Second Circuit Directs Consideration of an 'Efficient Market' Interest Rate for <b><i>Momentive</i></b> Cramdown Plan

In 2010, MPM issued approximately $1 billion in “springing” second-lien notes (the “Second-Lien Notes”). The Second-Lien Notes were to be unsecured until the previously exchanged Subordinated Notes were fully redeemed, at which point the “spring” in the lien would be triggered. Once triggered, the Second-Lien Notes would have a security interest in the Debtor's collateral. The exchanged Subordinated Notes were eventually redeemed, at which point the trigger occurred and the Second-Lien Notes became secured with second-priority liens junior to other pre-existing liens on the Debtor's collateral. A primary issue on appeal discussed below was whether the Second-Lien Notes had priority over the Subordinated Notes

In 2012, MPM again issued more debt, this time in the form of two classes of senior secured notes. Specifically, MPM issued $1.1 billion in first-lien secured notes (the “First-Lien Notes”), and $250 million in 1.5-lien secured notes (the “1.5-Lien Notes,” and, with the First-Lien Notes, the “Senior-Lien Notes”). Pursuant to the governing indentures (the “2012 Indentures”), the Senior-Lien Notes were to be repaid in full at maturity.

The 2012 Indentures also called for the recovery of a “make-whole” premium if MPM opted to redeem the notes prior to maturity. Because the Second-Lien Notes and the Sen- ior-Lien Notes were secured by the same collateral, the holders of those notes executed an intercreditor agreement, which provided that the Senior-Lien Notes stood in priority to the Second-Lien Notes as to their respective liens, but that each was junior to pre-existing liens on MPM's collateral. This raised two additional issues on appeal — whether the Senior-Lien Note holders were entitled to the make-whole adjustment, and what cramdown interest rate would apply if their Notes were replaced under the plan.

The plan provided for: 1) a 100% cash recovery of the principal balance and accrued interest on the Senior-Lien Notes; 2) an estimated 12.8%-28.1% recovery on the Second-Lien Notes in the form of equity in the reorganized Debtors; but 3) no recovery on the Subordinated Notes. The plan also gave the Sen- ior-Lien Notes holders a deathtrap option of accepting the plan and immediately receiving a cash payment of the outstanding principal and interest due on their Notes (without a make-whole premium), or rejecting the plan, receiving replacement notes with a present value equal to the allowed amount of such holder's claim, and then litigating in the bankruptcy court issues — including whether they were entitled to the make-whole premium and the interest rate on the replacement notes. The Senior-Lien Notes holders rejected the plan, electing the deathtrap option.

The Subordinated Notes holders and the Senior-Lien Notes holders opposed the plan. The Second-Lien Notes holders unanimously accepted it. The Subordinated Notes holders, who were to receive nothing, contended that, under relevant indenture provisions, their Notes were not subordinate to the Second-Lien Notes holders and, consequently, they were entitled to some recovery. The Senior-Lien Notes holders opposed the plan on the ground that the replacement notes they received did not provide for the make-whole premium, and carried a largely risk-free interest rate that failed to comply with the Bankruptcy Code because it was well below ascertainable market rates for similar debt obligations and thus was not fair and equitable because it failed to give them the present value of their claim.

The bankruptcy court confirmed the plan under a cramdown provision that allows a bankruptcy court to confirm a reorganization plan notwithstanding non-accepting classes if the plan “does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” 11 U.S.C. § 1129(b)(1).

The bankruptcy court concluded that the plan was fair to the Subordinated Notes holders, despite no recovery, because the 2006 Indenture called for their subordination to the Second-Lien Notes. It also held that the plan was fair to the Senior-Lien Notes holders because the 2012 Indentures did not require payment of the make-whole premium in the bankruptcy context, and because the interest rate on the proposed replacement notes, even though well below a market rate was determined by a formula that complied with the Code's cramdown provision. On appeal, the district court essentially agreed with the bankruptcy court.

