By Vijay Malik, Law Student, Creighton University, Omaha, NE

The issue of determining the present value of proposed future payments to creditors in a Chapter 13 plan has long confounded bankruptcy experts.  Whether future payments should be discounted to arrive at a present value is not disputed – in fact, it’s required in the Bankruptcy Code.  The issue that engenders disagreement, however, is what discount rate to use when making a present value calculation.

The Code neither specifies a rate nor the methodology to be used to calculate the rate.

Even our Supreme Court can’t agree.  In the landmark decision Till v. SCS Credit Corp., 541 U.S. 465, 124 S. Ct. 1951 (2004) Justice Steven’s plurality opinion hinges the interest rate used in present value analysis on three components:  opportunity cost, an inflation premium, and a premium for the risk of default.  Accordingly, the plurality concluded that the national prime rate, potentially adjusted upward to account for the risk of nonpayment, is appropriate.  Under this “prime-plus” approach for computing the discount rate, the creditor, whom the plurality believed was the more informed party, has the burden of proof to justify the level of risk.

The dissent, led by Justice Scalia, also believed the discount rate should incorporate a risk premium for potential nonpayment but that the discount rate should presumptively be the contract interest rate, subject to adjustment by the parties.  Justice Scalia noted that certain factors should be taken into account to arrive at the risk premium, including the probability of plan failure, the rate of depreciation of the collateral, the liquidity of the market in which the collateral is sold, and administrative expenses tied to claim enforcement.

Justice Thomas adopted a third approach, arguing that the Code compels the conclusion that the discount rate should not account for the risk of default but rather should be predicated on a risk-free rate.  Focusing on the language of the Code, the Justice explained that the focus of the Chapter 13 cramdown provision is only on the value of the property to be distributed, not on the value of a promise to distribute property.  He asserted that the court’s task is to identify property that the debtor proposes to distribute to the holder of the secured claim over the life of the Chapter 13 plan and then to arrive at a present value of the property with the assumption that the property will actually be distributed.

Bolstering his conclusion, Justice Thomas emphasized that several Chapter 13 confirmation standards already serve to protect creditors:  a Chapter 13 has to be proposed in good faith; a creditor who holds a claim that is crammed down must be allowed to retain a lien securing their claim; and a Chapter 13 plan must be feasible.  Under Justice Thomas’ analysis, the only factor that should be considered in arriving at a discount rate is the time value of money, which accounts for opportunity cost and inflation.  The prime rate, Thomas argued, accurately reflects opportunity cost and should be used to determine present value.  Justice Thomas concurred with the plurality because  the interest rate proposed by the debtor exceeded the risk-free prime rate, thereby providing adequate compensation to the creditor.

So where does all this leave us today?  Washington University School of Law Professor Rafael Pardo’s thoughtful work, Reconceptualizing Present-Value Analysis in Consumer Bankruptcy, offers a compelling alternative approach.  Professor Pardo argues that present value analysis in Chapter 13 cases necessitates use of a discount rate that accounts solely for projected inflation but for neither default risk nor opportunity cost.

Professor Pardo identifies the factors highlighted by the plurality and dissenting opinions in Till as those that should be used when calculating a discount rate to be used in a present value analysis.  Professor Pardo specifically focuses on the considerations of probability of default (Pd) and actual default costs (Cd) incurred, noting that they are irrelevant to a present value analysis because they are taken into account elsewhere in the Code – either in the context of plan confirmation or creditor recovery.  Written as an equation, the expected default costs (Ed) = the probability of default (Pd) multiplied by the actual default costs incurred (Cd).

Professor Pardo argues that the risk of default is an irrelevant consideration when conducting a present value analysis because financial feasibility is a prerequisite to confirmation and distinct from the standard used for cramdown confirmation.  Section 1325(a)(6) only allows a court to confirm a plan if it believes the debtor will be able to make all the payments under the plan, not some of the payments under the plan.  The court must be convinced that the risk of default, or Pd, equals zero.

To analyze the actual default costs incurred, Professor Pardo again turns to Till.  The factors the plurality and dissent identified as producing default costs were the value of the collateral securing the creditor’s secured claim, the illiquidity of repossessed collateral, and the administrative costs associated with claim enforcement in bankruptcy.  Professor Pardo contends that the Code allows for recovery of some of these costs outside of confirmation and prevents recovery of others.

First, in regard to costs related to the value of the collateral securing the creditor’s secured claim, Professor Pardo asserts that the Code already provides for adequately protecting a secured creditor’s interest in collateral the debtor retains by providing periodic cash payments to the creditor equivalent to the value of the creditor’s interest in collateral, granting the creditor an additional lien on the debtor’s property equal in value to the decrease in value of the creditor’s interest in the collateral, or other protection providing the indubitable equivalent of the value of the creditor’s interest in the collateral.

Second, in the context of costs stemming from the illiquidity of repossessed collateral, Pardo argues that because the Code prevents the recovery in Chapter 7 of default costs tied to an asset’s illiquidity, namely the asset is underwater and abandoned by the trustee with the creditor recovering less than his secured claim, such costs should not be subsumed into the calculation of a risk-adjusted discount rate.

Third, in reference to default costs resulting from the enforcement of a creditor’s claim, Professor Pardo argues that the Code provides a mechanism to recover for these costs outside of confirmation through the claim allowance process.  Notably, security agreements typically provide for collection costs incurred enforcing the agreement.  The creditor should be allowed to recover any administrative expenses as a part of their allowed claim.

Citing United Savings Bank Ass’n of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365, 108 S. Ct. 626 (1988), Professor Pardo argues that because the Code prohibits compensation for opportunity cost, the discount rate, not taking into account the risk of default, should take into account only inflation.  He argues that to use the prime rate as suggested by Justice Thomas would overcompensate creditors as it takes into account opportunity cost.  Professor Pardo submits that courts might estimate expected inflation by reducing the prevailing rate on a government bond with a maturity date approximating the Chapter 13 plan’s duration by the real rate for the riskless cost of capital, estimated some to be two percent.

Mr. Malik is a law student at Creighton University in Omaha, Nebraska. Prior to law school, Mr. Malik worked in real estate private equity and investing banking for various firms in New York and Washington, D.C.