United States: Second Circuit Rules On Chapter 11 Cram-Down, Make-Whole, And Subordination Issues

In Short

The Situation: In In re MPM Silicones, L.L.C., secured noteholders argued that replacement notes distributed to them under a cram-down chapter 11 plan should bear market-rate interest rather than the lower formula rate proposed in the plan and that they were entitled to a make-whole premium.

The Result: The U.S. Court of Appeals for the Second Circuit reversed in part lower court orders, ruling that new notes issued under the chapter 11 plan could not provide for below-market interest rates, since it was demonstrated that "efficient markets" existed that could be used to determine appropriate rates, but affirmed the lower courts' disallowance of the make-whole premium.

Looking Ahead: The decision provides important guidance regarding the appropriate rate of interest on replacement notes issued under a cram-down chapter 11 plan.

In In re MPM Silicones, L.L.C., Nos. 15-1682 et al. (2d Cir. Oct. 20, 2017), the U.S. Court of Appeals for the Second Circuit reversed in part an order confirming the chapter 11 plan of Momentive Performance Materials Inc. and its U.S. affiliates (the "debtors"), concluding that new bonds issued under the plan could not provide for a below-market interest rate. The Second Circuit affirmed two other rulings of the lower courts, one denying the noteholders' claims for $200 million in make-whole payments and the other rejecting arguments by subordinated noteholders who sought to improve their priority.

Background

In 2012, the debtors issued $1.35 billion of first-lien and mezzanine notes. The note indentures provided for the payment of make-whole premiums under certain circumstances and stated that, unless the debtors' obligation to pay the make-whole premiums was triggered, they could not voluntarily redeem the notes before October 2015.

The debtors filed for chapter 11 protection in April 2014. Their proposed chapter 11 plan provided that if noteholders rejected the plan, they would receive replacement notes bearing a below-market interest rate and the right to litigate their entitlement to the make-whole premiums. The noteholders rejected the plan and argued that they were entitled to a market interest rate as well as the make-whole premiums. Subordinated noteholders also objected to the plan, arguing that under their indenture, they were not subordinate in right of payment to second-lien noteholders.

With regard to the interest rate, the lower courts ruled against the noteholders. Citing to the U.S. Supreme Court's plurality opinion in Till v. SCS Credit Corp., 541 U.S. 465 (2004), the lower courts held that section 1129(b)(2) is satisfied by a plan that provides a secured creditor with a replacement note bearing interest at a risk-free base rate, plus a risk premium that reflects the repayment risk associated with the debtors (but excluding any profits, costs, or fees)—known as the "formula" or "prime-plus" rate method. Although Till involved a case under chapter 13, the Court suggested that the "formula" method might be applicable in chapter 11 cases.

The Second Circuit's Holdings

The Second Circuit reversed. Noting that the Supreme Court never conclusively stated in Till that the formula method should be applied in chapter 11 (and noted that the approach might not be suited to chapter 11), the Second Circuit adopted a two-step approach articulated by the Sixth Circuit in In re American HomePatient, Inc., 420 F.3d 559 (6th Cir. 2005). Under that test, "the 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." Because the noteholders presented evidence of the existence of a sophisticated market for cram-down loans, the Second Circuit concluded that, consistent with Till, a market rate is "preferable to a formula improvised by a court" and remanded the case below for additional findings on whether "an efficient market can be ascertained, and, if so, [to] apply it to the replacement notes."

Regarding make-whole premiums, the Second Circuit denied the noteholders' claims, reasoning that the bond indentures did not "clearly and unambiguously" provide for make-whole payments when the debtors filed for chapter 11, and that bankruptcy default and automatic acceleration did not equate to prepayment of the notes

Finally, in rejecting the appeal by the subordinated noteholders, the Second Circuit offered grounds different from those applied by the lower courts, which had concluded that the indenture was not ambiguous. Based on its review of the indenture, the Second Circuit determined that the language was in fact ambiguous, finding that two provisions of the indenture could not be reconciled without one of the provisions being rendered superfluous. Because the indenture was open to differing reasonable interpretations, the Second Circuit looked to extrinsic evidence, such as prospectuses, 8-Ks, and 10-Ks, which ultimately supported the lower courts' interpretation that the subordinated notes were in fact subordinate in payment to the claims of second lien lenders.

Three Key Takeaways

  1. In its reversal, the Second Circuit noted that the Supreme Court never conclusively stated in Till that the formula method should be applied in chapter 11 (and noted that the approach might not be suited to chapter 11).
  2. The Second Circuit adopted a two-step approach articulated by the Sixth Circuit in In re American HomePatient, Inc. Under that test, "the 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."
  3. The Second Circuit affirmed two other rulings of the lower courts, one denying the noteholders' claims for $200 million in make-whole payments and the other rejecting arguments by subordinated noteholders who sought to improve their priority.

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