Lenders rejoice. The Second Circuit recently issued its highly anticipated opinion in In re MPM Silicones, LLC, where it held that the appropriate cramdown interest rate in chapter 11 cases is the market rate (so long as an efficient market exists) rather than the formula rate applied by the US Supreme Court in individual debtors’ chapter 13 cases.
The opinion is significant considering that the Second Circuit encompasses the Bankruptcy Court for the Southern District of New York, which has traditionally been a common venue for many large chapter 11 cases. Where a secured claim is significantly large, even a small increase to the cramdown interest rate as result of applying the market rate can result in a substantial increase in the amount of deferred cash payments due to the secured creditor.
The Second Circuit’s opinion arose from an appeal taken by classes of senior lien noteholders that rejected the debtors’ chapter 11 plan. The plan had proposed to redeem the senior notes at par plus accrued interest, without payment of a makewhole, if the classes accepted the plan. The debtors had lined up exit financing to fund the redemption. If the classes rejected the plan, however, the plan proposed to repay their claims in full over time at a lower interest rate than the reorganized debtors would be paying to their exit lenders.
The bankruptcy court confirmed the chapter 11 plan through the cramdown provisions of section 1129(b) of the Bankruptcy Code, which allows a class of secured creditors to be crammed down if it receives deferred cash payments totaling at least the present value of the secured claims in the class. The debtors and the senior lien noteholders disputed the legal standard for determining the interest rate for calculating the amount of deferred cash payments needed to provide the noteholders with the present value of their claim.
The debtors argued, and the bankruptcy court and district court agreed, that the interest rate should be the “formula rate,” which equals the national prime rate (the rate a commercial bank charges a creditworthy commercial borrower), plus a plan-specific risk adjustment to the prime rate. Courts that have adopted this approach have generally approved a risk adjustment above the prime rate of 1% to 3%. Here, the bankruptcy court had approved a total interest rate under the formula approach of 4.1% for the first-lien noteholders and 4.85% for the 1.5 lien noteholders (who, together with the first-lien noteholders, comprise the senior lien noteholders). It was not disputed that these rates were below market in comparison with rates on comparable debt obligations.
The lower courts held that the formula rate applies because of the US Supreme Court’s plurality decision in Till v. SCS Creditor Corp., as well as an earlier Second Circuit opinion (also involving a chapter 13 debtor) in In re Valenti. In Till, the plurality rejected the market rate approach in the context of a cramdown for an individual chapter 13 debtor’s sub-prime auto loan. The Till plurality reasoned that market rates cover lenders’ transaction costs and overall profits, which the plurality said were not relevant in the context of a court administered and supervised cramdown loan. However, as it often does, the Supreme Court buried an important caveat in a footnote: “[T]here is no free market of willing cramdown lenders [in chapter 13 cases]. Interestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. Thus, when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce.”
Second Circuit Opinion
Seizing on the footnote in Till (and not even addressing its own Valenti opinion), the Second Circuit adopted the two-step approach of the Sixth Circuit in holding that the market interest rate is to be applied in chapter 11 cases unless there is no efficient market for determining the interest rate, in which case the court should apply the formula approach. Under this approach, an efficient market exists where, for example, it is possible to obtain a loan with a term, size and collateral comparable to the forced cramdown loan.
Although the Second Circuit stated it was not concluding that a market rate necessarily exists in the present case, it noted that the senior lien noteholders had presented evidence that, if credited, may establish a market rate. The evidence showed that, if the senior lien noteholders had accepted the plan, their treatment under the plan would have been to receive an immediate lump-sum cash payment. To prepare for that eventuality, the debtors had obtained quotes by lenders for proposed exit financing. The debtors were quoted rates between 5% and 6+%. The senior lien noteholders contended that they would receive around $150 million more under those rates than under the plan.
Ultimately, the Second Circuit remanded with the instruction that the bankruptcy court determine whether an efficient market rate exists and, if so, to apply that rate.
The Second Circuit’s holding as to the use of a market rate must now be followed by, among others, the Bankruptcy Court for the Southern District of New York. It will be interesting to see whether, in certain cases where the issue is significant, a debtor may engage in forum shopping to file its case in a jurisdiction that applies the formula approach. Even in the Southern District of New York, debtors will be even more sensitive to the potential for exit financing quotes to be used as evidence against them in establishing a market rate.