District Court Affirms Cramdown Interest Rate Calculation

On May 5, 2015, United States District Judge Vincent L. Bricetti affirmed the confirmation order issued by United States Bankruptcy Judge Robert D. Drain in the MPM Silicones LLC (Momentive' Chapter 11 cases. We discussed the facts and analyzed Judge Drain's ruling with respect to the applicable cramdown interest rate to be applied to secured claims under section 1129(b)(2)(A)(i) of the Bankruptcy Code in a January 2015 article in this newsletter (32 The Bankruptcy Strategist 3 (January 2015)), http://bit.ly/1Od6TWC. On appeal, the senior lien appellants argued that the plan of reorganization confirmed by Judge Drain violated section 1129(b) by using a “formula approach” to calculate the cramdown interest rate, and, in the alternative, by calculating the cramdown interest rate under the formula approach incorrectly.

The Bankruptcy Court's Analysis

Judge Drain held, among other things, that applicable rate should follow the formula approach laid out by the United States Supreme Court in Till v. SCS Credit Corp., 541 U.S. 465 (2004) where the cramdown interest rate is calculated by augmenting'a risk-free (or low-risk) base rate “to account for the risk of nonpayment posed by borrowers in the [] financial position of the debtor.” Id. at 471.

Judge Drain found additional support for his ruling in a pre-Till opinion in In re Valenti, 105 F.3d 55 (2nd Cir. 1997) where the Second Circuit rejected the efficient market approach (a position advanced by the senior lien appellants in Momentive), stating that courts adopting such an “approach misapprehend the 'present value' function of the interest rate,” Id. at 63.

On appeal, the district court agreed with the bankruptcy court's reliance on Valenti's analysis that the cramdown rate is meant “to put the creditor in the same economic position that it would have been had it received the value of its claim immediately. The purpose is not to put the creditor in the same position that it would have been had it arranged a 'new” loan. Id. at 63-64. The Valenti court continued: “[T]he 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 ' Otherwise, the creditor will receive more than the present value of its allowed claim.” Id. at 64

On appeal, the senior lien appellants contended that the district court should determine the interest rate using an “efficient market” approach and not to use the Till formula approach. Under the efficient market approach, the cramdown interest rate is based on the interest rate the market would pay on such a loan, or in the Momentive case, measured by “the rates on the exit and bridge financing the Debtors actually obtained. “

District Court Ruling

The district court disagreed with the appellants, noting that: 1) even though Till was decided in the context of a Chapter 13 case, its reasoning is applicable in the Chapter 11 context; 2) Till rejected the efficient market approach because it “imposes significant evidentiary costs, and aims to make each individual creditor whole rather than to ensure the debtor's payments have the required present value,” Till at 477; and 3) the efficient market approach “overcompensates creditors because the market lending rate must be high enough to cover factors, like lenders' transaction costs and overall profits, that are no longer relevant in the context of court-administered and court-supervised cramdown loans.” Id.

The district court further noted that the Second Circuit's reasoning in Valenti was applicable in the Chapter 11 context and found that the senior lien appellants provide no good reason why the cramdown interest rate should place Chapter 11 creditors ' but not Chapter 13 creditors ' in the same position that would have been had they arranged a new loan; or, similarly, why the cramdown interest rate should allow Chapter 11 creditors ' but not Chapter 13 creditors ' to “receive more that the present value of [their] allowed claim,” citing In re Valenti, 105 F.3d at 64

The court also rejected the senior lien appellants' attempt to distinguish Till and Valenti by pointing to a footnote in Till, which states, “when picking a cramdown rate in a Chapter 11 case, it might make sense to ask what an efficient market would produce.” Till at 476 n 14. The court rejected this position, noting that: 1) whether the market for a loan is truly efficient or not has no bearing on the Second Circuit's mandate in Valenti that the Bankruptcy Code does not intend to put creditors in the same position they would have been in had they arranged a new loan; and 2) the language in the Till footnote does not require the application of the efficient market approach in a Chapter 11 proceeding, but can fairly be read only to suggest that a court may want to consider marker rates in the Chapter 11 context.

The district court also rejected precedent from other circuits relied upon by the senior lien appellants, including In re American HomePatien , 420 F.3d 559 (6th Cir. 2005), cert denied, 549 U.S. 942 (2006) in which courts chose to apply the efficient market rate in Chapter 11 cases, presumably on the grounds that Till did not explicitly require the abandonment of the efficient market approach in Chapter 11 cases. That said, just as the Sixth Circuit filled the gaps in Till , the district court felt compelled to fill those same gaps by reference to Second Circuit precedent.

