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Tuesday, September 9, 2014

MPM Ruling Unwisely Endorses Till in Chapter 11

On August 26, Judge Drain, who sits in the White Plains courthouse in the Southern District of New York, delivered a surprising bench ruling confirming a plan of reorganization for the Momentive Performance Materials group of debtors ("MPM").   His rulings covered a number of issues, including interpretation of an inter-creditor agreement and denial of a make-whole premium to senior secured creditors, each of which was resolved against the senior secured creditors.  But probably the most explosive ruling, because it is not confined to the language of a particular contract, but, rather, presented as an interpretation of section 1129(B)(2)(A) of the Bankruptcy Code, was his expansive, almost literal, application of the Till plurality opinion to "cram up" the senior secured creditors with a below-market piece of 7-year paper.  

Judge Drain's analysis is noteworthy for four reasons.  First, the vast majority of Till-in-chapter-11 cases involve single-asset-real-estate or closely analogous fact patterns, in which the case is nothing more than a simple two-party dispute between the owner of the asset, who controls and dictates strategy to the debtor, and the mortgage holder, and there are no other significant creditor groups.  Rarely has any chapter 11 case involving a corporate group of debtors with multiple large creditor constituencies presented a Till litigation. 

Second, and a related point obviously, this is the first time a judge sitting in one of the main forums for complex chapter 11 cases has endorsed Till-in-chapter-11.  So it portends potential significance for future cases.  Judge Drain is a well-respected bankruptcy judge who practiced in an elite New York firm and his background will certainly give the analysis in his ruling more weight as a practical matter than a similar decision from a financially less-sophisticated judge or district (that said, Judge Drain has been known for a tendency to push the envelope in favor of junior constituencies -- see, e.g., the victory of the second lien bidder in the Westpoint Stevens 363 case (reversed on appeal at the District Court level, which reversal was then vacated by the Second Circuit on the ground the appeal had been moot under section 363(m)), or his decision in MacMenamin's Grill, that the safe harbor of 546(e) did not apply to private stock transactions (a distinctly minority view later rejected by the Second Circuit in Enron Creditors Recovery Corp v. Alfa).  

Third, his endorsement of Till conflicts with the decision of his fellow SDNY Judge Gerber in the DBSD case, who rejected, albeit with little explanation, a Till approach in the chapter 11 cramdown context.  As one of the creditor briefs (I forget which, sorry) summarizes the law in the Circuit: "There are four published Second Circuit decisions citing Till. Of those four decisions, only DBSD involved a corporate debtor and facts similar to this case and in that case Judge Gerber determined that Till was of limited value and that the market rate had to be considered. See DBSD, 419 B.R. at 209. The other three decisions in the Second Circuit all involved a single-asset real estate debtor and are thus inapposite to a complex chapter 11 case for the reasons set forth herein. Even so, two of those three decisions considered whether there was an efficient market before applying Till’s formula. See Mercury Capital Corp. v. Milford Conn. Assocs., L.P., 354 B.R. 1, 12 (D. Conn. 2006) (remanding confirmation order for determination of whether there was an efficient market for the debtor’s cramdown loan); In re 20 Bayard Views, LLC, 445 B.R. 83, 107-08 (Bankr. E.D.N.Y. 2011) (considering whether there was an efficient market before applying Till); but see In re Lilo Props., LLC, Case No. 10-11303, 2011 Bankr. LEXIS 4407 at *6 (Bankr. D. Vt. Nov. 4, 2011) (applying the Till formula without a discussion of whether there was an efficient market)."  Oddly (given that on the other issues his ruling cites decisions authored by Judge Gerber), Judge Drain ignored the DBSD conflict in his ruling, invoking instead bankruptcy court opinions from Vermont and EDNY.  

Last, the MPM reasoning departs from the main line of post-Till cases, which follow the American Homepatient line of reasoning that a court should look first to whether the relevant loan market is "efficient" and then, only if the answer is no, apply the Till formulaic approach.  Instead, Judge Drain applies the Till plurality approach in virtually undiluted fashion, as if it were settled law, rejecting the reference to the "rate an efficient market might produce" in footnote 14, and modifying the formula approach only to change the base on which the interest rate payable by the debtor was calculated to substitute a  "comparable Treasury" base for the "prime rate" base in the Till formula, in part because the pre-petition senior secured debt carried a fixed rate to begin with.

