Handing down an opinion almost a year in making, the Second Circuit made four significant pronouncements pertinent to major corporate reorganizations. In an opinion on Oct. 20 by Circuit Judge Barrington D. Parker, the appeals court abandoned the so-called Till formula for calculating the rate of interest paid to secured creditors in a chapter 11 cramdown.
Instead, the circuit court said that the interest rate on a crammed-down debt obligation must reflect the higher market rate, if one exists.
Although the cramdown ruling was favorable to lenders, Judge Parker’s second holding was favorable to debtors because he held that a so-called makewhole premium is not earned on debt that was automatically accelerated by bankruptcy. The Second Circuit’s opinion on that issue is starkly in conflict with the Third Circuit’s Energy Future opinion from November 2016 holding precisely the opposite.
In a third ruling, again favorable to creditors, Judge Parker refused to dismiss the appeal under the doctrine of equitable mootness because the lenders had made every conceivable effort at obtaining a stay pending appeal.
Finally, the appeals court arguably engaged in appellate fact-finding in upholding the lower court’s conclusion regarding contractual subordination.
The MPM Silicones Chapter 11 Plan
Bond indentures often contain provisions calling for yield maintenance, or makewhole premiums, to compensate bondholders for having to reinvest at lower interest rates if the loan is repaid before maturity. The provisions are designed as disincentives to refinance when interest rates drop.
Indentures are not crystal clear on whether the makewhole is due if prepayment occurs in chapter 11 cases when the debt is accelerated automatically on bankruptcy. And so it was with MPM Silicones LLC, also known as Momentive Performance, when the company was confirming its chapter 11 plan in 2014.
In confirming the plan over the objection of secured lenders claiming entitlement to a makewhole, the bankruptcy court issued four major rulings: (1) The secured lenders were not entitled to a makewhole; (2) In being given a new debt obligation in cramdown, the secured lenders were not entitled to a market rate of interest under the Supreme Court’s Till decision from 2004; (3) The appeal was not equitably moot, and (4) Subordinated notes were indeed subordinated to second-lien debt and were therefore not entitled to any distribution under the plan.
The secured lenders deprived of the makewhole and the subordinated lenders took appeals, but the district court upheld the bankruptcy court in May 2015. The bankruptcy and district courts denied stays pending appeal, and the Second Circuit denied a stay for lack of appellate jurisdiction.
The ensuing appeal in the Second Circuit was argued on Nov. 9, 2016. A week later, the Third Circuit handed down Delaware Trust Co. v. Energy Future Intermediate Holding Co. LLC (In re Energy Future Holdings Corp.), 842 F.3d 247 (3d Cir.). Written by Circuit Judge Thomas Ambro, Energy Future reversed the two lower courts in Delaware, ruled that the makewhole was owing, distinguished a leading Second Circuit case denying a makewhole, eviscerated the bankruptcy court’s MPM Siliconesopinion, and said that makewholes are owing under typically written indentures.
As a consequence of Energy Future, filing a major chapter 11 case in Delaware is a nonstarter if there is potential liability for a makewhole. On the other hand, New York is an attractive venue after MPM Silicones.
Although there is a split of circuits, the makewhole issue is not a likely case for the Supreme Court to grant certiorari, because the outcome turns on interpretation of an ambiguous contract governed by state law. Consequently, the split will endure unless New York State’s highest court opines on that state’s law and functionally decides whether makewholes are earned after bankruptcy, an outcome as to which Judge Ambro made an educated guess on state law.
In ruling that no prepayment premium was owing, Judge Parker described the bankruptcy and district courts as construing the indenture to mean that makewholes are “due only in the case of an ‘optional redemption’ and not in the case of an acceleration brought about by a bankruptcy filing.” Judge Parker said, “We agree too.”
His ruling in that respect was cabined by the Second Circuit’s decision in In re AMR Corp., 730 F.3d 88 (2d Cir. 2013), where, Judge Parker said, the appeals court upheld denial of a makewhole and “rejected nearly identical arguments.”
To overcome the effect of automatic acceleration that was the key to denial of a makewhole, the creditors contended that they should have been permitted to deaccelerate the debt. Judge Parker rejected that argument too, saying that “the automatic stay barred rescission of the acceleration of the notes.”
Judge Parker gave the Third Circuit’s Energy Future opinion nothing more than a “but see” citation, without discussion of where Judge Ambro went wrong. Where the Third Circuit based its conclusion in large part on New York law, Judge Parker had no similarly detailed discussion.
Till Inapplicable in Major Chapter 11s
In Till v. SCS Credit Corp., 541 U.S. 465 (2004), a plurality of the justices on the Supreme Court said that the interest rate to be paid to a secured lender being crammed down in chapter 13 on a subprime auto loan is the prime rate plus an upward adjust of 1% to 3% to cover the time-value of money, inflation and risk. The plurality rejected the notion of pegging the interest rate to market rates, because there usually is none for that type of consumer loan.
Employing Till, the bankruptcy court gave two issues of secured debt interest rates of 4.1% and 4.85%, based on a prime rate of 2.1%, to which the judge added 2.0% and 2.75%, respectively, for risk.
