On May 4, 2015, the District Court for the Southern District of New York affirmed Bankruptcy Judge Robert D. Drain’s ruling confirming the chapter 11 plan of MPM Silicones, LLC. The holdings of the District Court and the Bankruptcy Court are likely to have wide ranging ramifications, because they decrease the bargaining position of secured creditors in plan negotiations, while increasing the rights of debtors and junior creditors in contentious chapter 11 cases.

I. Background 

On August 26, 2014, Judge Drain ruled on several plan confirmation issues, including, most notably, that the debtors, Momentive Performance Materials, a manufacturer of silicone and quartz products, had satisfied the cramdown requirements of section 1129(b) of the Bankruptcy Code even though the interest rate on the replacement notes delivered to the senior secured creditors was lower than a market interest rate. See Corrected and Modified Bench Ruling on Confirmation of Debtors’ Joint Chapter Plan of Reorganization for Momentive Performance Materials Inc. and its Affiliated Debtors, In re MPM Silicones, LLC, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014). The plan provided that the holders of first lien and “1.5” lien notes would receive long-term replacement notes based on a formula interest rate. Section 1129(b) of the Bankruptcy Code requires that a class of secured creditors that does not accept the plan must receive “deferred cash payments . . . of a value, as of the effective date of the plan, of at least” the allowed secured claim of the creditor. The fundamental question determined by Judge Drain and the District Court was whether the discount rate for determining the present value of the future payments should be a market rate of interest. In this case, unlike many other chapter 11 cases, there was a readily available market rate because other lenders had offered to provide an exit facility to take out the senior secured notes in cash. The holders of the first lien and “1.5” lien notes argued that the cramdown interest rate for the replacement notes should be equal to the market rate.

Judge Drain overruled their objections and applied the “formula approach” to calculating cramdown interest rate, holding that section 1129(b) simply does not require payment of a fair market rate. Based on the “formula approach,” Judge Drain ruled that providing the holders of first lien and “1.5” lien notes with replacement notes with extended maturities at a rate which imposed a slight risk premium on a risk-free base rate satisfied the Bankruptcy Code’s cramdown standards. In his opinion, Judge Drain rejected the notion that holders of the first lien and “1.5” lien notes were entitled to an interest rate that included any profit component and, effectively, determined that his ruling that the plan was feasible led to the conclusion that there was very little risk of default on the first lien and “1.5” lien replacement notes that had to be addressed with a risk premium.

Judge Drain’s ruling on the cramdown interest rate issue caused a stir among restructuring professionals on both sides of the debtor/creditor aisle as it opened the door for expanded strategies by debtors (oftentimes in concert with junior creditors) to cramdown the claims of secured lenders with long-term replacement notes at below-market rates.

In addition to the cramdown interest rate issue, Judge Drain also ruled with respect to the following issues: (1) the appropriate construction of a make-whole provision that did not expressly require payment of a premium when the debt was accelerated, and (2) the scope of a contractual subordination provision. Each of these rulings highlights the supreme importance of precise drafting in bond documents.

The District Court affirmed all of these rulings.

II. Cramdown Interest Rate

In addressing the cramdown interest rate, the District Court agreed with the debtors’ argument that the cramdown interest rate should be calculated according to the Supreme Court’s decision in Till v. SCS Credit Corp, 541 U.S. 465 (2004), which results in a rate that applies an appropriate “risk of nonpayment” premium on a risk-free base rate, and does not take into consideration market based rates which factor in a profit component. Till was a chapter 13 case and since it was issued, lawyers, experts and courts have disagreed about whether it should apply to cases under chapter 11. The Supreme Court in Till recognized that there is no ready market for “exit” loans in chapter 13 cases and indicated that maybe the court should look to a market rate if one exists.

The holders of first lien and “1.5” lien notes argued that the use of the formula approach to calculate the cramdown interest rate in chapter 11, especially where a competing market rate was readily ascertainable, violated section 1129(b) (or alternatively, that the plan incorrectly applied the formula approach). Relying on the reasoning in Till and Second Circuit precedent, the District Court held that the creditor is not entitled to be in the same position that it would have been in had it arranged a new loan on the effective date and the present value calculation should not include the profit component of an efficient market rate approach. The District Court also affirmed Judge Drain’s use of the 7-year Treasury rate as the base risk-free rate. Neither the District Court nor Judge Drain held that the Treasury bill rate is the only permissible risk free rate but the District Court held that it is a permissible rate with which to start the analysis. Accordingly, the plan, providing for long-term replacement notes at a rate based on the 7-year Treasury bill rate with a small adjustment to reflect the risk inherent in the particular circumstances of the Momentive restructuring, provided the present value to which the senior secured creditors were entitled even though it was a below-market interest rate.

The District Court’s decision affirming Judge Drain’s ruling solidified the momentum shift towards debtors (and junior creditors), providing them with significant leverage in plan negotiations with secured creditors. Secured lenders and purchasers of debt should take note of the impact of this decision on negotiations and projected recoveries in future chapter 11 cases (particularly those filed in the Southern District of New York).