The Judge offers a remarkable twist on footnote 14, which I analyzed in this post.  Noting that Collier's and others have criticized the footnote for naively confounding DIP loans with exit financing, Judge Drain adopts their criticism, but uses it oddly, not as a means to discount Till as a chapter 11 precedent, but solely to discredit the footnote's reference to markets, leaving chapter 11 a non-market environment!  "In addition, there clearly was some form of market in the Till case. The market, in fact, had a lot of data behind it with regard to subprime auto loans. Nevertheless, the court referred to it as not a perfect market, when discussing those types of loans, for which Justice Scalia somewhat berated the plurality. But that fact, that the court again referred to a perfect market, underscores the notion that it wasn't really markets that was driving the court's analysis"

I have not seen this analysis in other post-Till cases.  As a description of Till, it is actually wrong; as I noted in my earlier posts, the interest rate in Till was the usury rate in Indiana, not a rate that moved up or down as the prime rate or LIBOR-based rates do.  That was why the creditor in TIll advocated for the "presumptive contract" approach, not the "coerced loan" approach, a change in tactics that the Supreme Court noted at the outset of argument, and it led to a key colloquy with Justice Breyer that, in my opinion, ensured he voted for the debtor, because he recognized that, under the creditor's approach, the rate would not change post-confirmation, even though the debtor had supposedly been rehabilitated, and that, in his mind, denied the debtor the benefit the statute was meant to provide. And most obviously, from a real world perspective, the leveraged loan market in 2014 is a lot more competitively priced than the subprime auto loan market has ever been.

As I put up 12 posts on Till-in-chapter 11 back in January, going through Till's facts, the briefs, the oral argument, the plurality opinion and the concurrence of Justice Thomas, as well as the post-Till application of the plurality opinion in some chapter 11 cases and offered evidence of the efficiency of the commercial loan markets, I think this is a subject where I might add some value.  So, although I always enjoyed practicing alongside the Judge when he was in private practice and in front of him since he took the bench,  I am going to briefly explain why this aspect of his decision in MPM is not well founded.

Like all opinions extending Till to chapter 11, Judge Drain observes that the language of 1129(b)(2)(A)(i) is identical to the language in 1325(a)(5)(B)(ii), the section at issue in Till, and further that the plurality opinion said that courts should take "essentially the same approach"  to the two sections.  As I explained earlier this year, that is a correct observation, but it does not necessarily mean quite what the advocates of Till-in-chapter-11 take it to mean.
First of all, the remark "essentially the same" obviously leaves room for differences between the two, depending on how strictly you read "essentially" and how you characterize the Till opinion (I show in my January posts, summarized below, that it is chapter-13-specific, which implies that the correlative section in chapter 11 should be interpreted in the context of chapter 11).  One vital fact overlooked by pretty much every analysis of the two sections is that the chapter 11 appearance of the wording appears in a clause subordinate to the well-developed phrase "fair and equitable", while the chapter 13 section contains no mention of "fair and equitable".  Fairly plainly, I think, this signals that Congress intended the chapter 11 version to be interpreted in the same vein as then-existing "fair and equitable" precedents, while its omission of the phrase from the chapter 13 context perhaps affords more leeway to plans and judges.  So the most informed way to understand the "essentially the same approach" remark is that the endorsed approach is chapter-focused; one interprets the language in 11 in the context of the entire chapter and interprets the language in 13 in the context of that chapter.

