Second Circuit Allows Efficient Market Interest Rates For Cramdown Loans

The United States Second Circuit has issued its ruling in the Momentive Performance Materials cases resolving three separate appeals by different groups of creditors of Judge Bricetti’s judgment in the United States District Court of the Southern District of New York, which affirmed Judge Drain’s confirmation of Momentive’s plan of reorganization. Significantly, the Second Circuit ruled that the Bankruptcy Court had erred in the process it used to calculate the “cramdown” interest rate applicable to replacement notes received by senior-lien noteholders under the plan.  The Second Circuit remanded the cases to the Bankruptcy Court to assess whether an efficient market rate can be ascertained, and, if so, to apply that typically higher rate to the replacement notes. This Bankruptcy Blog piece will cover this aspect of the judgment, while upcoming blog posts will cover the Second Circuit’s rulings affirming the Bankruptcy Court and District Court in finding that the second-lien notes stand in priority to the subordinated notes, and that the senior-lien noteholders are not entitled to a make-whole premium.  Our previous posts on these topics can be found here.

A so-called “deathtrap” can be an effective way to drive the confirmation of a plan of reorganization, particularly when paired with the Bankruptcy Code’s cramdown provisions.  The concept can be simple: one scenario involves a debtor, or other plan sponsor, proposing a plan of reorganization that gives a class of secured creditors two choices.  Option one – life: vote in favor of the plan and receive proposed treatment that the secured creditors can live with, but may not like.  Option two – death: vote against the plan and get crammed – that is, receive the value of their secured claim in deferred cash payments over several years – often an unpalatable option for secured lenders who want their involvement in a given situation to end so that they can put their capital and time to more efficient use elsewhere.  And if death wasn’t enough, a line of cases emanating from the Supreme Court’s decision in Till has led to the development of an additional coercive threat in some jurisdictions: these deferred cash payments (structured as secured takeback paper) can be designed with an interest rate that, rather than reflecting prevailing market rates, is a much lower national prime rate with a modest upward adjustment for risk – typically far lower than what lenders in the open market will command.
The Momentive debtors and their second-lien noteholders used this “deathtrap” technique in seeking to coerce their senior-lien noteholders to accept the proposed plan of reorganization: if the senior-lien noteholders voted for the proposed plan, they would receive payment in full, in cash, on confirmation of the plan, less a makewhole worth roughly $200 million to which they believed they were contractually entitled.  Vote against the plan and receive takeback paper (replacement notes) equivalent to the secured claim (again, excluding the makewhole) to be paid out over several years, at a below-market (or Till) rate of interest.  The difference was not insignificant – the senior-lien noteholders argued that the difference between the interest rate that their replacement notes received under Till compared to the 5-6+% that an efficient market would produce, amounted to as much as $150 million in lost interest over the life of the replacement notes.
Momentive’s senior-lien noteholders chose death and voted against the plan, but the Bankruptcy Court confirmed the Plan over their objection.  And, as predicted by the senior-lien noteholders, their takeback paper got killed in the market, trading down to 93 cents immediately after being issued, and despite being senior in reorganized Momentive’s capital structure. Unsurprisingly, appeals ensued, which we covered extensively here.
The District Court for the Southern District of New York affirmed the Bankruptcy Court’s confirmation of Momentive’s plan of reorganization, finding (among other things) that it was bound to follow the Supreme Court’s decision in Till, which it interpreted as requiring a “formula” rate of interest to be applied to takeback paper (the national prime rate plus a 1-3% upward adjustment for risk).  In so holding, the District Court declined to follow the interpretation of Till adopted in some other jurisdictions – most notably the Sixth Circuit – which have interpreted the Supreme Court’s decision in Till to allow Bankruptcy Courts to determine whether an efficient market exists for exit financing in chapter 11 bankruptcy cases.  If an efficient market exists, a bankruptcy court may set the applicable interest rate for takeback paper at a market rate, and only if that inquiry is unsuccessful, may it adopt the Till “formula” rate.
