The Bottom Line
On October 20, 2017, the U.S. Court of Appeals for the Second Circuit issued a long-awaited decision in In re MPM Silicones, LLC (“Momentive”) holding that, with one important exception, that the plan of reorganization confirmed by the bankruptcy court comports with Chapter 11. Case No. 15-1682 (2d Cir. Oct. 20, 2017).
The Second Circuit opinion has particular importance in its holding that the bankruptcy court had erred in the process that it used to determine the proper interest rate under the cramdown provision of Chapter 11, and that use of the market rate is appropriate where an efficient market exists. In affirming the bankruptcy court’s holding that the senior lien noteholders were not entitled to a make-whole premium, the Second Circuit has also introduced a split with the Third Circuit on an issue which has significant implications for borrowers and lenders, and should be taken into account in drafting future credit documents.
The appeal, brought by senior and subordinated noteholders, also challenged the bankruptcy court’s conclusions that their claims are subordinate to the second-lien noteholders’ claims, and presented a recurring issue as to when an appeal from a consummated bankruptcy plan of reorganization must be dismissed as equitably moot. These issues, while interesting, are not discussed here.
The Interest Rate Dispute
As a consequence of rejecting the debtors’ plan of reorganization, the senior noteholders received replacement notes which pay out their claim over time. Section 1129(b) of the Bankruptcy Code permits debtors to make such “deferred cash payments” to secured creditors, i.e., to “cramdown,” so long as those payments ultimately amount to the full value of the secured creditors’ claims. To ensure the creditor receives the full present value of its claim, the payments must carry the appropriate rate of interest.
In this case, bankruptcy court used the “formula” method to calculate the cramdown interest rate, following the Supreme Court’s plurality opinion in Till v. SCS Credit Corp., 541 U.S. 465 (2004). Using this approach, the bankruptcy court selected interest rates of 4.1% and 4.85% for the replacement notes, which were largely risk-free rates slightly adjusted for appropriate risk factors. It was undisputed that this rate was below market.
The Second Circuit reversed, pointing out that the plurality opinion in Till, a Chapter 13 case, acknowledged that the “formula” approach might not be suited to Chapter 11. Instead, the Second Circuit adopted the Sixth Circuit’s two-step approach, which, the court said, “best aligns with the Code and relevant precedent.” MPM Silicones, No. 15-1682, slip op. at 20. Under the two-step process, a court would first determine whether an efficient market exists, and if so, apply the market rate of interest to the replacement notes. If no efficient market exists, then the bankruptcy court should employ the “formula” approach endorsed by the Till plurality. Accordingly, the Second Circuit remanded to the bankruptcy court to ascertain if an efficient market rate exists and, if so, apply that rate.
The Make-Whole Dispute
The Second Circuit affirmed the bankruptcy court’s finding that the senior noteholders are not entitled to a make-whole premium. Make-wholes, also referred to as “prepayment penalties” or “yield maintenance premiums,” are contractual provisions in loan agreements or indentures requiring the borrower to pay an additional amount if the loan is paid ahead of schedule. Such provisions ensure that lenders receive their bargained-for return on investment. Here, the indentures governing the senior notes provided for the payment of a make-whole premium if the debtor were to “redeem the notes at its option” prior to their maturity date. Id. at 22. When the debtors in this case issued replacement notes to the senior noteholders, the replacement notes did not account for the make-whole premium. Bankruptcy Judge Drain rejected the holders’ contention that this failure to include that premium violated the indentures, reasoning that 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.
Interestingly, while this appeal was pending before the Second Circuit, the Third Circuit addressed the same issue in Energy Future Holdings (“EFIH”), 842 F.3d 247 (3d Cir. 2016), a case presenting very similar facts. Adjudicating the EFIH make-whole dispute after the bankruptcy court had issued its decision in Momentive, Bankruptcy Judge Sontchi followed Momentive and rejected the secured noteholders’ make-whole claims. After more than two years of litigation, the Third Circuit reversed and reinstated the make-wholes. The Court of Appeals expressly rejected Judge Drain’s interpretation of New York law as providing some presumption against make-wholes in bankruptcy, and held that there was no conflict between the acceleration provision and the make-whole provisions in the governing indentures; EFIH’s early payment of the notes constituted “optional redemption” triggering the make-whole regardless of the automatic acceleration upon bankruptcy.
Nearly a year later, the Second Circuit has rejected the Third Circuit’s approach with only a minimal “but see” reference to the EFIH decision. The Second Circuit relied on its decision in In re AMR Corp., 730 F.3d 88 (2d Cir. 2013), in which it rejected the noteholders’ argument that they were entitled to a make-whole premium following a debtor’s bankruptcy filing. Although AMR dealt with “prepayment” rather than “redemption,” and the indenture there expressly precluded make-whole recovery following acceleration, the Court found that these distinctions did not affect the case’s precedential value for the facts at hand.
Because the make-whole dispute turns almost exclusively on the interpretation of New York state law, it is unlikely that the Supreme Court will grant certiorari to resolve the circuit split. (In future cases, the split may be resolved through certification of the question to the New York Court of Appeals.) However, the appellants can petition for rehearing by the Second Circuit en banc. While en banc review in that Court is extremely rare, the split would be a significant factor in favor of granting the petition.
Why This Case is Interesting
This decision, compounded with the Second Circuit’s prior ruling in AMR, should inform the drafting of language in indentures and credit agreements going forward. Because the make-whole question turns on the interpretation of contract language and can be addressed in drafting, this case will likely help shape contractual provisions surrounding make-wholes.
It is impossible, however, to contract around the appropriate cramdown interest rate – this makes the cramdown analysis in the Second Circuit’s decision more impactful for future bankruptcy cases. The cramdown rate analysis thus sets important precedent regarding the rights of secured creditors.
It is still an open question how the appropriate cramdown interest rate will be determined on remand in Momentive. In particular, the fact that the effective date of the plan has already passed means that evidence is available regarding the replacement notes’ actual trading price as of the effective date – which indicated that the formula-based interest rate set by the court in the first instance was too low. It remains to be seen whether Judge Drain will hold a new evidentiary hearing and, if so, whether he will consider such evidence on remand.