A simple proposition—that secured lenders are entitled to receive payments with a present value at least equal to the amount of their claim—has proven surprisingly difficult to apply as courts have pondered whether to follow a “formula approach” or a “market approach” to establish an appropriate “cramdown” interest rate. (A primer is available here if you are new to the debate.)
Secured lenders have scored a significant win in the recent Second Circuit decision in the Momentive case, In re MPM Silicones. Siding with the Sixth Circuit, the Second Circuit has decided that the prevailing market rate for comparable debt should be used—if there is an efficient market for such debt—and that the formula approach should be used only if no efficient market exists.
Market-Rate Schmarket-Rate… What’s the Big Deal?
Theoretically, whether you build up from a base rate and fully adjust for the characteristics of a loan or whether you consider comparable market loans to determine an appropriate interest rate, you should end up at roughly the same place. In reality, however, courts applying a formula approach have approved interests rates that are lower than a market rate approach would support… sometimes absurdly so.
By way of analogy, consider an ordinary real estate valuation. A real estate appraiser will consider different valuation methods—market comparables, replacement cost, and income capitalization. These three approaches will often provide different values for a property, so an appraiser must reconcile the varying results. Sometimes differences are minor. But depending on the property and the appraisal’s objective, one of the approaches may be more suitable than the others.
Similarly, in the bankruptcy context, the formula approach and market approach can support different interest rates, and one of the approaches may be more suitable in Chapter 11 than the other. And uncertainty over which approach to apply in Chapter 11, combined with courts’ self-imposed reluctance to impose a risk premium of more than 1-3% under the formula approach, has spawned significant litigation with very real consequences.
The Original Momentive Rulings: The Formula Approach
Momentive, one of the world’s largest producers of silicone products, filed a Chapter 11 bankruptcy case in 2014. At the time, it had two outstanding series of senior lien notes, one in the principal amount of $1.1 billion with an 8.875% interest rate and the other in the principal amount of $250 million with a 10% interest rate. Momentive’s plan proposed, in essence, that these claims would be satisfied with long term replacement notes with a below-market rate of interest based on the “formula” approach, e.g., 4.1% and 4.85%, respectively. This represented a total reduction of approximately $70 million in the amount of interest payments over the life of the notes.
The lower courts approved this plan, expressing concern that a market rate of interest would “overcompensate” cramdown lenders. Why? Because market rates include transaction costs and profits indicative of new loans. By following the formula approach, the lower courts could disregard these add-ons and felt they could truly “put the creditor in the same economic position that it would have been in had it received the value of its claim immediately.” The decisions also reflected a general tendency to limit risk adjustments to a range of between 1-3%. The result was the approval of new notes that bore interest rates far below the original issue interest rates and current market rates, and an appeal to the Second Circuit.
The 2nd Circuit Reverses Course: A Market Approach Is Preferred
The Second Circuit rejected the lower courts’ reasoning. Disregarding available efficient market rates, it stated, would be a major departure from long-standing precedent dictating that the best way to determine value is exposure to an efficient market.
“[W]here, 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 [of Till], that such a rate is preferable to a formula improvised by a court.”
And what is an efficient market? In keeping with the Fifth Circuit, the Court described it as one where, for example, “they offer a loan with a term, size and collateral comparable to the forced loan contemplated under the cramdown plan.” The Second Circuit suggested that an efficient market might exist for notes similar to the replacement notes at issue in Momentive, but it remanded the question to the Bankruptcy Court to decide.
A Cliffhanger Ending…
Will Judge Drain decide that an efficient market exists on the remand?
Judge Drain’s bench ruling suggests he may not, as he noted that “it is highly unlikely that there will ever be an efficient market that does not include a profit element, fees and costs, thereby violating Till’s first principles, since capturing profit, fees and costs is the marketplace lender’s reason for being.”
But the Second Circuit opinion could be read to downplay his concerns, as it approvingly cited the testimony of the first lien noteholders’ expert, who testified that when notes are priced at the market rate noteholders are “being compensated for the underlying risk that they are taking” and not for any “imbedded profit.”
Stay tuned to find out what happens in Episode 4: The Cramdown Rematch.
The Bottom Line
Meanwhile, the Second Circuit’s opinion significantly reduces uncertainty around the application of Till’s formula rate to Chapter 11 cramdown notes in the Second Circuit and appears to be good news for secured creditors, who have been facing threats of cramdown with below-market take-back debt in restructuring negotiations, and a loss for debtors and unsecured creditors who might benefit by extracting value at their expense. Although it is also possible that the two-step approach adopted here could simply shift litigation efforts to focus instead on whether there exists an efficient market in the first instance.