Following the District Court’s ruling, it seemed likely that secured lenders in the Second Circuit – the heart of the financing world – would be stuck with a Till rate of interest on cramdown paper for the foreseeable future, handing debtors and plan sponsors a potent weapon for their strategic arsenal while increasing risk for distressed investors. Momentive’s senior-lien noteholders appealed the District Court’s decision to the Second Circuit, arguing that confirmation of Momentive’s plan of reorganization was not fair and equitable as required by section 1129(b) of the Bankruptcy Code (the “cramdown” provision), as the interest rate on their replacement notes was too low.
After oral argument in the Second Circuit in November 2016, the outcome seemed to some observers, on balance, more likely to result in the District Court’s decision being affirmed.  Nevertheless, the Second Circuit took a different view in its recent ruling, finding that the Bankruptcy Court erred in the process that it used to calculate the interest rate applicable to the replacement notes received by the senior-lien noteholders.  The Second Circuit remanded this issue to the Bankruptcy Court to assess whether an efficient market rate can be ascertained, and if so, to apply it to the replacement notes.
The Second Circuit’s ruling turned on whether a conclusive statement was made by the Supreme Court in Till as to whether the “formula” rate was generally required in chapter 11 cases.  Finding that the Supreme Court did not make a conclusive statement to that effect, the Second Circuit determined to follow the Sixth Circuit in interpreting footnote 14 of the Till decision to mean that efficient market rates for cramdown loans cannot be ignored in chapter 11 cases, and that an interest rate that is apparently acceptable to sophisticated parties dealing at arms-length is preferable to a formula improvised by a court.  Markets are “efficient” where, for example, “they offer a loan with a term, size, and collateral comparable to the forced loan contemplated under the cramdown plan”.[1] Interestingly, the Momentive debtors had sourced proposals for these very loans in the event that the senior-lien noteholders voted to accept the plan, which would have entitled the senior-lien noteholders to a lump sum payment in cash on the effective date of the plan.
The Second Circuit affirmatively followed the Sixth Circuit’s decision in In re American HomePatient, Inc.[2] and adopted the Sixth Circuit’s two-step approach as best aligning the Bankruptcy Code with relevant precedent.  The two-step approach looks to determine if an efficient market for exit loans in chapter 11 proceedings exists, and to apply the market rate if it does, failing which the Till formula rate should be used.
The Momentive debtors objected to the senior-lien noteholders’ appeal from the District Court on the basis that the appeal was equitably moot – the plan of reorganization having been confirmed, there was, in common parlance, no way to unscramble the egg. The Second Circuit disagreed, finding that no other modifications to the plan would be required other than adjusting the interest rate on the replacement notes.  This might require, at most, $32 million of additional annual payments by the debtors to their senior-lien noteholders over several years.  With the Second Circuit finding that its ruling would be unlikely to unravel the plan, or threaten the debtors’ emergence, and recognizing that the senior-lien noteholders had presented expert testimony in Bankruptcy Court that an efficient market did exist for exit financing (and that the debtors had sought and received offers for lump sum exit financing at 5-6+% from third-party lenders in the event the senior-lien noteholders voted in favor of the plan), it seems that the Bankruptcy Court, now freed from Till, will find that an efficient market exists, and will adjust the interest rate on the replacement notes accordingly – a win for secured creditors. The Second Circuit arrived at no conclusion with regard to the outcome of this inquiry, so we will follow the upcoming proceedings with interest and watch for potential appeals to the Supreme Court.
The Second Circuit affirmed Momentive’s plan of reorganization in all other respects, affirming the Bankruptcy Court’s confirmation order and the District Court’s rulings affirming the second-lien notes’ priority over subordinated notes, and denying the senior-lien noteholders’ entitlement to the make-whole premium. Upcoming blog posts will cover both these issues.