Second Circuit Decision in Momentive: Half a Loaf is Better Than None, But Even the American HomePatient Approach Does Not Conform to the Fair and Equitable Standard

On Friday, the Second Circuit panel that heard the senior secured lenders’ appeal in MPM Silicones issued its opinion affirming the lower courts’ holdings in all but one respect, that being the interest rate applicable to a cramdown / cram-up of the senior secured claims under 11 U.S.C. § 1129(b)(2)(A)(I).  The court held that the lower courts’ application of the Till formula had been incorrect as a matter of law.  Unfortunately, the error was limited, in the court’s analysis, to a conclusion that market evidence was irrelevant to an evaluation of a proposed cramdown interest rate, given that capital providers in the market would be seeking to make a profit, which, the lower courts believed, was not permissible under Till and the 2d Circuit’s predecessor, Valenti.  “We therefore conclude that the lower courts erred in categorically dismissing the probative value of market rates of interest.”  Opinion at 22.  Rather, the panel reiterated (per the majority opinion in 203 N. LaSalle, (which logically supersedes the plurality in Till), that “the best way to determine value is exposure to a market.”    

However, the court unfortunately did not evict the Till formula from chapter 11 altogether, nor did it resolve the contradiction between the sub-par recoveries Till tends to generate and the century of case law interpreting the “fair and equitable” standard to require 100% recovery for secured claims protected thereby.  Instead, in cursory terms, the panel announced that the Sixth Circuit’s two-step approach set forth in American Homepatient, just months after Till itself was handed down, constituted the best approach to evaluating a proposed interest rate under § 1129(b)(2)(A)(I).  Thus, they remanded to the bankruptcy court “so that the bankruptcy court can ascertain if an efficient market rate exists and, if so, apply that rate, instead of the formula rate.”  This indicates a superficial grasp of the precedents, given that 203 N. LaSalle (in a similar sticking-it-to-a-secured-creditor scenario) did not say “the best way to determine value is exposure to an efficient market” it just said "a market."  

Half a Loaf Is Better Than None

We should be grateful, I guess, that the Circuit at least modestly diminished Till in the chapter 11 context.  It could have been worse; the court could have perpetuated the mistakes so many lower courts made, namely reaching the conclusions that (1) without briefing, argument or explanation, and  while interpreting a section of the code where the “fair and equitable” standard does not appear, a plurality of the Supreme Court meant to overrule more than 100 years of its own decisions interpreting that standard to require 100% recovery on claims protected thereby before anyone junior can receive any distribution from the estate, and (2) creditors are not permitted to recover any amount that might constitute a profit or even a contribution margin, compared to some formula developed on a “seat of the pants” basis in random consumer bankruptcy cases in complete disregard of actual arms’-length transactions by willing lenders and borrowers.

Further, although the court should have developed the following point to a fuller extent, it is heartening to see that the court implicitly treated a 100% valuation as at least a parallel focus for the lower court: citing its own Valenti opinion, they wrote: “the goal of the cramdown rate is to put the creditor in the same economic position that it would have been in had it received the value of its allowed claim immediately.”  So, it is conceivable that the court on remand and its brethren in the future will have to look not only at the first step in the American Homepatient approach, i.e., are the credit markets efficient, but, even if they conclude “no”, and turn to the Till formula, they may have to add a sufficiently high risk premium to produce a 100% valuation “immediately” in the words of the Valenti opinion. In which case, economically, if not conceptually, the “Till in chapter 11” case law will die a deserved if unofficial death.

The American Homepatient Approach is Impractical

It would be truly amazing if the very first appellate panel to consider the question whether Till should apply to chapter 11, without the benefit of any development of the issue by lower courts, professionals in the field, or academic analysis (and frankly without having had a steady stream of large chapter 11 cases flowing through its docket), managed to hit the nail on the head with its proposed solution.  But I guess the American Homepatient judges were just idiots savants in the field of business reorganization. That they failed to recognize that chapter 11 has this magic phrase “fair and equitable” that was not at issue in Till is something only pedants might notice.

