On August 26, 2014, Judge Drain concluded the confirmation hearing in Momentive Performance Materials and issued several bench rulings on cramdown interest rates, the availability of a make-whole premium, third party releases, and the extent of the subordination of senior subordinated noteholders. This four-part Bankruptcy Blog series examines Judge Drain’s rulings in detail, with Part I of this series having provided you with a primer on cramdown in the secured creditor context. Today’s Bankruptcy Blog post, Part II of this series, will examine Judge Drain’s cramdown decision in more detail. Part III will focus on the extent of the subordination of senior subordinated noteholders, and Part IV will explore both the “make-whole” aspects of Judge Drain’s decision and third party releases.
Judge Drain’s Cramdown Holding: Interest Rate on Secured Debt May Be Below Market Even When Market Rate Determinants Exist
As we noted yesterday, one aspect of Judge Drain’s decision may give debtors additional negotiating leverage in attempting to set terms for payment of secured claims under a plan. Judge Drain’s bench ruling suggests that the allowed claim of a secured creditor may be satisfied by a long-dated replacement note with a below-market interest rate. This decision has the potential to positively affect exit financing needs for debtors and may even increase distributions to unsecured creditors in cases in which the allowed claims of secured creditors are deemed to have been fully satisfied.
Judge Drain’s Momentive decision is unambiguous when it comes to its support for the “formula” approach in determining a cramdown interest rate for a secured creditor and in elucidating the guiding first principles that dictate how to calculate the applicable cramdown interest rate for a secured creditor’s allowed claim in a chapter 11 case:
- First, a cramdown interest rate should not contain any profit or cost element, both being inconsistent with the present value approach for cramdown.
- Second, market testimony or evidence is only relevant when considering the proper risk premium to use in the formula approach.
- Third, the risk premium should not be used by creditors as a means of obtaining a market rate on their replacement notes.
The appropriate cramdown interest rate, therefore, is one that eliminates profit, eliminates fees, and compensates a secured creditor at an essentially riskless base rate, to be supplemented by a risk premium of between 1-3%, to account for a debtor’s unique risks emerging from chapter 11.
Momentive Performance Materials, a manufacturer of silicone and quartz products, filed for bankruptcy protection in the United States Bankruptcy Court for the Southern District of New York in April of 2014. Momentive filed its chapter 11 plan in May and revised its plan a number of times before its hotly contested confirmation hearing in August 26. As of December 31, 2013, Momentive had $4.1 billion of consolidated outstanding indebtedness. Momentive’s primary classes of creditors under its plan are as follows:
|Description||Estimated Amount of Claims in Class||Estimated Recovery|
|First Lien Notes||$1.1 billion (not including accrued interest)||100%|
|1.5 Lien Notes||$250 million (not including accrued interest)||100%|
|Second Lien Notes||$1.161 billion plus €133 million (not including accrued interest)||12.8% – 28.1%|
|Senior Sub Notes||$382 million (not including accrued interest)||0%|
|PIK Notes||$877 million||Less than 1%|
Momentive’s chapter 11 plan provided for its $1.1 billion first lien noteholders and $250 million 1.5 lien noteholders to be paid in full, in cash, without payment of any “make-whole” premiums or unpaid principal and accrued interest. Consistent with the prepetition term sheet and restructuring support agreement that the debtors had negotiated with Apollo (Momentive’s controlling shareholder and post-emergence equity owner) and the Ad Hoc Committee of Second Lien Noteholders, the plan also included a “deathtrap” provision for these senior noteholders: If the class of first lien notes or 1.5 lien notes voted to reject the plan, the rejecting class would receive replacement secured notes in a principal amount equal to its allowed secured claims, with an interest rate that Momentive considered sufficient on a present value basis to satisfy the cramdown requirements of the Bankruptcy Code. Notably, all parties agreed that the first lien and 1.5 lien notes were fully secured.
Holders of the first lien and 1.5 lien notes each voted as a class to reject confirmation of Momentive’s proposed plan of reorganization. Momentive sought to cram down the plan over the objection of these two secured classes, and the indenture trustees for the secured noteholders objected to confirmation of the plan. Among other things, they argued that the plan was not fair and equitable because it did not satisfy the present value test required by section 1129(b)(2)(A)(i) of the Bankruptcy Code.
