Bankruptcy Law Is More Ambiguous Than We Thought

Distressed investors and bankruptcy lawyers, listen up.

What can you trust?

Photograph: Getty Images

This post originally appeared in Money Stuff.

On Friday, the U.S. Court of Appeals for the Second Circuit issued a decision in In re MPM Silicones, LLC, a bankruptcy case involving the reorganization of Momentive Performance Materials Inc. The court decided a couple of questions that might be of interest to distressed investors and bankruptcy lawyers: It held that bondholders should not get early-redemption make-whole payments upon bankruptcy, and that if a debtor is going to satisfy secured bondholders' claims in full in a reorganization by giving them new bonds, those bonds should probably have a market-based rate of interest. 

But I want to focus on a boring obvious question that the court also decided, which is that Momentive's subordinated unsecured notes were junior to its second-lien secured notes. This is not, I would have thought, a subtle question of bankruptcy law. This is like: Companies issue bonds, and those bonds have a hierarchy of seniority, and the hierarchy is like first-lien secured bonds, second-lien secured bonds, senior unsecured bonds, subordinated unsecured bonds, preferred stock, common stock, etc. (Momentive also had "1.5-lien secured notes," which slices things rather fine.) And everyone knows that the things higher up in the hierarchy are senior to the things lower down in the hierarchy, and that if the company goes bankrupt the higher-up things should be paid off before the lower-down things get anything. And here that happened: The first-lien notes got fully paid, the second-lien notes got partially paid, and the subordinated notes got zeroed. But what the subordinated note holders here asked is: What if that's wrong? What if the subordinated notes are not actually subordinated to the second-lien notes?

The bankruptcy court and district court responded, effectively, no, come on, we live in a society here. Obviously everyone intended the secured notes to be senior to the subordinated notes; that is the whole point of those words, and of capital structure generally. But on appeal, the Second Circuit took the question more seriously, held that the answer was ambiguous ("Rather, we conclude that the Fourth Proviso renders the definition of Senior Indebtedness ambiguous as to whether it includes the Second-Lien Notes" -- a lovely sentence to show to any young person who is considering whether to go to law school), but ultimately agreed that, as the other courts had held, the junior debt was in fact junior to the senior debt.

This all takes seven pages and I have no huge substantive problem with any of it. But in some ways it ought to be of more interest to distressed investors than the stuff about make-wholes and interest rates. People think about that stuff. This stuff -- the idea that secured notes are senior to subordinated notes -- is too fundamental to think about. When a court starts thinking about it, and finds the relationship ambiguous and the questions difficult, then the whole system starts to feel slippery. If you can't trust the titles of the bonds -- if you can't assume that secured bonds outrank subordinated bonds just by reading the names, but have to carefully parse the indentures and intercreditor agreements and consider how a court will interpret their ambiguities -- then what can you trust?

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