On August 26, 2014, Judge Drain, of the Bankruptcy Court for the Southern District of New York, concluded the confirmation hearing in Momentive Performance Materials and issued several bench rulings on cramdown interest rates, the availability of a make-whole premium, third party releases, and the extent of the subordination of senior subordinated noteholders. This four-part Bankruptcy Blog series will examine Judge Drain’s rulings in detail, with Part I of this series providing you with a primer on cramdown in the secured creditor context. Part II of this series will examine Judge Drain’s cramdown decision in more detail. Part III will focus on the extent of the subordination of senior subordinated noteholders, and Part IV will explore both the “make-whole” aspects of Judge Drain’s decision and third party releases.
What You Need To Know: Cramdown
One aspect of Judge Drain’s decision may give debtors additional negotiating leverage in attempting to set terms for payment of secured claims under a plan. Judge Drain’s bench ruling suggests that the allowed claim of a secured creditor may be satisfied by a long-dated replacement note with a below-market interest rate. This decision has the potential to positively affect exit financing needs for debtors and may even increase distributions to unsecured creditors in cases in which the allowed claims of secured creditors are deemed to have been fully satisfied.
Judge Drain’s Momentive decision is unambiguous when it comes to its support for the “formula” approach in determining a cramdown interest rate for a secured creditor and in elucidating the guiding first principles that dictate how to calculate the applicable cramdown interest rate for a secured creditor’s allowed claim in a chapter 11 case:
- First, a cramdown interest rate should not contain any profit or cost element, both being inconsistent with the present value approach for cramdown.
- Second, market testimony or evidence is only relevant when considering the proper risk premium to use in the formula approach.
- Third, the risk premium should not be used by creditors as a means of obtaining a market rate on their replacement notes.
The appropriate cramdown interest rate, therefore, is one that eliminates profit, eliminates fees, and compensates a secured creditor at an essentially riskless base rate, to be supplemented by a risk premium of between 1-3%, to account for a debtor’s unique risks emerging from chapter 11.
Cram Session on Cramdown
Tomorrow’s post will delve into the details of what Judge Drain decided. Today, we will provide a quick primer on cramdown as it relates to secured creditors. Feel free to skip this part if you’re already a restructuring demon.
A cramdown is the involuntary imposition by a bankruptcy court of a plan of reorganization on a class of creditors following a vote to reject a proposed plan or reorganization by that class.
The Bankruptcy Code differentiates between secured claims, unsecured claims, and equity interests when guiding a bankruptcy court to determine whether it can confirm a plan of reorganization despite the rejection of the plan by a class of claims or equity interests.
If one or more classes of secured claims or equity interests reject a proposed plan, and the plan satisfies the other applicable provisions of section 1129(a), section 1129(b) of the Bankruptcy Code permits confirmation of the plan so long as it does not “discriminate unfairly” and is “fair and equitable” with respect to each rejecting class.
A plan discriminates unfairly against a class of claims or equity interests where another class of equal or junior rank in priority receives greater value under the plan of reorganization than the class that has rejected the plan, without reasonable justification for the disparate treatment.
The test for determining whether a plan is “fair and equitable” to a rejecting class depends upon whether the class contains secured claims, unsecured claims, or equity interests. In this Bankruptcy Blog post, we will only look at the provisions that address what is fair and equitable to secured claims, as Judge Drain’s decision in Momentive involved the claims of secured creditors. To put this in context, part of the cramdown controversy in Momentive revolved around whether the plan of reorganization that was proposed by the debtors provided secured noteholders with the full amount of their allowed claim. (The secured noteholders argued it didn’t, and so was not fair and equitable.)
Section 1129(b)(2)(A) of the Bankruptcy Code provides three ways for treatment afforded to a class of secured creditors to be considered fair and equitable:
- First, if the debtor plans to retain the collateral securing the allowed claims, the plan may provide that a secured creditor (1) retains its liens in the assets securing its allowed claim (to the extent of its allowed claim) and (2) receive deferred cash payments with a present value totaling at least the value of the collateral securing its allowed claims (or the allowed amount of its claims if there is sufficient collateral). More about deferred cash payments shortly.
- Second, if the debtor plans to sell the collateral free and clear of the secured creditor’s liens, the plan may provide for the secured creditor to credit bid its secured claim and (assuming the secured creditor is not the successful bidder), for the lien to attach to the proceeds of the sale up to the allowed amount of the secured claim.