Second, the remark appears right at the beginning of the legal analysis  and appears to be utterly prefatory, as it is not followed by any development of what the "approach" had been in chapter 11.
Third, neither in the Till opinion nor in its oral argument and briefs was there any discussion of what either section meant, only how the chapter 13 version of it was to be practically applied.   For example, the Solicitor General's brief in Till, which clearly served as a source for much of the plurality opinion's reasoning, states quite emphatically: "Disputes over present value and discount rates concern how courts should calculate that equivalence. Language quoted from Sections 361(3) and 1129(b)(2)(A)(i) does not in any way answer that question."  (Emphasis added).
So, for me, it is difficult to give much weight to the plurality's  remark that the two sections require essentially the same approach when the remark was neither preceded nor followed by any significant exposition of what either section meant.  Rather, the remark is better seen as an effort -- naive or disingenuous, the reader may pick -- on the part of the justices in the plurality to portray their approach as consistent with prior law, not as a departure therefrom.  I tend to go with the "naive" version -- I don't think they were trying to rewrite the historic standard that secured creditors have to get full value; I think they believed they were adopting a pragmatic approximation of that standard that was appropriate for the unique characteristics of chapter 13 cases.

As I explained,  and as anyone who goes back and reads the opinion critically and examines the oral argument and briefs can confirm, the Till decision is not in the slightest based on a textual analysis of the words of the statute, but is entirely driven by chapter-13-specific concerns about ease of administration and pragmatic allocation of the burden of trial when one party, the debtor, is unable to pay for adequate representation.  (Plus, the usury context noted above, that appears to have influenced Justice Breyer)   So I don't think it's reasonable to infer that the Court was establishing chapter 11 policy, and indeed, it would have been a ridiculous step to do so in a case where the subject was not presented in the grant of cert or the briefing.

I think this point really needs to be emphasized.  At the time the Bankruptcy Code was enacted in 1978, the leading cases on cramdown strongly protected the secured creditor's right to be compensated for any alteration the chapter 11 plan might work in its right to payment in full,  so long as the collateral value was there.  Even an extension of maturity was a basis to receive value.  Go back and read the exposition I laid out in January of the leading case on a creditor's rights in the face of cramdown at the time the Code was adopted, Consolidated Rock Products, to confirm that.  There is no sign in the Code, nor in the legislative history leading up to it, that Congress intended to depart from the concept of full recovery, in economic substance, on the secured claim when it enacted the Code in 1978.  And in Till, there was absolutely no contention in the briefs or oral argument that 1129(b) authorized delivery of secured debt having a present value less than a 100% recovery on the secured claim.   So it is extremely implausible -- one has to be almost to believe in a secret conspiracy of some kind -- to contend in the face of such widespread silence that 1129(b) changed the law to authorize delivery of secured debt with a present value less than 100 cents of the secured claim.  How did this come to pass with no discussion of any kind by anyone in any branch of government?  There is no answer, of course.  Yet here we are with numerous lower courts adopting such a view based on some dictum in a plurality opinion.  That sort of shallow thinking is the reason I wrote the posts on Till earlier this year, and why I write this one.

Judge Drain's ruling goes on to note, correctly of course, that the plurality opinion rejected a "coerced loan" or "forced loan" approach, and infers that he is required to do the same.   Unfortunately, that is a superficial line of reasoning.  One ought to look at the reasons why the plurality rejected that approach.  When one does so, one will see that the reasons are mainly unique to chapter 13 and not applicable to large, complex chapter 11s.  Judge Drain fails to look at those reasons (he says at one point in his ruling that he will come back to them later but unfortunately does not), and this, I think, is why he goes astray in his analysis.

Here are all two of the reasons the plurality opinion gives for not adopting the "coerced loan" approach:

"For example, the coerced loan approach requires bankruptcy courts to consider evidence about the market for comparable loans to similar (though nonbankrupt) debtors, an inquiry far removed from such courts’ usual task of evaluating debtors’ financial circumstances and the feasibility of their debt adjustment plans. In addition, the approach overcompensates creditors because the market lending rate must be high enough to cover factors, like lenders’ transaction costs and overall profits, that are no longer relevant in the context of court-administered and court-supervised cram down loans."

The first of those criticisms is obviously chapter-13-specific with its reference to “debt-adjustment plans”:  the four justices were saying that chapter 13 proceedings don’t involve evidence about market rates. 

