Courts and professionals have wrestled for years with the appropriate approach to use in setting the interest rate when a debtor imposes a chapter 11 plan on a secured creditor and pays the creditor the value of its collateral through deferred payments under section 1129(b)(2)(A)(i)(II) of the Bankruptcy Code. Secured lenders gained a major victory on October 20, 2017, when the Second Circuit Court of Appeals concluded that a market rate of interest is preferred to a so-called “formula approach” in chapter 11, when an efficient market exists. In re MPM Silicones (Momentive), LLC, 2017 WL 4700314 (2d Cir. Oct. 20, 2017).
In Momentive, the bankruptcy court categorically dismissed expert testimony presented by the lenders to demonstrate a market rate of 5-6+%. Because the debtor had offered to cash out the lenders (and prepared to borrow the funds necessary to do it), there was direct evidence of the economic terms on which an arm’s-length lender would have been willing to make a loan similar to the obligation held by the lenders after confirmation of the plan. The bankruptcy court declined to consider this evidence, instead relying on a formula approach offered by the debtor, which started with a risk-free rate and built to a rate of 4.1-4.85%. The economic difference was large, and justified multiple appeals, since the difference between the two rates translated to approximately $150 million over the term of the plan according to the lenders.
Since the Supreme Court addressed cramdown interest in the very different context of a chapter 13 case involving an automobile in Till v. SCS Credit Corp., 124 S.Ct. 1951 (2004), there has been an ongoing debate about whether building an interest rate through a formula approach or allowing the market to determine cramdown interest is more appropriate in chapter 11. (For an in-depth discussion of the odd Till plurality, and the very different approaches among the Supreme Court justices, see here, co-authored by our dearly departed colleague Mark Stingley, as well as Leah Fiorenza of our Atlanta office.)
In Momentive, the debtor argued that the Till decision required an application of the formula method. The Second Circuit reversed the bankruptcy and district court decisions, both of which found in favor of the debtor’s formula-driven interest rates. Addressing this issue for the first time in the chapter 11 context, the Second Circuit adopted the Sixth Circuit’s two-step process for selecting an interest rate. Specifically, when an efficient market exists in a chapter 11 case, a bankruptcy court should apply the market rate. Only when no efficient market exists should a bankruptcy court employ the formula approach. Momentive, pp.8-11.
The Second Circuit remanded the case to the bankruptcy court for further proceedings to determine whether there was an efficient market for the replacement notes being crammed down on the senior lenders. In so doing, the Second Circuit added certainty to this issue in an important venue for chapter 11 cases and raised the possibility that the Supreme Court may intervene.
Significantly, the Second Circuit also rejected the debtor’s argument that this issue was equitably moot. Because the secured lenders repeatedly tried to obtain a stay and given the sheer size of this case, the Second Circuit ruled that the additional annual payments that would be required at a higher interest rate over seven years would not unravel the confirmed plan or threaten the debtor’s emergence from bankruptcy.
There are several practical implications of Momentive. We expect more litigation in the future over what constitutes an “efficient market” for purposes of secured creditor cramdown, particularly in larger cases. In smaller chapter 11s, it may remain difficult for a creditor to demonstrate that the market is efficient, and it will be the rare case in which a debtor lays the groundwork by undertaking refinancing efforts that result in relevant and comparable interest rate proposals. (Indeed, could this create the perverse incentive whereby debtors don’t even seek exit financing for fear of creating a discoverable paper trail, and move directly to cramdown instead?) But even when the evidence is less comprehensive than in Momentive, courts may become more comfortable using market-driven analysis for the value indications it can provide, rather than relying solely on the “build-an-interest-rate” formula approach. Unless and until the Supreme Court addresses this issue in the chapter 11 context, however, this issue will likely remain the subject of further debate and litigation.