Cramdown Interest Rate

The Second Circuit also agreed, except for the Senior-Lien Notes holders' contention with respect to the method of calculating the appropriate interest rate for the replacement notes. The court noted that as a consequence of rejecting the plan, the Senior-Lien Notes holders received replacement notes, which pay out their claim over time. While the Code permits debtors to make such “deferred cash payments” to secured creditors (i.e., to “cramdown”). 11 U.S.C. § 1129(b)(2)(A)(i)(II), those payments must ultimately amount to the full value of the secured creditors' claims.

To ensure that the creditor receives the full present value of its secured claim, the deferred payments must carry an appropriate rate of interest. The rate selected by the bankruptcy court for the Senior-Lien Note holders' replacement notes was based on “formula” rates, which were largely risk-free, slightly adjusted for appropriate risk factors. The Senior-Lien Notes holders contended that because this rate was too low, the plan was not “fair and equitable.” They argued that the lower courts should have applied a market rate of interest, which is the rate MPM would pay to a contemporaneous sophisticated arms-length lender in the open market.

The bankruptcy court rejected this approach, and concluded that a cramdown interest rate should “not take market factors into account.” Viewing itself as largely governed by the principles enunciated by the plurality opinion in Till v. SCS Credit Corp., 541 U.S. 465 (2004), it concluded that the proper rate was what the plurality referred to as the “formula” or “prime-plus” rate. The district court agreed. The Senior-Lien Notes holders argued that the lower courts erred in concluding that the Till plurality opinion is wholly applicable to this Chapter 11 proceeding.

The Second Circuit substantially agreed with the Senior-Lien Note holders, recognizing that the applicability of the formula-rate approach in Chapter 11 cases has not been followed by all courts — pointing to the U.S. Court of Appeals for the Sixth Circuit's ruling in in In re American HomePatient, Inc., 420 F.3d 559 (6th Cir. 2005, where it concluded that efficient market rates for cramdown loans cannot be ignored in Chapter 11 cases and developed this two-part test:

[T]he market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.

The Second Circuit adopted this approach, stating: “We do not read the Till plurality as stating that efficient market rates are irrelevant in determining value in the Chapter 11 cramdown context. And, disregarding available efficient market rates would be a major departure from long-standing precedent dictating that the best way to determine value is exposure to a market,” citing Bank of Am. Nat'l Trust and Sav. Assn v. 203 N. LaSalle St. Pship, 526 U.S. 434, 457 (1999). The court concluded: “[W]here, as here, an efficient market may exist that generates an interest rate that is apparently acceptable to sophisticated parties dealing at arms-length, we conclude, consistent with footnote 14 [in Till], that such a rate is preferable to a formula improvised by a court.”

Make-Whole Provision

The indentures governing the Senior-Lien Notes contain Optional Redemption Clauses, which provided for the payment of a make-whole premium. The premium was intended to ensure that the Senior-Lien Notes holders received additional compensation to make up for the interest they would not receive if the Notes were redeemed prior to their maturity date. Pursuant to the plan, the Debtors issued replacement notes to the Senior-Lien Notes holders, which did not account for the make-whole premium. These holders contended that the failure to include that premium violated the indentures.

The bankruptcy court concluded that the Senior-Lien Notes holders were not entitled to the premium. It reasoned that under the indentures the make-whole premium would be due only in the case of an “optional redemption” and not in the case of an acceleration brought about by a bankruptcy filing. The district court agreed, as did the Second Circuit, relying on In re AMR Corp., 730 F.3d 88 (2d Cir. 2013) with the proposition that any payment on the accelerated notes following a bankruptcy filing would be a post-maturity payment. Therefore, a creditor's post-petition invocation of a contractual right to rescind an acceleration triggered automatically by a bankruptcy filing is barred, because it would be an attempt to modify contract rights and would be subject to the automatic stay.

Subordination

The lower courts concluded that the Plan, which provided no distribution to the Subordinated Notes holders, complied with the governing 2006 Indenture. The Subordinated Notes holders argued that this conclusion was erroneous because, under the terms of the 2006 Indenture, their claims were not subordinate to the Second-Lien Notes, whose holders recovered under the plan. The Debtors, on the other hand, contended that the 2006 Indenture gives the Second-Lien Notes priority over the Subordinated Notes. The Second Circuit agreed with the Debtors, finding the relevant indenture provisions ambiguous, but resolving the ambiguities in favor of the Debtors.

