US cramdown threatens secured lenders

Author: Zoe Thomas | Published: 9 Sep 2014
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A ruling in MPM Silicones’ Chapter 11 proceedings could be detrimental to the amount secured lenders in future reorganisations can expect to be repaid.

The ruling by Southern District of New York Judge Robert Drain at the end of August forced the cramdown of secured lenders to below market level notes. While the process is not uncommon, the judge used a formula established for Chapter 13 bankruptcies filed by individuals.

The restructured notes have an interest rate at treasury, plus a small risk adjustment. The ruling also eliminates the make whole secured lenders agreed to in the indenture.

An appeal is pending and creditors may still be able revert to previous cash offer. But the ruling’s ramifications could be far reaching. It may incentivise troubled companies to commence bankruptcy proceedings, while lenders could be less inclined to become involved with distressed debt.

"This decision represents a chink in the Bankruptcy Code’s intent to protect the interests of secured creditors," said Ropes & Gray partner Mark Bane who is representing Wilmington Trust, the indentured trustee for one group of secured creditors. "This new vulnerability poses a problem to both lenders and borrowers in bankruptcy, and even more so when a company is trying to avoid needing to file for bankruptcy."

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KEY TAKEAWAYS

  • A New York judge has ruled that secured creditors in Chapter 11 can be crammed down to below market rate restructured notes;
  • The decision is based on US Supreme Court ruling on a different chapter of the US bankruptcy code;
  • The decision could set a precedent against lenders, and possibility move distressed companies to choose bankruptcy rather than out of court restructurings.

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The ruling

The decision allows MPM Silicones to cramdown a pre-packed agreement that two groups of secured creditors voted against. The creditors will receive the treasury rate plus an additional 0.5% for the first group of secured creditor, and 0.75% for the other.

The decision leaves the interest rate far below market value, a risk most secured creditors don’t consider.

The judge also denied the make whole premium, however there is precedent for this. Other judges have ruled against make wholes when the language in the indenture is ambiguous.


Other than having a higher rate to begin with, there really isn’t an easy drafting or structural way around this risk


"While the make whole decision can be dealt with by clearer drafting, there is no way for investors to address the ruling on cramdown," said Gary Kaplan, a New York-based bankruptcy partner at Fried Frank. "The concern for a secured lender is that other than having a higher rate to begin with, there really isn’t an easy drafting or structural way around this risk."

Impact

The ruling could tarnish the US’s image as a creditor friendly market.

Security for lenders has allowed distressed companies to restructure their debt without the expense or burden of bankruptcy. "This decision could reverse this trend by chilling lenders’ willingness to lend to a troubled company," said Bane.

The ruling could also mean secured creditors in future cases receive less than unsecured lenders. The US bankruptcy code requires unsecured lenders to be paid the claim in cash or other forms, which can and often does include stock. Being able to receive stock while secured creditors have new notes with very low interest rates could leave unsecured creditors better off.

If the ruling is upheld, secured creditors may see their leverage in the bankruptcy process dwindle, sparking them to look for earlier compromises. For their part, debtors could potentially use the decision as a way to secure cheaper financing.

Judge’s reasoning

The judge in this case followed US Supreme Court precedent relating to a different bankruptcy chapter.

Its 2004 Till v SCS Credit Corp ruling cemented a federal court decision that created a formula to calculate how much a debtor must pay a secured creditor in a Chapter 13 bankruptcy. Chapter 13 is limited to individuals with regular income and under certain debt limitations. It is not an option for most business.

The formula was set at par plus between one and three percent, to account for risk adjustment to be determined by the judge.

In the MPM Silicones case, the judge chose to use treasury to better reflect long-term borrowing rate, but it further decreased creditor’s repayment.

Will it stand?

Until the MPM Silicones case, it was unclear whether this decision would apply to Chapter 11.

"Given that Judge Drain is well respected, has previous experience in financing and issued a very reasoned decision, there is a possibility of other judges following it," said Kaplan.

Judge Drain is still considering whether the creditors can change their votes to return to a previous cash offer. If they can, it should minimise the ruling’s impact.

The Till ruling included a footnote explaining that the formula was used in this situation because no efficient market was available to base the rate off of. The secured creditors argued that as a large company MPM Silicones would be able to obtain a competitive borrowing rate, which an individual in Chapter 13 could not. Therefore, an  efficient  market existed to base the restructured interest rate on. 

This will be an important point if the case reaches appeal.

Further reading

Federal judge: lessons from US bankruptcy

More detail on UK pre-packs needed

Bankruptcy – how remote is your note?