Momentive argued that the rates proposed in the plan were sufficient to satisfy the cramdown requirements of section 1129(b)(2)(A)(ii) of the Bankruptcy Code, while the first and 1.5 lien noteholders argued for higher interest rates based on their view of what typical lenders would expect for new notes on a like for like basis. Momentive had previously obtained the Bankruptcy Court’s authority to enter into a debtor in possession (DIP) financing facility, and the final DIP order authorized Momentive to enter into a commitment letter for a $1.0 billion exit financing facility with a term of seven years. If the first and 1.5 lien noteholders voted in favor of the plan, this exit facility, along with an equity infusion from Apollo and other investors, would provide Momentive with the liquidity to pay the allowed secured claims in cash. As Momentive had already obtained this binding assurance for exit financing, the senior secured creditors argued that evidence of what was a market rate was readily available and that the exit financing interest rate should be viewed as a proxy for the appropriate cramdown interest rate.
This dispute required the Court to undertake a present value calculation as to stream of cash flows being paid out by Momentive over seven years to the first lien noteholders and seven and a half years for the 1.5 lien noteholders.
As we saw in yesterday’s Bankruptcy Blog post, while this calculation is simple in practice, courts have developed varying ways of determining the appropriate cramdown interest rate, and Judge Drain’ decision in the cramdown context focused heavily on which method was most appropriate, and why.
Turning to Till
Judge Drain’s analysis of the appropriate method of calculating a cramdown interest rate focused on two significant chapter 13 cases, the Supreme Court’s plurality opinion in Till v. SCS Credit Corp, and the Second Circuit’s decision in In re Valenti. In Valenti, the Second Circuit adopted the “formula” approach in a chapter 13 case before the Supreme Court decided Till, and the Supreme Court cited favorably to Valenti in its Till decision. Even though they involved chapter 13 cases, Till and Valenti have been instrumental in leading courts in chapter 11 cases to move towards the “formula” approach applied in those cases. In his decision, Judge Drain concluded that both Till and Valenti quite clearly rejected the “forced loan” or “coerced loan” alternatives that were proposed in those cases, and which were also proposed by the senior lenders in the Momentive case. As a result, Judge Drain refused to consider a market-based analysis of interest rates for similar loans available in the open market to establish the appropriate cramdown interest rate.
Footnote Fencing: The Thrust
The indenture trustees for the first and 1.5 lien notes argued that section 1129(b)(2)(A)(ii) of the Bankruptcy Code requires the plan to provide for a rejecting class of secured creditors to receive a market interest rate on their replacement notes, particularly when the market rate is readily determinable. This reasoning echoes the approach taken by some courts to determine a cramdown interest rate in a chapter 11 case and relies upon Footnote 14 from Till.
In footnote 14 to the Till decision, the Supreme Court drew a distinction between the lack of a free market for lenders to chapter 13 debtors in a cramdown context and the general availability of financing in a chapter 11 case. The footnote states that when choosing the appropriate cramdown interest rate in a chapter 11 context, it might make sense to ask what interest rate an efficient market would produce. This has led some courts, such as the Sixth Circuit in In re American Homepatient, to focus first on whether sufficient evidence is available to conclude that an efficient market exists, before moving to the coerced loan approach or the formula approach if it does not.
The indenture trustees supported their view that a market rate was the most appropriate cramdown interest rate for paying out their secured claims over time by referencing the loan commitment obtained by Momentive to support the cash-out option for the secured noteholders under Momentive’s plan. This commitment provided for a higher interest rate than was being provided to the replacement secured notes, with the committed $1 billion first lien backup takeout facility being priced, for example, at 5%, and with a seven year term. Momentive’s chapter 11 plan also proposed to stretch payment on the replacement first lien notes out over seven years, with a 3.60% interest rate as of August 26, 2014, based on a seven-year Treasury note rate plus 1.5 percent. Momentive planned a repayment schedule for the 1.5 lien notes of 7.5 years, with an interest rate of 4.09%.
