What a Friday opinion. Earlier today, the Second Circuit issued its long-awaited decision on the appeal of three different creditor groups of Momentive Performance Materials’ 2014 confirmed plan of reorganization on issues including debt subordination, makewhole premium entitlement and cramdown interest rate. The Debtwire legal analyst team unpacks this precedent-setting opinion below.
In terms of outcome, the status quo is pretty much left in place, though the legal holdings will have significant impact for cases in the Second Circuit. Today’s opinion affirmed much of the Momentive lower courts’ outcomes—though it differed a bit on reasoning—which included rejecting a makewhole premium entitlement argument from noteholders. In rejecting their entitlement to the sum, the Second Circuit acknowledged a split in its view of redemptions with the Third Circuit’s recent makewhole decision in Energy Future Holdings.
But on one issue, the Second Circuit has remanded. In a creditor-side victory sure to dull the sting of forced take-back debt in the Second Circuit, the Court of Appeals rejected the straight application of the SCOTUS Till decision which applied a “formula” approach to cramdown interest rate—effectively prime rate plus 1%-3%. Acknowledging the differences between Chapter 13 and Chapter 11 debtors, the Second Circuit has adopted a two-step post-Till Sixth Circuit approach to calculating cramdown interest—if there’s an efficient market for replacement debt, figure out the market rate; otherwise, formula rate.
Lay of the land
As a refresher, the prepetition Momentive notes basically fell into three categories: (1) Senior-Lien Notes with first-liens and 1.5-liens whose indentures included a makewhole premium for redemptions before October 2015; (2) Second-Lien Notes that had “sprung” into their second-priority liens upon an exchange of certain Subordinated Notes; and (3) the remaining unsecured Subordinated Notes that were not exchanged into Second-Lien Notes.
Under the confirmed plan, Senior-Lien Notes received replacement notes equal to the present value of their claim (without makewhole) due to their rejecting vote (otherwise, they would have been cashed out without any payment on the makewhole), Second-Lien Notes took the new equity, and Subordinated Notes got zilch. Notably, the interest on those replacement notes issued to the rejecting Senior-Lien Noteholders followed Till with a largely risk-free formula rate of treasury rate plus a risk factor—well below market.
In their appeals, Senior-Lien Noteholders wanted their makewhole premium paid and a market rate interest on their replacement notes while Subordinated Noteholders argued that they were not subordinated to the Second-Lien Notes after all, and thus deserved some recovery.
Don’t know what you’ve got Till it’s gone
We start with incendiary issue number one—cramdown interest rate. In the much dissected Till case, SCOTUS decided that, in a Chapter 13 case with respect to a USD 4,000 prepetition secured auto-loan that had a 21% interest rate, replacement notes could be issued with an interest rate based on a formula—prime rate plus some amount of calculated risk adjustment, usually between 1%-3%, based on the circumstances. SCOTUS explicitly rejected a market rate approach for this Chapter 13 debtor as those rates included lenders’ transaction costs and overall profits irrelevant in the cramdown scenario.
The Till opinion remarked that such an approach could also be applied in Chapter 11 cramdown scenarios, but then also noted in the famous footnote 14 that Chapter 11 might also require consideration of the fact that an efficient market for such debt may exist in that context and what interest rates that market would generate, a consideration not relevant for Chapter 13 debtors. Notably, while the Momentive lower courts adopted Till for the Chapter 11 cramdown context, in In re American HomePatient, Inc., the Sixth Circuit applied Till only when an efficient market did not exist.
For the Momentive replacement notes, that Till formula meant “interest rates of 4.1% and 4.85%,” which were below the alleged market interest rates at the time of roughly 5-6+%. Importantly, the Second Circuit noted that Momentive had in fact made efforts to obtain exit financing at those market rates should the Senior-Lien Noteholders have accepted the plan and chosen the cash option.
“We adopt the Sixth Circuit’s two-step approach, which, in our view, best aligns with the Code and relevant precedent,” the Second Circuit announced today. “[D]isregarding available efficient market rates would be a major departure from long-standing precedent dictating that the best way to determine value is exposure to the market.” (internal quotation omitted) Thus, the Second Circuit remanded to the bankruptcy court to “ascertain if an efficient market rate exists and, if so, apply that rate, instead of the formula rate,” which Senior-Lien Noteholders argued could give them USD 150m more than the plan had offered.
