How a Cram Up Works in Bankruptcy?
In most bankruptcy cases, senior classes of creditors have more power as compared to junior classes of creditors. This means that the re-organization plans are generally meant to satisfy the needs of senior classes of creditors. However, there are some cases in which companies give importance to the needs of junior stakeholders as well.
There have been several instances in the past wherein the debtor company has adopted a plan which favors the junior creditor classes despite objections from the senior ones. In effect, this is a cram-down on the senior lenders by the junior lenders. Since it is a cram down, but the effects are flowing in the opposite direction, it is known as a cram up.
In this article, we will have a closer look at what cram up is and what are the different methods of using a cram up.
What is a Cram Up?
In many cases, bankrupt companies do not have access to replacement financing. This means that they cannot take more loans at a given time period. However, its underlying business is strong. Hence, if they had access to credit, over time, they would be able to pay off all creditors, whether junior or senior!
In such cases, the senior creditors are often anxious and want to get back their money as soon as possible. Hence, they are not willing to hold on for longer periods of time. They want the debtor company to simply sell their assets and pay back the senior creditors. Here, the senior creditors are acting in haste. If they were to simply hold on to their debt, then there is a reasonable chance that everybody, including the junior debtors, would get paid.
In such scenarios, the senior debtors are acting unreasonably. In such cases, the debtor company often restructures the debt owed to the senior creditors. This means that instead of selling assets and paying the senior creditors immediately, the debtor company decides to use the funds in the business, generate more revenue and pay the junior creditors as well. This process is known as a cram up.
Cram Up Methodologies
There are two methodologies that are commonly used by companies while doing a cram up. They have been mentioned below:
- The first type of cram up involves the reinstatement of debt. This means taking back the debt to the original terms and conditions. When companies are unable to pay their debt because of bankruptcy-related cash crunch, the entire debt becomes due immediately.
In such situations, if the company pays back the coupon payments that they have missed, then they can reinstate the terms of the old debt. In such cases, it is the responsibility of the borrower to make good any loss which may have arisen to the creditor because of the failure of the debtor to stick to the agreed-upon terms.
In such cases, it is common for companies to start paying back the installments due to the lenders some time before the voting takes place. By doing so, the debtor company is able to prove that the claims of senior creditors have not been impaired. As a result, they fall into the category of unimpaired claims which do not have voting rights. By preventing the senior creditors from voting, the debtor company is able to make their opinion irrelevant.
Since the entire debt would not be due immediately, this strategy is useful in times when the interest rate in the market is high. If the company were to refinance its debt, it would have to pay a higher interest rate. This arrangement is also favorable when there is a long time pending for the debt to mature, and the management is confident that the financial situation of the company would improve drastically by then.
- The second type of cram up arrangement is called deferred payments. In this situation, the debtor company obtains a court-approved plan to provide the creditors with funds at a later date. In order to arrive at this value, the court first finds the present value of the debt. It then adds the current market rate of interest to the debt in order to determine what the amount should be at a future date.
It needs to be understood that the interest rate which has been agreed upon between the debtor and creditor becomes irrelevant. Instead, the current market rate is applied. It is no surprise then that this arrangement is often preferred when the current market rates are low.
It also needs to be understood that this arrangement can only become a reality if the organization has sufficient collateral to extend the loan. The court only approves the deferred payments if they are sure that such a deferral would not impact the creditors in a negative manner.
Hence, it is clear that different methodologies of cram up are used by debtor companies based on external market conditions and prevailing interest rates.
When higher rates are offered in the market, a reinstatement is preferred, whereas when lower rates are offered, deferred payments are preferred.
However, a cram up is a risky move since the senior creditors are often important stakeholders for a firm, and imposing their will on the secured creditors can cost the firm in the long run.
Authorship/Referencing - About the Author(s)
The article is Written By “Prachi Juneja” and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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- The Role of Creditors Committee in Bankruptcy
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- The Impact of Bankruptcy on Shareholders
- Reporting Requirements in Bankruptcy
- Why Investors and Banks Must be Protected When Firms and Tycoons Go Bankrupt
- Cram Down in Bankruptcy Proceedings
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- Cross Border Bankruptcies
- Investing in a Bankrupt Company
- The World without Bankruptcy Laws