Further, while acknowledging that there are bankruptcy court and district court decisions in the Second Circuit that follow the American HomePatient approach, the district court found that those cases did not mandate that an efficient market rate approach be followed, but simply held that courts should consider whether an efficient market rate exists before determining the cramdown interest rate. See, e.g., In re 20 Bayard Views, LLC , 445 B.R. 83, 107-08 (Bankr. E.D.N.Y. 2011) (explaining that “[c]ourts in the Circuit have concluded that the two-step analysis described in American HomePatien t is an appropriate way to determine the interest rate that should apply in a Chapter 11 cramdown situation,” but finding that no efficient market existed), Mercury Capital Corp. v. Milford CT Assocs., L.P., 354 B.R. 1, 12 (D. Conn. 2006) (holding that the bankruptcy court “did not necessarily err as a matter of law” in applying the formula approach, but remanding for consideration of whether an efficient market existed).

In fact, Judge Drain in Momentive did consider whether an efficient market rate existed, but concluded that such a rate does not exist because the financing obtained by the Debtors necessarily included a “built-in profit element” and “recovery for costs and fees.” See In re MPM Silicones, LLC 2014 WL 4436335, at *29.

The senior lien appellants alternatively attacked how the bankruptcy court applied the formula approach because it chose to use the seven-year Treasury rate, rather than the national prime rate used in Till as the base risk-free rate. The district court agreed with the bankruptcy court that Till does not obligate a bankruptcy court to choose the national prime rate and that using the Treasury rate makes sense because it is often used as a base rate for longer-term corporate debt. Similarly, the district court found that the risk premiums in a range of between 1% to 3% used by the bankruptcy court were well within the bounds of reasonableness. In fact, the bankruptcy court applied risk premiums of 2.0% and 2.75% to the Replacement Notes issued under the plan in Momentive, which the court found acceptable and therefore would not be disturbed.

Possible Alternatives

On May 26, 2015, an appeal of the court's ruling was filed with the Second Circuit. So we may have to wait for the circuit court decision before the cramdown interest rate issue is finally resolved in the Second Circuit.

In the interim, there are some other possible ways that this issue could be resolved in the context of Chapter 11 cases, such as: 1) drafting provisions in secured loan documents that explicitly state that a make-whole premium is due upon acceleration of a debt, including acceleration arising from a Chapter 11 filing; and that in the event cramdown paper is issued under a plan, that it provide similar adequate compensation; 2) a possible legislative change based upon the American Bankruptcy Institute's December 2014 report by the Commission to Study the Reform of Chapter 11 that rejected Till and the formula approach in Chapter 11 cases and recommended supporting the use of a market-efficient approach that affords a secured lender a profit component; 3) case law developments such as rulings by the Delaware Bankruptcy Court on March 26, 2015 in In re Energy Future Holdings, Inc . (finding that if the automatic stay were lifted the trustee for the first lien noteholders could decelerate the notes and that a genuine issue of material fact existed as to whether the trustee could establish cause to lift the automatic stay retroactively to decelerate the notes owed by a putative solvent debtor) and the Ninth Circuit Bankruptcy Appellate Panel's ruling in In re Dunlap Oil , 2014 WL 6883069 B.A.P. 9th Cir, Dec. 5, 2014) (no cap or range on risk premium to be applied under Till formula with the burden on secured creditors to submit evidence to prove that risks under proposed plan warrant a higher cramdown interest rate); or 4) standing orders such as the ones in the bankruptcy courts for the Northern and Southern Districts of Mississippi where the current rebuttable presumptive Till rate is 5%.

Conclusion

While the Momentive decision has certainly shaken up the lending markets, the alternatives discussed above may counter the impact that the case is having on secured lending. At the same time, the potential cramdown of secured claims at below market rates of interest should be carefully evaluated by distressed debt investors ' at least until the Second Circuit rules on the pending Momentive appeal. Until then, it is evident that Momentive represents a shift of power toward debtors and junior creditors in Chapter 11 cases for the foreseeable future.

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. His work focuses on diverse interests in federal and bankruptcy court litigation and advice and risk assessment regarding transactional matters, including asset purchases and structured finance transactions. He may be reached at [email protected].