Maturity nixes redemption
But when it comes to the makewhole issue, the Second Circuit stuck by the lower courts. In sum, the reasoning was as most expected it to be before that bombshell Third Circuit Energy Future Holdings decision that changed the game—bankruptcy acceleration makes any post-bankruptcy payment on the debt a post-maturity payment which is not a redemption that would trigger a premium.
In Momentive, the Senior-Lien Notes indentures contained clauses that triggered payment of a makewhole premium if Momentive redeemed the notes at its option prior to 15 October 2015. That premium was neither paid nor accounted for the issuance of replacement notes via the October 2014 plan. The lower courts found that the redemption was a post-maturity event due to the acceleration of the maturity date by the bankruptcy, and thus could only be payable if the premium was explicitly triggered by the act of acceleration. The acceleration clause noted that upon acceleration, “premium, if any” would be due, which the lower courts did not find to be sufficiently explicit to trigger payment of the makewhole premium at an accelerated maturity date.
Citing its previous reasoning in In re AMR Corp., the Second Circuit held that redemptions are pre-maturity date payments, and that since the bankruptcy accelerated the maturity date to the petition date, payments made under the plan were incapable of being redemptions. While AMR spoke specifically to premiums triggered by “prepayments,” not “redemptions,” the Second Circuit—unlike the Third Circuit in EFH—found no distinction.
Further, even if a redemption were possible following the maturity date, the Second Circuit found that such redemption here was not at Momentive’s “option.” “Rather, the obligation to issue the replacement notes came about automatically by operation of separate indenture provisions, the Automatic Acceleration Clauses. A payment made mandatory by operation of an automatic acceleration clause is not one made at [Momentive’s] option.” Thus, as the payment was no longer optional, even if the “premium, if any” language in the acceleration clauses was sufficiently explicit, it could not revive the redemption premium as it did not come due under the specific terms of the redemption clauses.
Finally, the Second Circuit held that the Senior-Lien Noteholders’ contractual right to rescind acceleration and clear the maturity obstacle would have required relief from the automatic stay. “Therefore, just as in AMR, because the right to rescind acceleration here would serve as ‘an end-run around their bargain by rescission,’ the lower courts correctly concluded that the automatic stay barred rescission of the acceleration of the Notes.”
Ambiguous, yet still subordinate
Let’s get a bit deeper into the indentures. The Subordinated Noteholders argued that they were not in fact subordinated to the Second Lien Notes under the fourth exception to the definition of Senior Indebtedness contained in the indentures. The lower courts disagreed, finding the indentures unambiguous. While the Second Circuit disagreed about the ambiguity of the indentures, it came to the same result as the lower courts through extrinsic evidence.
In the applicable 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,” and the fourth exception to this definition was “any Indebtedness or obligation of the Company . . . 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.” Appellants argued that because the Second Lien Notes were junior in lien priority to other Momentive debt—the Senior-Lien Notes for instance—it was exempted under this proviso from being Senior Indebtedness with respect to the Subordinated Notes.
The lower courts, bending around the “in any respect” language in the exception, found that the exception unambiguously referred to payment priority, not lien priority. The Second Circuit, however, did not agree “that the Fourth Proviso unambiguously incorporates a distinction between lien subordination and payment subordination” and thus found the language ambiguous as there was no way to read the indenture without one provision making another superfluous.
The Second Circuit thus moved to extrinsic evidence that: (1) Momentive “repeatedly represented to the Securities Exchange Commission and to the financial community that the Second Lien Notes were Senior Indebtedness;” and (2) “the Subordinated Notes holders’ interpretation [(a)] generates the irrational outcome that the springing of the Second-Lien Notes’ security interest . . . would actually strip those notes of their status of Senior Indebtedness,” and (b) “would mean that no senior notes classes would qualify as Senior Indebtedness because each was secured in some respect by a junior lien.” Thus, in light of that evidence, the Second Circuit resolved the ambiguity by holding “that the most reasonable interpretation of the Indenture is that the Second-Lien Notes are Senior Indebtedness.”
No mootness for slight tweaks
Finally, the debtors had hoped to avoid all this with a ruling that the appeals had become equitably moot. While appeals of substantially consummated reorganization plans are assumed to be moot, the Chateaugay II factors can overcome that presumption in the Second Circuit. Those factors consider the possibility that effective relief can be ordered that will not affect the debtor’s re-emergence or unravel intricate transactions. A showing that the appellants did everything they could to stay the effectiveness of the plan also helps in the Chateaugay II analysis.
