On October 20, 2017, the Second Circuit issued its opinion in Momentive Performance Materials Inc. v. BOKF, NA v. Wilmington Savings Fund Society, FSB (In re MPM Silicones, LLC), __ F.3d __, 2017 WL 4700314 (2d Cir. Oct. 20, 2017), affirming in part and reversing in part a decision by the District Court for the Southern District of New York. The District and Bankruptcy Court decisions were previously discussed in our client alerts on May 14, 2015, and November 12, 2014, respectively. Notably, the Second Circuit ruled that the Bankruptcy Court should have considered whether there was an efficient market before using the “formula approach” to calculate the “cramdown” interest rate that secured lenders should receive in a chapter 11 plan. This Second Circuit ruling, which is consistent with the approach taken by the Sixth Circuit, significantly weakens a chapter 11 debtor’s threat of “cramming down” its secured lenders in a plan of reorganization, thereby increasing secured lenders’ leverage in negotiations with distressed borrowers. I. Background On May 4, 2015, the District Court affirmed an August 26, 2014 ruling by Judge Drain regarding several confirmation issues, including that the debtors had satisfied the cramdown requirements of section 1129(b) of the Bankruptcy Code even though the interest rate on the replacement notes delivered to the senior secured creditors was lower than a market interest rate. See U.S. Bank Nat’l Ass’n v. Wilmington Savings Fund Society, FSB v. Momentive Performance Materials Inc. (In re MPM Silicones, LLC), 531 B.R. 321 (S.D.N.Y. 2015). The plan provided that the holders of first lien and “1.5” lien notes (the “Senior Lenders”) would receive long-term replacement notes based on a formula interest rate. 2017 WL 4700314, at *2. Section 1129(b) of the Bankruptcy Code requires that a class of secured creditors that does not accept the plan must receive “deferred cash payments . . . of a value, as of the effective date of the plan, of at least” the allowed secured claim of the creditor. One of the questions determined by Judge Drain and the District Court was whether the discount rate for determining the present value of the future payments should be a market rate of interest. In this case, unlike many other chapter 11 cases, there was a readily available market rate because other lenders had offered to provide an exit facility to take out the senior secured notes in cash. The Senior Lenders argued that the cramdown interest rate for the replacement notes should be equal to the market rate. Id. at *9. The District Court affirmed Judge Drain’s application of the “formula approach” to calculate the cramdown interest rate, holding that section 1129(b) does not require payment of a market interest rate, and further affirmed the use of the treasury rate rather than the prime rate as the starting point to calculating the interest rate under the “formula approach.” Both the District Court and Bankruptcy Court decisions noted that there was a minimal risk that the doctrine of equitable mootness would prevent the senior lenders from effectively contesting the decision on appeal. Id. at *14. In addition to the cramdown interest rate issue, the District Court affirmed the following rulings by Judge Drain: (1) the appropriate construction of a make-whole provision that did not expressly require payment of a premium when the debt was accelerated, and (2) the scope of a contractual subordination provision. Id. at *3. The Second Circuit affirmed the District Court’s rulings regarding (1) the make-whole provision, and (2) the scope of the contractual subordination provision, but reversed with respect to the method of calculating the interest rate on the senior lenders’ notes. The court adopted the “two-step” approach to calculating interest rates used by the Sixth Circuit and remanded to the Bankruptcy Court, ruling that, prior to using the “formula rate,” the Bankruptcy Court should have first determined whether an efficient market existed and then applied the market rate, and it should only employ the formula approach if it found that an efficient market did not exist. 2017 WL 4700314, at *10. Further, in a continuing blow to the doctrine of equitable mootness, the court held that the Senior Lenders’ appeal was not equitably moot, finding that the potential increase in the interest rate on the senior lenders’ new notes would not unravel the plan or threaten the debtors’ emergence from bankruptcy. Id. II. Cramdown Interest Rate The Second Circuit held that the use of the formula approach to calculate the cramdown interest rate in chapter 11, without first considering whether an efficient exit lending market existed, violated section 1129(b) of the Bankruptcy Code. The court stated that the “lower courts erred in categorically dismissing the probative value of market rates of interest” and remanded to allow the Bankruptcy Court to determine whether an efficient market rate exists. Id. The court further stated that, if an efficient market rate did exist, the Bankruptcy