Cramdown Interest Rates in Chapter 11

In Till v. SCS Credit Corp., 541 U.S. 465 (2004), the U.S. Supreme Court applied a formula to determine the appropriate cramdown interest rate with respect to the treatment of secured claims in a Chapter 13 case ' holding that the appropriate interest rate is determined by taking a risk-free base rate, such as the prime rate or the Treasury rate, and adding a risk premium of between 1% and 3% to reflect the repayment risks unique to the particular debtor. However, Till left an unanswered question about how to determine an applicable cramdown interest rate for allowed secured claims in Chapter 11 cases.

Since Till , courts have relied on language contained in footnote 14 in Till as providing guidance as to how such a rate should be determined in Chapter 11 cases. Footnote 14 in substance states that while there is no readily apparent Chapter 13 cramdown interest rate because there is no free market of Chapter 13 cramdown lenders, the same may not be true in Chapter 11 because lenders advertise financing for Chapter 11 debtors-in-possession. This has opened the door for arguments about the use of market rates to determine cramdown interest rates in Chapter 11 cases. However, questions still remain over how and when to apply either a market interest rate or formula based rate in Chapter 11 cases.

Recently, in a bench ruling in In re MPM Silicones, LLC, issued on Aug. 26, 2014 (No. 14-22503-RDD (Bankr. S.D.N.Y. Aug. 26, 2014) and later corrected on Sept. 9, 2014 (see In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014)) (Momentive ), the United States Bankruptcy Court for the Southern District of New York (USBJ Drain), held, among other things, that the debtors could cram down their plan of reorganization on their secured lenders under section 1129(b)(2)(A)(i) of the Bankruptcy Code by providing them with replacement notes paying a below-market interest rate using a formula approach to calculate the applicable interest rate.

The' Dilemma

In 2012, Momentive Performance Materials and its affiliates (the Debtors) issued $1.1 billion of first-lien notes (First Lien Notes) and $250 million of “1.5-lien” notes (1.5 Lien Notes) due 2020 ' the holders of First Lien Notes and 1.5 Lien Notes will collectively be referred to as the “Noteholders.”

The Debtors proposed a plan that contained a death-trap clause, which provided that the Noteholders could elect either to vote in favor of the plan and receive payment of their claims in full in cash, without a make-whole premium, or if they rejected the plan, the Noteholders would receive seven-year replacement notes in the face amount of their allowed claims, bearing a below-market interest rate equal to the applicable Treasury rate plus a small risk premium, while preserving their right to litigate their rights to the make-whole premium.

The Noteholders voted against the plan, noting: 1) that they were entitled to the make-whole premiums based on the acceleration of their debt by virtue of the bankruptcy filing and the proposed early repayment via the replacement notes to be issued under the plan and further because; 2) the proposed treatment of their secured claims under the plan was not “fair and equitable” and therefore could not be crammed down on them because the plan did not apply a market interest rate to the replacement notes.

The Debtors' Argument

As a result of the Noteholders' rejection of the plan, the Debtors were required to satisfy the cramdown requirements of section 1129(b)(2)(A)(i) of the Bankruptcy Code, which provides that a plan is “fair and equitable” to a non-accepting class of secured creditors if it provides that creditors: 1) retain the liens securing their claims; and 2) receive deferred cash payments with a present value at least equal to the allowed amount of their claims.

The Debtors argued that the proposed treatment of the Noteholders' claims was consistent with the present value formula standard set out in Till. On the other hand, the Noteholders argued that it was not proper to apply Till's formula approach. Instead, the Noteholders, relying on footnote 14 in Till, claimed that a market rate was readily available, looking to the Debtors' exit financing commitment as evidence of that rate.

In response, the Debtors argued that Till “is not intended to put current creditors on par with market lenders,” but rather to provide a base rate of interest “plus some compensation for the risk that such replacement notes are not repaid as scheduled.” Therefore, under the Debtors' theory, it followed that the formula set out in Till is not subject to a market check, even if one is available.

