Judge Vincent Bricetti of the United States District Court for the Southern District of New York issued a ruling in the Momentive Performance Materials cases affirming the bankruptcy court’s confirmation rulings on Monday, May 4. Key themes raised in this case of interest to distressed investors and addressed in Judge Bricetti’s ruling include the appropriate interpretation of certain indenture subordination provisions, an affirmation of the Till “formula” approach to cramdown interest rates in the Second Circuit (discussed in this post), and a reminder that the ability to receive a make whole based on automatic acceleration requires explicit language in the applicable indenture.
Based on Judge Bricetti’s ruling, distressed investors looking at cases within the Second Circuit with potential for a “cram up” (i.e., a cram down imposed on secured creditors) should consider as their base case that debtors will opt to cram up secured debt at the below-market “formula” rate of interest, which courts in the Second Circuit likely will support.
Cramdown Interest Rate
In its September 2014 confirmation rulings, the bankruptcy court in Momentive was unambiguous in its support for the “formula” approach for determining the interest rate applicable to a secured creditor’s claim in a cram up scenario: prime or treasury base rate plus a risk adjustment based on the profile of the reorganized business, generally between 1 to 3 percent. The bankruptcy court’s approach followed clear Second Circuit precedent in In re Valenti and somewhat less clear Supreme Court precedent in Till v. SCS Credit Corp., both chapter 13 cases applied to the chapter 11 context.
At the time of Momentive’s bankruptcy filing in April 2014, Momentive’s first lien noteholders held $1.1 billion in 8.875% First-Priority Senior Secured Notes due 2020, issued in 2012, and its 1.5 lien lenders held $250 million of 10% Senior Secured Notes due 2020, also issued in 2012, for a combined claim of $1.35 billion, excluding applicable premiums, prepayment penalties, make wholes, or similar claims.
Momentive’s plan of reorganization presented first and 1.5 lien noteholders with a deathtrap, which, unfortunately for these noteholders, carried that grim name for a reason. If they voted in favor of Momentive’s plan, their combined claims would be paid in full, in cash, though they had to waive their make whole and postpetition interest claims, valued at between $100-$200 million, decreasing their potential recoveries by 7 to 13 percent.
If Momentive’s first and 1.5 lien noteholders voted against the proposed plan, their claims would be satisfied with long-dated replacement notes with a below-market rate of interest based on the “formula” approach (ultimately 4.1 percent for the first lien noteholders and 4.85 percent for the 1.5 lien noteholders). This represented a total difference of approximately $70 million in the amount of interest payments for the first lien noteholders over the life of their seven year notes.
The first and 1.5 lien noteholders ran the gauntlet with a vote against Momentive’s plan, but the bankruptcy court confirmed Momentive’s plan over their objections.
Trapped, but far from dead, the first and 1.5 lien noteholders upped the stakes and appealed, arguing before the district court that, among other things, the plan was unconfirmable because the cramdown interest rate should have been based on the “efficient market” method used by the Sixth Circuit (among other jurisdictions), which seeks to determine what interest rate an efficient market would produce, and not the less favorable “formula” approach used in the Second Circuit.
Unpersuaded, the district court affirmed the bankruptcy court’s use of Valenti’s “formula” approach to cramdown interest rates and dismissed the first and 1.5 lien noteholders’ arguments that a different approach was more appropriate. As the district court explained, although Till compelled courts to use the “efficient market” method in chapter 13 cases, the decision left the proper method in a chapter 11 context an open question. Noting that the Sixth Circuit had filled that gap by continuing to use the “efficient market” approach it had taken in its prior precedent, In re American HomePatient, the district court concluded that it should likewise to continue to use the “formula” approach taken in the Second Circuit’s own (Valenti). The district court thus held that Valenti applied in chapter 11 cases, and concluded that the bankruptcy court’s decision was correct in the Second Circuit.
It is safe to say that we are unlikely to see an efficient market approach being used in the Second Circuit in the future, absent either action from Congress (as has been recommended by the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11), or a successful appeal by the first lien noteholders either at the Second Circuit or Supreme Court level. An appeal to the Second Circuit would require that Circuit to distinguish Valenti as precedent on the basis that it involved a chapter 13 case and not chapter 11. If the Supreme Court grants certiorari once the Second Circuit has ruled, it would need to distinguish Till on similar grounds. For the time being, distressed investors involved in cases in the Second Circuit can assume that, in a cram up scenario, debtors will opt to provide secured debt with replacement notes at the below-market “formula” rate of interest and that courts in the Second Circuit will be supportive of this approach. On May 26, 2015, however, the noteholders appealed the district court’s decision, giving the the Second Circuit an opportunity, if it is so inclined, to take a position on cramdown interest rates in chapter 11 cases.