Last week, the Second Circuit established an “efficient market”-based approach for calculating cramdown interest rates. Adopting a test established by the Sixth Circuit, the Second Circuit held that courts must apply a market interest rate where an efficient market exists. See Momentive Performance Materials Inc. v. BOKF, NA (In the Matter of: MPM Silicones, L.L.C.), — F.3d —-, 2017 WL 4700314, No. 15-1682, (2d Cir. Oct. 20, 2017).  The decision will be welcomed by secured creditors (and distressed investors) who previously could be forced to accept replacement debt with below-market interest rates under a chapter 11 plan. Lower “formula”-based interest rates are still possible in the Second Circuit, but only where a market does not exist for comparable new debt.

Background

In 2014, the Momentive debtors proposed a chapter 11 plan that was confirmed over the objection of the debtors’ senior secured creditors (i.e., cramming down these senior secured creditors). A bankruptcy court may confirm a chapter 11 plan without the consent of an impaired class so long as the plan does not discriminate unfairly, and is fair and equitable, to those classes that are impaired and have rejected the plan. See 11 USC 1129(b)(1). The Momentive debtors’ plan included a “death trap” for the holders of the first-lien and 1.5-lien senior secured notes (the Senior-Lien Noteholders). These Senior-Lien Noteholders could either (1) accept the plan, in which case they would immediately receive full payment in cash of the outstanding principal and interest due on their notes but would give up any right to a make-whole premium payment, or (2) reject the plan, in which case they would receive long-dated replacement notes with a present value that the debtors argued was equal to the value of the Senior-Lien Noteholders’ claim, with litigation to continue with respect to whether the Senior-Lien Noteholders were entitled to the make-whole premium and the correct interest rate on the replacement notes.

The Senior-Lien Noteholders rejected the plan and argued, among other things, that the replacement notes carried an interest rate well below market for similar debt. Accordingly, the Senior-Lien Noteholders argued that the plan could not be confirmed because it was not fair and equitable in that the replacement notes did not give the Senior Lien Noteholders the present value of their claims. The bankruptcy court disagreed, finding that the plan was fair and equitable because the interest rate was determined by a formula that complied with the Bankruptcy Code’s cramdown provision. On appeal, the district court agreed.

Second Circuit’s Analysis

The Senior-Lien Noteholders raised several arguments on appeal to the Second Circuit, of which only one—the calculation of the replacement notes’ interest rate—found favor with the Second Circuit.

For context, the Bankruptcy Code allows a debtor to make deferred cash payments to secured creditors as part of a cramdown. However, for these payments to result in “fair and equitable” treatment to creditors, the deferred payments must equal (over time) the present value of the secured creditors’ claims. To ensure the full present value is paid, deferred payments must carry an appropriate rate of interest. In Momentive, the interest rate for replacement notes to the Senior-Lien Noteholders was based on a formula, which generated significantly below market rates compared to comparable debt. The debtors argued such rates were justified as in line with how rates were calculated in Till v. SCS Credit Corp., 541 U.S. 465 (2004)—a prior Supreme Court case considering cramdown rates in connection with confirmation of a chapter 13 plan. The “formula” method starts with the national prime rate, with the bankruptcy court to then make a risk adjustment based on the plan before it. Bankruptcy courts applying the formula have generally approved upward adjustments of only 1% to 3%.

In considering this approach, the Second Circuit noted that the Supreme Court had, in establishing the formula approach for chapter 13 cases, acknowledged that a different approach might be warranted in chapter 11 cases, where there is typically a more open market with numerous lenders sometimes willing to extend financing post-petition. The Second Circuit also observed that the Sixth Circuit had relied on this same distinction in 2005, when it adopted a two-part process for selecting an interest rate in chapter 11 cramdowns:

[T]he market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.

The Second Circuit joined the Sixth Circuit, adopting this two-step approach and 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 … that such a rate is preferable to a formula improvised by a court.”

Accordingly, the Second Circuit remanded the issue to the bankruptcy court to consider whether an appropriate market rate exists for these replacement notes and, if so, to apply such rate.

Take-Away

The Second Circuit’s decision ensures that secured creditors will receive market interest rates if available, thus promoting a more efficient market approach in bankruptcy cases. It’s the “if available” aspect of the Second Circuit’s ruling that secured creditors will need to focus on next.