In footnote 14 in Till, the plurality said that the chapter 13 formula may not be suited to chapter 11, where there may be a market for similar loans to large bankrupt companies. Judge Parker adopted the approach of the Sixth Circuit in In re American HomePatient Inc., 420 F.3d 559 (6th Cir. 2005), by departing from the Till formula if there is an “efficient market” for similar loans to companies in chapter 11. He said that American HomePatient “best aligns with the Code and relevant precedent.”
Preparing for the confirmation of its plan, MPM Silicones scoured the market because the company would have been required to cash out the secured lenders had they accepted a plan that offered them no makewhole. The lenders argued that they should be entitled to interest on crammed-down debt of between 5% and 6%, reflecting offers the company had received for loans to finance confirmation.
Without intimating what the result should be, Judge Parker remanded the case for the bankruptcy court to “ascertain if an efficient market rate exists and, if so, apply that rate, instead of the formula rate.” He said the lower courts erred “in categorically dismissing the probative value of market rates of interest.”
The debtor argued that the appeals court should dismiss the appeal on the ground of equitable mootness, because the plan had long since been implemented. Citing In re Chateaugay Corp., 988 F.2d 322 (2d Cir. 1993), Judge Parker said that the “chief consideration” is whether the “appellant sought a stay of confirmation.” If a stay was sought, the circuit will allow relief on appeal if it is “at all feasible” without knocking the props out from under the plan.
Because raising the interest rate to the level sought by the creditor would only increase the reorganized company’s costs by $32 million spread over seven years, Judge Parker said that the appeal was not equitably moot.
In that regard, like the issue we discuss next, the appeals court may have engaged in appellate fact-finding by concluding that a higher interest rate would not cripple the reorganized company financially. Some might contend that Judge Parker should have remanded the case for the bankruptcy court to decide whether the interest rate could be raised without disrupting the reorganized company’s finances.
Plan confirmation precipitated an intercreditor dispute regarding the contractual subordination of one debt issue that turned on the definition of “senior debt.” The erstwhile subordinated lenders constructed a sophistic but not frivolous argument to relieve themselves of the burden of subordination. Had they prevailed, they would have been entitled to a distribution under a plan that otherwise offered them nothing.
Finding the indenture to be unambiguous, the two lower courts agreed that the debt indeed was subordinated. Judge Parker reached the same conclusion, but he said the indenture was ambiguous.
In contract or statutory interpretation, courts search for a meaning that renders nothing superfluous. Any interpretation of the indenture, Judge Parker said, would result in making some words superfluous. “Where, as here, varying interpretations render contractual language superfluous, we are not obligated to arbitrarily select one as opposed to another,” the judge said.
The differing reasonable interpretations made the indenture “ambiguous as a matter of law,” Judge Parker said.
When a contract is ambiguous, courts look to extrinsic evidence. Judge Parker then cited the numerous instances of SEC filings and other public statements before bankruptcy where the debtor said that the debt was subordinated. In what arguably amounts to appellate fact-finding, he said it “was widely understood in the investment community that the Second-Lien Notes had priority.”
Judge Parker rejected another argument that, he said, would result in an “irrational outcome.” That argument was based on the notion that the granting of a security interest to the senior debt resulted in taking away senior status.
Upholding the lower courts on a different theory, Judge Parker had “little trouble concluding that extrinsic evidence establishes that the most reasonable interpretation of the indenture is that” the notes qualify as senior debt.
Evidently, Judge Parker believed that the record supported only one conclusion and that any other finding by the bankruptcy court would have been clearly erroneous. Perhaps it would have been better had he said so, to avoid the accusation of appellate fact-finding.
Regardless of whether the record led to any other plausible conclusion, relying on public filings is akin to making a decision on an ambiguous statute based on legislative history. Led by the Supreme Court, the use of legislative history is out of fashion, because statements by legislators are not necessarily in tune with the statute.
Similarly, public filings can represent the debtor’s unilateral view about a complex transaction. Conceivably, a company could attempt to achieve a result by making SEC filings that it was unable to achieve in negotiating the transaction originally. Nonetheless, purchasers of securities in the secondary market are presumably aware of the issuer’s subsequent description of the transaction.
This feature of the opinion will add a significant new wrinkle to the business of buying distressed debt based a novel interpretation of an ambiguous provision in the deal documents. With the Second Circuit telling lower courts they can or perhaps should interpret creditors’ rights based on the debtor’s public statements, courts may be unlikely adopt interpretations that run afoul of the issuer’s pronouncements.
The Circuit Split
The Second and Third Circuits are now split on entitlement to a makewhole given language commonly used in some indentures. Unless the Second Circuit reverses course on a motion for rehearing or rehearing en banc, the split will persist.
The losing side in the Third Circuit had filed a motion for rehearing en banc, which was being held in abeyance by the appeals court pending the Second Circuit’s opinion in MPM Silicones. In the meantime, however, the parties settled; the rehearing motion was withdrawn; and the Energy Futuredecision became final.
Although the Second Circuit is loath to grant rehearing en banc, a motion for reconsideration by the entire circuit bench would not be a surprise. As occurred in the Fifth Circuit in Janvey v. Golf Channel Inc., 834 F.3d 570 (5th Cir. Aug. 22, 2016), the lenders pursuing a makewhole might ask on rehearing that the appeals court certify the underlying state law issue to the New York Court of Appeals, that state’s highest court.
However, state law was not so much a focus of Judge Parker’s decision as it was the Third Circuit’s Energy Future opinion, where the losing side was seeking certification to the state tribunal before the parties settled.