Whether that is true or not of chapter 13, it’s obviously not true of chapter 11 cases, where bankruptcy judges hear evidence of market comps all the time, in contexts from lift – stay appraisals to solvency determination in avoidance actions to cram-downs at confirmation.   I cannot think of a determination of value in chapter 11 that does not involve some evidence about market value.  For example, to cite the most pertinent example, when parties present to the judge their estimates of a debtor's reorganization value, the most common method is the DCF, or discounted cash flow method, in which the debtor's projected net cash flow for several post-reorganized years is discounted to present value, and the typical discounting rate is the WACC, or weighted average cost of capital, in which all the inputs are determined by arrived at by referring to market rates, whether they be rates specific to the debtor, or to similar companies, or to broad swaths of the market.  And that's how you get to the asset side of the post-reorganization balance sheet.  That quantifying the liability side would be done by excluding market evidence is utterly incoherent.   Like all chapter 11 judges, Judge Drain sits through testimony market value testimony repeatedly, so it's not very convincing to then adopt  a line of reasoning that "considering evidence about the market" is "far-removed" from his "usual task".  That is the usual task of bankruptcy judges in commercial bankruptcies!  Honestly, the Till plurality was comprised of four men and women with no experience in private commercial practice, finance, or chapter 11; they were just ignorant of how chapter 11 worked, and those who are expert in it should be correcting that ignorance, not perpetuating it.  

The second factor identified by the plurality is vaguely worded, but in my judgment, based on the topics that were addressed in briefing and oral argument, its reference to “court-supervised cram-down loans” is a reference to the role of the chapter 13 trustee in collecting and disbursing payments from debtors under confirmed chapter 13 plans, a mechanism that is inapplicable to chapter 11s; performance under chapter 11 plans, post-emergence, is generally free of court supervision.  A chapter 11 debtor is considered reorganized, and gets a discharge, the day it comes out of 11; the chapter 13 debtor is discharged and rehabilitated only when s/he completes the payments under the plan. Also, under section 1322(d), a chapter 13 plan cannot extend payments beyond five years from the date of confirmation, a creditor protection not found in chapter 11.  These are all vital differences that need to be recognized when contemplating Till-in chapter-11 disputes.  The two chapters do not work the same way.  Even though the text of one section in one chapter resembles the text of another section in another chapter, the two chapters are not the same.   And of course it is the statute as a whole, not the phrase in isolation, that a court is charged with interpreting.  

Chapter 11 courts need to recognize this, instead of just superficially thinking that the plurality ruling reaches chapter 11 cases.   The only justification the plurality offers for its bald contention that the "coerced loan" approach should be rejected -- because "transaction costs" and "profits" are allegedly "no longer relevant" to cramdown paper -- rests on what they call the chapter-13-specific  "context of court-administered and court-supervised cramdown loans".  Thus, the whole point appears, as a matter of logic, not to carry over to chapter 11.  There is zero logic in Till that makes the "coerced loan" approach inappropriate in chapter 11.  The right way to interpret 1129(b)(2)(A)(i) is in the context of the rest of chapter 11, not by latching onto a plurality opinion from a case that interprets partially similar wording in the context of chapter 13.  Unfortunately, Judge Drain fails to read the plurality opinion this closely and simply concludes that cramdown rates must be evaluated on a not-for-profit basis.   

This troubles me for three additional reasons, which might be called policy reasons, as opposed to the statutory interpretation and case law interpretation fallacies I have just laid out.  First, at the highest conceptual level, profit, like price or cost, is information, and information is what makes a judgment valid.  Excluding information because it is unreliable is one thing; excluding it as a matter of substantive law strikes me as deeply contrary to basic modern Western notions of how decisions are arrived at and justice is delivered fairly.   Second, it results in a bizarre and inconceivable subsidy of companies emerging from chapter 11 versus their solvent competitors, in that the latter, obviously, have to borrow at market rates which include a profit component, while the newly emerged debtor is apparently, according to the Till-in-chapter-11 dogma, entitled as a matter of law to cheaper borrowing costs.  As I wrote in criticizing Justice Thomas's concurrence in Till  (which, the reader may be forgiven for not recalling, opined that, once a bankruptcy judge made an affirmative feasibility finding, the secured creditor was entitled to receive nothing more than the risk-free rate on the repayment paper (because every bankruptcy judge is apparently always right when s/he makes a financial evaluation and we citizens are just so lucky they have chosen to deploy their talents on the bench, not running banks and hedge funds where they of course would make billions of dollars with such omniscience)): 

