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Un-Till Death Do Us Part? Assessing the Rights of Secured Creditors in Chapter 11

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Un-Till Death Do Us Part? Assessing the Rights of Secured Creditors in Chapter 11 Educational Materials Monday, September 28, 2015 | 10:30 AM – 11:30 AM Un- Till Death Do Us Part? Assessing the Rights of Secured Creditors in Chapter 11 Presented by: Un-Till Death Do Us Part? Assessing the Rights of Secured Creditors in Chapter 11 Table of Contents Outline …………………………………..…………………………………………………………………………………................1 The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy by Charles J. Tabb…………………….………………………………….…….8 The Rights of Secured Creditors After RESCAP by Douglas G. Baird............................................ 53 In re MPM Silicones, LLC (2014)…………………………………………………………………………………...............69 In re Residential Capital, LLC 501 B.R. 549 (Bkrtcy.S.D.N.Y. 2013)……………………..………...............96 In re SW Boston Hotel Venture, LLC 748 F.3d. 549 (1st Cir 2014)………………………..….…..............172 Un-Till Death Do Us Part? For many decades, the absolute priority rule has been the central organizing principle of the Bankruptcy Code: A fully secured senior creditor is entitled to be paid in full. Exactly how this right is to be vindicated, however, remains remarkably unsettled. Several important cases over the past several years underscore the extent to which the rights of secured creditors are in flux. 1. Sources of secured creditor rights under the Bankruptcy Code: U.S. Constitution, statute, case law. The conventional wisdom is that efforts to tinker with the secured creditor’s rights were constitutionally suspect. This has been the case ever since the Supreme Court’s decision in Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555, 601–02 (1935) (striking down the Frazier-Lemke Act). In contrast to ordinary general creditors, secured creditors have property rights that the Fifth Amendment’s Takings Clause protects. This aura of constitutional protection affects the way judges approach many provisions of the Bankruptcy Code, from grants of adequate protection to the reluctance to approve priming dip loans. It bears asking whether secured creditors’ rights are as inviolable as this conventional wisdom suggests. For one scholar’s view that they are not, see Charles J. Tabb, The Bankruptcy Clause, the Fifth Amendment, and the Limited Rights of Secured Creditors in Bankruptcy, 2015 U. Ill. L. Rev. 765 (2015). 2. Adequate protection. Senior Lender is owed $100 and has a security interest in all Debtor’s assets. Debtor files for bankruptcy. If Senior Lender were able to exercise its rights under nonbankruptcy law at the time the petition was filed, it would receive only $50. Debtor’s assets include a Treasury bill for $50. Few of its other assets will be worth much if the firm is liquidated outside of bankruptcy. By contrast, in Chapter 11, going-concern value can be preserved. By the time Chapter 11 is over, Debtor will end up being worth $60 or $140 with equal probability. For this reason, Debtor has an expected value of $100. At the start of the case, Senior Lender demands adequate protection. Does putting the Treasury bill in an escrow account provide the Senior Lender with adequate protection? It might seem that this is not enough. The expected value of Senior Lender’s collateral at the end of the reorganization is $100. This is the amount that needs to be adequately protected. Associates Commercial Corp. v. Rash, 520 U.S. 953, 954 (1997), suggests that this amount provides the proper baseline. Rash was a Chapter 13 case, but the decision turned on the Court’s interpretation of §506. It held that “the ‘proposed disposition or use’ of the collateral is of paramount importance to the valuation question.” If 1 Debtor plans on remaining intact as a going concern, its value in a liquidation outside of bankruptcy is not relevant. The court in ResCap relied on Rash when it held that a going-concern valuation was the appropriate benchmark for adequate protection, at least when the debtor planned a going-concern sale from the start. See Official Committee of Unsecured Creditors v. UMB Bank (In re Residential Capital, LLC), 501 Bankr. 549, 594 (Bankr. S.D.N.Y. 2013). But it is possible to take a different view. The standard justifications for adequate protection center around the idea that the bankruptcy process itself should not jeopardize a secured creditor’s nonbankruptcy entitlement. It would seem to follow that if a secured creditor could not realize more than foreclosure value outside of bankruptcy, it should not be able to demand protection for a greater amount while the reorganization is underway. This should still be the case even if the senior lender’s priority over general creditors is fully recognized at the time of the reorganization. The American Bankruptcy Institute (ABI) Commission to Study the Reform of Chapter 11 has endorsed this idea that the senior lender should be limited to foreclosure value. In practice, basing adequate protection on foreclosure value could utterly change the dynamics of large Chapter 11s, as it will make it much easier for courts to approve priming dip loans. 