Court was required to apply that rate. Id. The decision stated that the lower courts had misinterpreted the Supreme Court’s decision in Till v. SCS Credit Corp, 541 U.S. 465 (2004), which had held that, in a chapter 13 case, the cramdown interest rate should be calculated according to the “formula approach.” Pursuant to the formula approach, the interest rate is determined by applying an appropriate “risk of nonpayment” premium on a risk-free base rate and does not take into consideration market-based rates, which, among other things, also factor in a profit component. The Second Circuit’s opinion references a footnote in the Till plurality opinion, which stated that, while the “formula” approach was appropriate in chapter 13 cases, it might not be in chapter 11 cases and, when picking a cramdown interest rate in a chapter 11 case, “it might make sense to ask what rate an efficient market would produce.” Id. at 476 n.14. Accordingly, the Second Circuit adopted a “two-step” approach from the Sixth Circuit, pursuant to which “‘the market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula endorsed by the Till plurality.'” In re MPM Silicones, LLC, 2017 WL 4700314, at *9 (quoting In re Am. HomePatient, Inc., 420 F.3d 559, 568 (6th Cir. 2005)). Because the Bankruptcy Court explicitly declined to consider market forces, the Second Circuit remanded to allow the Bankruptcy Court to ascertain whether an efficient market exists pursuant to this two-step approach. The opinion states that markets for financing are efficient where “they offer a loan with a term, size, and collateral comparable to the forced loan contemplated under the cramdown plan” and that expert testimony from the Senior Lenders in this case, “if credited, would have established a market rate.” Id. at *9 (citations omitted). This expert testimony established that the debtors “went out into the market seeking lenders to provide” financing to pay the Senior Lenders, which would have been required if the Senior Lenders accepted the plan, and potential exit lenders quoted the debtors interest rates. Id. However, the Second Circuit also acknowledged that both the District Court and Bankruptcy Court “made express their view that the rate produced by that process may not in fact have been produced by an efficient market.” Id. at n.12. Further, the Bankruptcy Court opinion demonstrates that Judge Drain believes an efficient market will rarely, if ever, exist under these circumstances. Judge Drain had also discussed the Sixth Circuit’s two-step approach, stating that “the first step of the two-step approach is almost, if not always a dead end” and the courts that apply the first step spend “considerable time determining that there is no efficient market” prior to moving to the second step and applying either a prime plus approach or a base rate plus approach. In re MPM Silicones, LLC, 2014 WL 4436335, at *28 (Bankr. S.D.N.Y. Sept. 9, 2014). Accordingly, while the Second Circuit’s opinion appears to at least imply that it believes there is an efficient market in this case, Judge Drain has clearly displayed a skepticism as to whether an efficient exit lending market for a chapter 11 debtor can ever exist, making it difficult to predict how the case will be decided on remand. Additionally, the Senior Lenders had argued at both the Bankruptcy Court and District Court level that, even if the formula approach were applied, the use of the treasury rate (which does not incorporate any default risk) was impermissible as the base rate in the formula approach, and that, instead, the prime rate (which does incorporate default risk) should have been used as base rate in the formula approach. However, the Senior Lenders did not press this argument before the Second Circuit, and, therefore, the opinion does not address it. 2017 WL 4700314, at *9 n.7. Consequently, if Judge Drain were to determine on remand there was no efficient market, it appears nothing in the Second Circuit’s opinion prevents him from upholding the “treasury plus” interest rate that he originally calculated. III. Interpretation of Make-Whole Provision The Senior Lenders also argued that, in accordance with their respective indentures, they were entitled to a make-whole premium because the debtors “repaid” the first lien notes and “1.5 lien” notes prior to the original maturity date pursuant to the plan, albeit with new notes and not in cash. To justify the make-whole claim, they referred to language in the indentures that provided: in the event of a bankruptcy, then, “the principal of, premium, if any, and interest on all of the notes shall become immediately due and payable.” Id. at *11. Judge Drain had overruled their objection, holding that (A) unless the parties have clearly and specifically provided for payment of a make-whole when the debt has been accelerated before the original maturity date of the notes, a make-whole will not be owed because the notes are not being prepaid or redeemed; and (B) the language cited above was not clear and specific enough. Judge Drain reasoned that in order to be entitled to the make-whole, the relevant language must be “either an explicit recognition that the make-whole would be payable notwithstanding acceleration of the loan or . . . a provision that requires the borrower to pay a make-whole whenever debt is repaid prior to its original maturity.” 