Credit funds that invest in distressed debt, whether through secondary trading or loan origination, not only must evaluate the borrower's credit quality and business plan, but, with the help of their lawyers, must also keep current on bankruptcy and appellate court decisions that bear on the interpretation and enforceability of their documents. Among the important areas that are dealt with in recent court decisions are call protection and the ability of borrowers to force debt restructurings that impair value—areas which have a direct effect on recoveries that debtholders can expect in a bankruptcy.

This is the third in a series of podcasts featuring issues of concern to credit funds, and our first of several planned on the topic of distressed debt.

Related court decisions:

Alyson Brooke Gal (Allen): Hello, and welcome to our podcast. This is the third in our series of podcasts focused on issues that are important to credit funds, and the first of a series focusing on distressed debt. My name is Alyson Gal (Allen), and I am a partner at Ropes & Gray in our finance practice, with a particular focus on representing credit funds as lenders and as investors in debt. Joining me is Steve Moeller-Sally, a partner in our business restructuring group. Our topic today is the recent decision by the Second Circuit Court of Appeals in a case that is commonly referred to as "Momentive." Momentive is such a fascinating and important case, and Steve is part of the team here that represents the indenture trustee for the so-called 1.5 lien notes in the Momentive bankruptcy, and so has an insider's view on what this case means.

Stephen Moeller-Sally: Thanks, Alyson. In today's conversation, we are focusing on two aspects of the recent Second Circuit decision. The first issue is when secured bondholders can expect to recover a "make-whole" as part of their claims. The second is whether they can be forced in what we call a "cramdown" plan to accept debt securities that have a market value that is demonstrably lower than the amount of their secured claims. 

Alyson Brooke Gal (Allen): These issues are really important to credit funds because they directly impact the recoveries that holders of debt can expect to receive in bankruptcy. For example, in the Momentive case, if the make-whole were found to be applicable and enforceable, this would have increased the amount of the senior secured lenders' claims by around $200 million. And the bankruptcy court's "cramdown" decision resulted in the lenders' nominal 100% recovery actually being worth approximately 92-94% of par, based on the trading price of the cramdown securities that they received. Steve, can you explain what Momentive is all about, and what our role is in the case? 

Stephen Moeller-Sally: Sure. We represent the indenture trustee for the 1.5 lien notes. Momentive filed for bankruptcy in the Southern District of New York in 2014 with three tranches of secured notes – $1.1 billion in first lien notes, $250 million in 1.5 lien notes and about $1.2 billion in second lien notes. The first lien and 1.5 lien notes were acknowledged to be oversecured, and so many of the holders were counting on receiving distributions in the case worth not only their full principal plus interest, but also including the make-whole premium. The second lien notes received equity under the bankruptcy plan, so they were not directly affected by the court's decisions on the make-whole and the cramdown. However, they would benefit from any value taken away from the senior lien noteholders.

Alyson Brooke Gal (Allen): Steve, before we go on to describe what happened in the case, let's pause for a second and quickly review what a make-whole premium is. A make-whole is a premium that noteholders are entitled to receive if their notes are redeemed before a specified date. It is intended to compensate holders for not receiving the contractual rate of return through that date. Make-wholes are sometimes explicitly tied to optional redemptions, and are sometimes written to apply more broadly. Many indentures are silent on whether the make-wholes apply on acceleration, and a recurring issue in bankruptcy cases in the past ten or twelve years – ever since Calpine – is whether noteholders are entitled to the additional value represented by the make-whole when their debt is accelerated by a bankruptcy filing.

Stephen Moeller-Sally: It's important to remember that make-wholes were the talk of the distressed investing market in 2014 when Momentive filed for bankruptcy. Energy Future Holdings, which also filed in 2014 in the Delaware bankruptcy court, had drawn a lot of attention to make-wholes when it announced the previous year that it planned to refinance certain notes issued by its subsidiary, EFIH, and to use a bankruptcy filing to trigger an acceleration in order to get around the make-whole that would otherwise be due. This announcement ignited a debate about the enforceability of make-wholes in bankruptcy. The Momentive plan of reorganization was structured to test the distressed investing market's conviction on the make-whole issue. The first and 1.5 lien notes would each receive a toggle treatment: if the class accepted the plan, the holders would be paid par plus accrued interest in full, in cash, on the effective date – but would waive any claim to the make-whole premium; if the class rejected the plan, the holders would receive replacement notes at a rate to be set by the court – what we call cramdown notes – in an amount that would include the make-whole to the extent it was allowed by the bankruptcy court. The rate on the cramdown notes was to be set by the court, but all signs pointed to the court deciding on a below-market rate–for reasons we'll discuss a little bit later.