The court noted: “We do not agree with the lower courts that the Fourth Proviso unambiguously incorporates a distinction between lien subordination and payment subordination. Rather, we conclude that the Fourth Proviso renders the definition of Senior Indebtedness ambiguous as to whether it includes the Second-Lien Notes. Nevertheless, we conclude that this ambiguity should be resolved in Debtors' favor given the plethora of evidence in the record that the parties intended the Second-Lien Notes to be Senior Indebtedness.”

The Second Circuit went on to discuss extrinsic evidence such as statements contained in SEC filings that supported a view that the Second Lien Notes had priority over the Subordinated Notes. The court also noted that the Subordinated Notes holders' interpretation generates the irrational outcome that the springing of the Second-Lien Notes' security interest, which was meant to enhance the note holder' protection, would actually strip those notes of their status as Senior Indebtedness, and therefore their priority over the Subordinated Notes.

Finally, the Subordinated Notes holders' proposed interpretation of the phrase that “in any respect” covers all junior liens would mean that no senior note classes would qualify as Senior Indebtedness because each was secured in some respect by a junior lien. For example, the First-Lien Notes were secured in part by a second priority lien on collateral securing a prepetition revolving credit facility.

Equitable Mootness

The Second Circuit declined to dismiss any of these appeals as equitably moot, largely because the appellants did everything possible to timely prosecute their appeals, including seeking a stay from every court involved. Also, the economic impact that the limited remand may have on the outcome of the case was not relatively material when compared with the distributions made or to be made under the plan, said the court, relying on In re Chateaugay Corp., 988 F.2d 322, 325 (2d Cir. 1993) (listing factors to be considered for mootness).

Conclusion

This decision is favorable to secured lenders because it somewhat reduces the risk that a formula rate of interest would be used to cramdown a secured claim and instead directs bankruptcy courts to consider using a market-based rate if such a rate exists. That said, the decision leaves a number of unresolved matters.

Introducing the concept of an “efficient market” to the analysis is problematic. The term is often used to describe a situation where all information is available to the parties, parties act rationally, there is lack of any cash or regulatory constraints or barriers to entry, there are no economies of scale, profits or marginal costs, all transactions are frictionless and there no arbitrage of any kind. As one may surmise, the real world does not operate that way. So asking courts to consider a rate that exists in an efficient market is like searching for the Holy Grail.

On the other hand, what courts can strive to achieve is to find a rate that results in an outcome that provides the right recovery for the secured creditor as required under the Bankruptcy Code. One of the key hurdles to overcome is the existence of an efficient market rate — a battle of experts is inevitable. Litigation risk will be high, and costs potentially will skyrocket. If the matter proceeds, courts presumably will use experts to help them arrive at a common-sense outcome while striving to find the elusive efficient market Holy Grail rate.

And, while all of this is unfolding, debtors will have to make strategic decisions about lining up exit financing, being very careful not to do so too early and having it possibly used against them in a cramdown battle. In effect, this litigation risk may have a chilling effect on timing of such financing.

Forum shopping is also a natural concern, as debtors choose where to file their Chapter 11 cases depending on jurisdictions that use only a formula rate approach. So, while the decision may provide some theoretical temporary comfort to secured creditors, other problems lurk.

*****
Robert W. Dremluk is a partner in the New York office of Culhane Meadows PLLC, and a member of The Bankruptcy Strategist'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 Oct. 20, 2017, the U.S. Court of Appeals for the Second Circuit, in Momentive Performance Materials, Inc. v. BOKF, NA (In re MPM Silicones, L.L.C. “MPM”) –F.3d–, 2017 WL 4700314, Nos. 15-1682 (2nd Cir. Oct.20, 2017), reversed in part and remanded to the bankruptcy court an order confirming the Debtor's Chapter 11 plan of reorganization. The appellate court instructed the bankruptcy court to apply an “efficient market rate” of interest to the senior secured notes issued under the plan, if such a rate could be ascertained, in lieu of a “formula rate” of interest that had been applied. The Second Circuit affirmed the balance of judgment on appeal by denying any make-whole recovery, refusing to subordinate claims of certain second lien creditors and finding that the doctrine of equitable mootness did not apply.

