Hot Topics Affecting Secured Creditors in Bankruptcy Proceedings December 8, 2016 American College of Investment Counsel
Section 1 Make-Whole Payments
Make-Whole Provisions: Offer yield protection to investors, allowing parties to agree in advance on a measure of damages for prepayment of debt. Are often applicable in conjunction with optional pre-payment or optional redemption provisions of indentures or loan agreements; and May also require yield protection payments following automatic acceleration of debt prior to stated maturity. 2
Make-Whole Summary: Make-whole payments have been the subject of intense litigation, the takeaways from which can be summarized as follows -- If styled as a premium due on prepayment, indenture must expressly provide that the premium will be due on voluntary acceleration as well as involuntary bankruptcy acceleration. If styled as a premium due on early redemption courts disagree on whether the indenture must expressly provide for payment on automatic and involuntary bankruptcy acceleration. Clarity of granting language in the documents is crucial. 3
Courts Look to the Note Purchase Agreement To determine if a make-whole payment will be due, courts: look to the plain language of the relevant agreement; and determine whether relevant bankruptcy provisions block any makewhole payments owed. Determinative Factor = does the agreement provide for payment following an acceleration if the agreement provides that the premium is due on prepayment or, in certain courts, early redemption? 4
Agreement Language Must be Clear and Express Three approaches to make-whole language: If indenture provides that a make-whole is not payable after acceleration, then courts will enforce the agreement as written. In re AMR Corp., 730 F.3d 88 (2d Cir. 2013). If indenture provides that a premium is due on prepayment then makewhole will only be due after acceleration if agreement expressly provides that the premium will be due at such time. In re Energy Future Holdings Corp., No. 16-1351, 2016 WL 6803710 (3d Cir. Nov. 17, 2016) ( EFIH ). If indenture provides that a premium is due on early redemption courts disagree on whether agreement must further specify that the premium will be due following acceleration and whether a bankruptcy filing triggering acceleration constitutes voluntary redemption. Compare EFIH with In re MPM Silicones, LLC, No. 14-22503-RDD, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014), aff d, 531 B.R. 321 (S.D.N.Y. 2015). 5
2 nd Circuit Approach: AMR (No Make- Whole Payable) If agreement provides no make-whole will be due on bankruptcy acceleration, then Courts will enforce the agreement as written: the unpaid principal amount of the [notes] then outstanding, together with accrued but unpaid interest thereon and all other amounts due thereunder (but for the avoidance of doubt, without Make-Whole Amount), shall immediately and without further act become due and payable[.] AMR Court refused to allow the make-whole on bankruptcy acceleration. 6
SDNY Approach Following AMR: Momentive (No Make-Whole Payable) Momentive Court found the following language insufficiently specific: If an Event of Default occurs [on account of the issuer s bankruptcy], the principal of, premium, if any, and interest on all the Notes shall ipso facto become immediately due and payable without any declaration or other act on the part of the Trustee or any Holders. The holders argued that the cram down paper constituted a voluntary redemption. The court disagreed, ruling that the bankruptcy filing resulted in the automatic (and therefore the involuntary) acceleration of the maturity date. 7
2 nd Circuit Application of the Automatic Stay to Block Debt Deceleration The AMR court, followed by the Momentive court, concluded that the automatic stay bars noteholders from issuing rescission notices and decelerating the relevant debt. Holders in both cases sought to rescind acceleration so that the debt would not be paid in full in Bankruptcy and to further demonstrate the optional nature of the Debtors prepayment. According to Judge Drain in Momentive, the purpose of the rescission notice would be to resurrect the right to the make-whole claim by decelerating the debt, and the effect of rescission would be to increase the size of claims, constituting an act to control property of the estate by exercising a contract right to the estate s detriment and attempting to recover, by deceleration, a claim against the debtors. 8
3 rd Circuit Approach: EFIH (Make- Whole Due) Applying New York law, court found the following language gave rise to make-whole requirement: 1L Indenture: on the bankruptcy filing all outstanding Notes shall be due and payable immediately without further action or notice. 2L Indenture: acceleration causes all principal of and premium, if any, interest... [,] and any other monetary obligations on the outstanding [Second Lien] Notes [to] be[come] due and payable immediately Note the similarity of this language to the language at issue in Momentive. Momentive remains subject to appeal. Court did not address noteholders right to decelerate. 9