Footnote Fencing: The Parry
Despite what Judge Drain referred to as “very clear guidance” from Till with respect to the appropriate method for calculating cramdown interest rates in a secured creditor context, and the obligation and duty for the Bankruptcy Court for the Southern District of New York to follow the Second Circuit in Valenti in, Judge Drain nevertheless recognized that some courts (in particular the Sixth Circuit in In re American Homepatient) felt that Till was “not directly on all fours” as a result of Footnote 14, and had continued to apply the coerced-loan approach unless no efficient market existed. Despite noting another court’s conclusion that the efficient market analysis is almost, if not always a dead end, this split led Judge Drain to engage in an extensive analysis of Footnote 14 and its implications, before ruling against the secured noteholders on their Footnote 14 related arguments.
Judge Drain noted that the Supreme Court in Till had expressly rejected market-based methodologies in favor of the “formula” approach for calculating a cramdown interest rate, and that both Till and Valenti stated similar reasons for doing so: the objective of the cramdown interest rate is to put a creditor in the same economic position it would have been in had it received the value of its allowed claim immediately, and not in the same position that it would have been in had it arranged a new loan. As a secured creditor’s allowed claim does not include any degree of profit, the court in Valenti concluded that neither should a cramdown interest rate account for profit.
The Court’s decision points out that Till also distinguished cramdown interest rates from market rate loans, and that the Supreme Court in Till had ruled that a creditor who is paid on an allowed secured claim over time is not entitled to be put in to the same economic position than if that creditor had been allowed to foreclose on the collateral securing the allowed claim, and then loaned the proceeds in a new transaction.
Consistent with Tilland Valenti, Judge Drain concluded that the appropriate cramdown interest rate is one that eliminates profit, eliminates fees, and compensates a secured creditor at an essentially riskless base rate, to be supplemented by a risk premium of between 1-3%, to account for a debtor’s unique risks emerging from chapter 11.
Judge Drain provided the following Till inspired guiding first principles that dictate how to calculate the applicable cramdown interest rate for a secured creditor’s allowed claim in a chapter 11 case: first, a cramdown interest rate should not contain any profit or cost element, both being inconsistent with the present value approach for cramdown; second, market testimony or evidence is only relevant when considering the proper risk premium to use in the formula approach; and third, the risk premium should not be used by creditors as a means of obtaining a market rate on their replacement notes.
Footnote Fencing: The Riposte
Judge Drain addressed in detail the Footnote 14-related arguments raised by the secured noteholders. In his decision, Judge Drain stated that the only basis for a market cramdown interest rate based argument is Footnote 14 in Till because neither Till nor Valenti provides any other basis for the argument. In Judge Drain’s view, this is a “very slim reed indeed” on which to argue for a market-based approach to cramdown interest, in contrast to the balance of the Till decision, which stands firmly in favor of the “formula” approach.
The Momentive court makes it clear that it views Footnote 14 as referring to, and deriving from, a specific statement in the Till decision, namely that a cramdown rate of interest need not ensure that creditors be ambivalent as to whether they foreclosed on collateral or were paid out on their secured claims over time.
The time value of money concept means that a creditor would clearly prefer to receive the value of its secured claim immediately, whether by foreclosure or immediate payment, so that it can then lend its proceeds out again. This is preferable to being forced to continue to lend to a debtor over time, through being paid out in installments on its secured loan at a rate that does not include any profit element. This preference to be paid out immediately, rather than lend to a debtor over time at no profit, explains why there is no readily apparent chapter 13 interest rate, because there is no readily apparent market of lenders that are willing to lend on any basis other than a market basis.
After finding that no market for involuntary loans exists, the Supreme Court in Till then contrasted this to the very active market for debtor in possession (or DIP) financing, where third parties willingly seek to lend money, and debtors willingly seek to borrow it, and questioned whether it might make sense in the chapter 11 context to ask what interest rate an efficient market would therefore produce.
Judge Drain found this inquiry to be unavailing, relying upon Collier for the proposition that the only similarity between DIP financing and the loans imposed upon dissenting creditors at cramdown was that they both occurred during the pendency of a chapter 11 case. Noting that no precedent supported the proposition that a DIP financing rate should be used as a proxy for a cramdown interest rate, and indeed no parties had ever argued for this, Judge Drain concluded that cramdown loans were more akin to exit loans, given that both occur at confirmation. For this reason, the Court considered it inappropriate to consider a DIP financing interest rate as a proxy for the rate at which a secured creditor should be paid over time on its allowed secured claim.