3. Reorganization value. Senior Lender has a security interest in all of Debtor’s assets, apart from one piece of intellectual property (IP). In the grand scheme of things, this IP is useful, but not critical. Debtor uses the IP in its own business and derives some modest additional revenue from licensing it to others. Debtor files for bankruptcy amidst a wave of unfair publicity and threats of overzealous government regulation. At the time of the petition, there was a substantial chance that Debtor would be liquidated. During the course of the reorganization, Debtor’s management team spends aggressively on clever advertising and adroit lobbying. The strategy proves successful, and Debtor is able to reorganize. To what extent is the Senior Lender entitled to the increase in value attributable to the advertising and lobbying campaign? Some of the money came from proceeds of Senior Lender’s collateral, and some came from licensing revenues from the IP. Senior Lender has rights to most, but not all, of Debtor’s prepetition assets. How much of the increase in value during the case belongs to it and how much to the general creditors? ResCap raised, but did not squarely confront this question, as the affected secured creditors could not show that any of the proceeds of their collateral were used to make the investments in goodwill that led to an increase in value during the course of the case. See 2 Official Committee of Unsecured Creditors v. UMB Bank (In re Residential Capital, LLC), 501 Bankr. 549, 610–12 (Bankr. S.D.N.Y. 2013). The Bankruptcy Code provides that the secured creditor is entitled to the proceeds of its collateral unless the court orders otherwise “based on the equities of the case.” §552(b)(2). How exactly this language should be understood remains largely unexplored. 4. Measuring the cramdown interest rate. Debtor proposes a plan of reorganization in which it proposes to pay Senior Lender the amount of its secured claim over five years. There is a well-functioning market for exit financing. If Debtor chose to use it, Debtor could borrow and pay Senior Lender in full. This exit financing would have the same duration and same terms as what Secured Lender would receive under the plan. To what extent should the interest rate Debtor would pay for the exit financing affect the way in which the bankruptcy judge assesses the interest rate Debtor proposes to pay under the plan? There are two strikingly different approaches to this question. The first adopts the following reasoning. Under §1129(b)(2)(A), the secured creditor is entitled to the value of its secured claim. It must be given a note that has a rate of interest sufficient to make the note equal in value to the amount that the Senior Lender’s collateral would fetch if Senior Lender were to foreclose on it immediately. The interest rate of the exit financing is the best approximation of the rate the note should have. It is the most sensible way to account for the risks associated with delay. This central lesson of BFP v. Resolution Trust Corp., 511 U.S. 531 (1994), and Bank of America Nat. Trust & Savings Ass’n v. 203 North LaSalle Street Partnership, 526 U.S. 434 (1999), is that the market provides the best measure of value. The mysterious footnote in Till v. SCS Credit Corp., 541 U.S. 465, 476 n.14 (2004), to the extent it stands for anything, is consistent with this approach, even if it confuses dip with exit financing: Because every cramdown loan [in Chapter 13] is imposed by a court over the objection of the secured creditor, there is no free market of willing cramdown lenders. Interestingly, the same is not true in the Chapter 11 context, as numerous lenders advertise financing for Chapter 11 debtors in possession. For a court that adopts this reasoning, see In re Am. HomePatient, Inc., 420 F.3d 559, 567–68 (6th Cir. 2005). But, there is an entirely different way to think about this question. We should resist that idea that market benchmarks are ever going to be readily available. Discovering the “market” will dissolve into an expensive battle between experts. More importantly, even if market rates for loans to the debtor were 3 available, they would provide the wrong benchmark. Indeed, the market interest rate for a new loan is necessarily too high. Interest rates reflect not just the riskiness associated with a particular loan, but also costs associated with originating the loan and profits the lender expects to enjoy. Neither should be included in an interest rate that is supposed to ensure only that the secured creditor receives a stream of payments equal to the value of its collateral.
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