3 rd Circuit Approach: EFIH (Make- Whole Due) (continued) Court made much of the fact that these make-whole provisions were styled as optional redemption premiums rather than prepayment premiums. Court distinguished cases that refused to enforce prepayment premiums. Court noted that, by definition, there can be no prepayment after debt is accelerated. By contrast, the court reasoned that redemption may still be effected postacceleration, and make-whole provisions may be enforced postacceleration when they are not prepayment premiums. Court also noted critically that EFIH s bankruptcy filing was voluntary and EFIH had the option to reinstate the notes original maturity date, but chose not to do so. 10
How to Avoid Litigation and Ensure Your Right to a Make-Whole Payment Borrowers/Debtors and junior creditors will attack plain vanilla make-whole provisions. Parties must use clear and unambiguous terms specifying the situations in which secured parties are entitled to make-whole payments: Note purchase or other financing agreements should provide that a make-whole amount is due regardless of any acceleration or action taken by a secured party to protect its rights and the manner of calculating the make-whole should be based upon actual damages. ACIC Model Form 2 contains appropriate language expressly providing for payment of make-whole following acceleration. 11
Make-Whole Payment Amounts Agreement language will also determine, among other things: the applicable rate of interest; whether default interest is due; and what fees and expenses must be paid by the debtors. 12
Make-Whole Payment Amounts (continued) Note purchase or other financing agreements should provide that the make-whole is a liquidated damages provision rather than a claim for unmatured interest or a penalty; and represents a reasonable forecast of damages caused by prepayment. In two 2013 make-whole cases, School Specialty (Case No. 13-10125 KJC (Bankr. D. Del.) and GMX Resources (Case No. 13-11456 (Bankr. W.D. Okla.)), courts found that the make-whole provisions provided for liquidated damages that were enforceable as a matter of state law, rejecting arguments that such payments were unmatured interest, or that the amounts were penalties or plainly disproportionate to the claimants lost interest. Courts generally find formula keyed to treasury rate reasonable. 13
Make-Whole Payment Amounts (continued) In School Specialty, although the fact that the make-whole amount was more than 35% of the amount of the applicable term loan concerned the Court, it found that the applicable standard is whether the Make Whole Payment is plainly disproportionate to the possible loss, and not whether the payment is disproportionate to the principal amount of the loan. Court found that the payment was allowable under New York law because it was negotiated at arm s length and was calculated to preserve the lenders bargained-for yield. 14
Make-Whole Conclusion If an opportunity presents itself to renegotiate agreement terms, noteholders should give special regard to any make-whole provisions and revise to ensure clarity and enforceability. Bottom line: Notwithstanding the recent Third Circuit decision in EFIH, it remains prudent to assume for drafting purposes that all ambiguities will be construed in favor of the borrower/debtor. 15
Section 2 Cramdown Interest Rate
Cramdown of Secured Creditors, Section 1129(b)(2)(A)(i) For the purpose of this subsection, the condition that a plan be fair and equitable with respect to a secured class includes the following requirements: With respect to a class of secured claims, the plan provides (i) (I) that the holders of such claims retain the liens securing such claims, whether the property subject to such liens is retained by the debtor or transferred to another entity, to the extent of the allowed amount of such claims; and (II) that each holder of a claim of such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claim, of a value, as of the effective date of the plan, of at least the value of such holder s interest in the estate s interest in such property; 17
Formula Rate or Market Rate Courts have been split on the proper rate of interest for cramdown debt in chapter 11 cases. Formula rate approach Start with a risk-free interest rate and add a debtor-specific risk premium to reflect the creditor s risk of nonpayment. Market rate approach Look to whether there is evidence of an efficient market for financing similar to the cramdown debt. If an efficient market exists, use that interest rate, else use the formula rate. 18
Till v. SCS Credit Corp., 541 U.S. 465 (2004) Chapter 13 individual debtor sought to lower the interest rate on an auto loan with a prepetition 21% interest rate. Adopted formula approach to cramdown interest rate courts should begin with the risk-free rate and add a premium (1-3% for most debtors) to compensate for risk of non-payment. Rejected various proposed market rate tests. Footnote 14 can be read to suggest that in the chapter 11 context it may make sense to consider the rate of an efficient market: when picking a cram down rate in a Chapter 11 case, it might make sense to ask what rate an efficient market would produce. In the Chapter 13 context, by contrast, the absence of any such market obligates courts to look to first principles and ask only what rate will fairly compensate a creditor for its exposure. 19