The Debtors further argued that: 1) the Noteholders made much of footnote 14 in Till, which states that “when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce,” Till, 541 U.S. at 476 n.14; and 2) there is no stated requirement or preference to perform a market analysis. The Debtors asserted that footnote 14 must be read in conjunction with and be reconciled with footnote 18 in Till. Footnote 18 provides that “if the court could somehow be certain a debtor would complete his plan, the prime rate would be adequate to compensate any secured creditors forced to accept cramdown loans.” Stated differently, no further analysis beyond selecting a base interest rate, let alone a market rate, would be necessary. Till 541 U.S. at 479 n.18.

Accordingly, the Debtors calculated the cramdown rates by applying Till's formula approach in a two-step process. First, they chose a base rate by “taking [a] cue from ordinary lending practices that “reflects the financial market's” estimate of the amount a commercial bank should charge a creditworthy commercial borrower to compensate for the opportunity costs of the loan, the risk of inflation and the relatively slight risk of default.” Till 541 U.S at 479. The second step of the formula approach required the court to adjust the base rate to “account for the risk of nonpayment posed by borrowers in their financial position,” Id. at 465 or as the Debtors described it, the add-on risk premium.

With respect to the add-on risk premium, the Debtors' expert analyzed “the nature of the security, and the duration and feasibility of the reorganization plan” as required by Till, and focused on the specific facts presented by analyzing six additional factors: 1) sustainable capital structure; 2) likelihood of repayment or financing; 3) capital structure sustainability in downside (sensitivity) scenarios; 4) sufficient liquidity; 5) collateral; and 6) business fundamentals. The Debtors' expert concluded that the replacement notes to be issued to the Noteholders under the plan would adequately compensate the Noteholders for any risks attendant to extending credit to the reorganized Debtors.

The Noteholders' Response

The Noteholders challenged this analysis, claiming that the add-on risk premium was too low because the Debtors faced a number of business and operational hurdles. In response, the Debtors argued that the Debtors' financial projections had been rigorously scrutinized, took into account such matters, and that the add-on risk premium was therefore appropriately determined. The Noteholders also argued that the Debtors' proposed cramdown interest rates did not reflect the present value of their allowed claims. In response, the Debtors noted that the Till formula is designed to calculate the present value of such claims and that no separate or additional present value analysis is required. In other words, the plan satisfied the second prong of section 1129(b)(2)(A)(i) because the cramdown rates used in the plan provided the Noteholders with deferred cash payments aggregating the present value of their allowed claims.

The Debtors stated that in adopting the formula approach, Till rejected cramdown approaches that provided creditors more than “present value.” Till U.S. 541 at 476. (These considerations lead us to reject the coerced loan, presumptive contract rate and cost of funds approaches. Each of these approaches ' aims to make each individual creditor whole rather than to ensure the debtors' payments have the requisite present value.) Stated differently, Till does not require debtors to first determine the result under the formula approach and subsequently perform a present value analysis ' or vice versa.

Finally, the Noteholders claimed that the selection of the Treasury rate instead of the prime rate as the base rate was improper. The Debtors refuted this argument, noting that neither Till nor binding case law in the Second Circuit require the prime rate to be used as the “one size fits all” base rate, citing General Motors Acceptance Corp. v. Valenti (In re Valenti), 105 F.3d 55, 64 (2nd Cir, 1997), which held that the appropriate rate of interest was the rate of interest on a U.S. Treasury instrument having a maturity equivalent to the repayment schedule under the plan, plus a premium reflecting the risk to the creditors in receiving deferred payments under the plan. In effect, Valenti applies substantively the same formula promulgated in Till except for using a Treasury rate as the benchmark rate. In further support of their position, the Debtors noted that using the prime rate as a benchmark simply cannot account for the difference in maturity timeframes and because it is a short-term floating rate that is not used in practice as a benchmark for bonds with longer-term maturities and fixed rate coupons.

The Court's Ruling

The court agreed with the Debtors that the formula approach is the correct way to calculate the cramdown interest rate for secured creditors in a Chapter 11 case. However, because the Treasury rate rather than the prime rate was used, the court held that the risk premium had to be slightly increased to make the plan confirmable. The rates were adjusted upward by 50 basis points with respect to the First Lien Notes, and 75 basis points as to the 1.5 Lien Notes, with the resulting rates still remaining well below market rates.