Background

In 2006, MPM issued $500 million in subordinated unsecured notes (the “Subordinated Notes”). In 2009, MPM issued secured second-lien notes and offered the holders of Subordinated Notes the option of exchanging their notes for newly issued discounted secured second-lien notes. A portion of the Subordinated Notes was ultimately exchanged.

In 2010, MPM issued approximately $1 billion in “springing” second-lien notes (the “Second-Lien Notes”). The Second-Lien Notes were to be unsecured until the previously exchanged Subordinated Notes were fully redeemed, at which point the “spring” in the lien would be triggered. Once triggered, the Second-Lien Notes would have a security interest in the Debtor's collateral. The exchanged Subordinated Notes were eventually redeemed, at which point the trigger occurred and the Second-Lien Notes became secured with second-priority liens junior to other pre-existing liens on the Debtor's collateral. A primary issue on appeal discussed below was whether the Second-Lien Notes had priority over the Subordinated Notes

In 2012, MPM again issued more debt, this time in the form of two classes of senior secured notes. Specifically, MPM issued $1.1 billion in first-lien secured notes (the “First-Lien Notes”), and $250 million in 1.5-lien secured notes (the “1.5-Lien Notes,” and, with the First-Lien Notes, the “Senior-Lien Notes”). Pursuant to the governing indentures (the “2012 Indentures”), the Senior-Lien Notes were to be repaid in full at maturity.

The 2012 Indentures also called for the recovery of a “make-whole” premium if MPM opted to redeem the notes prior to maturity. Because the Second-Lien Notes and the Sen- ior-Lien Notes were secured by the same collateral, the holders of those notes executed an intercreditor agreement, which provided that the Senior-Lien Notes stood in priority to the Second-Lien Notes as to their respective liens, but that each was junior to pre-existing liens on MPM's collateral. This raised two additional issues on appeal — whether the Senior-Lien Note holders were entitled to the make-whole adjustment, and what cramdown interest rate would apply if their Notes were replaced under the plan.

The plan provided for: 1) a 100% cash recovery of the principal balance and accrued interest on the Senior-Lien Notes; 2) an estimated 12.8%-28.1% recovery on the Second-Lien Notes in the form of equity in the reorganized Debtors; but 3) no recovery on the Subordinated Notes. The plan also gave the Sen- ior-Lien Notes holders a deathtrap option of accepting the plan and immediately receiving a cash payment of the outstanding principal and interest due on their Notes (without a make-whole premium), or rejecting the plan, receiving replacement notes with a present value equal to the allowed amount of such holder's claim, and then litigating in the bankruptcy court issues — including whether they were entitled to the make-whole premium and the interest rate on the replacement notes. The Senior-Lien Notes holders rejected the plan, electing the deathtrap option.

The Subordinated Notes holders and the Senior-Lien Notes holders opposed the plan. The Second-Lien Notes holders unanimously accepted it. The Subordinated Notes holders, who were to receive nothing, contended that, under relevant indenture provisions, their Notes were not subordinate to the Second-Lien Notes holders and, consequently, they were entitled to some recovery. The Senior-Lien Notes holders opposed the plan on the ground that the replacement notes they received did not provide for the make-whole premium, and carried a largely risk-free interest rate that failed to comply with the Bankruptcy Code because it was well below ascertainable market rates for similar debt obligations and thus was not fair and equitable because it failed to give them the present value of their claim.

The bankruptcy court confirmed the plan under a cramdown provision that allows a bankruptcy court to confirm a reorganization plan notwithstanding non-accepting classes if the plan “does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” 11 U.S.C. § 1129(b)(1).