Judge Drain further buttressed his rejection of market interest related arguments by pointing out that Footnote 15 of the Till decision makes it clear that the Supreme Court disagrees with the use of a coerced loan approach (which, as we have seen, aims to set the cramdown interest rate at the level a creditor can obtain new loans of comparable duration and risk) in the chapter 13 context, and that in Footnote 18 of the Till decision, the Supreme Court considered the prime rate alone (with no adjustment whatsoever) to be an acceptable cramdown interest rate under the Bankruptcy Code, so long as a court could somehow be certain that a debtor would complete its plan of reorganization.
In his decision, Judge Drain echoed the Supreme Court’s view in Till that each of the alternative approaches to calculating a cramdown interest rate is complicated, imposes significant evidentiary costs, and focuses on what he regards as the wrong objective – making the secured creditor whole, rather than ensuring that a debtor’s deferred cash payments on an allowed secured claim have the required present value.
The court also rejected the notion that Momentive’s exit loan commitment rates were relevant in considering the appropriate rate for a cramdown interest rate, finding that they included a profit element, which, regardless of how the exit loans were structured, failed to meet the Till and Valenti standards.
The court concluded its review of Footnote 14 arguments by holding that “Footnote 14 should not be read in a way contrary to Till and Valenti’s first principles,” outlined above.
The Risk Premium
The indenture trustees for the first and 1.5 lien noteholders also objected to the risk premium that the debtors used to determine the appropriate cramdown interest rate – 1.5% above the Treasury rate for the first lien notes and 2% above the Treasury rate for the 1.5 lien notes.
Judge Drain ruled in favor of Momentive on this point, finding that the risk premium was appropriate in light of the circumstances of the estate, the nature of the security (both the collateral and the terms of the underlying agreements), the duration and feasibility of the reorganization plan, and the terms of the notes. The court further blessed the choice of the Treasury rate by the debtors as an appropriate base rate for longer-term debt, finding that the prime rate correlates more closely to the rate banks charge one another on overnight loans.
As to the appropriate risk premium, the Court questioned whether the 1-3% range in risk premiums applied in Till (which used the prime rate as the base rate) might not be higher if the Treasury rate had been used in that case. Judge Drain reasoned that the difference in interest rates between Treasury debt and debt issued by financial institutions to preferred clients at the prime rate could mostly be accounted for by risk. Treasury debt, because the U.S. government is the primary obligor, is considered to be largely risk free. Even the highest grade commercial borrowers have the potential for default, and Judge Drain considered that potential to be accounted for by the difference between the Treasury rate and the prime rate.
This analysis led Judge Drain to the conclusion that, when Treasury debt is used as a base rate (as opposed to the prime rate), it was appropriate to augment that rate by an additional margin to compensate the lender for risk. Judge Drain then suggested that it would be appropriate for the first lien replacement note cramdown interest rate to be increased by an additional 0.5% and for the 1.5 lien replacement note cramdown interest rate to be increased by an additional 0.75%.
Below is a chart that sets out what was proposed by Momentive in its pre-confirmation plan, and what Judge Drain ultimately considered appropriate as cramdown treatment:
|Creditor||Proposed Treatment||Court Proposed Treatment|
|$1.0 billion first lien notes||Seven-year Treasury note rate plus 1.5 percent, 3.60% as of August 26, 2014.||Seven-year Treasury note rate plus 2.0 percent, 4.1% as of August 26, 2014.|
|$250 million 1.5 lien notes||Imputed 7.5 year Treasury note rate (based on weighted averaging of the rates for seven-year and ten-year Treasury notes) plus 2 percent, 4.09%, as of August 26, 2014.||Imputed 7.5 year Treasury note rate (based on weighted averaging of the rates for seven-year and ten-year Treasury notes) plus 2.75%, 4.85% as of August 26, 2014.|
The decision in Momentive provides both debtors and secured creditors clear guidance as to how Judge Drain views the calculation of the appropriate interest rate in a secured creditor cramdown situation. While the decision is not what the secured creditors in Momentive had hoped for, it does add to the body of case law applying the Till “formula” approach in this situation. Ultimately, the appropriate methodology for a cramdown interest rate is a value allocation tug-of-war between debtors, secured creditors and more junior creditors, and this decision affords additional weight to debtors in that battle. Coalescing around a common formula, no matter which it is, is ultimately beneficial to setting the expectations of all parties facing involved in distressed situations, and more certainty will assist in being able formulate and confirm plans of reorganization expeditiously.