On October 20, 2017, the United States Court of Appeals for the Second Circuit issued an important decision regarding the manner in which interest must be calculated to satisfy the cramdown requirements in a chapter 11 case.1 The Second Circuit sided with Momentive's senior noteholders and found that "take back" paper issued pursuant to a chapter 11 plan should bear a market rate of interest when the market rate can be ascertained, as opposed to a rate set using the "formula approach" (generally the prime rate plus 1% to 3%). In so holding, the Second Circuit found that the United States Supreme Court's decision in Till v. SCS Credit Corp.2 (which determined the rate of interest in the context of a cramdown in an individual debtor chapter 13 case) did not conclusively require the use of a formula approach in a chapter 11 context, and agreed with other courts, including the United States Court of Appeals for the Sixth Circuit,3 that a market rate should apply in circumstances in which it can be established.
Background
Between 2006 and 2012, MPM Silicones, LLC and its affiliates (collectively, "Momentive") incurred substantial debt obligations pursuant to various note indentures. One such incurrence, in 2012, was in the form of two classes of senior secured notes (the "Senior Lien Notes"). Pursuant to the governing indentures, the Senior Lien Notes were to be repaid in full by their maturity date of October 15, 2020, and carried fixed interest rates of 8.875% and 10%. The indentures also called for the recovery of a make-whole premium if Momentive opted to redeem the notes prior to maturity.
In April 2014, Momentive filed a chapter 11 petition. Momentive proposed a Plan with a "deathtrap" provision that was designed to resolve the make-whole dispute by providing the holders of Senior Lien Notes with a choice: (i) accept the Plan and receive a cash payment on account of all claims arising under their Notes, plus any accrued and unpaid interest at the non-default interest rate provided under the governing documents (without a make-whole premium), or (ii) reject the Plan and receive replacement notes (i.e. "takeback paper") with a present value equal to the allowed amount of the Senior Noteholders' claim using a formulaic (non-market) approach to determining the interest rate, while retaining their right to continue to fight for a make-whole premium. At the time the Plan was proposed, holders of the two classes of Senior Lien Notes would have received replacement notes under the rejection scenario that were based on a formulaic comparison to treasuries: one class would receive 7 year notes with an interest rate equal to the treasury rate plus 1.5%, or approximately 3.6%; and the other 7.5 year notes with an interest rate equal to the treasury rate plus 2%, or approximately 4.09%.
In deriving the formulaic interest rate if the Senior Noteholders rejected the Plan, the Debtors relied on Till, where the Supreme Court concluded that the proper way to determine cramdown interest in a chapter 13 case was not the market rate, but instead a rate that provides for a base interest rate plus some compensation for the risk that the takeback paper is not repaid as scheduled. Although Till was decided under chapter 13—which is exclusively applicable to individuals—its applicability to chapter 11 cases has long been debated. In its decision, the Supreme Court recognized the similarities between the two chapters,4 and, without offering definitive guidance, it observed that:
Because every cramdown loan is imposed by a court over the objection of the secured creditor, there is no free market of willing cramdown 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 cramdown 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.5
The Senior Lien Noteholders voted to reject the Plan, and the Debtors sought to confirm the Plan by utilizing the cramdown provisions of chapter 11, which provide that a plan can be confirmed by the Bankruptcy Court even if it had been rejected by a class of creditors, 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. The Senior Lien Noteholders objected, arguing that because the interest rate of the replacement notes was too low, the Plan was not "fair and equitable" as required by the Bankruptcy Code because it did not provide them with "deferred cash payments totaling at least the allowed amount of [their] 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 [the property subject to the creditor's lien]." 11 U.S.C. §1129(b)(2)(A)(i) (emphasis added). Relying on the Till footnote, the Senior Lien Noteholders argued that to provide them with a par recovery as of the effective date of the plan, the replacement notes should include a market rate of interest, which is the rate Momentive would pay to a contemporaneous sophisticated arms-length lender in the open market. In that regard, the Senior Lien Noteholders argued that had they accepted the Plan and a cash-out payment for their notes, Momentive would have to secure exit financing to cover the lump-sum payment. To prepare for that possibility, Momentive went into the market seeking lenders to provide that financing, and the lenders quoted rates of interest ranging between 5 and 6+%, significantly higher than the proposed rate of interest of the replacement notes. In response, Momentive contended that under Till, they were not required to put the Senior Lien Noteholders on par with market lenders, but instead to provide for a base interest rate plus some compensation for the risk that such replacement notes are not repaid as scheduled.