The bankruptcy court concluded that the plan was fair to the Subordinated Notes holders, despite no recovery, because the 2006 Indenture called for their subordination to the Second-Lien Notes. It also held that the plan was fair to the Senior-Lien Notes holders because the 2012 Indentures did not require payment of the make-whole premium in the bankruptcy context, and because the interest rate on the proposed replacement notes, even though well below a market rate was determined by a formula that complied with the Code's cramdown provision. On appeal, the district court essentially agreed with the bankruptcy court.

Cramdown Interest Rate

The Second Circuit also agreed, except for the Senior-Lien Notes holders' contention with respect to the method of calculating the appropriate interest rate for the replacement notes. The court noted that as a consequence of rejecting the plan, the Senior-Lien Notes holders received replacement notes, which pay out their claim over time. While the Code permits debtors to make such “deferred cash payments” to secured creditors (i.e., to “cramdown”). 11 U.S.C. § 1129(b)(2)(A)(i)(II), those payments must ultimately amount to the full value of the secured creditors' claims.

To ensure that the creditor receives the full present value of its secured claim, the deferred payments must carry an appropriate rate of interest. The rate selected by the bankruptcy court for the Senior-Lien Note holders' replacement notes was based on “formula” rates, which were largely risk-free, slightly adjusted for appropriate risk factors. The Senior-Lien Notes holders contended that because this rate was too low, the plan was not “fair and equitable.” They argued that the lower courts should have applied a market rate of interest, which is the rate MPM would pay to a contemporaneous sophisticated arms-length lender in the open market.

The bankruptcy court rejected this approach, and concluded that a cramdown interest rate should “not take market factors into account.” Viewing itself as largely governed by the principles enunciated by the plurality opinion in Till v. SCS Credit Corp. , 541 U.S. 465 (2004), it concluded that the proper rate was what the plurality referred to as the “formula” or “prime-plus” rate. The district court agreed. The Senior-Lien Notes holders argued that the lower courts erred in concluding that the Till plurality opinion is wholly applicable to this Chapter 11 proceeding.

The Second Circuit substantially agreed with the Senior-Lien Note holders, recognizing that the applicability of the formula-rate approach in Chapter 11 cases has not been followed by all courts — pointing to the U.S. Court of Appeals for the Sixth Circuit's ruling in in In re American HomePatient, Inc., 420 F.3d 559 (6th Cir. 2005, where it concluded that efficient market rates for cramdown loans cannot be ignored in Chapter 11 cases and developed this two-part test:

[T]he market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.

The Second Circuit adopted this approach, stating: “We do not read the Till plurality as stating that efficient market rates are irrelevant in determining value in the Chapter 11 cramdown context. And, disregarding available efficient market rates would be a major departure from long-standing precedent dictating that the best way to determine value is exposure to a market,” citing Bank of Am. Nat'l Trust and Sav. Assn v. 203 N. LaSalle St. Pship, 526 U.S. 434, 457 (1999). The court concluded: “[W]here, as here, an efficient market may exist that generates an interest rate that is apparently acceptable to sophisticated parties dealing at arms-length, we conclude, consistent with footnote 14 [in Till], that such a rate is preferable to a formula improvised by a court.”

Make-Whole Provision

The indentures governing the Senior-Lien Notes contain Optional Redemption Clauses, which provided for the payment of a make-whole premium. The premium was intended to ensure that the Senior-Lien Notes holders received additional compensation to make up for the interest they would not receive if the Notes were redeemed prior to their maturity date. Pursuant to the plan, the Debtors issued replacement notes to the Senior-Lien Notes holders, which did not account for the make-whole premium. These holders contended that the failure to include that premium violated the indentures.

The bankruptcy court concluded that the Senior-Lien Notes holders were not entitled to the premium. It reasoned that under the indentures the make-whole premium would be due only in the case of an “optional redemption” and not in the case of an acceleration brought about by a bankruptcy filing. The district court agreed, as did the Second Circuit, relying on In re AMR Corp., 730 F.3d 88 (2d Cir. 2013) with the proposition that any payment on the accelerated notes following a bankruptcy filing would be a post-maturity payment. Therefore, a creditor's post-petition invocation of a contractual right to rescind an acceleration triggered automatically by a bankruptcy filing is barred, because it would be an attempt to modify contract rights and would be subject to the automatic stay.