Here, it was undisputed that the appealing creditors tried to stay the plan with everything they had—seeking extended stays at every rung of the appellate ladder following confirmation. “Thus their diligence is not in question,” the Second Circuit remarked.
But while the debtors argued that failing to dismiss the appeals as moot would mean facing “cascading effects of rewriting the plan,” the Second Circuit held that due to “the limited nature of the remand . . . we do not believe these concerns will materialize.” Specifically, a reevaluation of replacement note interest “might require, at most, USD 32 million of additional annual payments over seven years” and not the “nearly USD 200 million . . . [that] would be required to pay the Senior-Lien Notes holders’ makewhole premium.” Further, no redistribution would be needed as the Court affirmed the lower courts’ decisions on subordination. Thus, “[g]iven the scale of the Debtors’ reorganization,” the Court was “not persuaded that a payment of, perhaps, USD 32 million in annual payments over seven years . . . would unravel the plan, threaten Debtors’ emergence, or otherwise materially implicate the concerns identified in Chateaugay II.”
For a 30-page opinion, it certainly packs quite a punch. First, it is a clear victory for secured creditors on the issue of cramdown interest, thwarting any Second Circuit debtors from forcing creditors into below-market paper should such a market exist. Effectively, for the Senior-Lien Noteholders, this decision could lead the bankruptcy court to collapse the value delta between the two options these holders were given under the plan–cash now without makewhole or replacement notes without makewhole—by basically forcing these noteholders into the position of the exit lenders that would have been required had the Senior-Lien Noteholders taken cash. It’s clear protection for secured creditors in the Second Circuit.
On the other hand, where contested, confirming a plan issuing replacement notes could lead to lengthy and expensive factual trials over the existence of a market and an appropriate rate, which the Second Circuit acknowledged. “We understand that the complexity of the task of determining an appropriate market rate will vary from case to case. But, at the end of the day, we have no reason to believe the task varies materially in difficulty from the myriad tasks which we regularly rely on the expertise of our bankruptcy courts to resolve.” Notably, a debtor’s own attempt to secure exit financing might be key evidence of the appropriate rate in these inquiries.
Second, we now have a circuit split between the two key bankruptcy jurisdictions on whether redemptions are possible after a debt’s acceleration. In the Third Circuit, redemptions can happen at any time, and seemingly any postpetition refinancing of a debt within the redemption premium schedule of the original indenture would trigger a premium unless the acceleration language explicitly excepted the payment of the premium. In the Second Circuit, however, should a debt accelerate upon filing of the bankruptcy—which it often does under the documents—optional redemptions are over as (1) payment is now mandatory, not optional and (2) redemptions are really just prepayments by another name. Thus, expect debtors with significant makewhole exposure to give a lot of consideration to an SDNY venue.
That is, unless and until SCOTUS is presented with, and decides to resolve, this split.
Jack is a former practicing restructuring attorney and Debtwire’s Head of Legal Analysis for the Americas. Prior to joining Debtwire, Jack practiced in the New York offices of Akin Gump Strauss Hauer & Feld LLP and Willkie Farr & Gallagher LLP. He has represented debtors, official committees and ad hoc groups in several high-profile restructurings.
Any opinion, analysis or information provided in this article is not intended, nor should be construed, as legal advice, including, but not limited to, investment advice as defined by the Investment Company Act of 1940. Debtwire does not provide any legal advice and subscribers should consult with their own legal counsel for matters requiring legal advice.
 To reflect the time-value of money, inflation and the risk of non-payment only.
 Recall, this was after the Bankruptcy Court bumped up the initially proposed rates as the debtors’ rates pegged the interest on the treasury rate, not the prime rate, which reflects additional risk. The District Court rejected the argument that the prime rate should have been used to begin with.
 “And, as the First-Lien Notes holders concede,” the Second Circuit pointed out, “the plain meaning of the term redeem is to repay a debt security at or before maturity.” (internal quotation omitted)
 What if the documents don’t and it’s only the operation of the law—the nature of bankruptcy—that accelerates the debt? No answer here, but we don’t see a reason why the Second Circuit’s ruling today isn’t equally applicable to acceleration by operation of bankruptcy law.