Cram-up, take two: Efficient markets and forced-refinance interest rates

Yet another crucial distinction between New York and Delaware restructuring practice has emerged from the latest stage of the Momentive (MPM Silicones) case. The Second Circuit Court of Appeals in October 2017 dealt secured creditors both a surprising defeat and a potentially far-reaching victory, both in notable contrast to opposing positions taken in Delaware.

On the one hand, yield-maintenance, prepayment premiums triggered by automatic bankruptcy acceleration remain unenforceable in New York, as opposed to Delaware’s affirmation of such payments in the Energy Future Holdings case. This mild defeat for secured lenders can likely be avoided by simple redrafting of loan agreements and bond indentures, as noted a year ago in this column.

The potentially more significant victory lies in a departure from longstanding practice allowing debtors to refinance secured debt at rates largely divorced from market valuations. As noted in last year’s Q1 column, Momentive convinced the New York bankruptcy court to impose a restructuring plan on dissenting secured creditors, forcing them to accept full payment of their claims in the form of replacement bonds. These new bonds bore below-market interest rates artificially established by the court using a so-called “formula approach” developed by the U.S. Supreme Court, adding a 1 to 3 percent risk premium to a risk-free U.S. Treasury rate. This produced interest rates of about 100 basis points less than arms-length market rates available from and actually quoted by contemporaneous lenders, depriving the bondholders of between $150 to $200 million in future payments.

The bondholders won a mild but significant victory in challenging these depressed interest rates on appeal. Such a nonconsensual refinancing of secured debt is possible under the Bankruptcy Code only if the replacement bonds provide total payment equal to the full amount of the secured bond claims, valued “as of the effective date of the plan.” This statutory language is an inarticulate but intentional incorporation of the notion of present value; that is, payments to be made over time (via replacement bonds) have to be increased to account for the greater value of a payment in full immediately (as of the effective date of the plan). The generally agreed method of arriving at this present value is by identifying a discount rate (interest rate) that will reflect the time value of money, the risk of inflation, and the risk that the borrower in question might default before completing full payment.

The courts have long struggled with identifying the proper interest rate to reflect these factors, but also to avoid overcompensating secured bondholders at the expense of unsecured creditors and debtors’ reorganizations. US courts, including the Supreme Court, have clearly signaled their preference for market-based evidence of value and risk in the bankruptcy context, but they have also expressed concern that an otherwise healthy and efficient market might be skewed by the unique circumstances of a debtor forcibly refinancing defaulted obligations in bankruptcy.

So, for example, the U.S. Supreme Court in 2004 in a case called Till v. SCS Credit Corp dealt with a similar context involving reorganization of an individual’s affairs under chapter 13 of the Bankruptcy Code. Establishing the proper approach to “cram down” replacement financing of a subprime auto loan, the court concluded that the distressed debt market did not accurately reflect the desired rate for a forced-refinancing in bankruptcy because market rates included such factors as transaction costs and profits, which should be excluded from the establishment of a court-implemented and supervised refinancing. Instead, a divided court directed lower courts to begin with a risk-free rate, such as the prime rate (or similar maturity U.S. Treasury bills), and add a risk factor of 1 to 3 percent to account for the specific debtor’s risk of default. This ruling was confined to the individual reorganization context, but the court wondered aloud in a much-debated footnote whether in a Chapter 11 business reorganization case “it might make sense to ask what rate an efficient market would produce.”

While most lower courts after Till simply extrapolated the “prime+” formula to Chapter 11 reorganization cases, the Second Circuit in the Momentive case took up the Supreme Court’s suggestion and directed the Bankruptcy Court to explore “if an efficient market rate exists and, if so, apply that rate, instead of the formula rate.” The Momentive court noted with seeming approval the bondholders’ expert evidence “that, if credited, would have established a market rate.” Momentive had sought exit financing to pay off its bonds in full, and the rates quoted in this search exceeded the formula rate by about 100 basis points. The court acknowledged that this evidence did not lead to an undisputed conclusion of an efficient market rate, but by directing the lower courts to consider the possibility, the Second Circuit set the stage for a radical transformation of cram-down interest rate calculation in New York and a potentially substantial redistribution of value to secured bondholders, away from unsecured creditors and reorganizing estates.

The battle is far from over, and the victory may be Pyrrhic. Vast sums will now likely be spent on competing economics and finance experts offering theoretical argument about whether the market for Chapter 11 exit financing represents an “efficient market” and whether that market reflects the proper value (discount rate) for non-consensual refinancing of secured debt like that in Momentive. If free-market adherents win the day, debtors might be forced to pay substantially more to impose their refinancing plans on nonconsenting secured creditors.

On the other hand, if courts take the Supreme Court’s comments in Till seriously, the market rate for distressed debt may end up being simply a different starting point on a path to a similar destination. Even if, for example, the market quoted Momentive exit financing at higher rates, those rates very likely include factors that the Till court directed should be backed out, such as transaction costs and profit (though the bondholders’ expert predictably denied this, the bankruptcy judge seemed unconvinced), not to mention the skewed effects of a now-healthy debtor still bearing the stigma of its sojourn in bankruptcy. Add to this the lack of (positive) information the market could have absorbed about the reorganizing debtor, and it seems most likely that the “market” rate should be slightly reduced in light of such factors, just as the risk-free rate is increased to take into account actual risk in the Till formula approach. If the formula rate is generally calculated by increasing the risk-free rate by at least 100 basis points, it may well be that the unadjusted market rate should be reduced by at least that much, which is the spread under controversy in Momentive. Much ado about nothing?

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Jason Kilborn
Professor Jason Kilborn teaches business and commercial law at John Marshall Law School in Chicago.  His primary focus is on the comparative analysis of insolvency systems for individuals, though his interest extends to international bankruptcy as well. He recently co-authored a book on international co-operation in cross-border insolvency cases, published by Oxford University Press. Jason KilbornProfessor of LawUIC John Marshall Law School, Chicago300 S. State St. Chicago, IL 60604USAT: +1 (312) 386 2860+1 (312) 386 2860E: [email protected]W: Call Send SMS Call from mobile Add to Skype You'll need Skype CreditFree via Skype

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