On May 5, 2015, United States District Judge Vincent L. Bricetti affirmed the confirmation order issued by United States Bankruptcy Judge Robert D. Drain in the MPM Silicones LLC (Momentive' Chapter 11 cases. We discussed the facts and analyzed Judge Drain's ruling with respect to the applicable cramdown interest rate to be applied to secured claims under section 1129(b)(2)(A)(i) of the Bankruptcy Code in a January 2015 article in this newsletter (32 The Bankruptcy Strategist 3 (January 2015)), http://bit.ly/1Od6TWC. On appeal, the senior lien appellants argued that the plan of reorganization confirmed by Judge Drain violated section 1129(b) by using a “formula approach” to calculate the cramdown interest rate, and, in the alternative, by calculating the cramdown interest rate under the formula approach incorrectly.

The Bankruptcy Court's Analysis

Judge Drain held, among other things, that applicable rate should follow the formula approach laid out by the United States Supreme Court in Till v. SCS Credit Corp. , 541 U.S. 465 (2004) where the cramdown interest rate is calculated by augmenting'a risk-free (or low-risk) base rate “to account for the risk of nonpayment posed by borrowers in the [] financial position of the debtor.” Id . at 471.

Judge Drain found additional support for his ruling in a pre-Till opinion in In re Valenti, 105 F.3d 55 (2nd Cir. 1997) where the Second Circuit rejected the efficient market approach (a position advanced by the senior lien appellants in Momentive), stating that courts adopting such an “approach misapprehend the 'present value' function of the interest rate,” Id. at 63.

On appeal, the district court agreed with the bankruptcy court's reliance on Valenti's analysis that the cramdown rate is meant “to put the creditor in the same economic position that it would have been had it received the value of its claim immediately. The purpose is not to put the creditor in the same position that it would have been had it arranged a 'new” loan. Id. at 63-64. The Valenti court continued: “[T]he 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 ' Otherwise, the creditor will receive more than the present value of its allowed claim.” Id. at 64

On appeal, the senior lien appellants contended that the district court should determine the interest rate using an “efficient market” approach and not to use the Till formula approach. Under the efficient market approach, the cramdown interest rate is based on the interest rate the market would pay on such a loan, or in the Momentive case, measured by “the rates on the exit and bridge financing the Debtors actually obtained. “

District Court Ruling

The district court disagreed with the appellants, noting that: 1) even though Till was decided in the context of a Chapter 13 case, its reasoning is applicable in the Chapter 11 context; 2) Till rejected the efficient market approach because it “imposes significant evidentiary costs, and aims to make each individual creditor whole rather than to ensure the debtor's payments have the required present value,” Till at 477; and 3) the efficient market approach “overcompensates creditors because the market lending rate must be high enough to cover factors, like lenders' transaction costs and overall profits, that are no longer relevant in the context of court-administered and court-supervised cramdown loans.” Id.

The district court further noted that the Second Circuit's reasoning in Valenti was applicable in the Chapter 11 context and found that the senior lien appellants provide no good reason why the cramdown interest rate should place Chapter 11 creditors ' but not Chapter 13 creditors ' in the same position that would have been had they arranged a new loan; or, similarly, why the cramdown interest rate should allow Chapter 11 creditors ' but not Chapter 13 creditors ' to “receive more that the present value of [their] allowed claim,” citing In re Valenti, 105 F.3d at 64

The court also rejected the senior lien appellants' attempt to distinguish Till and Valenti by pointing to a footnote in Till, which states, “when picking a cramdown rate in a Chapter 11 case, it might make sense to ask what an efficient market would produce.” Till at 476 n 14. The court rejected this position, noting that: 1) whether the market for a loan is truly efficient or not has no bearing on the Second Circuit's mandate in Valenti that the Bankruptcy Code does not intend to put creditors in the same position they would have been in had they arranged a new loan; and 2) the language in the Till footnote does not require the application of the efficient market approach in a Chapter 11 proceeding, but can fairly be read only to suggest that a court may want to consider marker rates in the Chapter 11 context.

The district court also rejected precedent from other circuits relied upon by the senior lien appellants, including In re American HomePatien , 420 F.3d 559 (6th Cir. 2005), cert denied, 549 U.S. 942 (2006) in which courts chose to apply the efficient market rate in Chapter 11 cases, presumably on the grounds that Till did not explicitly require the abandonment of the efficient market approach in Chapter 11 cases. That said, just as the Sixth Circuit filled the gaps in Till , the district court felt compelled to fill those same gaps by reference to Second Circuit precedent.

