bills in which there are differences. Among them are the numerous amendments which do not pertain directly to bankruptcy reform and were added to the Senate Bill shortly before it passed. A Conference Committee will attempt to work out a compromise on those provisions. Given the problems which consumer bankruptcies and the cram-down provisions are creating for the motor vehicle industry, bankruptcy reform legislation is a priority for the industry as a whole. All of its members should be taking a leadership role in attempting to make sure that cram-down relief is preserved if Bankruptcy Reform moves forward.