The court clearly was guided by the principles enunciated in Till, and to the extent there was any concern about Till being a plurality opinion, the court also found support for the formula approach used in Valenti . The court noted that both Till and Valenti shared similar reasons for rejecting market-based approaches in setting a cramdown rate in Chapter 13 cases, or as the circuit court in Valenti stated, “the forced loan approach misapprehends the 'present value' function of the interest rate. The objective of Section 1325(a)((5)(B)(ii) is to put the creditor in the same economic position it would have been in had it received the value of its allowed claim immediately. The purpose is not to put the creditor in the same position that it would have been in had it arranged a 'new loan.'” (emphasis in original) Valenti , 105 F.3d at 63-4. “Moreover, ' the value of a creditor's allowed claim does not include any degree of profit. There is no reason, therefore, that the interest rate should account for profit.” Id. at 64.

The court found that under the formula approach, the proper rate for secured lenders' cramdown notes begins with a risk-free base rate, such as the prime rate used in Till, or the Treasury rate used in Valenti , which is then adjusted by a percentage reflecting a risk factor based on the circumstances of the debtor's estate, the nature of the collateral security, the terms of the cramdown note itself, and the duration and feasibility of the plan.

The court further noted that both Till and Valenti held that, generally speaking, the foregoing risk adjustment should be between 1% and 3% above the risk-free base rate, cautioning that the formula approach “is not a back door to applying a market rate.” Momentive transcript at 73.

“The focus, therefore, should be generally on the risk posed by the debtor within a specified band, as opposed to market rates charged to comparable companies. Nothing could be clearer than the two Courts' statements on that point.” Id. “Therefore, as a first principle, the cramdown interest rate ' should not contain any profit or cost element and market-based evidence should not be considered except, arguably and if so secondarily, when setting a proper risk premium under the formula approach taken in Till and Valenti.”

The court also made some observations about footnote 14 in Till. The court questioned whether the footnote provides any support for a market analysis in Chapter 11 cases ' stating that using DIP loan rates in Chapter 11 cases is illusory, since lenders want to make DIP loans to obtain fees, costs and profits, all of which cannot be considered for cramdown purposes under Till and Valenti. Thus, the court found footnote 14 to be a “very slim reed on which to require a market-based approach in contrast to every other aspect of Till.” Id . at 78 Indeed, the court concluded that any market-based approach generally misinterprets Till and Valenti and that such approaches are almost, if not always, dead ends ' a result which should not be surprising because it is highly unlikely that there will ever be an efficient market that does not include a profit element, fees and costs, thereby violating Till's and Valentis ' first principles, since capturing profit, fees and costs is the marketplace lender's reason for being. Id. at 81

In summary the court concluded that: 1) a cramdown interest rate should not include any profit or cost element, as both are inconsistent with the present value calculation required for cramdown; 2) market testimony or evidence is only relevant to determining the proper risk premium to apply in the formula approach; and 3) creditors should not use the risk premium as a way to obtain a market interest rate on their replacement notes.

Conclusion

This case provides much-needed transparency with respect to the cramdown interest rate to be used in connection with treatment of secured claims in Chapter 11 cases by clearly setting forth the principles upon which such analysis is to be performed ' a formula approach that uses a base rate and applies an add-on risk factor to provide the secured creditor with the present value of its secured claim as required under 1129 (b)(2)(a)(i) (II) of the Bankruptcy Code. This case also provides meaningful guidance to allow parties to resolve this issue consensually and may impact a debtor's ability to exit Chapter 11 more easily if secured creditors can be paid in notes with below market interest rates. Likewise, there is the potential for increasing distributions to unsecured creditors by possibly reducing payments to secured creditors under a plan. In the final analysis, the formula approach is a relatively simple way to calculate cramdown interest rates for secured claims and if followed should avoid long expensive evidentiary cramdown hearings ' leading to more plans being confirmed in an expedient cost-effective manner.

Robert W. Dremluk is a partner in the New York office of Culhane Meadows PLLC and a member of this publication's Board of Editors. He may be reached at [email protected].