Courts Adopting a Market Rate Approach Certain courts have found Till to not be binding in a chapter 11 case. In re American HomePatient, Inc., 420 F.3d 559 (6 th Cir. 2005) Established a two-step approach: courts should first determine whether an efficient market exists, and only use the formula method if no efficient market exists. Evidence of efficient market primarily established through expert testimony. Courts applying the two-step approach have generally found that no efficient market exists and then apply the formula method. 20
MPM Silicones Court Empowers Chapter 11 Debtors with New Cram Down Tool Debtors filed a Plan with a deathtrap provision : if creditors voted to accept the plan they would receive payment in full of their claims, but would concede their claims to contested make-whole amounts; if the creditors rejected the Plan and pursued the make-whole amounts they would receive replacement notes bearing interest rates significantly less than the original issue rates and significantly below market. Creditors voted to reject the Plan, arguing that Till does not control in chapter 11 because there is an efficient market for chapter 11 loans. Pointed to market evidence to derive the cramdown rate. Momentive had lined up $1 billion in exit financing Submitted expert reports supporting use of market rates (argued for rates of approximately 6-7.5%) 21
MPM Silicones Court Empowers Chapter 11 Debtors with New Cram Down Tool (continued) The Bankruptcy Court: Approved the Plan s use of the Till formula Per Till, rejected reference to market rate for cramdown interest rate. Overcompensation of creditors for profit and transaction costs Purpose of cramdown rate is not to pretend a new loan was made by the creditor, which would include profits to the creditor Rejected objectors arguments that there is a difference between chapter 11 and chapter 13 debtors under Till. Bankruptcy Court s decision affirmed by District Court, appeal to Second Circuit pending 22
ABI Proposed Reforms seek to Correct MPM Silicones Decision American Bankruptcy Institute Issued Final Report in December 2014. Proposes to overturn the MPM Silicones decision with respect to cramdown interest and proposes a market-based approach to adjusting interest rates; and Advocates accounting for actual, debtor- and industry-specific risks in arriving at interest rate. 23
Section 3 Gas Gathering Litigation
Midstream Services Agreements Midstream oil and gas companies provide transportation, storage, processing and other logistical services to upstream exploration and production ( E&P ) companies. The services agreements under which midstream companies operate are routinely structured as long-term contracts requiring a large initial expenditure by the midstream service providers to build infrastructure in the form of, among other things, pipes, storage, or processing facilities necessary to provide upstream customers the contracted-for services. 25
Midstream Oil and Gas Agreements Involve Unique Economic Risks if Rejected Early termination or rejection of midstream services agreements can produce devastating economic losses given that the required infrastructure is often built to particular customer specifications. Midstream companies are therefore eager to avoid having such agreements rejected in E&P counterparty bankruptcies. Note, however, that where the debtor needs the pipeline capacity, then the debtor may not be in a position to reject alternatives are invariably uneconomical 26
The Bankruptcy Code Allows Debtors to Reject Contracts under Limited Circumstances Section 365 of the Bankruptcy Code provides debtors with the right to reject executory contracts or unexpired leases, but not contracts that are non-executory. The word executory is not defined in the Bankruptcy Code, but most courts hold a contract to be executory if the obligations of both parties are so far underperformed that the failure of either party to complete performance would constitute a material breach and thus excuse the performance of the other. Covenants do not create reciprocal obligations that may be excused by failure of performance and, as such, agreements that create them generally will not be subject to rejection pursuant to section 365. 27
The Developing Dispute over Midstream Contracts in Bankruptcy Midstream service providers have included covenant provisions in their agreements in an attempt to avoid having such agreements rejected in bankruptcy. With the increasing number of E&P bankruptcies, Bankruptcy Courts have begun to analyze whether or not they may be rejected under section 365 notwithstanding the covenant provisions. Only one court (In re Sabine, in the Southern District of New York) has fully addressed this question, finding the applicable covenant provisions insufficient to prevent rejection of the agreements, but at least one Texas court has signaled its strong disagreement with the In re Sabine holding. 28
