Cramdown

A Cramdown refers to a legal maneuver by a debtor concerning bankruptcy, forcing a creditor to accept less than what they owe on secured debt. It seeks to save the debtors from getting homeless or losing their businesses by preventing bias toward creditors and offering ways for the debtors to repay the loan.

The legal intervention is the result of the provision of cramdown in Chapter 11 and 13 bankruptcy in the US. Cramdown in bankruptcy allows debtors to propose repayment plans using expert legal guidance for implementation despite creditors’ displeasure. It covers only secured debts like car loans or mortgage loans.

• A cramdown in bankruptcy involves a debtor legally compelling a creditor to accept less than what is owed on secured debt.
• The cramdown provision aims to prevent homelessness or business loss, balance favoritism, and enable manageable loan repayment.
• It is a bankruptcy court action used to strike a balance between efficient reorganization and fair treatment of creditors, often allowing the debtor's principal balance to be reduced to the asset's current value.
• Cramdown reduces secured debt payments, easing financial burdens, yet impacts creditors' total returns, affecting collections from loans to debtors.

A cramdown means changes made to the loan contract between the debtor and the creditor if a bankruptcy court accepts the terms enforceable upon the creditor. It facilitates lesser payment amounts to the creditor for secured loans backed by collateral instead of the total loan amount. It results in the imposition of a newly court-written loan contract overruling the objections of the creditor to safeguard the assets and financial rehabilitation of debtors. The word cramdown is used because, many times, loan changes are crammed into the creditor’s documents. 

These provisions come into being only when a debtor has taken a secured loan from the creditor and faces difficulty repaying it. It applies to the bankruptcy court for a new repayment plan to reduce the principal or interest on secured loans supported by the current value of the collateral. In a way, the debtor tries to justify its offer to the creditor with its new fair and equitable repayment plan. Furthermore, if the court finds the repayment structure proposed by the debtor suitable, then it crams down the edited terms of the loan onto the dissident creditor.

Hence, the creditor has only one way to accept the revised amount or repayment schedule of the loan. It has positive implications for the debtor and negative ones for the creditor. The debtor gets a new lifeline to safeguard their homes or businesses from liquidations or dispossession. They also get a fresh financial beginning for themselves as it reduces their monthly income, leading to decreased debt obligations. However, costly and complex expert legal guidance is needed to perform it.

On the other hand, creditors have to accept less than acceptable loan amounts from the debtor. Creditors lose control over the loan terms as the court overtakes it. Any such cramdowns on a frequent basis may create uncertainty in lending markets.

There are numerous sound reasons for bankruptcy courts to impose cramdown, as listed below:

• The cramdown round allows for equitable negotiations and resolution in restructuring the debt repayment terms to arrive at a fairer resolution that benefits all concerned parties.
• To keep assets from being liquidated, guarantee the debtor’s financial stability, and safeguard creditors’ interests.
• Cramdown is utilized to strike a compromise between the requirement to attempt to produce the most efficient reorganization feasible and the need to treat pre-existing creditors fairly. They have their roots in the Code's wording.
• Requests for cramdowns by borrowers are considered non-routine litigation and need to be disclosed to Fannie Mae (Federal National Mortgage Association) right away.
• A plan can only be squeezed down if it is fair and equitable or if it discriminates unfairly (i.e., it must meet the absolute priority criterion).  
• It permits the lowering of a debt’s principal balance to the asset's current value, especially in Chapter 13 bankruptcy.

Let us use a few examples to understand the topic.

Example # 1

The recent ruling in In re Topp by the 8th Circuit has a substantial effect on how Chapter 11 bankruptcy plans calculate cramdown interest rates. The court decided that the Treasury bill rate, not merely the prime rate, might be used as the starting point for the formula approach in calculating cramdown rates, adhering to the guidelines established in Till v. SCS Credit Corp. In areas where there is an absence of established precedent, such as the Ninth Circuit, this ruling gives debtors the ability to argue for reduced rates.

The decision highlights the significance of taking into account the creditor’s risk of nonpayment. It creates opportunities for courts to accept rates that take into account the lender's risk, such as rates based on the prime rate without increases, the Treasury rate with uncertainty, or other rates. Hence, such a broader strategy may result in less expensive exit funding, especially in circuits where guidance could be more precise, which might raise the number of Chapter 11 petitions.

Example # 2

Let us say, Maya Bennett, the proprietor of a failing bookstore in Greenville, filed for Chapter 11 bankruptcy. The property, valued at $300,000, was the collateral for a secured loan of $250,000 held by her lender, Coastline Credit Unions. Maya, noting the recent case where the law permitting lower cramdown rates, offered a five-year payback plan with a three percent interest rate.

Coastline responded with 7%, claiming that Maya’s company carried a greater risk. In the end, the court decided on a 4.5% rate that would balance the creditor's risk and Maya's capacity to reorganize her debt and maintain the bookshop.

Lenders may not approve frequent usage of cramdown for future loan applications by customers. However, the process gets approved by courts using stringent conditions like fairness tests, reasonable faith efforts, and legal expertise. The fairness test makes sure that creditors get at least the collateral’s value. Reasonable faith effort must establish the debtor’s genuine effort to repay their debts and must have paid the required amount before applying for it.

The most suitable cramdown interest rate consists of fees and profit elimination. Cramdowns are vital in restructuring and bankruptcy in the financial world. The best cramdown is the one where it is supplemented by up to a 3% risk premium concerning debtors’ risk. Nevertheless, the actual percentage could be higher or lower based on debtor risk and market conditions. Furthermore, it also prevents the domino effect of financial distress by acting as a safety net for weak debtors.  

It is essential to know the pros and cons of cramdown for the benefit of debtors and creditors, as shown below:

This article has been a guide to what is Cramdown. Here, we explain the concept along with its reasons, examples, advantages, disadvantages, and implications. You may also take a look at the useful articles below –

• Chapter 9 Bankruptcy
• Chapter 10 Bankruptcy
• Chapter 15 Bankruptcy