The Bankruptcy Court confirmed the Plan via cramdown, holding that the interest rate on the proposed replacement notes, while well below market rate, was determined by a formula that complied with the Bankruptcy Code's cramdown provision. The Bankruptcy Court read Till and the Second Circuit's opinion on cramdown rates in the context of another chapter 13 debtor, In re Valenti6 (a pre-Till case, the Second Circuit held that the market rate of interest should be fixed at the rate on a United States Treasury instrument with a maturity equivalent to the repayment schedule under the debtor's reorganization plan, adjusted to reflect the risk to the creditor in receiving deferred payments, and concluded that a 1%-3% risk premium would be fair), to require that the cramdown rate not incorporate any profit element. The Bankruptcy Court did, however, find that the rate of interest applied in Momentive necessarily included an element of risk in comparison to the treasury rate, which the Momentive debtors had used as their base rate, and accordingly found that the interest rate on the replacement note should be increased by .5% and .75%, to approximately 4.1% and 4.85%, respectively.
Various appellants, including the Senior Lien Noteholders, appealed, and the United States District Court for the Southern District of New York affirmed the Bankruptcy Court's confirmation order (our client alert regarding that decision can be found here). Certain parties, including the Senior Lien Noteholders, appealed to the Second Circuit.
Decision
The Second Circuit agreed with the Senior Lien Noteholders, and held that where an efficient market may exist that generates an interest rate that is acceptable to sophisticated parties dealing at arms'-length, such rate is preferable to a formula improvised by a court. The Second Circuit noted that the plurality in Till made no conclusive statement as to whether the formula rate was generally required in chapter 11 cases. Relying on Till's "footnote 14," as well as on the notion that chapter 11 differs from chapter 13 (which does not involve an efficient market and often has an unsophisticated borrower), the Second Circuit adopted the Sixth Circuit's two-part process for selecting an interest rate in chapter 11 cramdowns. The Second Circuit, therefore, concluded that the market rate should be applied where there exists an efficient market for post-bankruptcy financing, but if no such market exists for the chapter 11 debtor, the Bankruptcy Court should employ the formula approach endorsed by the Till plurality.
In the initial hearing in front of the bankruptcy court, the Senior Lien Noteholders presented expert testimony, which, if credited, arguably would have established a market rate that would have given them significantly higher recoveries. Although such testimony was highlighted by the Second Circuit in its opinion, the Second Circuit was not prepared to decide on its credibility, and instead remanded the case to the Bankruptcy Court to determine whether an efficient market existed for financing in the Momentive case and also whether the proposed exit financing represented the appropriate market rate.
Discussion
As noted by the Second Circuit, the Plan was objectionable to the Senior Lien Noteholders because, in essence, it required them to lend Momentive, as a debtor, a significant sum of money, but to receive a much lower rate of interest than any other lender would have received for offering the same type of loan on the open market. The Second Circuit pointed out that disregarding available efficient market rates would be a major departure from the long-standing precedent that the best way to determine value is exposure to a market, and expressed confidence in the ability of a bankruptcy court to determine an appropriate market rate on a case-by-case basis. It is an open question as to whether the Bankruptcy Court will determine on remand that there was an efficient market for the type of financing being offered under Momentive's plan—as described above, in this case the Senior Lien Noteholders presented expert testimony regarding the market rate—and it remains to be seen whether the Bankruptcy Court will find that the exit financing that was being offered reflects an appropriate market interest rate given its view that such financing incorporated some degree of a profit element.
In future cases, the standard enunciated by the Second Circuit may lead to further litigation regarding whether or not an efficient market for exit financing exists, and if it does, what an appropriate market rate of interest would be. Nevertheless, this decision is a significant win for similarly situated secured creditors, who have a better chance of avoiding being "crammed-up" through the provision of take-back paper at below-market interest rates, despite the Supreme Court's decision in Till.
Footnotes
1 This client alert is limited to the interest rate calculation; click here for a subsequent client alert addressing the Second Circuit's holding in Momentive that the debtors' senior noteholders were not entitled to make whole premiums.
2 541 U.S. 465 (2004). For a refresher on the Till decision, please refer to our client alert here.
3 See Bank of Montreal v. Official Comm. of Unsecured Creditors (In re American HomePatient, Inc.), 420 F.3d 559, 568-569 (6th Cir. 2005) (declining to adopt the Till formulaic approach "blindly" and instead concluding that "where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.").
4 Although the cramdown provisions of chapter 13 and chapter 11 are not identical, they share the same general concepts regarding their ability to provide takeback paper to holders of secured claims in a rejecting class. Compare 11 U.S.C. § 1325(a)(5)(B)(ii) (requiring that "the value, as of the effective date of the plan, of property to be distributed under the plan on account of such claim is not less than the allowed amount of such claim") (emphasis added) with 11 U.S.C. § 1129(b)(2)(A)(i)(II) (requiring 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 holders interest in the estate's interest in such property") (emphasis added).
5 See Till, 541 U.S. at 476, footnote 14 (emphasis added).
6 In re Valenti, 105 F.3d 55 (2d Cir. 1997).
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