2014 WL 4436335, at *15 (Bankr. S.D.N.Y. Sept. 9, 2014). Judge Drain found the “premium, if any” language to be insufficient to “overcome or satisfy the requirement under New York law that a make-whole be payable specifically notwithstanding acceleration or payment prior to the original maturity date under the terms of the parties’ agreements.” Id. at 16. The District Court, agreeing with the Bankruptcy Court, held that the Senior Lenders were not entitled to a make-whole premium. 2017 WL 4700314, at *3. The District Court reasoned that accelerating the balance of a loan forfeits the right to prepayment consideration because there simply is no prepayment—the notes became due as the result of the acceleration. This is true even if the acceleration results automatically as the result of the bankruptcy filing unless there is a clear and unambiguous clause that calls for payment of the make-whole premium even if the debt is accelerated as a result of such filing. Here, neither the acceleration clause nor the make-whole provision clearly and unambiguously called for the payment of the make-whole premium upon acceleration of the debt upon a bankruptcy filing, and, therefore, the Senior Lenders were not entitled to the make-whole payment. 531 B.R. 321, 336-37 (S.D.N.Y. 2015). The Second Circuit agreed with the District Court, finding that, because the acceleration of the notes occurred automatically upon the debtors’ bankruptcy filing, the maturity date was automatically moved to the petition date. 2017 WL 4700314, at *11 (citing In re AMR Corp., 730 F.3d 88 (2d Cir. 2013)). The court stated that, because the make-whole premium was only payable if redemption occurred “at or before maturity,” any payment after the bankruptcy filing was necessarily a post-maturity payment, which did not entitle the Senior Lenders to the make-whole premium. Id. The court also rejected the Senior Lenders’ argument that the lower courts had disregarded their contractual right to rescind the automatic acceleration, holding that rescission would be barred by automatic stay. Id. at *11-12. IV. Interpretation of Subordination Provision The Second Circuit also decided an appeal by the subordinated noteholders, who argued that the second lien notes did not constitute “Senior Indebtedness” per the defined terms under the debt documents. Id. at *3. The District Court had agreed with the Bankruptcy Court that the second lien notes did constitute “Senior Indebtedness” per the defined terms under the debt documents, and, therefore, the fact that the plan did not provide distributions to the holders of the subordinated notes did not violate the absolute priority rule under section 1129(b) of the Bankruptcy Code. Under the relevant indenture, “Senior Indebtedness” was defined as: all Indebtedness . . . unless the instrument creating or evidencing the same or pursuant to which the same is outstanding expressly provides that such obligations are subordinated in right of payment to any other Indebtedness of the Company[;] . . . provided, however, that Senior Indebtedness shall not include, as applicable: . . . 4) any Indebtedness or obligation of the Company or any Restricted Subsidiary that by its terms is subordinate or junior in any respect to any other Indebtedness or obligation of the Company . . . including any Pari Passu Indebtedness. 531 B.R. 321, 325 (S.D.N.Y. 2015). The subordinated noteholders argued that this definition provided that “Senior Indebtedness” expressly excluded debt that was “subordinated in right of payment” or “subordinate or junior in any respect” to any other debt. The subordinated noteholders argued that the fact that the second liens were expressly subordinate to the first priority liens meant the second noteholders were subordinate or junior in respect of their liens. The District Court disagreed and explained that the definition of “Senior Indebtedness” only excluded indebtedness subject to payment subordination, not indebtedness subject to lien subordination, and therefore, the second lien notes, which were lien subordinated only, were not excluded from the definition. Accordingly, the District Court concluded that the second lien notes unambiguously constituted Senior Indebtedness. 