The senior secured note holders recently lost their appeal of the bankruptcy court's decision confirming Momentive's chapter 11 plan.1
The US District Court affirmed two key rulings by the bankruptcy court.2 First, when a debt instrument provides for payment of a make-whole premium on early redemption, if the premium is to be payable in a bankruptcy case, the make-whole provision must explicitly state that the right of payment applies upon automatic acceleration of the debt following a bankruptcy filing. If the provision is not sufficiently specific, the premium may not be allowed under New York law.
Second, the district court noted that a chapter 11 plan of reorganization may impose an interest rate on a new debt instrument forced upon a lender under the plan ("cram down paper") that is calculated based on a US Treasury rate plus a risk premium of 1-3%, even though the lender clearly will not be able to liquidate the cram down paper on the effective date of the plan for the full amount of its claim.3
The refusal of the bankruptcy and district courts to enforce the make-whole provision or require the debtor to pay a market rate on the cram down paper effectively resulted in a transfer from the senior note holders to the second lien note holders of approximately $200 million on account of the make-whole premium, and $110 million attributable to the below-market interest rate.4 While the decision surprised many in the lending community, as discussed below, it appears that, on a going forward basis, it may be possible to address the case's most draconian effects through careful drafting of new loan documentation.
MPM Silicones, LLC (Momentive), one of the world's largest producers of silicone and silicone derivative products, filed a chapter 11 bankruptcy case in April 2014. At the time of its filing, Momentive had outstanding first lien notes (referred to as the "senior lien notes"), second lien notes, and subordinated notes. The senior lien notes consisted of two series, one in the principal amount of $1.1 billion with an 8.875% interest rate (referred to as the "first lien notes"), and the other in the principal amount of $250 million with a 10% interest rate (referred to as the "1.5 lien notes"). Both series were to mature on October 15, 2020. The senior lien notes included a make-whole premium due upon voluntary redemption of the notes prior to October 15, 2015. As of the bankruptcy filing, the make-whole premium had a value of approximately $200 million.
Momentive's chapter 11 plan offered two alternative treatments for the senior lien notes. If the holders of the senior lien notes voted to accept the plan, they would be paid all principal and accrued interest on the senior lien notes in full, in cash, upon the plan's effective date, but would waive any right to receive a distribution in respect of the make-whole premium.
If the senior lien note holders rejected the cash option and sought to enforce the make-whole claim, the debtor proposed to provide cram down paper paying the first lien notes over 7 years at an interest rate equal to the 7-year Treasury rate plus a 1.5% risk premium, totaling approximately 3.6% as of the confirmation hearing. The 1.5 lien notes would be paid over 7 ½ years, at the 7 ½-year Treasury rate plus a 2% risk premium, totaling approximately 4.1% as of the confirmation hearing. (Momentive had obtained stand-by financing to fund the cash payment in the event the senior lien notes voted to accept the cash option. Notably, the stand-by financing, which presumably was obtained in the open market, carried a significantly higher interest rate than the proposed interest rate on the cram down notes). Momentive's plan gave holders of second lien notes equity in the reorganized company, and paid nothing on the subordinated notes.
The holders of the senior lien notes rejected the plan and challenged Momentive's proposed interest rate on the cram down paper and Momentive's attempt to avoid payment of the make-whole premium. The bankruptcy court confirmed Momentive's plan,5 imposing a slightly increased rate on the cram down paper and denying the make-whole claim in its entirety.
Disallowance of the Make-Whole Premium
A key question in Momentive was whether the automatic debt acceleration resulting from Momentive's bankruptcy filing constituted a prepayment as contemplated by the make-whole provision.
The holders of the senior lien notes argued that the cram down paper issued under Momentive's plan constituted a prepayment and voluntary redemption of the notes that triggered their right to a make-whole payment. The bankruptcy court disagreed, ruling that the bankruptcy filing resulted in the automatic acceleration of the maturity date of the notes so that any subsequent payment thereon was not a "prepayment."6
Because the indenture in Momentive did not specifically provide that the make-whole payment would be payable in the event of the acceleration of the debt due to a voluntary bankruptcy filing, the premium was disallowed.
Calculating Cram Down Interest Rates
The fundamental purpose of a make-whole premium is to protect bargained-for interest rates when market rates subsequently decline during the term of the loan. Essentially, make-whole premiums are intended to discourage borrowers from refinancing debt to take advantage of lower rates, thereby forcing an existing fixed-rate lender to re-deploy funds at the lower, then-prevailing market rate. Here, not only did Momentive's senior lien note holders lose their make-whole protections, which were intended to compensate them for the difference between their original contract rate and the subsequently prevailing market rates, they also were required to accept a rate of interest lower than the then-prevailing market rate of interest because of the methodology employed to calculate the interest rate on the cram down paper.
