Introduction

When a company files for bankruptcy with the hope of refinancing its secured debt and reorganizing, it has the opportunity to propose a reorganization plan proposing how soon, in what amount, and in what manner creditors’ claims are paid. But a debtor does not have carte blanche to pay creditors however it wishes. A class of creditors not being paid in full may reject the plan, which will prevent confirmation on a consensual basis. Nonetheless, by satisfying additional requirements, a debtor can “cramdown” its plan on those creditors and obtain court approval of the plan.

Disputes involving “cramdown” frequently arise in the context of debtors seeking to refinance their secured debt at a lower interest rate in order to improve their cash position going forward. Needless to say, secured lenders aren’t thrilled at the prospect of being forced to accept an interest rate lower than they bargained for with their borrower. A recent decision by the U.S. Bankruptcy Court for the Southern District of New York in the bankruptcy case of Momentive Performance Materials Inc. has intensified this fear and put secured lenders and distressed debt investors on notice that there may be more risk on the horizon in bankruptcy cases.

Cramdown 101

The Bankruptcy Code provides a mechanism by which a debtor may confirm its plan over the dissent of an impaired class of claims or equity interests. This mechanism is termed a “cramdown” of a plan on those creditors taking such a haircut. Upon the debtor’s request, the court is required to confirm the plan over the objection of an impaired class of claims or interests if the plan does not “discriminate unfairly” and is “fair and equitable” with respect to each dissenting, impaired class of claims or interests.

In order to be crammed down, a debtor’s plan may discriminate in its treatment of similarly situated classes. However, it cannot be confirmed if it discriminates unfairly with respect to a dissenting class. Though courts employ different tests in determining whether a plan discriminates unfairly, a plan does not “discriminate unfairly” with respect to a dissenting class if the plan protects the legal rights of the class in a manner consistent with the treatment of other classes that hold similar legal rights.

To determine whether a plan discriminates unfairly, many courts ask whether the discrimination has a reasonable basis and is proposed in good faith, whether the debtor can confirm the plan without the discrimination, and whether the degree of discrimination is proportionate to its rationale.

Additionally, a cramdown plan must provide for the “fair and equitable” treatment of any impaired and dissenting class. The Bankruptcy Code establishes separate standards for determining whether a plan is “fair and equitable” with respect to an objecting class depending on whether the class is composed of secured claims, unsecured claims, or ownership interests.

In order for a plan of reorganization to be fair and equitable with respect to an objecting class of secured claims where the debtor is seeking to keep the collateral and provide replacement liens to the secured creditor, the plan must provide for the secured claimants to receive “deferred cash payments totaling with a present value equal to the secured claim.” In order to calculate the present value of deferred cash payments, it is necessary to estimate and apply an interest rate that properly reflects investment risk, duration, and the time value of money of the deferred cash payments during their expected time horizon. This becomes the critical issue in many bankruptcy cases.

Bankruptcy Court Rules That Secured Lender Could Be Crammed Down With Non-Market Cram Down Rate

In Momentive’s chapter 11 case, Momentive submitted a plan of reorganization proposing that secured noteholders voting in favor of the plan would be paid in full in cash, but would waive their make-whole claim. The plan also proposed that secured noteholders voting to reject the plan would merely receive replacement notes with a principal amount equal to their allowed make-whole claims bearing interest at the applicable Treasury rate, plus a small premium of 1.5% for certain first lien noteholders (for a total yield of 3.6%), and a premium of 2% for certain “1.5 lien noteholders” (an informal term applied to noteholders with priority below first lienholders but above second lienholders) (for a total yield of 4.1%).

Both groups of noteholders voted to reject the plan, and following a trial, the court was forced to decide whether the plan’s treatment of the claims satisfied the cramdown standard.  Momentive argued that its plan satisfied the cramdown guidelines set forth by the U.S. Supreme Court in a case involving a cramdown in a chapter 13 (an individual consumer case). In that decision, the Supreme Court ruled that the appropriate interest rate should be the “prime plus” or “formula” approach, which is calculated by taking the prime rate and adjusting it upward to account for risk of nonpayment.

The secured noteholders, however, argued that the Supreme Court’s formula approach was limited to chapter 13 cases where the proper market rate could not be easily determined. The noteholders argued that the appropriate interest rate for their replacement notes should be the market interest rate for loans of similar priority, which was ascertainable based on Momentive’s proposed exit financing facility.

The judge agreed conceptually with using the formula approach to determining the proper cramdown interest rate for the replacement notes, but denied confirmation of Momentive’s plan because Momentive’s proposed rates were slightly too low. The judge advised that the plan would pass muster if the rates were increased by 0.50% for the first lien replacement notes and 0.75% for the 1.5 lien replacement notes. The resulting rates, much to the lienholders’ dismay, were well below market rates.

Practical Implications for Lenders

The indenture trustees for the noteholders have appealed the bankruptcy court’s ruling, and secured lenders of every stripe are hopeful that the ruling will be overturned. Even if the decision is overturned, this decision in one of the nation’s busiest bankruptcy courts is unsettling for the commercial credit markets. Moreover, other bankruptcy courts may find the ruling persuasive and may use it as a template in other cases.

If the decision is upheld and/or advanced by other courts, secured lenders would understandably conclude that they have lost leverage in bankruptcy reorganization cases, causing a ripple effect in the market and leading to tighter underwriting standards, higher fees and increased interest rates.

Finally, this ruling could impact distressed debt investors who may be more cautious in purchasing distressed debt, and who may decide that the increased risk requires a higher price. Stay tuned for the results of the appeal and other decisions addressing this same issue.