- Third, the plan may provide the secured creditor with the “indubitable equivalent” of its allowed secured claim. This is the catch-all provision when the plan provides treatment that does not squarely comply with one of the first two options. Although this term is not defined in the Bankruptcy Code, the U.S. Supreme Court in RadLAX made it clear that a plan proponent cannot use “indubitable equivalence” to do an end run around the other two tests.
Because Momentive involves the first type of cramdown and that is (at least in the post-RadLAX era) the test most subject to judicial interpretation, we will focus on the first test.
Present Value Calculations
The principle areas of dispute under the first test revolve around how long a debtor can stretch repayments to a secured creditor and how the present value of the secured claim is determined. Because these were the two critical points in the cramdown discussion in Momentive, it is worth going into a more detailed explanation of these concepts.
When it comes to the length of time a debtor may stretch repayments, the seven years that Momentive proposed for first lien creditors, and the 7.5 years that it proposed for 1.5 lien creditors is common, although shorter repayment periods are also frequently proposed, and debtors have been known to propose longer periods.
Section 1129(b)(2)(A)(i)(II) raises the issue of present value when it requires “deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property.” It is an open question, though, whether that present value must be a calculation that determines the current market worth of a future sum of money or stream of cash flows given a specified rate of return, or whether the Bankruptcy Code permits something different.
A Quick Example
To explain how a present value calculation is performed, and why it is important, consider the following example: As a secured creditor, you have an allowed secured claim of $7 million, and more than enough collateral secures your claim. A debtor has a few options when determining what treatment to give your allowed secured claim under its chapter 11 plan. The first is to sell the collateral securing your claim, in which case you either would receive a replacement lien on the proceeds of the sale and then satisfy your claim in cash, or you would be entitled to credit bid and acquire your collateral. In theory, you could receive $7 million in cash or value from the debtor as soon as the debtor’s chapter 11 plan of reorganization becomes effective. Alternatively, the debtor could decide to keep the collateral securing your claim because the debtor projects that, upon emergence from bankruptcy, its reorganized business will be able to handle paying you $1 million per year over seven years (total: $7 million) to satisfy your claim, and it needs that collateral to run its business.
As every aspiring lottery winner knows, if you have the choice between an equal sum of money now or later, the time value of money concept means that money is worth more today than in the future, so it’s best to take the money and run (and reinvest it).
As a secured creditor, you are going to argue that, if you were given the money you are owed today, you could reinvest it at a market rate of, let’s say 5%. In your view, if the debtor is going to pay you over seven years at a 5% interest rate, then it needs to pay you the equivalent of almost $10 million (well, $9,849,702.96 to be precise), so that the debtor has paid you in full on your allowed claim as required by the Bankruptcy Code.
Looking at it from the reverse angle, if you add up the payments the debtor will make each year to you over seven years (adding up to the $10 million number above), the appropriate discount rate to get your $7 million allowed secured claim is 5%.
From the debtor’s perspective, the value of the interest rate or discount rate that is applied is of great concern: At 5%, its total payments will be $9,849,702.96 on a $7 million allowed secured claim over seven years. At 3%, the debtor will pay $8,609,117.06 over seven years, almost $1.25 million less.
You can see why, when the numbers are magnified to the levels of secured debt at issue in Momentive (approximately $1.25 billion), both debtors and secured creditors really care what the applicable cramdown interest rate will be on an allowed secured claim that is paid out over time.
Courts Weigh In
So how have courts determined what interest rate to apply? Unfortunately, the Bankruptcy Code does not provide guidance on the appropriate method to use to calculate a cramdown interest rate in the context of a secured creditor cramdown. Courts have therefore diverged on the appropriate method to use. In Momentive, Judge Drain considered the two main alternatives that have emerged over the years:
(1) the “formula” or “prime plus” approach, which takes a risk free rate then adjusts upwards for risk, and
(2) the coerced loan approach, which calculates the appropriate interest rate for the cramdown of a secured creditor by determining the interest rate that a secured creditor could obtain if it foreclosed on the collateral securing its claim and subsequently reinvested the proceeds into assets substantially similar to those of the debtor, and for a similar period, as proposed by the debtor’s plan.
Other approaches also exist, such as the cost of funds approach and the presumptive contract rate approach. We’ll focus more closely on the Supreme Court’s chapter 13 Till approach because courts, Judge Drain included, have wrestled with how to apply Till’s holding on interest rates in the context of chapter 11.
