Second Circuit Adopts Two-Step Market-Based Approach to Chapter 11 Cramdown Interest Rates and Affirms Bankruptcy Court’s Subordination of Certain Notes and Denial of “Make-Whole” Premium
The Business Advisor
The Second Circuit Court of Appeals recently released its decision in In the matter of MPM Silicones, L.L.C. (MPM).1 In the consolidated appeals, certain noteholders argued, among other issues, that the cramdown provisions of the confirmed chapter 11 plan of Momentive Performance Materials Inc. (MPM) improperly eliminated or reduced the value of their notes. The Court of Appeals affirmed plan confirmation, but remanded the case to the bankruptcy court to employ a two-step analysis to establish interest rates under the cramdown plan. Under the Second Circuit’s ruling, bankruptcy courts must first determine whether an efficient market exists, and, if so, use the market rate of interest for replacement notes. Second, only if no efficient market exists, the court employs the formula method used in Till v. SCS Credit Corp., a United States Supreme Court decision in a chapter 13 case. 2
MPM, a silicone manufacturer, commenced a voluntary chapter 11 case after issuing four series of notes in the mid-2000s: subordinated notes, second-lien notes, and 2012 senior-lien notes, which debt offering included two classes of senior secured notes: $1.1 billion in first-lien secured 8.875% notes and $250 million in 1.5-lien secured 10% notes. The indentures for the senior secured notes called for a “make-whole” premium if MPM opted to redeem the notes prior to maturity.
In April 2014, MPM and its affiliated debtors each filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code. In September 2014, the bankruptcy court confirmed the MPM debtors’ joint plan of reorganization, which provided, among other things, for (i) a 100% cash recovery of principal and interest on the senior-lien notes; (ii) an estimated 12.8%-28.1% recovery on the second-lien notes in the form of new equity; and (iii) no recovery on the subordinated notes.
Indenture trustees for three groups of noteholders appealed decisions of the bankruptcy court and district court, challenging the lower courts’ use of the “formula” method to calculate the proper interest rate in this chapter 11 cramdown. The formula method endorsed by the Supreme Court in Till uses adjusted risk-free rates that are lower than the market rates on comparable debt instruments. The Court of Appeals also considered issues related to the subordination of claims, the senior-lien noteholders’ entitlement to the “make-whole” premium, and the equitable mootness of the appeals.
The Court of Appeals concluded that, with one exception, the plan confirmed by the bankruptcy court and affirmed by the district court comported with the applicable provisions of the Bankruptcy Code. However, on the issue of cramdown interest rates, the Court of Appeals concluded that the lower courts erred in not considering evidence of market rates on comparable debt instruments and remanded the matter to the bankruptcy court to determine the proper interest rate under the cramdown provisions of the Bankruptcy Code. The decision creates new law in the Second Circuit.
Because the senior-lien noteholders rejected the debtors’ plan, they received replacement notes that paid their claims over time.3 The Bankruptcy Code allows “debtors to make such ‘deferred cash payments’ to secured creditors (i.e., to ‘cramdown’),”4 provided those payments carry an interest rate that ensures creditors receive the full present value of their secured claims. 5
The bankruptcy court chose, for the first-lien and 1.5-lien noteholders’ replacement notes, rates of 4.1% and 4.85%, respectively. To calculate these rates, the bankruptcy court used the “formula” method, beginning with risk-free rates and then adjusting for appropriate risk factors.6 The parties agreed that the “formula” rate was lower than market rates for comparable debts. The bankruptcy court reasoned that the United States Supreme Court’s Till decision required use of the formula method, even in a chapter 11 case—that “a cramdown interest rate should not take market factors into account.”7 The district court agreed.