In Till v. SCS Credit Corp. , 541 U.S. 465 (2004), the U.S. Supreme Court applied a formula to determine the appropriate cramdown interest rate with respect to the treatment of secured claims in a Chapter 13 case ' holding that the appropriate interest rate is determined by taking a risk-free base rate, such as the prime rate or the Treasury rate, and adding a risk premium of between 1% and 3% to reflect the repayment risks unique to the particular debtor. However, Till left an unanswered question about how to determine an applicable cramdown interest rate for allowed secured claims in Chapter 11 cases.

Since Till , courts have relied on language contained in footnote 14 in Till as providing guidance as to how such a rate should be determined in Chapter 11 cases. Footnote 14 in substance states that while there is no readily apparent Chapter 13 cramdown interest rate because there is no free market of Chapter 13 cramdown lenders, the same may not be true in Chapter 11 because lenders advertise financing for Chapter 11 debtors-in-possession. This has opened the door for arguments about the use of market rates to determine cramdown interest rates in Chapter 11 cases. However, questions still remain over how and when to apply either a market interest rate or formula based rate in Chapter 11 cases.

Recently, in a bench ruling in In re MPM Silicones, LLC, issued on Aug. 26, 2014 (No. 14-22503-RDD (Bankr. S.D.N.Y. Aug. 26, 2014) and later corrected on Sept. 9, 2014 (see In re MPM Silicones, LLC, No. 14-22503, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014)) (Momentive ), the United States Bankruptcy Court for the Southern District of New York (USBJ Drain), held, among other things, that the debtors could cram down their plan of reorganization on their secured lenders under section 1129(b)(2)(A)(i) of the Bankruptcy Code by providing them with replacement notes paying a below-market interest rate using a formula approach to calculate the applicable interest rate.

The' Dilemma

In 2012, Momentive Performance Materials and its affiliates (the Debtors) issued $1.1 billion of first-lien notes (First Lien Notes) and $250 million of “1.5-lien” notes (1.5 Lien Notes) due 2020 ' the holders of First Lien Notes and 1.5 Lien Notes will collectively be referred to as the “Noteholders.”

The Debtors proposed a plan that contained a death-trap clause, which provided that the Noteholders could elect either to vote in favor of the plan and receive payment of their claims in full in cash, without a make-whole premium, or if they rejected the plan, the Noteholders would receive seven-year replacement notes in the face amount of their allowed claims, bearing a below-market interest rate equal to the applicable Treasury rate plus a small risk premium, while preserving their right to litigate their rights to the make-whole premium.

The Noteholders voted against the plan, noting: 1) that they were entitled to the make-whole premiums based on the acceleration of their debt by virtue of the bankruptcy filing and the proposed early repayment via the replacement notes to be issued under the plan and further because; 2) the proposed treatment of their secured claims under the plan was not “fair and equitable” and therefore could not be crammed down on them because the plan did not apply a market interest rate to the replacement notes.

The Debtors' Argument

As a result of the Noteholders' rejection of the plan, the Debtors were required to satisfy the cramdown requirements of section 1129(b)(2)(A)(i) of the Bankruptcy Code, which provides that a plan is “fair and equitable” to a non-accepting class of secured creditors if it provides that creditors: 1) retain the liens securing their claims; and 2) receive deferred cash payments with a present value at least equal to the allowed amount of their claims.

The Debtors argued that the proposed treatment of the Noteholders' claims was consistent with the present value formula standard set out in Till. On the other hand, the Noteholders argued that it was not proper to apply Till's formula approach. Instead, the Noteholders, relying on footnote 14 in Till, claimed that a market rate was readily available, looking to the Debtors' exit financing commitment as evidence of that rate.

In response, the Debtors argued that Till “is not intended to put current creditors on par with market lenders,” but rather to provide a base rate of interest “plus some compensation for the risk that such replacement notes are not repaid as scheduled.” Therefore, under the Debtors' theory, it followed that the formula set out in Till is not subject to a market check, even if one is available.