III. Make-Whole Premium

The holders of the first and “1.5 lien” notes also objected to the plan on the grounds that, in accordance with their respective indentures, they were entitled to a make-whole premium because the debtors “repaid” the first lien notes and “1.5 lien” notes prior to the original maturity date pursuant to the plan, albeit with new notes and not in cash. To justify the make-whole claim, they referred to language in the indentures that provided: in the event of a bankruptcy, then, “the principal of, premium, if any, and interest on all of the notes shall become immediately due and payable.” Judge Drain overruled their objection, holding that (A) unless the parties have clearly and specifically provided for payment of a make-whole when the debt has been accelerated before the original maturity date of the notes, a make-whole will not be owed because the notes are not being prepaid or redeemed, and (B) the language cited above was not clear and specific enough. Judge Drain reasoned that in order to be entitled to the make-whole, the relevant language must be “either an explicit recognition that the make-whole would be payable notwithstanding acceleration of the loan or … a provision that requires the borrower to pay a make-whole whenever debt is repaid prior to its original maturity.” In re MPM Silicones, LLC, 2014 WL 4436335 *15 (Bankr. S.D.N.Y. Sept. 9, 2014). Judge Drain found the “premium, if any” language to be insufficient to “overcome or satisfy the requirement under New York law that a make-whole be payable specifically notwithstanding acceleration or payment prior to the original maturity date under the terms of the parties’ agreements.” Id. at 16.

The District Court, agreeing with the Bankruptcy Court, held that the holders of the first and “1.5 lien” notes were not entitled to a make-whole premium. The District Court reasoned that accelerating the balance of a loan forfeits the right to prepayment consideration because there simply is no prepayment: the notes became due as the result of the acceleration. This is true even if the acceleration results automatically as the result of the bankruptcy filing unless there is a clear and unambiguous clause that calls for payment of the make-whole premium even if the debt is accelerated as a result of such filing. Here, neither the acceleration clause nor the make-whole provision clearly and unambiguously called for the payment of the make-whole premium upon acceleration of the debt upon a bankruptcy filing, and therefore the holders of the first and “1.5 lien” notes were not entitled to the make-whole.

This decision highlights the importance not only of being precise when drafting and negotiating debt documents and, particularly make-whole premiums, but that creditors acquiring debt of distressed entities need to do assiduous diligence of the documents governing the credit. To obtain a make-whole payment upon the occurrence of a bankruptcy, the debt documents should expressly and unambiguously provide that the make-whole premium (or whatever other term the applicable documents use to define the make-whole obligation) would be paid notwithstanding the acceleration or advancement of the original maturity date of the notes as a result of the filing of a bankruptcy case.

IV. Subordination

The final issue affirmed by the District Court was, as the District Court described it, whether the second lien notes constituted “Senior Indebtedness” per the defined terms under the debt documents. The District Court agreed with the Bankruptcy Court that the second lien notes did constitute “Senior Indebtedness” per the defined terms under the debt documents, and, therefore, the fact that the Plan did not provide distributions to the holders of the subordinated notes did not violate the absolute priority rule relating to unsecured claims in section 1129(b) of the Bankruptcy Code. Under the relevant indenture, “Senior Indebtedness” was defined as:

all Indebtedness . . . unless the instrument creating or evidencing the same or pursuant to which the same is outstanding expressly provides that such obligations are subordinated in right of payment to any other Indebtedness of the Company[;] . . . provided, however, that Senior Indebtedness shall not include, as applicable:

4) any Indebtedness or obligation of the Company or any Restricted Subsidiary that by its terms is subordinate or junior in any respect to any other Indebtedness or obligation of the Company . . . including any Pari Passu Indebtedness.

The subordinated noteholders argued that this definition provided that “Senior Indebtedness” expressly excluded debt that was “subordinated in right of payment” or “subordinate or junior in any respect” to any other debt. The subordinated noteholders argued that the fact that the second liens were expressly subordinate to the first priority liens meant the second noteholders were subordinate or junior in respect of their liens. The District Court disagreed and explained that the definition of “Senior Indebtedness” only excluded indebtedness subject to payment subordination, not indebtedness subject to lien subordination, and therefore, the second lien notes, which were lien subordinated only, were not excluded from the definition. As a result, the group of subordinated bondholders owed approximately $382 million were not entitled to recover anything under the plan.

As with the make-whole ruling, the subordination ruling further underscores the need for precision when drafting debt documents. Additionally, creditors considering purchasing debt, in order to determine their rights and potential recovery under a chapter 11 plan, should carefully review the debt documents to evaluate their placement in any lien/payment order of priority.

V. Conclusion & Practice Pointers

The District Court’s debtor-friendly decision regarding the cramdown interest rate will likely fortify debtors’ and junior creditors’ efforts to strong arm secured creditors in plan negotiations and, potentially, undermine the recoveries of those secured creditors. Specifically, debtors and junior creditors will likely use this ruling to force secured creditors either to take paper with a lower interest rate or accept a discounted cash payment to avoid receiving notes with below market interest rates in plan negotiations. Original lenders and debt acquirers should be aware of (and price in to their credit and pricing decisions) the potential take-back paper they may be required to accept in a cramdown scenario. While there is an argument that this result is not new and that it is dictated by Till, courts have disagreed about the applicability of the formula rate analysis in chapter 11 cases up until now. There may still be room to argue for a market rate analysis but the fact that the District Court agreed with Judge Drain’s ruling and analysis will make this more difficult. Additionally, as noted above, the District Court’s decisions regarding the make-whole and subordination issues illustrate the importance of precise drafting of debt documents and underscore the notion that careful analysis of the terms and provisions of debt documents is imperative when evaluating the risks in buying paper in the secondary market.

The full and original memorandum was published by Gibson Dunn on May 14, 2015 and is available here.