I think the Second Circuit selected American Homepatient as the governing framework for no reason other than it was the only alternative to a full adoption of Till that was readily available, and it enabled them to get the opinion out the door, nearly one year after oral argument and two years since the case landed on their docket.

But however practical it may have been for the panel to paste American Homepatient into the opinion and hit “upload”, it is not a practical solution for chapter 11 cases generally.  First, the term “efficient market” is not a practical concept, nor is it something bankruptcy judges understand or are equipped to investigate.  It is an academic construction, and it literally means “perfect efficiency” --  perfect information, perfect rationality of participants, no limitations of any kind (including cash constraints or regulation), no barriers to entry, no economies of scale, no profits above marginal cost, frictionless transacting, and no arbitrage of any kind.  That is why it is an academic concept. In the real world, none of those conditions, let alone all of them, occur consistently.  And there does not seem to be any point in establishing a factual inquiry that can only come out one way.  That would be a rule of law. 

As I’ve written before, I believe the source of the reference to “efficient market” in Till was a colloquy between Justice Breyer and counsel for SCS Credit in which Justice Breyer inquired why the contract rate on the Tills’ debt did not change as the overall interest rate environment changed, and SCS Credit’s counsel said the rate had been fixed at the usury rate threshold, not floating.  As Breyer wound up in the plurality, it is likely this realization influenced his rejection of the “contract rate” theory proffered by SCS, but the footnote represents an effort to leave the door open to a third solution, the “efficient market” one.  But as the word “efficient” is not a realistic description of any relevant market, the footnote should have used “competitive” or “robust” or “normally functioning” or some other commercially attainable adjective, not one of the ultimate “ivory tower” constructions of the 20^th century.

In addition, a conceptual problem not noticed by these appellate courts is that in the context of financial markets, the term “efficient market” relates to secondary trading, not primary issuance. It arose initially out of Eugene Fama’s summer job, when he was asked to use his bright mind to find a pattern in stock movements that would help brokers make money.  He couldn’t. Instead he inferred that, having found empirical evidence that there were no systematic arbitrage opportunities in the stock market, given that that is one characteristic of an efficient market, then therefore the stock market must be efficient. That in turn led to the creation of index funds and him getting the Nobel Prize for Economics, among other things. Of course, over time subsequent researchers have found persistent strategies for outperformace, among which are small-cap stocks outperforming large-caps and momentum strategies beating pure fundamentals, whereupon some really clever soul pointed out that capitalization-weighted index funds are the ultimate momentum strategy, but I digress.

Second, bankruptcy judges have demonstrated that they do not understand what an efficient market is or how to think about that question.  (Indeed, this is a problem shared by their Article III colleagues. Per Justice White: "The legal culture's remarkably rapid and broad acceptance of the ECMH [efficient capital markets hypothesis] has not been matched by an equally broad and deep understanding." and "Confusion and contradiction are inevitable when traditional legal analysis is replaced with economic theorization [sic] by the federal courts.").  See generally Geoffrey Christopher Rapp, Proving Markets Inefficient: The Variability of Federal Court Decisions on Market Efficiency in Cammer v.Bloom and Its Progeny, 10 U. Miami Bus. L. Rev. 303 (2014)
Available at: http://repository.law.miami.edu/umblr/vol10/iss2/2.

Too many bankruptcy judges doing "Till in chapter 11 'analysis'"adopt what I have called elsewhere the “loan market as Santa Claus” paradigm.  The borrower comes in with a wish list in its chapter 11 plan.   It wants to stay highly leveraged while paying debt service in crumb-sized increments for a really long time.  Heads equity wins, tails lenders lose.   Every expert agrees: “there ain’t nobody in their right mind who would make that loan on a par basis.”  So, the bankruptcy judge sagely frowns and says, “well, that must mean the loan market is not efficient!  Borrower, there are no dissatisfied customers in my court!  Go ahead and give that lender prime plus 3 on your wildly overleveraged cash flow! That’s fair and equitable!”)