"Justice Thomas’s interpretation also leads to nonsensical outcomes in the real world that Congress cannot have intended.  If no debtor under a confirmed plan can be compelled to pay more than a risk-free rate, then all debtors wind up paying less than the most creditworthy citizens, the most creditworthy businesses and pretty much all state and local governments, even less than members of Congress and justices on the Supreme Court probably pay on their mortgages! 

"Were his interpretation extended to the chapter 11 context,  companies in chapter 11 would be entitled to turn all their debt into 30-year interest-only bonds with interest at the rate the U.S. Treasury pays on its 30–year bonds.  What a huge financing advantage it would give them over their competitors – for decades!  And, as a consequence, they would be much more likely to reduce their debt as little as possible in the reorganization, since it would be the cheapest kind of capital possible.  It is hard to believe Congress thought the public interest would be served by a reorganization process that reduced corporate debt as lightly as possible.  One also wonders why Congress bothered to provide for disclosure and voting by secured creditors in chapter 11, if a non-consensual approach was only capable of producing a risk-free rate.  Finally, since the Bankruptcy Code does not require insolvency as a prerequisite for filing an 11 or proposing a plan, this kind of interpretation would invite companies to resort frequently and  liberally to chapter 11 just to re-price their debt downward in a falling rate environment.  It is absurd to think that these outcomes were intended by Congress." 

Albeit to a lesser degree, Judge Drain's approach is susceptible to the same criticisms.  MPM gets to carry debt far cheaper than the market believes it deserves.  The debtor had procured stand-by exit financing to take out the secured creditors, and its rates -- fairly obvious and persuasive evidence of the debtors' credit risk  -- were set at LIBOR plus 400 bps, in the case of the first lien, and LIBOR plus 600 bps in the case of the layered one-and-a-half lien.   Those rates were over 100 bps higher than the rates the Judge approved, meaning the debtors saved millions of dollars each year by going with the cramdown paper.  That is a huge subsidy for them vis-a-vis their competitors once they emerge. I find it inconceivable that Congress intended such a systematic subsidy for reorganized debtors.  The Judge simply swept that evidence aside with his reasoning that market rates were not relevant because they contained elements of profit.   

Last, forcing senior secured creditors to systematically provide such a subsidy upends the policy of the Code that chapter 11 is supposed to induce negotiated, consensual outcomes.  If a debtor knows as a matter of legal certainty that it can impose a below-market rate on a senior secured creditor, why would it ever choose not to?  It would be financially irrational to do otherwise, and only some sort of corruption or incompetence would explain not doing so.  Specifically, why would it ever refinance the creditor, which would necessarily require going into the market and incurring higher debt service post-emergence?  Debtors would never provide for unimpairment, unless the secured creditor's collateral were sold during the case.  By the same token, why would a debtor negotiate new payout terms with the creditor, except over how much of a haircut the creditor would take:  "I can give you 96 cents on the dollar now, or I can give you paper worth 95 cents under Till, which would you rather have?"  That's all the negotiation you'll see one year. Maybe the next year, the figures are 93 and 92, depending on where interest rates go.  You can't imagine senior secured paper ever getting 100 cents on the dollar again, except, as I said before, in the sale of collateral context.  

That is just an incoherent reading of the statute as a whole.  It turns on its head a carefully crafted complex of substantive provisions such as unimpairment, and procedural provisions such as disclosure and voting, as to all of which cramdown has historically served as a backdrop or last resort, that guides constituencies to negotiated resolutions in the main and thereby reduce the amount of judicial resources needed to reorganize businesses.  Instead it makes cramdown the default rule, and negotiated outcomes aberrations, and thereby renders all the other sections of chapter 11 dealing with claim treatment mere exceptions to that rule.