Instead of replacing the contract rate with new notes at the prevailing market rate, Momentive proposed to apply a rate even lower than the market rate, utilizing the "formula" method for selecting interest rates. Momentive began with the rate on a 7 or 7 ½-year Treasury (with the term corresponding to the plan's proposed payment term for the notes), and then added a risk premium of 1.5% to 2% to account for the risk of non-payment given assumptions about Momentive's post-reorganization pro-forma financial condition. The senior lien note holders objected and argued that Momentive should have used an "efficient market" approach that would apply the interest rate that lenders in the market would charge Momentive on a similar new loan, thus providing the true equivalent of a cash pay-out of their secured claims on the effective date of the plan. The senior lien note holders argued that the rate that would be produced in an efficient market was readily discernible, as evidenced by the rate obtained by Momentive on the stand-by financing that had been arranged to fund the cash option provided to holders of the senior lien notes under the plan.
Citing precedent from the Supreme Court (Till v. SCD Credit Corp.)7 and the Second Circuit (In re Valenti),8 the court decided that the formula approach, under which a premium of 1-3% is added to a base interest rate, was the correct method for determining a cram down interest rate in the Southern District of New York. Although both Till and Valenti involved the restructuring of fully-encumbered auto loans of individual chapter 13 debtors where no established market for such loans existed, and the Tillcourt specifically posited that it might make sense in a chapter 11 case to "ask what rate an efficient market would produce,"9 in Momentive the district court held that bankruptcy courts in the Second Circuit (unlike courts in the Sixth Circuit) were bound to apply the formula approach in the context of chapter 11 as a matter of Second Circuit precedent in Valenti.10
The Momentive courts explained that the function of interest payments under a bankruptcy plan is to provide creditors with the present value of their claims, that is, to compensate them for the fact that their claims are not being paid immediately, and that the purpose "is not to put the creditor in the same position that it would have been in had it arranged a 'new' loan," which would likely be an arms'-length transaction resulting in a degree of profit for the lender."
Both courts approved of Momentive's use of Treasury rates because they often serve as the base rate for long-term corporate debt. However, the bankruptcy court determined that Momentive should amend its plan to include an additional risk premium (and the district court affirmed this finding). This resulted in an 0.5% increase to the 1.5% risk premium previously proposed by Momentive for the $1.1 billion first lien notes (resulting in a 4.1% interest rate), and a 0.75% increase to the 2.0% risk premium for the $250 million 1.5 lien notes (resulting in a 4.85% interest rate).
Drafting Make-Whole Provisions: For creditors, Momentive indicates the need for explicit and unambiguous language specifying if and when a make-whole premium is due following default and acceleration of the debt in a bankruptcy case. Courts following Momentive will likely reject arguments that the right to receive a make-whole premium can be implied from other contractual terms.11
Creditors will want to make sure that acceleration clauses are clear and explicit in stating the circumstances under which a make-whole premium is due upon acceleration of a debt, including automatic acceleration resulting from a bankruptcy filing. For example, in other cases courts have enforced premiums where the documents state that if the debt "is accelerated during the [period during which a prepayment premium would be due] for any reason other than casualty or condemnation, Borrower shall pay, in addition to all other amounts outstanding under the Loan documents, a prepayment premium."12 Likewise, the make-whole provision itself should eliminate any ambiguity as to whether the premium is payable upon acceleration and specify the types of acceleration that will, or will not, trigger payment of a make-whole premium. Loan documents should also explain the financial justification for make-whole premiums, to reduce the risk that a bankruptcy court will disallow them as penalties.
Had the senior lien note indenture in Momentive specifically provided that the make-whole premium would be payable in the event of an acceleration resulting from a voluntary bankruptcy filing, presumably both courts would have enforced the make-whole. We say "presumably" because the courts in Momentiveattributed their disallowance of the make-whole premium to their close reading of the underlying documents, not on the basis of a per se rule against make-whole premiums.
Cram Down Interest: Unless overturned on appeal,13 Momentive may become a clarion call attracting even more bankruptcy cases to the Southern District of New York, particularly those close cases where owners believe that value can be restored to their equity through a reduction of contractual interest to rates that are below prevailing market rates payable to the senior lenders. While Momentive seems to imply that creditor make-whole protections generally can be preserved through careful drafting, lenders should also review their standard make-whole provisions to insure that they work to provide adequate, but not punitive, compensation not only in situations where the lender receives a cash payment, but also where the lender receives cram down paper during the applicable make-whole period. Further, because such make-whole periods generally run only for a limited period of time within the term of a loan,14 in addition to clearly drafting the make-whole provision to apply to the receipt of cram down paper as well as cash, lenders should consider extending the make-whole period in such situations at least through the original maturity date of the loan in order to protect themselves from damages incurred as a result of the differential between prevailing market rates and a formula-derived rate received on cram down paper imposed under a restructuring plan.15 Additionally, in capital structures involving several tiers of secured debt, senior lien holders may be able to negotiate for a turn-over from junior lien holders in the event that senior lenders receive cram down paper at below prevailing market rates.