On October 20, 2017, the United States Court of Appeals for the Second Circuit issued its long-awaited decision in Momentive, bringing much-needed clarity to some of the most important issues facing secured creditors of bankrupt businesses. In an apparent split decision for secured creditors, the Second Circuit ruled that:
“Cramdown” Chapter 11 plans must provide secured creditors with a “market rate” of interest (at least where an efficient market for similar instruments exists), rather than the generally lower “formula” interest rate; but
Under the particular language of the indentures at issue, the secured creditors were not entitled to collect their “make-whole” premium when receiving replacement notes under a Chapter 11 plan of reorganization because no “redemption” had occurred.
The decision also put another crack in the doctrine of “equitable mootness,” which previously often protected consummated chapter 11 plans from being substantially altered as a result of an appeal. That doctrine has come under steady criticism from a number of circuit courts in recent years, and appears to be less likely than ever to be applied to cut off appellate rights.
The genesis of the Momentive make-whole litigation was a classic Chapter 11 “deathtrap” plan. Momentive’s first lien and 1.5 lien noteholders had clauses in their indentures entitling them to a “make-whole premium” if their notes were prepaid. During the course of the bankruptcy case, the noteholders argued that the debtors were required to pay the make-whole claims, but the debtors disagreed. Hoping to circumvent the make-whole claims, the Momentive debtors proposed a plan of reorganization offering the two groups of noteholders a stark choice. If creditors accepted the plan, they would receive payment in full, in cash, of their principal and accrued interest, but they would waive their make-whole claims. If the secured creditors rejected the plan, they could litigate for their make-whole claims, but would be paid with new notes bearing a below-market interest rate rather than cash.
Both creditor groups voted to reject the plan and filed objections to the plan’s confirmation, arguing that the interest rates on the new notes were unacceptably low and that the issuance of the new notes constituted a prepayment that triggered the debtors’ obligation to pay the make-whole premiums. The bankruptcy court confirmed the plan over the creditors’ objections, holding that the admittedly below market-rate interest rates on the new notes were permissible under the “formula-based” (as opposed to market-based) approach to determining interest rates established by the Supreme Court in Till v. SCS Creditor Corp., 541 U.S. 465 (2004). The bankruptcy court also ruled that the debtors were not obligated to pay the make-whole premiums, finding that the issuance of the notes was not a prepayment under the indentures. On appeal, the district court upheld the bankruptcy court’s rulings. The creditors then took a further appeal to the Second Circuit, which largely reversed the bankruptcy court.
Where an efficient market interest rate is available, it should be used
Strangely, until quite recently the leading case on determining an appropriate interest rate for notes being issued under even multi-billion dollar cramdown bankruptcy plan was Till: a Chapter 13 case dealing with notes being issued to a creditor that had a loan secured by a pickup truck. In that case, a plurality (rather than a majority) of the Supreme Court endorsed a “formula” under which the interest rate for new secured notes issued under a cramdown bankruptcy plan is set at the prime rate plus a risk premium of typically between one and three percent. Needless to say, an appropriate interest rate for a truck loan may fall well short of the rate the market would demand on a risky loan to a troubled business. The Momentive Chapter 11 plan exploited this difference to compel dissatisfied creditors to accept below-market rate notes.
On appeal, however, the Second Circuit noted that the Supreme Court in Till “made no conclusive statement as to whether the formula rate was generally required in Chapter 11 cases.” Given that opening, and the well-established principle that “the best way to determine value is exposure to a market,” the Second Circuit decided that a different tact was in order. Adopting the approach originally developed by the Sixth Circuit, the court ruled that a “market rate should be applied in Chapter 11 cases where there exists an efficient market.” Only where no efficient market exists should Till’s “formula-based” approach be used.
Rounding out that analysis, and providing significant comfort to secured creditors, the Second Circuit quoted approvingly from Fifth Circuit precedent holding that markets are efficient where “they offer a loan with a term, size, and collateral comparable to the forced loan contemplated under the cramdown plan.” The court further observed that evidence provided by the creditors regarding the willingness of the credit markets to provide exit financing to the debtors—had it been credited by the bankruptcy court—would have been sufficient to establish the existence of an efficient market. Given the now well-developed market for bankruptcy exit financing, this approach suggests that bankruptcy courts in the Second Circuit will now generally find that an efficient market exists and therefore apply a market-based approach to determining a cramdown interest rate. If so, Till may finally be on the way out for major Chapter 11 cases.
The make-wholes fail, but a drafting solution may exist
After addressing the interest rate dispute, the Second Circuit turned to the question of whether the debtors would also be compelled to pay the make-whole premiums to noteholders. Ultimately the court held that they were not payable in this instance, but declined to adopt a bright-line rule against their payment. Instead, the Second Circuit observed that, under the terms of the governing indentures, the make-whole amounts were only due upon a redemption, which the court interpreted to mean as a pre-maturity payment. The notes’ maturity, however, had been accelerated by the debtors’ bankruptcy filing. Accordingly, the court found that the post-acceleration payment contemplated by the plan was not a “redemption” and therefore did not trigger the make-whole obligation.
On one level, the Second Circuit has created a seemingly important conflict with the Third Circuit, which recently considered a similar question in the Energy Future Holdings bankruptcy cases and concluded that the make-whole amounts would be payable. But there is perhaps less to the split than meets the eye: neither the Second Circuit nor the Third Circuit adopted a bright-line rule for or against the payment of make-whole claims as a matter of bankruptcy law. Instead, both decisions determined that it was a question of contract interpretation, and simply reached different interpretations of the indentures at issue. The solution, which is already being adopted, is simply to draft indentures to clearly provide for payment of a make-whole not only upon “early redemption,” but also in the event of a payment following an acceleration of the debt.
Equitable mootness takes another hit
Finally, the Second Circuit ruled that the appeal would not be dismissed as “equitably moot.” Equitable mootness is a court-created doctrine allowing for an appeal from a confirmed bankruptcy plan to be dismissed if granting any relief in the appeal would create inequitable results. Appellate courts generally note that where a reorganization plan has been “substantially consummated” (i.e., put into effect) an appeal may—but will not necessarily—become moot.
Courts often consider five factors in determining whether an appeal should be declared moot: (1) Can effective relief be ordered? (2) Would the relief affect the debtor’s emergence from bankruptcy? (3) Would the relief unravel intricate bankruptcy exit transactions? (4) Were affected parties able to participate in the appeal? (5) Did the appellant diligently seek to stay the plan? Disputes regarding mootness often boil down to whether an appeal would “knock the props out from under” a reorganization plan.
In Momentive the Second Circuit applied these factors and held that the appeal was not moot because the noteholders consistently prosecuted their objections to the plan and, upon its confirmation sought a stay. The court also found that compelling the reorganized debtors to pay up to “$32 million of additional annual payments over seven years” as a result of the make-whole premium would not jeopardize the Debtors’ reorganization.
On balance, Momentive represents a positive development for secured creditors of bankrupt businesses. First, it provides significant comfort (even if not an absolute guaranty) that they will be entitled to a market rate of interest on any takeback paper that they are compelled to accept. Second, even though the Second Circuit denied payment of a make-whole premium under the particular contractual language of the case, the court’s reasoning suggests that make-whole premiums would be enforceable if expressly payable upon acceleration. Corporate finance lawyers take note. Finally, Momentive further limits the circumstances in which equitable mootness will apply to cut off creditors’ appellate rights, even where a declaration that an appeal is not moot will impose additional liability on the reorganized debtors.