Till concerned a chapter 13 debtor’s sub-prime auto loan. Like chapter 11, chapter 13 permits a cramdown; a debtor may distribute future property to a creditor, so long as that property’s “value, as of the effective date of the plan, … is not less than the allowed amount of such claim.”8 A plurality of the Till Court endorsed the “formula” method for calculating an interest rate in that scenario. The Supreme Court in Till explicitly rejected a market-based rate calculation and directed bankruptcy courts to begin with a largely risk-free rate—specifically, the “national prime rate,” which the Supreme Court explained “reflects the financial market’s estimate of the amount a commercial bank should charge a creditworthy commercial borrower to compensate for the opportunity costs of the loan, the risk of inflation, and the relatively slight risk of default.”9 The parties may then present evidence at a hearing regarding any “plan-specific risk adjustment.” 10
In MPM, the Second Circuit concluded that Till does not control the interest rate calculation in chapter 11 cramdown cases. The plurality opinion in Till did not decide the issue, and even questioned whether the “formula” rate would be appropriate in chapter 11 cases. In footnote 14, the Till Court observed that “there is no free market of willing cramdown lenders” in chapter 13 cramdowns, while “the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. Thus, when picking a cramdown rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce.” 11
In reliance on that footnote, the Court of Appeals for the Sixth Circuit, in a 2005 decision, adopted a two-part process for calculating an interest rate in a chapter 11 cramdown. In In re American HomePatient, Inc., the Sixth Circuit held that a “market rate” is proper “where there exists an efficient market.”12 Otherwise, “the bankruptcy court should employ the formula approach endorsed by the Till plurality.”13 In MPM, the Second Circuit observed that courts have found markets to be “efficient” if, for instance, “they offer a loan with a term, size, and collateral comparable to the forced loan contemplated under the cramdown plan.” 14
In MPM, the Second Circuit adopted that two-step approach, holding that “where, as here, an efficient market may exist that generates an interest rate that is apparently acceptable to sophisticated parties dealing at arms-length, we conclude, consistent with footnote 14 [in the Till case], that such a rate is preferable to a formula improvised by the court.”15 The Court of Appeals noted that the senior-lien noteholders offered expert testimony before the bankruptcy court “that, if credited, would have established a market rate” of “between 5 and 6+%.”16 The Court of Appeals concluded that the lower courts erred in dismissing the probative value of that evidence, and directed the bankruptcy court to determine on remand “if an efficient market rate exists and, if so, [to] apply that rate, instead of the formula rate.” 17
The Second Circuit affirmed the lower courts’ decisions that the senior-lien noteholders were not entitled to a make-whole premium. As the Court of Appeals explained, “[a] make-whole premium is a ‘contractual substitute for interest lost on Notes redeemed before their expected due date,” and is intended “to ensure that the lender is compensated for being paid earlier than the original maturity of the loan for the interest it will not receive.” 18
The creditors raised three arguments on this issue: (1) that MPM redeemed the notes in question “at its option” under optional-redemption clauses in the 2012 indentures; (2) that the acceleration clauses in the indentures provide for the premium; and (3) that the noteholders have a contractual right to rescind acceleration and obtain the make-whole premium.
With respect to the first point, the court explained that it “rejected nearly identical arguments in its 2013 decision in In re AMR Corp.19 In AMR, the court held that, because default changes the maturity date of a debt to the date of the bankruptcy petition, a payment after that date cannot be a voluntary prepayment.20 MPM’s issuance of the replacement notes was not “at its option,” as the acceleration clauses in the indentures triggered the maturity of the notes upon the commencement of the debtors’ bankruptcy cases. Therefore, the notes could not have been redeemed before their accelerated maturity dates.
The Court of Appeals also held that the senior-lien noteholders could not have rescinded acceleration in order to reinstate the notes’ original maturity dates. The Second Circuit found that “a creditor’s post-petition invocation of a contractual right to rescind an acceleration triggered automatically by a bankruptcy filing is barred because it would be an attempt to modify contract rights and would therefore be subject to the automatic stay.” 21
Both the bankruptcy court and the district court held that the subordinated noteholders’ claims were subordinate to the second-lien noteholders’ claims under the unambiguous terms of the 2006 indenture. The Second Circuit agreed that the indenture gave the second-lien noteholders priority over the subordinated notes, but found that the indenture’s terms were ambiguous.
The Court of Appeals found that the second-lien notes “are not subordinated in right of payment to any other indebtedness and that therefore they satisfy the Baseline Definition of Senior Indebtedness” under the 2006 indenture. But that definition was subject to six exceptions, including the “Fourth Proviso,” which exempts “any Indebtedness or obligation of the Company … that by its terms is subordinate or junior in any respect to any other Indebtedness or obligation of the Company.” 22
The subordinated noteholders argued that the Fourth Proviso exempted the second-lien notes because the liens supporting those notes “are junior to the liens supporting the first-lien notes.”23 The Second Circuit explained that the lower courts distinguished “‘lien subordination’ and ‘payment (or debt) subordination,’ concluding that the Fourth Proviso unambiguously carves out from the Baseline Definition only the latter and not the former.”24 Therefore, the lower courts concluded, the Proviso does not apply to the second-lien notes.