The Debtors further argued that: 1) the Noteholders made much of footnote 14 in Till, which states that “when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce,” Till, 541 U.S. at 476 n.14; and 2) there is no stated requirement or preference to perform a market analysis. The Debtors asserted that footnote 14 must be read in conjunction with and be reconciled with footnote 18 in Till. Footnote 18 provides that “if the court could somehow be certain a debtor would complete his plan, the prime rate would be adequate to compensate any secured creditors forced to accept cramdown loans.” Stated differently, no further analysis beyond selecting a base interest rate, let alone a market rate, would be necessary. Till 541 U.S. at 479 n.18.

Accordingly, the Debtors calculated the cramdown rates by applying Till's formula approach in a two-step process. First, they chose a base rate by “taking [a] cue from ordinary lending practices that “reflects the financial market's” estimate of the amount a commercial bank should charge a creditworthy commercial borrower to compensate for the opportunity costs of the loan, the risk of inflation and the relatively slight risk of default.” Till 541 U.S at 479. The second step of the formula approach required the court to adjust the base rate to “account for the risk of nonpayment posed by borrowers in their financial position,” Id. at 465 or as the Debtors described it, the add-on risk premium.

With respect to the add-on risk premium, the Debtors' expert analyzed “the nature of the security, and the duration and feasibility of the reorganization plan” as required by Till, and focused on the specific facts presented by analyzing six additional factors: 1) sustainable capital structure; 2) likelihood of repayment or financing; 3) capital structure sustainability in downside (sensitivity) scenarios; 4) sufficient liquidity; 5) collateral; and 6) business fundamentals. The Debtors' expert concluded that the replacement notes to be issued to the Noteholders under the plan would adequately compensate the Noteholders for any risks attendant to extending credit to the reorganized Debtors.

The Noteholders' Response

The Noteholders challenged this analysis, claiming that the add-on risk premium was too low because the Debtors faced a number of business and operational hurdles. In response, the Debtors argued that the Debtors' financial projections had been rigorously scrutinized, took into account such matters, and that the add-on risk premium was therefore appropriately determined. The Noteholders also argued that the Debtors' proposed cramdown interest rates did not reflect the present value of their allowed claims. In response, the Debtors noted that the Till formula is designed to calculate the present value of such claims and that no separate or additional present value analysis is required. In other words, the plan satisfied the second prong of section 1129(b)(2)(A)(i) because the cramdown rates used in the plan provided the Noteholders with deferred cash payments aggregating the present value of their allowed claims.

The Debtors stated that in adopting the formula approach, Till rejected cramdown approaches that provided creditors more than “present value.” Till U.S. 541 at 476. (These considerations lead us to reject the coerced loan, presumptive contract rate and cost of funds approaches. Each of these approaches ' aims to make each individual creditor whole rather than to ensure the debtors' payments have the requisite present value.) Stated differently, Till does not require debtors to first determine the result under the formula approach and subsequently perform a present value analysis ' or vice versa.

Finally, the Noteholders claimed that the selection of the Treasury rate instead of the prime rate as the base rate was improper. The Debtors refuted this argument, noting that neither Till nor binding case law in the Second Circuit require the prime rate to be used as the “one size fits all” base rate, citing General Motors Acceptance Corp. v. Valenti (In re Valenti), 105 F.3d 55, 64 (2nd Cir, 1997), which held that the appropriate rate of interest was the rate of interest on a U.S. Treasury instrument having a maturity equivalent to the repayment schedule under the plan, plus a premium reflecting the risk to the creditors in receiving deferred payments under the plan. In effect, Valenti applies substantively the same formula promulgated in Till except for using a Treasury rate as the benchmark rate. In further support of their position, the Debtors noted that using the prime rate as a benchmark simply cannot account for the difference in maturity timeframes and because it is a short-term floating rate that is not used in practice as a benchmark for bonds with longer-term maturities and fixed rate coupons.

The Court's Ruling

The court agreed with the Debtors that the formula approach is the correct way to calculate the cramdown interest rate for secured creditors in a Chapter 11 case. However, because the Treasury rate rather than the prime rate was used, the court held that the risk premium had to be slightly increased to make the plan confirmable. The rates were adjusted upward by 50 basis points with respect to the First Lien Notes, and 75 basis points as to the 1.5 Lien Notes, with the resulting rates still remaining well below market rates.