Further, while acknowledging that there are bankruptcy court and district court decisions in the Second Circuit that follow the American HomePatient approach, the district court found that those cases did not mandate that an efficient market rate approach be followed, but simply held that courts should consider whether an efficient market rate exists before determining the cramdown interest rate. See, e.g., In re 20 Bayard Views, LLC , 445 B.R. 83, 107-08 (Bankr. E.D.N.Y. 2011) (explaining that “[c]ourts in the Circuit have concluded that the two-step analysis described in American HomePatien t is an appropriate way to determine the interest rate that should apply in a Chapter 11 cramdown situation,” but finding that no efficient market existed), Mercury Capital Corp. v. Milford CT Assocs., L.P. , 354 B.R. 1, 12 (D. Conn. 2006) (holding that the bankruptcy court “did not necessarily err as a matter of law” in applying the formula approach, but remanding for consideration of whether an efficient market existed).

In fact, Judge Drain in Momentive did consider whether an efficient market rate existed, but concluded that such a rate does not exist because the financing obtained by the Debtors necessarily included a “built-in profit element” and “recovery for costs and fees.” See In re MPM Silicones, LLC 2014 WL 4436335, at *29.

The senior lien appellants alternatively attacked how the bankruptcy court applied the formula approach because it chose to use the seven-year Treasury rate, rather than the national prime rate used in Till as the base risk-free rate. The district court agreed with the bankruptcy court that Till does not obligate a bankruptcy court to choose the national prime rate and that using the Treasury rate makes sense because it is often used as a base rate for longer-term corporate debt. Similarly, the district court found that the risk premiums in a range of between 1% to 3% used by the bankruptcy court were well within the bounds of reasonableness. In fact, the bankruptcy court applied risk premiums of 2.0% and 2.75% to the Replacement Notes issued under the plan in Momentive, which the court found acceptable and therefore would not be disturbed.

Possible Alternatives

On May 26, 2015, an appeal of the court's ruling was filed with the Second Circuit. So we may have to wait for the circuit court decision before the cramdown interest rate issue is finally resolved in the Second Circuit.

In the interim, there are some other possible ways that this issue could be resolved in the context of Chapter 11 cases, such as: 1) drafting provisions in secured loan documents that explicitly state that a make-whole premium is due upon acceleration of a debt, including acceleration arising from a Chapter 11 filing; and that in the event cramdown paper is issued under a plan, that it provide similar adequate compensation; 2) a possible legislative change based upon the American Bankruptcy Institute's December 2014 report by the Commission to Study the Reform of Chapter 11 that rejected Till and the formula approach in Chapter 11 cases and recommended supporting the use of a market-efficient approach that affords a secured lender a profit component; 3) case law developments such as rulings by the Delaware Bankruptcy Court on March 26, 2015 in In re Energy Future Holdings, Inc . (finding that if the automatic stay were lifted the trustee for the first lien noteholders could decelerate the notes and that a genuine issue of material fact existed as to whether the trustee could establish cause to lift the automatic stay retroactively to decelerate the notes owed by a putative solvent debtor) and the Ninth Circuit Bankruptcy Appellate Panel's ruling in In re Dunlap Oil , 2014 WL 6883069 B.A.P. 9th Cir, Dec. 5, 2014) (no cap or range on risk premium to be applied under Till formula with the burden on secured creditors to submit evidence to prove that risks under proposed plan warrant a higher cramdown interest rate); or 4) standing orders such as the ones in the bankruptcy courts for the Northern and Southern Districts of Mississippi where the current rebuttable presumptive Till rate is 5%.

Conclusion

While the Momentive decision has certainly shaken up the lending markets, the alternatives discussed above may counter the impact that the case is having on secured lending. At the same time, the potential cramdown of secured claims at below market rates of interest should be carefully evaluated by distressed debt investors ' at least until the Second Circuit rules on the pending Momentive appeal. Until then, it is evident that Momentive represents a shift of power toward debtors and junior creditors in Chapter 11 cases for the foreseeable future.

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. His work focuses on diverse interests in federal and bankruptcy court litigation and advice and risk assessment regarding transactional matters, including asset purchases and structured finance transactions. He may be reached at [email protected].