2017 WL 4700314, at *4. The Second Circuit did not agree with the lower courts that the language in the indenture was unambiguous; nevertheless, the court affirmed the District’s Court’s ruling that the second lien notes constituted Senior Indebtedness based on “the plethora of evidence in the record” that the parties so intended, including that the debtors had repeatedly represented to the SEC and the financial community that the second lien notes were Senior Indebtedness. Id. V. Equitable Mootness Finally, the debtors argued that the Senior Lenders’ appeal was equitably moot, asserting that granting the Senior Lenders’ requested relief would alter the terms of the chapter 11 plan which had been subject to “intense-multi-party negotiation,” would throw into doubt the viability of the plan and “cause debilitating financial uncertainty” to the reorganized debtors. Id. at *13. The Second Circuit rejected this argument, primarily because the Senior Lenders had sought a stay of the debtors’ plan prior to its implementation and the court did not believe that a potential upward adjustment of the Secured Lenders’ interest rate would unravel the plan or threaten the debtors’ emergence from bankruptcy. Id. Specifically, the opinion states that when a reorganizational plan has been substantially consummated, it is presumed that an appeal is equitably moot. The presumption gives way when the following five factors are met: i. effective relief can be ordered; ii. relief will not affect the debtor’s re-emergence; iii. relief will not unravel intricate transactions; iv. affected third parties are notified and able to participate in the appeal; and v. the appellant diligently sought a stay of the reorganization plan. Id. (citing Frito-Lay Inc. v. LTV Steel Co.. (Chateaugay II), 10 F.3d 944 (2d Cir. 1993)). However, the Second Circuit noted that a special emphasis should be placed on the fifth factor stating that, “if a stay was sought, we will provide relief if it is at all feasible, that is unless relief would knock the props out from under the authorization for every transaction that has taken place and create an unmanageable, uncontrollable situation for the Bankruptcy Court.” Id. The court then determined that, considering the scale of the debtors’ reorganization and the fact that an interest rate adjustment would require a payment of, at most, $32 million over seven years, the appeal was not equitably moot. Id. at 13-14. VI. Conclusion and Practice Pointers By increasing the likelihood that a debtor will be required to pay a market interest rate to cram down a plan on secured lenders, the opinion clearly reduces a debtor’s leverage in negotiations with secured creditors. However, under the two-step approach adopted by the Second Circuit, bankruptcy judges appear to retain significant discretion to determine that no efficient market exists, after which they are free to apply the “formula approach” described in Till. Thus, the Second Circuit’s decision may have limited impact if bankruptcy courts do not find that efficient markets exist in the relevant circumstances. And because the Second Circuit did not specifically address whether a bankruptcy court must apply a “prime plus” or “treasury plus” interest rate under the formula approach, it remains to be seen what how bankruptcy courts in the Second Circuit will calculate cramdown interest rates. Accordingly, original lenders and debt acquirers should monitor how bankruptcy courts apply the Second Circuit’s decision in cramdown situations to evaluate and price distressed notes. Additionally, as noted previously, the Second Circuit’s decision regarding the make-whole and subordination issues illustrate the importance of precise drafting of debt documents and underscore the notion that careful analysis of the terms and provisions of debt documents is imperative when evaluating the risks in buying paper in the secondary market. Finally, with respect to equitable mootness, the Second Circuit’s decision manifests the growing reluctance to invoke the doctrine of equitable mootness. It suggests that, even after a plan’s substantial consummation, there is a significant risk that the terms of the plan will be altered so long as the objecting party diligently sought a stay of the chapter 11 plan. Thus, parties and practitioners should be mindful of this risk unless or until a chapter 11 confirmation order is final and non-appealable.  Krause, Jeffrey C., Moskowitz, Alan & Rosenthal, Michael A., MPM Silicones, LLC – The Dawn of a New Age for Debtors?, Gibson Dunn Client Alert (May 14, 2015).  Rosenthal, Michael A. & Weisser, Josh, Silence Is Golden: Second Lien Creditor Rights Post-Momentive, Gibson Dunn Client Alert (Nov. 12, 2014). The following Gibson Dunn lawyers assisted in preparing this client update: Michael A. Rosenthal, Matthew G. Bouslog and Dylan Cassidy. Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization practice group, or the following: Michael A. Rosenthal – New York (+1 212-351-3969, email@example.com) Matthew G. Bouslog – Orange County (+1 949-451-4030, firstname.lastname@example.org) Please also feel free to contact the following practice group leaders: Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, email@example.com) Jeffrey C. Krause – Los Angeles (+1 213-229-7995, firstname.lastname@example.org) Robert A. Klyman – Los Angeles (+1 213-229-7562, email@example.com) David M. Feldman – New York (+1 212-351-2366, firstname.lastname@example.org) © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.