The Till Formula Approach
One of the leading decisions in this area is a Supreme Court case, Till v. SCS Credit Corp. In Till, the Supreme Court determined – in the context of a chapter 13 case – that the “formula” approach was the most appropriate method to determine the discount (or interest) rate to apply to the cramdown of a secured creditor.
Although it was a chapter 13 case, Till has been instrumental in the attempt to harmonize the various approaches chapter 11 debtors take in their present value calculations for secured creditor cramdowns, towards the “formula” approach favored by this case. This is largely due to the close similarity of the cramdown provisions provided for in section 1325(a)(5)(B)(iii) of the Bankruptcy Code, as well as the Supreme Court’s statement in Till that Congress likely intended for the same approach to be taken when determining the appropriate interest rate under the various Bankruptcy Code provisions that require a net present value calculation.
In short, the following summarizes the formula approach:
Prime Rate + Risk Factor = Cramdown Interest Rate
Let’s look at this in more detail:
(1) Start with the prime rate, the lowest rate of interest at which money is lent by a financial institution to a commercial borrower, typically available only to the strongest borrowers in the market, then
(2) Add an additional amount to that prime rate number to account for the additional risk of lending to a debtor, usually 1%-3% but sometimes more, according to the Supreme Court in Till.
And voilà! You have your appropriate cramdown interest rate.
In Till, two joint chapter 13 debtors who owed a little under $5,000 to a lender on a used vehicle they owned could not reach agreement with their lender on the appropriate interest rate to pay the lender on the deferred monthly payments they proposed to make on its secured claim. The joint chapter 13 debtors proposed an interest rate of 9.5%. They calculated this rate by taking the prevailing prime rate and adding a 1.5% risk premium to account for the risk of them defaulting (as above, the “formula” approach). Their secured lender, on the other hand, contended that it should receive an interest rate of 21%. That rate was based on the rate of return the lender could earn if allowed to foreclose on the collateral securing the loan and then reinvest the proceeds of the sale of the collateral to borrowers in a similar distressed situation (as above, the “coerced loan” approach). The joint chapter 13 debtors sought to cram down their secured creditor using the 9.5% interest rate, and the $5,000 dispute made it all the way to the Supreme Court.
In a plurality opinion, the Supreme Court adopted the “formula” approach for chapter 13 cases, after having considered and then rejected alternative approaches as being too complicated, imposing too significant evidentiary costs, and misguided insofar as they sought to make a creditor whole, rather than ensure that a debtor’s payments have the requisite present value to equal the secured creditor’s allowed claim, up to the value of its interest in the collateral that secures its claim.
The Supreme Court left open the method for selecting the appropriate risk factor, though noted that the circumstances of the individual estate, the collateral and the nature of the security in the collateral and the duration and feasibility of the restructuring plan were all relevant inquiries. The Supreme Court also noted that other courts applying this formula approach had approved adjustments ranging from 1%-3%, though this range was not set in stone.
Of course, if the Supreme Court had fully and finally resolved the controversy in the chapter 11 context, then everyone would not be talking about Momentive. In the now famous footnote 14 to the opinion, the Supreme Court seemingly left the door open for other approaches in the chapter 11 context:
This fact helps to explain why there is no readily apparent Chapter 13 cram down market rate of interest. Because every cram down loan is imposed by a court over the objection of the secured creditor, there is no free market of willing cram down 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 cram down 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.
As you can see from this footnote, the Supreme Court drew a distinction between the lack of a free market for lenders to chapter 13 debtors in a cramdown context, to the general availability of financing in a chapter 11 case. Arguments have been raised, by debtors and commentators, that the reference to financing in a chapter 11 case is to debtor in possession (or DIP) financing, which may not be analogous to the type of financing at issue in a secured creditor cramdown context. Regardless, the footnote states that when choosing the appropriate cramdown interest rate in a chapter 11 context, it might make sense to ask what interest rate an efficient market would produce. This has subsequently led to courts in some chapter 11 cases to focus first on whether sufficient evidence is available to conclude that an efficient market exists, before moving to the formula approach, and has been seized upon as a basis for secured creditors to increase the yield on the deferred cash payments for their allowed secured claims.
How will Judge Drain deal with Till and footnote 14? In tomorrow’s post, we’ll look at the Momentive decision in more detail and find out.