Sophisticated real estate lenders spend significant amounts of time and energy attempting to insulate themselves from potential bankruptcy filings by their borrowers. A primary reason, which many an experienced real estate lender has found out the hard way, is the risk that a debtor in bankruptcy may “cram down” a plan of reorganization over its lender’s objection. Under a typical cramdown plan, a debtor may stretch out payments to its secured creditor for several years and attempt to replace its negotiated interest rate with a new, below- market rate of interest. An ongoing debate in the Chapter 11 context is whether cramdown interest must be provided at market rates (e.g., a rate the debtor could obtain on a new loan in the open market), the rate negotiated for in the secured creditor’s loan documents, or a below-market interest rate determined by a risk- adjusted formula.
On August 26, 2014, Judge Robert D. Drain of the Bankruptcy Court for the Southern District of New York issued a bench ruling in In re MPM Silicones, LLC, Case No. 14-22503 (RDD), a Chapter 11 case regarding several aspects of the plan of reorganization proposed by debtor Momentive Performance Materials, Inc., a specialty chemicals manufacturing company, and its affiliated debtors (“Momentive”).1 Judge Drain held, among other things, that the debtors could satisfy the cramdown provisions of Section 1129(b) via a formula-based approach to arrive at a below-market rate. On May 4, 2015, Judge Vincent Briccetti of the Southern District of New York affirmed the rulings of Judge Drain in U.S. Bank National Association v. Wilmington Savings Fund Society, FSB et al. (In re MPM Silicones, LLC), Case No. 14-CV-7492 (VB).
In Momentive, the holders of $1 billion of “First Lien” notes and $250 million of so-called “1.5 Lien” notes were oversecured. The debtors sought to “cram down” the noteholders and satisfy their claims with replacement notes. The debtors proposed that the replacement notes for the First Lien noteholders would have a principal amount equal to the noteholders’ allowed claims, provide for first-priority liens, and have a seven-year maturity with interest equal to the treasury rate plus 1.5 percent. Similarly, the debtors proposed that the replacement notes for the 1.5 Lien noteholders would have a principal amount equal to the noteholders’ allowed claims, provide for second priority liens, and have a seven-and-a-half year maturity with an interest rate equal to the treasury rate plus 2 percent. The First Lien and 1.5 Lien noteholders voted to reject the plan and filed objections to confirmation of the plan, arguing, among other things, that their treatment under the plan was not “fair and equitable” as required by Section 1129(b).
Below-Market Interest Rate
The noteholders asserted, among other things, that their plan treatment was not fair and equitable because the interest rate was below market and therefore did not satisfy the requirements of the Bankruptcy Code. Section 1129(b)(2)(i)(II) of the Bankruptcy Code provides that if a rejecting class of secured creditors is not paid in full in cash on the effective date of the plan of reorganization, their treatment must have a present value equal to the value of their secured claims. The noteholders argued that the replacement notes with a below-market interest rate were not worth the value of their secured claims. As evidence that the debtors’ proposed interest rate was below market, the noteholders pointed to the debtors’ two exit credit facilities with the same lien priority as the replacement notes that both provided for higher interest rates, specifically LIBOR plus 4 percent (with a LIBOR floor of 1 percent) and LIBOR plus 6 percent (with a LIBOR floor of 1 percent).
The parties’ arguments and Judge Drain’s decision focused on two cases: Till v. SCS Credit Corp., 541 U.S. 465 (2004) and In re Valenti, 105 F.3d 55 (2d Cir. 1997), which both analyzed the proper interest rate to apply to replacement notes distributed to secured creditors under Chapter 13 of the Bankruptcy Code – which contains a substantially similar cramdown provision to Chapter 11. In Till, a plurality of the U.S. Supreme Court held that the cramdown interest on replacement notes should be the “prime plus” or “formula” method, which is calculated by using the prime rate and adjusting upward to reflect credit and collateral risk.2 The plurality further noted with approval that courts applying this method typically set a risk premium of between 1 percent and 3 percent over the prime rate. In a much debated footnote, however, the plurality opinion stated that the cramdown interest in a Chapter 11 might be calculated differently because, unlike the Chapter 13 context, in which there is no free market of willing cramdown lenders, “the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession” and thus it “might make sense to ask what rate an efficient market would produce.” See Till, 105 F.3d at fn. 14 (emphasis contained in original). Citing this footnote, the noteholders argued that the appropriate interest rate for their replacement notes should be the market interest rate for loans of equivalent priority. Alternatively, the noteholders argued that even applying the Till approach of calculating interest, the interest rate of the replacement notes was too low because it was based on the treasury rate as opposed to the prime rate.
Judge Drain adopted the Till formula approach for calculating the interest rate on the replacement notes but held that, just as in Till, the prime rate – not the treasury rate – was the appropriate benchmark rate. He therefore refused to confirm the plan of reorganization unless the interest rate of the replacement notes was increased by 0.5 percent for the First Lien replacement notes and 0.75 percent for the 1.5 Lien replacement notes, which still resulted in a below-market interest rate. In so holding, Judge Drain rejected the noteholders’ argument that footnote 14 of the Till decision suggested that the appropriate interest rate for replacement notes in a cramdown context should be set by the market. Judge Drain reasoned that the Till plurality and the Second Circuit in Valenti had specifically rejected an approach that would require bankruptcy courts to consider evidence about market interest rates because, according to Till, such an approach “overcompensates creditors because the market lending rate must be high enough to cover factors . . . like lenders’ transaction costs and overall profits.” Judge Drain extended this reasoning from Chapter 13 cramdown rates to Chapter 11 cramdown rates, which he stated should likewise “not contain any profit or cost element.”
In the District Court, Judge Briccetti cited Judge Drain’s analysis with approval, and further explained that while Till’s footnote 14 suggests that a court may want to consider market rates in the Chapter 11 context, it “certainly does not require the application of the efficient market approach in Chapter 11 proceedings.”
Why is this Important?
Specifically, real estate lenders should be on notice that in a cramdown, not only can the term of the note be stretched out for many years, but the interest rate may be below market, applying only the formulaic risk-based approach. The Momentive decision will provide debtors, including in single-asset real estate cases, the ability to propose below-market interest rates, allowing debtors to confirm plans with lower costs than under the pre-petition negotiated terms. The reduction of post-confirmation interest costs will also allow debtors to buttress their arguments regarding the feasibility of their proposed plans of reorganization.
While cases in other courts have applied the efficient market rate in the Chapter 11 context, see e.g., In re American HomePatient, 420 F.3d 559 (6th Cir. 2005), cert. denied, 549 U.S. 942 (2206), Judge Briccetti’s affirmation of Judge Drain’s decision adds fuel to the controversy, and ensures further debate as to the appropriate cramdown interest rate in future Chapter 11 cases.
Of note, the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11, released in 2015, recommends rejection of the Till formula-based interest rate approach adopted in Judge Drain’s ruling in the Chapter 11 context. Instead, the Commission has proposed a market approach, requiring that bankruptcy courts determine interest rates based on the cost of capital for similar debt issued to companies comparable to the reorganized debtor. In the event that a market rate cannot be determined, the Commission has suggested that bankruptcy courts should use a risk-adjusted interest rate reflecting the reorganized debtor’s risk profile and taking into account market factors. The Commission’s proposals, however, are subject to the Congress enacting legislation.
In the meantime, decisions such as Momentive highlight the need for continued vigilance in underwriting standards. Furthermore, careful bankruptcy planning, including the use of bankruptcy remote single purpose entities and non-recourse carve-out guaranties will continue to be of prime importance to real estate lenders.