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U.S. Appeals Court limits cramdowns on secured creditors

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Banks and other lenders scored an important victory Friday when a federal appeals court issued an opinion restricting a debtor’s ability to “cram down” a bankruptcy plan on senior secured creditors.

The decision by the U.S. Second Circuit Court of Appeals reversed a 2014 decision by the U.S. Bankruptcy Court for the Southern District of New York.

The appeals court ruled that Momentive Performance Materials should use what’s known as a “market rates” formula to determine the appropriate payout for a series of replacement notes to be issued to bondholders. Momentive’s Chapter 11 plan called for senior creditors to receive replacement notes bearing interest at substantially below market rates – an outcome that some argued could have made it more difficult for junk-rated companies to obtain financing at attractive rates.

“The alternative could have resulted in a road map for debtors to devise bankruptcy reorganization plans that cram down over-secured lenders with below market rate replacement notes rather than paying them in full, in cash,” the Loan Syndications and Trading Association, an industry trade group, said in a statement posted on its website.

While the senior creditors in this case were bondholders, the ruling applies to any kind of senior creditor, including banks and other kinds of lenders.

In 2012, Momentive, a silicone and quartz manufacturer controlled by Apollo Global Management, issued $1.1 billion of first priority senior notes due 2020 that paid 8.875% interest and $250 million of senior secured notes due 2020 that paid 10% interest. The company filed for chapter 11 in April 2104.

Its reorganization plan offered senior creditors a choice: They could accept new notes that paid lower interest (5% for long-term refinancing of the first-priority notes and 7% for bridge financing of the senior secured notes) and waive their right to a “make whole” provision entitling them to a premium on interest that would have accrued to maturity in the event of a prepayment. Alternatively, they would have to litigate their entitlement to the make whole provision and accept new notes paying even less – the applicable Treasury rate, plus a modest premium.

Holders of both classes of notes rejected the plan, but it was passed over their objections by the presiding bankruptcy judge. Judge Drain accepted the debtor’s argument that their proposed plan satisfied the cram as applied by the U.S. Supreme Court in a 2004 decision, Till v. SCS Credit Corp.

A U.S. district court subsequently upheld the bankruptcy court’s decision.

But the appeals court disagreed, ruling that Till did not compel the court to use the formula rate and concluding that if a market rate exists it should be used.

“We do not read the Till plurality as stating that efficient market rates are irrelevant in determining value in the Chapter 11 cramdown text,” the court’s opinion stated. “And, disregarding available efficient market rates would be a major departure from long-standing precedent dictating that ‘the best way to determine value is exposure to a market.’”

The LSTA filed an amicus brief alongside the Managed Funds Association and the Securities Industry and Financial Markets Association backing the use of market rates to more accurately determine the value of what was owed.

“The issue to us was it was fundamentally wrong,” said Elliot Ganz, senior counsel for the LSTA, in an interview. “Under [bankruptcy code] section 1129 you’re required to do something that’s fair and equitable and it seem to us that fair and equitable is not replacing par notes with a claim that is immediately significantly below par.

Although Momentive lost the decision over the rate formula, it won a bigger victory involving whether creditors could enforce “make whole” premiums on a bankruptcy filing. In that instance, the panel sided with Momentive and two lower court rulings that disallowed creditors from claiming they were due the make-whole premium that lenders normally receive from corporate borrowers who pay off loans early.

If Momentive wishes to appeal the market-rates decision, it can request an en banc hearing of the full court, or file for a review with the U.S. Supreme Court.

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Court cases Bankruptcy CDOs Loan Syndications & Trading Association Apollo Global Management