Unlike the lower courts, the Second Circuit found ambiguity in the language of the Fourth Proviso. But, in resolving that ambiguity in favor of the debtors, the court cited “the plethora of evidence in the record that the parties intended the Second-Lien Notes to be Senior Indebtedness.”25 That evidence included MPM’s representations to the Securities and Exchange Commission “in prospectuses, 8-Ks and 10-Ks,”26 of which the subordinated noteholders were aware.
The Court of Appeals also emphasized that the subordinated noteholders’ interpretation of the Fourth Proviso would produce questionable results. It would mean that (1) “the springing of the Second-Lien Notes’ security interest, which was meant to enhance the note holders’ protection, would actually strip those notes of their status as Senior Indebtedness and therefore their priority over the Subordinated Notes”; and (2) “no senior note classes would qualify as Senior Indebtedness because each was secured in some respect by a junior lien.” 27
Finally, the Second Circuit rejected the debtors’ effort to dismiss the appeals on equitable-mootness grounds.
The MPM court recognized that, because the plan at issue had been substantially consummated, the presumption is that any appeal is equitably moot. Rebuttal of that presumption requires satisfaction of five factors,28 but courts “place significant reliance” on the fifth factor: whether “appellant diligently sought a stay of the reorganization plan.”29 According to the Second Circuit, appellants in MPM had “promptly and consistently sought a stay in three different courts.” 30
The remand will concern only the interest rate for the senior-lien noteholders’ replacement notes. The court highlighted the debtors’ acknowledgement that a change in that rate “might require, at most, $32 million of additional annual payments over seven years.”31 The Second Circuit found that such payments, in all likelihood, would not “materially implicate the concerns identified” in Chateaugay II.32 Focusing on the fifth factor (noted below) from Chateaugay II, the Court of Appeals said that “[i]f a stay was sought, we will provide relief if it is at all feasible.”33
1 Momentive Performance Materials Inc. v. BOKF, NA (In the Matter of: MPM Silicones, L.L.C), __ F.3d __, No. 15-1682, 2017 U.S. App. LEXIS 20596 (2d Cir. Oct. 20, 2017).
2 541 U.S. 465 (2004).
3 MPM, 2017 U.S. App. LEXIS 20596, at *20.
4 Id. (citing 11 U.S.C. § 1129(b)(2)(A)(i)(II)).
7 Id. at *21 (internal quotation marks omitted).
8 11 U.S.C. § 1325(a)(5)(B)(ii).
9 Till, 541 U.S. at 479.
10 MPM, 2017 U.S. App. LEXIS 20596, at *23.
11 Id. at *24 (quoting Till, 541 U.S. at 476 n.14).
12 420 F.3d 559, 568 (6th Cir. 2005).
14 MPM, 2017 U.S. App. LEXIS 20596, at *25 (quoting In re Texas Grand Prarie Hotel Realty, L.L.C., 710 F.3d 324, 337 (5th Cir. 2013)).
15 Id. at *27.
16 Id. at *26.
17 Id. at *28.
18 Id. at *28 n.13 (quoting In re Energy Future Holdings Corp., 842 F.3d 247, 251 (3d Cir. 2016)).
19 730 F.3d 88 (2d Cir. 2013).
20 Id. at 103.
21 MPM, at *33 (internal quotation marks omitted) (quoting id. at 102-103).
22 Id. at *12.
23 Id. at *13.
25 Id. at *14.
26 Id. at *17.
27 Id. at *18-20.
28 The court explained that the presumption “gives way . . . where (i) effective relief can be ordered; (ii) relief will not affect the debtor’s re-emergence; (iii) relief will not unravel intricate transactions; (iv) affected third-parties are notified and able to participate in the appeal; and (v) appellant diligently sought a stay of the reorganization plan.” Id. at *35 (internal quotation marks omitted) (citing In re Charter Commc’ns. Inc., 691 F.3d 476, 481 (2d Cir. 2012)). See also In re Chateaugay Corp., 988 F.2d 322 (2d Cir. 1993) (“Chateaugay II”).
30 Id. at *36.
31 Id. at *37.
32 Id. at *37-38. See also supra, n.28.
33 MPM, 2017 U.S. App. LEXIS 20596, at *35 (quoting Deutsche Bank AG, London Branch v. Metromedia Fiber Network, Inc. (In re Metromedia Fiber Network, Inc.), 416 F.3d 136, 144 (2d Cir. 2005) (alteration in original).