Alyson Brooke Gal (Allen): So the choice presented to the noteholders was to walk away with cash, but in an amount that did not include the make-whole, or to roll the dice on the make-whole being allowed and to take the risk that the interest rate on the cramdown notes would result in below par values?

Stephen Moeller-Sally: Exactly right! If the noteholders elected to litigate over the make-whole premium, they were not only sacrificing the certainty of cash, but also taking a risk on the value of the cramdown notes they would receive.  As it happened, both classes of senior secured notes voted against the plan, and therefore toggled into the cramdown note scenario. Unfortunately for the noteholders, the bankruptcy court determined that the make-whole premium was not payable. In addition, as we will talk about in a moment, the court established a rate for the cramdown notes that resulted in the notes trading at significant discounts to par.

Alyson Brooke Gal (Allen): So the noteholders got less than they wanted, and in a currency that further depressed their recoveries?

Stephen Moeller-Sally: Yes, it was a tough day for the noteholders, and they immediately prepared an appeal. In its recent opinion on these issues, the Second Circuit agreed with the bankruptcy court's decision on the make-whole. The senior lien indentures provided for the payment of a make-whole premium upon an optional redemption of the notes. The Second Circuit reasoned that, since the filing of the bankruptcy case accelerated the notes, any payment on the notes following the bankruptcy filing was, in effect, a post-maturity payment and not an optional redemption. The holders had argued that, since the Bankruptcy Code gives the debtors the power to reinstate the notes, any payment on the bonds in a bankruptcy would be optional.

Alyson Brooke Gal (Allen): And didn't the senior lien holders even try to rescind the acceleration to bolster the argument that any payment on the notes would be an optional redemption?

Stephen Moeller-Sally: They certainly did, but the bankruptcy court determined that the automatic stay would not permit the holders to de-accelerate the notes, and the Second Circuit agreed with that as well. Basically, the Second Circuit agreed with the bankruptcy court that a "rule of specificity" governed the payment of make-whole premiums following an acceleration. In other words, according to the Second Circuit, the default rule under New York law is that a make-whole is not owed unless your indenture or credit agreement specifically provides for payment of that premium following an acceleration.

Alyson Brooke Gal (Allen): So on the make-whole issue, it seems like both the bankruptcy court and the Second Circuit looked at the fact that the indentures provided that the make whole was due on "optional redemption" and reasoned that since bankruptcy automatically accelerated the notes, that meant that no make-whole was owed. But didn't the Third Circuit come to pretty much the opposite conclusion in EFIH, based on nearly identical indenture language?

Stephen Moeller-Sally: That's right. The Third Circuit viewed the indentures through a different lens, and focused on cases addressing the presumption under New York law that indenture provisions remain fully enforceable after acceleration, unless there is some explicit provision that nullifies them. In other words, the Third Circuit determined that the optional redemption provision operated independently of the acceleration provisions of the indenture and that the burden was on EFIH to specify in the indenture that the make-whole would not be payable after acceleration, rather than on the noteholders to specify that it would be.

Alyson Brooke Gal (Allen): On the make-whole point, it is surprising to me that probably the two most important Circuits for bankruptcies, the Second and Third, came out so differently. How is this conflict likely to be resolved? Is this issue going before the Supreme Court?

Stephen Moeller-Sally: It's not clear that this split will be resolved. Ordinarily, a question of state-law contract interpretation would not be reviewable by the Supreme Court. But here, we have the context of a bankruptcy and the overlay of the automatic stay and other provisions of the Bankruptcy Code, like reinstatement, which may provide a jurisdictional hook. For the moment, we will have to wait until next week when cert. petitions for the Second Circuit's Momentive ruling are due.

