2nd Circuit Reverses Course on Cramdown Interest Rates

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 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.

Mette Kurth

Cramdown Interest 101

The Bankruptcy Code allows a debtor to confirm—or cramdown—a reorganization plan over creditors’ objections if certain criteria are met. One requirement is that, if secured claims are to be paid over time, the secured creditors must receive cash payments with both a nominal value and a present value at least equal to their claims. This recognizes the economic reality that $100 today is worth more than $100 paid in $10 increments over 10 years.

Determining if the nominal value of a payment stream equals the face value of a claim is “attorney math,” e.g., simple addition.  But to create a future payment stream with the same value as a lump sum payment today requires establishing an interest rate that reflects the characteristics of those deferred payments—e.g., investment risk, duration, time value of money, etc.  If the interest rate is correct, then the discounted present value of the payment stream equals the nominal value of the claim today.  Simple, right? (If you are lost, try this explanation from Math Is Fun or a refresher from the Harvard Business Review.)

But how do you come up with an appropriate interest rate? The legal brains who wrote the Bankruptcy Code provided no practical, mathematical guidance, leaving lawyers and judges to muddle through on their own, or with the help of valuation experts. Confusion and litigation ensued.

The Formula Approach

To illustrate, in 1998 an Indiana couple bought a used truck for about $6,000. They financed the purchase at a 21% interest rate, ultimately ending up in bankruptcy owing over $8,000 on an old truck worth about $4,000. The couple wanted to keep their truck and pay the lender principal plus interest at what they felt was more reasonable rate of 9.5%. But the finance company held out for 21%, which it felt was needed to compensate for the high risk loan. The fight over the truck, and the interest rate, ended up before the Supreme Court in the seminal case Till v. SCS Credit Corp.

The Supreme Court adopted a “formula approach” for coming up with an interest rate, which people also refer to as—wait for it—the Till Method.  Under this approach, you build a cramdown interest rate from the ground up by starting with the prime rate and then adjusting  for factors such as the debtor’s circumstances, the nature of the proposed “loan”, and the duration and feasibility of the debtor’s plan. Add that all together and, viola, you have your cramdown interest rate.

But Till leaves a lot of unanswered questions.  (Why start with the prime rate and not a risk-free treasury bill, you might be wondering?) In a cliffhanger footnote, the Supreme Court itself pondered whether Till’s formula approach should be applied in the very different context of Chapter 11 cases, which often involve large commercial loans negotiated between sophisticated parties. That is an excellent question that a lot of bankruptcy professionals would like an answer to.

The Efficient Market Approach

While some cases have applied Till’s formula approach in the context of Chapter 11 cases, others have adopted a so-called “efficient market” approach.  The question these courts grapple with is what interest rate lenders in the market would charge on a similar new loan.  If an efficient market exists for the type of “loan” in question, in theory, you can look to the markets to tell you an appropriate interest rate that will compensate the lender for risk and the time value of money. While that is theoretically sound, one of the real world difficulties is that cramdown plans are inherently coercive, and there is no market for coerced loans.

Other Theoretical Approaches

Other approaches that are possible include a coerced loan approach, a presumptive contract approach, or a cost of funds approach.  The goal of all of these methodologies is the same, e.g., to create a concrete framework for applying present value theory.  For an in depth, academic discussion of all of these approaches, Northwestern University Law Review has published an excellent article.

No Easy Answers…

What is clear is that establishing a cramdown rate in a Chapter 11 case is going to be significantly more complex than simply applying a few qualitative adjustments to the prime rate or referencing some sort of “Blue Book” of cramdown interest rates.  To establish an appropriate cramdown interest rate requires knowing the legal jurisdiction you are in and the latest cases on the issue, and often, involving a financial expert to support your position.

Mette K.