New Bankruptcy Challenges for Secured Creditors. The Bankruptcy Code provides secured creditors with significant advantages over their unsecured counterparts. During the past year, however, courts have chipped away at secured creditors’ rights in three important areas: enforcement of “make whole” provisions, protection against “cram downs” under a chapter 11 plan, and credit bidding.
“Make Whole” Payment Risks. Two recent decisions by courts in leading bankruptcy jurisdictions—Delaware and the Southern District of New York—have disallowed “make whole” premiums that otherwise would have been payable to secured noteholders. In re Energy Future Holdings Corp., 527 B.R. 178 (Bankr. D. Del. 2015); In re MPM Silicones, LLC (“Momentive”), 2014 Bankr. LEXIS 3926 (Bankr. S.D.N.Y. Sep. 9, 2014), aff’d case no. 14 CV 7471 (VB) (S.D.N.Y. May 4, 2015). A “make whole” premium compensates a creditor for the value of future interest income lost when a borrower repays prior to maturity. Typically, the borrower must pay not only all principal and interest then owing, but also a premium based on the net present value of future interest payments that will not be paid as a result of early repayment.
In Energy Future, the debtor sought to use debtor in possession financing proceeds to prepay in full a series of 10% first lien secured notes. The debtor stood to benefit from the significantly lower interest rate (4.25%) for the debtor in possession financing, versus the 10% interest rate applicable to the notes’ interest. The notes required payment of a “make whole” premium upon an optional prepayment. The debtor, however, claimed that it did not have to pay the “make whole” premium because its bankruptcy filing caused the immediate acceleration of the notes’ maturity. The indenture trustee for the noteholders commenced an adversary proceeding asserting that the debtor was liable to pay the “make whole” premium and simultaneously filed a motion seeking a declaration that it could de-accelerate the notes without violating the automatic stay provisions of 11 U.S.C. § 362(a).
The Energy Future court held that the indenture trustee could not rescind acceleration without violating the automatic stay. The court indicated, however, that the trustee may be able to seek relief nunc pro tunc from the automatic stay “to waive the default and deaccelerate the Notes,” which would have the effect of making the payment an optional prepayment—thus causing the “make whole” premium to be due. If the court denied the motion, or granted it without nunc pro tunc relief, then at most, the noteholders would have a damage claim for denial of the rescission right. The court determined that material facts needed to be resolved before it could determine whether cause existed to lift the automatic stay.
The Bankruptcy and District Courts in Momentive reached a similar result, even though the context was different from Energy Future. In Momentive, the debtors proposed a reorganization plan under which senior noteholders would be paid in full, but without approximately $200 million in “make whole” compensation for future interest through the original maturity of the notes. The senior noteholders objected, arguing that the plan violated the terms of the applicable indenture. The Momentive courts disagreed, holding that the bankruptcy filing resulted in an automatic acceleration of the senior notes. In order for the “make whole” premium to apply, the indenture needed to specifically provide that such a payment was due in the event of automatic acceleration. Absent such specificity, the noteholders had no enforceable claim to the “make whole” premium. Nor did the Bankruptcy Court allow the senior noteholders to rescind the automatic acceleration of the notes that occurred upon the bankruptcy filing, holding that the automatic stay barred de-acceleration.
Cram Down Interest Rates. The same Bankruptcy Court in Momentive also confirmed, over the objection of secured creditors, a chapter 11 plan that provided for interest at 2% over the risk-free Treasury rate, even though the debtors were not able to obtain comparable rates from replacement lenders. The District Court affirmed.
A chapter 11 plan may be confirmed over a secured creditor’s objection only if the plan satisfies the “cram down” requirements in Bankruptcy Code section 1129(b)(2)(A). Although the Code provides three alternatives for structuring a cram down, by far the most common is to provide the secured creditor with deferred payments “of at least the value” of the creditor’s claim, determined “as of the effective date of the plan.” This might suggest that in order to be crammed down, a secured creditor must receive installment payments whose total present value equals or exceeds that of its claim. Indeed, that is precisely what a four-justice plurality of the Supreme Court said in the landmark Till decision, which interpreted a similar provision in the Bankruptcy Code governing the confirmation of plans for individual debtors under chapter 13. Till v. SCS Credit Corp., 541 U.S. 465 (2004). The Supreme Court in Till, however, also held that “present value” does not include the lenders’ transaction costs or profits, but rather only what is required to compensate lenders for the risks of inflation and default. Although the Supreme Court did not specify the precise method for determining the compensation a lender should receive, it noted that courts “generally” had approved an adjustment of 1% to 3% over a comparable risk-free rate (such as prime).