In my article, I analogized this to a person who says, “you know, I could really build up my nest egg if I could pick up some Facebook shares at half price. I’ll put in an order right now for 5,000 shares at that price."  Pause.  "Why, it didn’t clear!  There must be something wrong with this market!”

Less sarcastically, the point is, very simply, you cannot tell anything about “the market” by looking at one participant, one transaction or one set of terms.  Rather, you would look at the market-wide volume of transactions, the number of firms competing to offer capital, the cost of finding them, the bid-ask spreads and so forth.  But on as broad and deep a scale as one can reasonably encompass.  Then, if you concluded, “yeah, we have some well-functioning capital markets in this country,” you would go on to say, “OK, if someone wanted to raise money on the value of this collateral, given this cash flow, what are the best terms they could get from these well-functioning capital markets?” Which is what CFOs are paid to find out.  But I have yet to see a bankruptcy court do anything like that. The vast majority seem to fall for the “I’m not getting what I need, it must be the market’s fault” spiel, and wind up saying silly things like “I find as a fact that the credit market in the U.S. is not efficient”, when they have not the slightest clue what that means.  And systematically their decisions only serve to encourage debtors to propose deliberately off-market repayment terms, to elicit such a finding from an unsophisticated decisionmaker.

Third, it is indeed ironic (and the irony reinforces my belief that the Second Circuit just grabbed at American Homepatient because it was handy, not because it had any compelling analytic foundation) that we now have two circuits telling bankruptcy judges to figure out “market efficiency” as if they were the FTC or something, in order to accommodate a plurality opinion that elsewhere calls market analysis a task “far removed from the usual tasks of bankruptcy judges.”  Bankruptcy judges, even the ones who may be able to comprehend some of the thousands of research papers on market efficiency, don’t have the professional education and training or the staff to assess whether the United States credit markets are efficient.  It is unfortunate for judges in these circuits that such an impossible inquiry is left in their inboxes.  “Please handle. Thx.  2d Cir.  P.S. Let’s touch base at the retreat!”

In some cases, it may be moot, because the forces driving the reorganization may not want to hang around and wait for ivory tower concepts to be debated by economics Ph.D’s (note to self: get one!) while dozens of meters tick at $1000/hour. They may often just opt for the commercially reasonable solution of raising the money.  But the risk is that too many judges issue silly opinions saying “The U.S. capital markets are not efficient” and then it will be the lenders who wind up throwing in the towel until some appellate court realizes that …

Neither American Homepatient nor Till Conforms to the Fair and Equitable Standard.

As I’ve written before, and as any reader can verify, chapter 11 contains the “fair and equitable” standard and chapter 13 does not.  That standard has been black letter law for over 100 years. It means that a plan has to provide 100% recovery to anyone protected by it before anyone junior can receive or retain anything.  Whether it produces 100% or not is a question of fact, not of rule or formula.  Changing that standard is for Congress, not courts.  The Till court was free to adopt a formula for payouts because the fair and equitable standard did not appear in the statute there at issue.  When the standard appears, as it does in all chapter 11 cramdowns, courts must ignore Till completely, not just as the rule of decision, but also as the fallback.  All they should ask is whether the plan payout is worth 100 cents on the dollar.  It does not matter whether the capital markets are efficient.  That entire field of study was barely in existence when Congress enacted the Bankruptcy Code in 1978.  No reference to it appears in the cramdown sections of the Code or their legislative history. As the majority in 203 N. LaSalle interpreted the relevant statute , they did not say “the best way to determine value is exposure to an market” they did not say "an efficient market."

Whether a particular capital market is efficient or not is analytically irrelevant to the application of section 1129(b)(2) and courts should kick its ivory tower butt out of Code jurisprudence altogether, because such academic, costly and overwrought inquiries are inconsistent with the goal of efficiently administering bankruptcy cases themselves. A further irony: making bankruptcy judges investigate "credit market efficiency' makes them less efficient.