Alyson Brooke Gal (Allen): And on the Till issue, I have to say, when I first heard about the bankruptcy court's decision in Momentive and that the judge had ruled that Till requires that cramdown rates be set without regard to the market rate, I was actually stunned. Make-wholes, at least based on many of the decisions, are at least something that can be addressed through clear drafting. But if the Momentive Bankruptcy Court is right and cramdown rates can be set at below-market levels, there really isn't an obvious clean solution for distressed debt investors to protect themselves from cramdown. So when I heard that the Second Circuit had reversed the bankruptcy court's decision on the Till issue, I thought "phew"! Steve, was I right to be relieved? Where does the Second Circuit decision actually leave us?

Stephen Moeller-Sally: First, why don't we explain to our listeners why we call this "the Till issue."

Alyson Brooke Gal (Allen): Oh, sure! What we are referring to when we talk about "the Till issue" relates to a Supreme Court case decided in 2004. That case involved a Chapter 13 bankruptcy – which is a type of bankruptcy that is limited to individuals. The issue was whether the Tills, an Indiana couple that had borrowed $4,800 to buy a used pickup truck, were required to continue to pay the lender the contract rate of 21%, or whether they could restructure the debt at the lower proposed rate of 9.5%. In that context, the Supreme Court decided that it was not necessary for the debtor to pay the contract rate or even a "market rate" to the subprime lender, and could instead restructure the loan at a rate based on a formula that took the prime rate and then adjusted it upwards to reflect the additional risk inherent in the loan.

Stephen Moeller-Sally: And since that decision, it's been an open question whether Till would apply equally to corporate reorganizations under chapter 11. The bankruptcy court in Momentive had decided that it was bound by Till to apply the formula approach and wasn't allowed to consider any market information. This was a stunning decision to many market participants, especially because the debtors had lined up exit financing from major Wall Street banks to pay off the secured notes in the event that the holders decided to cash out and waive the make-whole. The formula approach resulted in interest rates significantly below the rates for the exit financing and also below the rates that the senior lien holders had argued were "market" based on expert testimony. The Second Circuit overruled the bankruptcy court and adopted a two-step approach that had been endorsed by the Sixth Circuit in an earlier case. Under this approach, the court must first determine whether an efficient market exists for the contemplated financing. If an efficient market does exist, the market rate should be applied to the cramdown loans. Only if no efficient market exists should the court turn to the formula approach applied in the Supreme Court's Till decision. The ultimate result of the Second Circuit opinion is that the case has been remanded back to the bankruptcy court, which is now charged with determining whether an efficient market rate can be ascertained, and if so, to decide what that rate is. In addition to the remand, it is possible that a cert. petition will be filed in the Supreme Court on the Till issue. Unlike the make-whole, this issue is clearly within the Supreme Court's jurisdiction, but there is still no guarantee that the Justices will grant cert.

Alyson Brooke Gal (Allen): Wow, so more to come! Before we wind up our conversation on this case, we should touch on what credit funds can actually do to protect themselves against loss of value because of these issues. On the make-whole, careful documentation seems to be the key to enhancing the likelihood that the make-whole will be found to apply. In secondary trading, credit fund investors and their lawyers should carefully review the make-whole provisions before investing to confirm that they are clear as to whether they apply on acceleration. And in loan origination, the credit fund investors can work with their counsel to construct documents that are clear. But Steve, what about the cramdown risk? What can credit fund investors do to protect themselves against that risk?

Stephen Moeller-Sally: Unlike with make-wholes, there is no magic language that can resolve the cramdown risk. And even under the Second Circuit decision, establishing an efficient market rate is not a given. It will certainly not always be easy and will often be costly. In most cases, it will turn into a battle of the experts on both steps of the analysis: whether there is an efficient market and, if so, what is the efficient market rate? That said, a properly drafted make-whole provision can at least provide oversecured lenders with additional claim value that could offset any discount arising from a below-market cramdown rate. We have also been seeing efforts to address cramdown risk in intercreditor agreements, including restrictions on the ability of junior lien holders to support cramdown plans and turnover requirements based on the market value of securities distributed to senior lienholders. Investors considering such approaches should work closely with their finance and bankruptcy counsel to assess the risk in specific structures and to craft appropriate provisions to address each particular case.

Alyson Brooke Gal (Allen): Boy, you bankruptcy lawyers certainly keep intercreditor negotiations interesting! That is all the time we have today. Thanks very much for listening. For those interested in learning more about the case, we have included links on the website listing for this podcast to both the original bankruptcy court and the recent Second Circuit decisions in Momentive, as well as the Third Circuit's decision in EFIH.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.