Editor’s Note: The Secured Credit Committee recently hosted a webinar titled “Understanding Make-Whole and No-Call Provisions: Key Takeaways From Recent Decisions.” This webinar discussed recent cases such as AMR Corp. (American Airlines), School Specialty, GMX Resources and Chemtura. Click here to review this webinar.
Over the years, the pendulum has swung between periods when bankruptcy courts are inclined to fully protect the rights of secured creditors and periods when courts are inclined to question some of those rights, strengthening the hand of chapter 11 debtors and their unsecured creditors. On Aug. 26, 2014, Hon. Robert D. Drain of the U.S. Bankruptcy Court for the Southern District of New York issued a ruling in Momentive Performance Holdings [1] that may shift leverage in restructuring cases away from senior creditors by enabling debtors to satisfy secured creditors by issuing replacement notes at below-market interest rates. If followed, the court’s ruling could have a significant market impact, undermining protections for secured creditors and providing a new source of value for debtors and unsecured creditors.
Background
Momentive and its affiliates formulated their reorganization plan against the backdrop of a dispute between the debtors and oversecured holders of $1 billion of first-lien notes and $250 million of 1.5 lien notes as to the noteholders’ entitlement to a “make-whole” premium in addition to unpaid principal and accrued interest. In light of this dispute, the plan sought to “cram down” the noteholders, satisfying their claims with replacement notes, unless they voted to accept the debtors’ plan and waive the right to assert any make-whole claim that they might have, in which case they would be paid in cash in full.
By rejecting the plan, the holders would preserve their right to argue for make-whole claims, but they would receive replacement notes with a principal amount equal to their allowed claims, rather than cash. The first lien noteholders’ replacement notes would have first-priority liens, a seven-year maturity and a fixed coupon equal to the yield on treasury notes of matching maturity, as of the effective date, plus 1.5 percent, or an estimated total yield of 3.6 percent at the time of the decision. The 1.5 lien noteholders’ replacement notes would have second priority liens, a seven-and-a-half year maturity and a fixed coupon equal to the yield on treasury notes of matching maturity, as of the effective date, plus 2 percent, or an estimated total yield of 4.1 percent at the time of the decision. Both the first lien and 1.5 lien noteholders voted overwhelmingly to reject the plan and filed confirmation objections, both asserting their entitlements to make-whole payments and arguing that the treatment afforded to them by the plan — as a consequence of their rejection — was not permissible under the Bankruptcy Code.
The Noteholders’ Objections
The noteholders’ primary argument with respect to their plan treatment was that the interest rate and other terms of the replacement notes failed to meet the so-called “cramdown standard” of § 1129(b) of the Bankruptcy Code, which is applicable to rejecting classes of secured creditors. Section 1129(b) requires that if a plan does not provide for the immediate payment of secured creditors, it must provide them with “deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property.” In other words, the value of the replacement notes distributed to the secured creditors must equal the value of their secured claims.
The noteholders argued that replacement notes paying a below-market rate of interest were worth less than their secured claims and thus failed to satisfy the § 1129(b) standard. To show that the proposed rates were below market, the noteholders pointed to the debtors’ two prearranged credit facilities with the same lien priority as the replacement notes, which were intended to refinance the notes in the event they accepted the plan and both paid higher interest rates than the proposed replacement securities. The exit facility arranged to refinance the first-lien notes, a term loan facility with a seven-year maturity, had an indicative interest rate of 5 percent — 1.4 percent higher than the replacement first-lien notes — and the exit facility arranged to refinance the 1.5 lien notes, a bridge facility backstopping a contemplated notes offering, had an indicative interest rate of 7 percent — 2.9 percent higher than the replacement 1.5 lien notes.
The Court’s Bench Ruling
The court held that the calculation of the interest rate on the replacement notes was governed by the U.S. Supreme Court case of Till v. SCS Credit Corp.,[2] which concerned the calculation of cramdown interest on replacement notes distributed to a secured creditor under chapter 13 and concerned individual bankruptcies. Although applicable to a different category of debtor, the text of the chapter 13 cramdown provision is substantially identical to the chapter 11 cramdown provision applicable to the Momentive noteholders. Interpreting the chapter 13 provision, the Supreme Court endorsed the “prime plus” or “formula” method of calculating chapter 13 cramdown interest that had been employed by some courts, which uses the prime rate as a starting point and adjusts upward to reflect credit risk and collateral risk. The Court noted approvingly that courts applying this method had typically set a risk premium of between 1 percent and 3 percent over the prime rate.
The noteholders argued that Till did not apply to chapter 11, and pointed to a footnote in which the Supreme Court suggested that chapter 11 cramdown interest might be calculated by asking “what rate an efficient market would produce.” The bankruptcy court reasoned that this footnote was belied by the reasoning of Till, which had rejected the view that cramdown interest must match market rates, reasoning that it “overcompensates creditors because the market lending rate must be high enough to cover factors … like lenders’ transaction costs and overall profits….”[3]
However, the bankruptcy court also held that the debtors’ proposed risk premiums were set too low because they were benchmarked off treasury yields, whereas the 1 percent to 3 percent risk premiums endorsed in Till were benchmarked off the prime rate. Therefore, the court held that the first-lien replacement notes required an additional 0.5 percent risk spread — for a total rate of 4.1 percent, and the replacement 1.5 lien notes required an additional 0.75 percent risk spread — for a total rate of 4.85 percent.
Future Implications
If adopted by other courts, the court’s opinion could shift significant additional leverage to debtors and unsecured creditors, enabling them to satisfy secured lenders with long-term replacement notes at below-market rates. In certain circumstances, this could reduce the need for exit financing and thus provide increased value to unsecured creditors. Moreover, in light of the decision, an opportunistic company — solvent or near-solvent — could use a bankruptcy filing to primarily reduce the interest rate on its debt by satisfying secured creditors with replacement notes if an impaired accepting class of unsecured creditors could be obtained. However, it remains to be seen whether the decision will be further adopted and how secured financing markets and lenders will respond to this significant new possible risk to recoveries.
[1] In re MPM Silicones, LLC, No. 14-22503-RDD, 2014 WL 4637175 (Bankr. S.D.N.Y. Sept. 17, 2014).
[2] 541 U.S. 465 (2004).
[3] Id. at 477.