The court clearly was guided by the principles enunciated in Till, and to the extent there was any concern about Till being a plurality opinion, the court also found support for the formula approach used in Valenti . The court noted that both Till and Valenti shared similar reasons for rejecting market-based approaches in setting a cramdown rate in Chapter 13 cases, or as the circuit court in Valenti stated, “the forced loan approach misapprehends the 'present value' function of the interest rate. The objective of Section 1325(a)((5)(B)(ii) is to put the creditor in the same economic position it would have been in had it received the value of its allowed claim immediately. The purpose is not to put the creditor in the same position that it would have been in had it arranged a 'new loan.'” (emphasis in original) Valenti , 105 F.3d at 63-4. “Moreover, ' the value of a creditor's allowed claim does not include any degree of profit. There is no reason, therefore, that the interest rate should account for profit.” Id. at 64.

The court found that under the formula approach, the proper rate for secured lenders' cramdown notes begins with a risk-free base rate, such as the prime rate used in Till, or the Treasury rate used in Valenti , which is then adjusted by a percentage reflecting a risk factor based on the circumstances of the debtor's estate, the nature of the collateral security, the terms of the cramdown note itself, and the duration and feasibility of the plan.

The court further noted that both Till and Valenti held that, generally speaking, the foregoing risk adjustment should be between 1% and 3% above the risk-free base rate, cautioning that the formula approach “is not a back door to applying a market rate.” Momentive transcript at 73.

“The focus, therefore, should be generally on the risk posed by the debtor within a specified band, as opposed to market rates charged to comparable companies. Nothing could be clearer than the two Courts' statements on that point.” Id. “Therefore, as a first principle, the cramdown interest rate ' should not contain any profit or cost element and market-based evidence should not be considered except, arguably and if so secondarily, when setting a proper risk premium under the formula approach taken in Till and Valenti.”

The court also made some observations about footnote 14 in Till. The court questioned whether the footnote provides any support for a market analysis in Chapter 11 cases ' stating that using DIP loan rates in Chapter 11 cases is illusory, since lenders want to make DIP loans to obtain fees, costs and profits, all of which cannot be considered for cramdown purposes under Till and Valenti. Thus, the court found footnote 14 to be a “very slim reed on which to require a market-based approach in contrast to every other aspect of Till.” Id . at 78 Indeed, the court concluded that any market-based approach generally misinterprets Till and Valenti and that such approaches are almost, if not always, dead ends ' a result which should not be surprising because it is highly unlikely that there will ever be an efficient market that does not include a profit element, fees and costs, thereby violating Till's and Valentis ' first principles, since capturing profit, fees and costs is the marketplace lender's reason for being. Id. at 81

In summary the court concluded that: 1) a cramdown interest rate should not include any profit or cost element, as both are inconsistent with the present value calculation required for cramdown; 2) market testimony or evidence is only relevant to determining the proper risk premium to apply in the formula approach; and 3) creditors should not use the risk premium as a way to obtain a market interest rate on their replacement notes.

Conclusion

This case provides much-needed transparency with respect to the cramdown interest rate to be used in connection with treatment of secured claims in Chapter 11 cases by clearly setting forth the principles upon which such analysis is to be performed ' a formula approach that uses a base rate and applies an add-on risk factor to provide the secured creditor with the present value of its secured claim as required under 1129 (b)(2)(a)(i) (II) of the Bankruptcy Code. This case also provides meaningful guidance to allow parties to resolve this issue consensually and may impact a debtor's ability to exit Chapter 11 more easily if secured creditors can be paid in notes with below market interest rates. Likewise, there is the potential for increasing distributions to unsecured creditors by possibly reducing payments to secured creditors under a plan. In the final analysis, the formula approach is a relatively simple way to calculate cramdown interest rates for secured claims and if followed should avoid long expensive evidentiary cramdown hearings ' leading to more plans being confirmed in an expedient cost-effective manner.

Robert W. Dremluk is a partner in the New York office of Culhane Meadows PLLC and a member of this publication's Board of Editors. He may be reached at [email protected].