Courts and commentators have pondered whether Till should govern cram downs in chapter 11 cases. The Supreme Court left this issue open in a footnote, which stated that “when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce.” 541 U.S. at 476 n.14. Relying on this footnote, a number of courts have held that, when considering whether to cram down a secured creditor, a bankruptcy court must first determine whether an efficient market interest rate can be determined. Only in the absence of such an efficient market should the court apply the Till approach. See, e.g., In re Am. Homepatient, Inc., 420 F.3d 559 (6th Cir. 2005). The Momentive courts disagreed, finding the Supreme Court’s footnote to apply only to the appropriate rate for debtor in possession financing, and not to a cram down under a plan. The courts also interpreted the 1% to 3% risk adjustment discussed in Till not as simply a general guideline, but rather as a specific range to use in chapter 11 cases “unless there are extreme risks” for the crammed down creditor. The correct cram down rate must be “premised on a base rate that is riskless, or as close to riskless as possible, plus a risk premium in the range of 1 to 3 percent, if at all, depending on the Court’s assessment of the debtors’ ability to fully perform the replacement notes.”
Momentive was not the first case to apply Till to a chapter 11 cram down, but it is clearly the most noteworthy. Although Momentive’s discussion of cram down interest rates has yet to be cited—favorably or otherwise—by another published decision, it is already having a material effect on how secured creditors and debtors view the threat of a cram down in chapter 11. The decision currently is on appeal to the Second Circuit.
Credit Bidding. Bankruptcy Code section 363 governs the sale of assets in a bankruptcy case. Section 363(k) permits a secured creditor to credit bid in a sale of its collateral, rather than bidding cash, “unless the court for cause orders otherwise.” While the Code does not define “cause,” courts historically have applied the exception sparingly, and usually only in the face of creditor misconduct, or bona fide disputes concerning the creditor’s claims or liens.
The Bankruptcy Court for the District of Delaware has held that “cause” existed to limit a secured creditor’s right to credit bid when it was necessary to promote a competitive bidding environment for a debtor’s assets. In re Fisker Automotive Holdings, Inc., 510 B.R. 55 (Bankr. D. Del. 2014). The court limited a secured creditor’s credit bid based on (i) evidence that “bidding will not only be chilled without the cap; bidding will be frozen” because the only competing bidder would not bid if the full amount of the credit bid was permitted, and (ii) a stipulation between the debtor and the creditors’ committee that the secured creditor’s claim was “partially secured, partially unsecured and of uncertain status for the remainder.” The court found these factors constituted sufficient cause to cap the credit bid at $25,000,000, which coincided with the amount the creditor had paid for the claim in the secondary market. The court noted that it “may deny a lender the right to credit bid in the interest of any policy advanced by the [Bankruptcy] Code, such as to ensure the success of the reorganization or to foster a competitive bidding environment.” Id. at 60, n.14.
The court in Free Lance-Star Publishing also limited credit bidding. 512 B.R. 798 (Bankr. E.D. Va. 2014). Prior to the debtor’s bankruptcy filing, a party with a “loan-to-own strategy” (“DSP”) acquired secured claims against the debtor. Unbeknownst to the debtor, DSP unilaterally filed liens on additional assets in which it previously did not have a security interest. DSP also aggressively pushed the debtor toward a bankruptcy process in which DSP would acquire the debtor’s assets through a credit bid.
In finding cause to limit DSP’s credit bid under section 363(k), the court held that “DSP’s overly zealous loan-to-own strategy” had “depressed enthusiasm for the sale in the marketplace [because p]otential bidders now perceive the sale of the business to DSP as a fait accompli.” Id. at 807. The court accordingly limited DSP’s total credit bid to a fraction of its claim, and did not allow DSP to credit bid on the assets in which DSP had unilaterally filed its lien.
To date, Fisker and Free Lance-Star do not appear to have resulted in wholesale limitations of a secured creditor’s credit bid rights. Nonetheless, both serve as cautionary tales for parties who acquire loans of distressed companies seeking to own the company. Despite section 363(k) generally permitting credit bidding, it is not an absolute right. If a court finds that a credit bid will dampen the likelihood of a robust auction, or that a secured creditor may have engaged in overly aggressive tactics, the court may limit the credit bid, or even potentially eliminate it, in order to advance the objective of fostering a competitive bidding environment.