Subordination

The lower courts concluded that the Plan, which provided no distribution to the Subordinated Notes holders, complied with the governing 2006 Indenture. The Subordinated Notes holders argued that this conclusion was erroneous because, under the terms of the 2006 Indenture, their claims were not subordinate to the Second-Lien Notes, whose holders recovered under the plan. The Debtors, on the other hand, contended that the 2006 Indenture gives the Second-Lien Notes priority over the Subordinated Notes. The Second Circuit agreed with the Debtors, finding the relevant indenture provisions ambiguous, but resolving the ambiguities in favor of the Debtors.

The court noted: “We do not agree with the lower courts that the Fourth Proviso unambiguously incorporates a distinction between lien subordination and payment subordination. Rather, we conclude that the Fourth Proviso renders the definition of Senior Indebtedness ambiguous as to whether it includes the Second-Lien Notes. Nevertheless, we conclude that this ambiguity should be resolved in Debtors' favor given the plethora of evidence in the record that the parties intended the Second-Lien Notes to be Senior Indebtedness.”

The Second Circuit went on to discuss extrinsic evidence such as statements contained in SEC filings that supported a view that the Second Lien Notes had priority over the Subordinated Notes. The court also noted that the Subordinated Notes holders' interpretation generates the irrational outcome that the springing of the Second-Lien Notes' security interest, which was meant to enhance the note holder' protection, would actually strip those notes of their status as Senior Indebtedness, and therefore their priority over the Subordinated Notes.

Finally, the Subordinated Notes holders' proposed interpretation of the phrase that “in any respect” covers all junior liens would mean that no senior note classes would qualify as Senior Indebtedness because each was secured in some respect by a junior lien. For example, the First-Lien Notes were secured in part by a second priority lien on collateral securing a prepetition revolving credit facility.

Equitable Mootness

The Second Circuit declined to dismiss any of these appeals as equitably moot, largely because the appellants did everything possible to timely prosecute their appeals, including seeking a stay from every court involved. Also, the economic impact that the limited remand may have on the outcome of the case was not relatively material when compared with the distributions made or to be made under the plan, said the court, relying on In re Chateaugay Corp., 988 F.2d 322, 325 (2d Cir. 1993) (listing factors to be considered for mootness).

Conclusion

This decision is favorable to secured lenders because it somewhat reduces the risk that a formula rate of interest would be used to cramdown a secured claim and instead directs bankruptcy courts to consider using a market-based rate if such a rate exists. That said, the decision leaves a number of unresolved matters.

Introducing the concept of an “efficient market” to the analysis is problematic. The term is often used to describe a situation where all information is available to the parties, parties act rationally, there is lack of any cash or regulatory constraints or barriers to entry, there are no economies of scale, profits or marginal costs, all transactions are frictionless and there no arbitrage of any kind. As one may surmise, the real world does not operate that way. So asking courts to consider a rate that exists in an efficient market is like searching for the Holy Grail.

On the other hand, what courts can strive to achieve is to find a rate that results in an outcome that provides the right recovery for the secured creditor as required under the Bankruptcy Code. One of the key hurdles to overcome is the existence of an efficient market rate — a battle of experts is inevitable. Litigation risk will be high, and costs potentially will skyrocket. If the matter proceeds, courts presumably will use experts to help them arrive at a common-sense outcome while striving to find the elusive efficient market Holy Grail rate.

And, while all of this is unfolding, debtors will have to make strategic decisions about lining up exit financing, being very careful not to do so too early and having it possibly used against them in a cramdown battle. In effect, this litigation risk may have a chilling effect on timing of such financing.

Forum shopping is also a natural concern, as debtors choose where to file their Chapter 11 cases depending on jurisdictions that use only a formula rate approach. So, while the decision may provide some theoretical temporary comfort to secured creditors, other problems lurk.

*****
Robert W. Dremluk is a partner in the New York office of Culhane Meadows PLLC, and a member of The Bankruptcy Strategist'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].