In re Sabine Sabine filed for bankruptcy on July 15, 2015 and sought to reject agreements with two of its midstream providers. Providers objected claiming that the agreements were covenants running with the land under Texas law. The agreements, among other things, provided: Sabine agreed to dedicate all oil and gas produced from certain wells to the performance of the agreements, and Under the relevant contracts, parties agreed that the agreements were covenants running with the land. The court held that the agreements neither contained nor included covenants running with the land. 29
In re Sabine (continued) Sabine court found that under Texas law, a covenant runs with the land when: (1) it touches and concerns the land; (2) it relates to a thing in existence or specifically binds the parties and their assigns; (3) it is intended by the original parties to run with the land; and (4) the successor to the burden has notice. Court also noted that many courts have also required that the parties have horizontal privity of estate. The court held: (1) that the dedications contained in the agreements concerned only minerals extracted from the ground, which constitute personal property, not real property, under Texas law, and (2) no horizontal privity existed. 30
In re SandRidge Energy, Inc. Sandridge filed for bankruptcy in June 2016 and sought to reject certain agreements with Williams Midstream Gas Services. Debtors and Williams agreed that the court would make no findings as to whether the relevant agreements contained covenants running with the land. In response, Judge Jones stated on the record, I ve been looking for an opportunity to correct the state of New York or whatever it is with regard to issues around covenants in gas gathering agreements. Issue has been raised in other cases, but not yet reduced to judgment. 31
In re Warren Resources Warren Resources, another recently bankrupt E&P company, leveraged the Sabine decision to negotiate improved economic terms in one of its existing prepetition midstream services agreements in exchange for agreeing to add language proposed by the midstream service provider aiming to strengthen and clarify the covenant provisions of the existing agreement. In addition to changes to economic terms of the agreements, the agreements were revised to (i) clarify that the agreement creates a covenant running with the land and that the parties intend for the agreement to do so, and (ii) provide for the execution of an independent instrument of dedication. 32
Section 4 Unsecured Creditor Attacks on Blanket Liens
Unsecured Creditors Are Challenging Secured Creditors Postpetition Liens Unsecured creditors have also sought to erode secured creditors all asset blanket liens. Using section 552, unsecured creditors have successfully impaired secured parties rights to postpetition proceeds of the sale of collateral and postpetition enhancements to enterprise value. 34
What is Section 552? Section 552 establishes the extent of a creditor s prepetition security interests in a debtor s postpetition property and cuts-off all prepetition liens on property acquired postpetition. The section allows proceeds, products, offspring or profits of prepetition property to continue to be subject to a postpetition security interest if a prepetition agreement so provides, unless the court finds that the equities of the case mandate otherwise. 35
Why Section 552 Matters A number of new challenges using section 552 have negated the ability to continue prepetition liens to postpetition collateral. Effect is muted where secured creditor provides postpetition financing, and thereby obtains new, replacement liens in postpetition collateral. 36
Some Courts Have Strictly Read 552, Limiting Secured Parties Prepetition Liens Courts interpreting the definitions of proceeds, products, offspring or profits have given those terms a strict interpretation. In re Las Vegas Monorail Co., court held that postpetition income stream was not proceeds of the secured parties prepetition liens in contract rights and net project revenues. Courts have also found postpetition assets do not fall into definition of proceeds under section 552 where soft or unencumbered assets have been used to enhance, improve or protect assets. Often impossible to secure a lien on such soft assets. 37
Courts Also May Limit a Secured Party s Rights After Finding that the Equities of the Case Require a Limitation Courts invoke equities of the case exception where a debtor has used unencumbered assets or provided postpetition services to improve prepetition collateral. Exception is often invoked when the secured creditor is over-secured. Recently, 9 th Cir. B.A.P. rejected a trustee s creative use of the exception which should be limited to instances where collateral value was directly enhanced by estate s other, unencumbered assets. (In re Endreson, 548 B.R. 258) 38
ABI Proposals on 552 The ABI Commission Report : Debtor-friendly. Would prohibit a debtor from waiving its 552 rights as a part of DIP financing or similar agreements. May diminish secured creditor s recoveries by limiting ability to share in increases of goodwill and overall enterprise value. 39
Strategies to Protect a Secured Party s Collateral Package To improve the chances of having prepetition liens cover after-acquired property, creditors should: (i) have transaction documents make specific reference to the debtor s going concern and enterprise value; (ii) include in the collateral any and all value generated by the assets; (iii) require that only funds encumbered by a lien be used to enhance or pay postpetition expenses related to the applicable collateral; (iv) seek replacement liens in all collateral as adequate protection; (v) require in postpetiton financing or cash collateral orders that debtors waive the protections of section 552(b)(1); and (vi) push for roll-up DIPs whenever possible. 40 24
Section 5 Case Appendix
MPM Silicones (Make-Whole Denied) Case: In re MPM Silicones, LLC, No. 14-22503-RDD, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014), aff d, 531 B.R. 321 (S.D.N.Y. 2015): Debtors filed an adversary proceeding seeking a declaratory judgment that on account of an automatic acceleration upon the bankruptcy filing no make-whole payments were required. Indenture trustees for the relevant indentures argued that payment was required notwithstanding the acceleration. Court reasoned that the automatic acceleration of debt caused by a bankruptcy filing does not trigger a debtor s obligation to pay a make-whole premium in the absence of an explicit provision providing that the premium is payable despite acceleration. Holding was affirmed by the District Court for the Southern District of New York and is currently on appeal to the 2 nd Circuit, but has been called into question by the 3 rd Circuit s decision in EFIH. 42
Section 552: In re Residential Capital, 501 B.R. 549 (Bankr. S.D.N.Y. 2013) Facts: Proposed a plan of reorganization treated junior secured noteholders ( JSNs ) as undersecured. The JSNs contended that they were entitled to postpetition interest because they were over-secured based on the value of their pre- and postpetition collateral and they had a lien on all Proceeds, products offspring, rents, issues, profits and returns of and from, and all distributions on and rights arising out of any of the [collateral described in the JSN Security Agreement]. Holdings: Because 552(b)(1) only applies to collateral acquired postpetition that is directly attributable to prepetition collateral, without the addition of estate resources, the JSNs had failed to meet their burden of establishing that goodwill portion of the amounts generated by certain sales were proceeds of their prepetition collateral. Debtor had used unencumbered assets, including soft assets, to improve the assets prior to sale. Accordingly, JSNs claims were limited to the value of their specific prepetition collateral and postpetition increases in goodwill were not attributed to the value of the JSNs claims, thus prohibiting the JSNs from sharing in the overall postpetition increase in enterprise value. 43
Section 552: In re Premier Golf Properties, LP, 477 B.R. 767 (B.A.P. 9th Cir. 2012) Holding: The Ninth Circuit Bankruptcy Appellate Panel found that a lender s liens in the debtor golf club operator (covering the debtor s personal property, general intangibles, license fees and all proceeds thereof, and real estate, all rents, profits, issues, and revenues from the real property) did not extend to postpetition green fees or driving range fees because, in part, the value arose from postpetition services provided by the debtor (such as regular planting, seeding, mowing, repositioning holes, watering, fertilizing, and maintaining the golf course), and not from the prepetition collateral alone. This post-petition revenue therefore did not fit within the definition of proceeds under 552 and secured creditors were limited to value of their prepetition collateral. 44
Section 552: In re Cafeteria Operators, LP, 299 B.R. 400 (Bankr. N.D. Tex. 2003) Facts: Secured lenders of a restaurant chain possessed a blanket lien on all of the debtors assets which, per the security agreement, extended to the proceeds of its collateral. Among other things, the secured lender s collateral included the ingredients used in the food preparation. Holding: Bankruptcy court held that while some portion of the debtor s revenues were proceeds of the collateral (specifically that part attributable to the various ingredients), the portion attributable to the labor of debtor s workers was not proceeds of the lender s collateral. The court held that the value of the secured creditor s interest in the postpetition revenues should be limited to the value attributed to its prepetition inventory based upon the equities of the case exception to 552(b)(1). 45
This document has been prepared by Chapman and Cutler LLP attorneys for informational purposes only. It is general in nature and based on authorities that are subject to change. It is not intended as legal advice. Accordingly, readers should consult with, and seek the advice of, their own counsel with respect to any individual situation that involves the material contained in this document, the application of such material to their specific circumstances, or any questions relating to their own affairs that may be raised by such material. 2016 Chapman and Cutler LLP 46