- The Enforceability of a Make-Whole Provision in Bankruptcy: It Says What It Says
- May 24, 2017 | Authors: Jonathan J. Kim; Bradford J. Sandler
- Law Firms: Pachulski Stang Ziehl & Jones LLP - Los Angeles Office; Pachulski Stang Ziehl & Jones LLP - New York Office
For more than a decade, make-whole premiums, also referred to at times as prepayment premiums, prepayment fees, yield maintenance premiums, or similar terms, have been a common feature in bond indentures and credit agreements. The basic purpose of a make-whole premium is to compensate the investor or lender if the debt is paid prior to its maturity date for the loss of the bargained-for return that the investor or lender would have otherwise received. Debtor-borrowers often benefit from such provisions by obtaining lower interest rates and/or fees than they would otherwise pay absent such provisions.
Given the current low interest rate environment, the enforceability of make-whole provisions has been the subject of intense litigation involving millions of dollars-sometimes tens or hundreds of millions of dollars-as debtors seek to refinance debt that was entered into during periods of higher interest rates and investors seek to maintain their contractual rates of return.
The enforceability of make-whole premiums in bankruptcy has been questioned by some courts. For the most part, disputes regarding the enforceability of a make-whole provision focus on the following: (1) Does the contractual language of the relevant credit agreement or indenture provide for payment of the make-whole amount? and, if so, (2) Has a bankruptcy filing or other default accelerated the debt, causing it to be already due and payable, thereby arguably negating the make-whole requirement?
Specifically, a make-whole clause may be held ineffective following an automatic acceleration, as certain courts have held that there cannot be any “prepayment” following a debt’s deemed maturity upon acceleration. A number of courts have held, however, that a make-whole premium is still payable, provided that the applicable credit agreement provides for such payment following an acceleration.
Other arguments that may be litigated include whether the make-whole amount: (i) represents an unenforceable penalty under applicable state law, (ii) represents a claim for unenforceable unmatured interest under Section 502(b)(2) of the U.S. Bankruptcy Code, (iii) represents a secured or unsecured claim, and (iv) is unreasonable. Broadly speaking, such arguments are of limited viability, as many courts have rejected these arguments (depending on the specific case’s circumstances).
More recent decisions give investors clearer guidance on what provisions they should demand in the parties’ documentation to better ensure obtaining such claim amounts in Chapter 11 cases. That is, the right to payment of a make-whole amount will likely hinge on the plain (or ambiguous) language of the parties’ agreement. Arguably, recent case law may help substantially change the dynamics and leverage of creditor constituencies in a bankruptcy case involving investors asserting make-whole premiums, including with respect to the amount of debt a secured lender can credit bid or the debt amount which the debtor is required to restructure. Cases like the 3rd U.S. Circuit Court of Appeals’s Energy Future decision (Del. Trust Co. v. Energy Future Intermediate Holding Co. LLC, 842 F.3d 247 (3d Cir. 2016)) will also likely impact ongoing debt restructurings outside of bankruptcy and the negotiation of new debt issuances.
The Energy Future Decision
In a November 2016 ruling, the 3rd Circuit overturned refusals by both the Delaware Bankruptcy Court and District Court to enforce make-whole payments from Energy Futures Holding Company LLC and EFIH Finance Inc. The appellate court ruled that the relevant indenture provisions supported the payments and remanded the case to the Bankruptcy Court for further proceedings.
In Energy Future, the first lien and second lien indenture trustees each initiated adversary proceedings in Bankruptcy Court in Delaware claiming the power company’s refinancing of its outstanding debt during the Chapter 11 case entitled the respective holders to hundreds of millions of dollars in make-whole payments. The pertinent provisions in the indentures were: (i) a redemption provision (the indentures provided that Energy Future could redeem all or part of the notes at a redemption price equal to 100 percent of the principal amount of the notes redeemed, plus the “applicable premium” (i.e., the make-whole amount) and interest), and (ii) an acceleration provision that provided that all outstanding notes would become immediately due and payable if Energy Future filed for bankruptcy.
Both the Bankruptcy Court and the District Court upheld the debtor’s view that no make-whole amount was due, because payment of debt after its accelerated maturity date is not a “prepayment” and the acceleration provision itself did not contain an explicit statement that the make-whole amount was due after acceleration. The 3rd Circuit reviewed the entirety of the two applicable provisions and found them not to be inconsistent. It concluded that nothing in the acceleration provision negated the requirement for the make-whole payment because acceleration had no relevance to whether the make-whole payment was due at that time; if the optional redemption occurred prior to the stated maturity date, then the make-whole payment was due.
Of particular importance to the 3rd Circuit was that the redemption provision clearly stated that upon any voluntary repayment-a “redemption”-the make-whole amount would be due if there was repayment before the specified maturity date. Citing certain New York and federal court cases, the 3rd Circuit distinguished between a “prepayment”-which some courts have viewed as being impossible once the maturity date is accelerated after a Chapter 11 filing-and a “redemption,” which simply means repayment, whether before or after maturity. The 3rd Circuit reasoned that “by avoiding the word ‘prepayment’ and using the term ‘redemption,’ [the parties to the agreement had] decided that the make-whole would apply without regard to the Notes’ maturity” and “if [Energy Future] wanted its duty to pay the make-whole optional redemption to terminate on acceleration of its debt, it needed to make clear that [the acceleration provision] trumps [the redemption provision.]”
The 3rd Circuit also noted that the redemption was voluntary (“optional”) in that the debtor had the option through its plan of reorganization to reinstate the original maturity date under the Bankruptcy Code, instead of repaying the notes; the noteholders did not want to be repaid, and the redemption was made over noteholder objections during the Chapter 11 case. The 3rd Circuit explained that the debtor openly acknowledged that the refinancing was being intentionally done to cut its interest expense.
The 3rd Circuit’s ruling in Energy Future again puts parties on notice that the viability of make-whole provisions will very likely turn on the precise language regarding the circumstances under which these payments become due. Clear and express language in debt documentation providing for, for instance, the payment of make-whole amounts after acceleration or upon redemption prior to a date certain will be critical in demonstrating the parties’ intent that make-whole amounts are due if the debt is repaid after acceleration.
Proceedings Since the Energy Future Decision
On December 15, 2016, Energy Future petitioned the 3rd Circuit for a rehearing or rehearing en banc to reconsider its ruling allowing some $800 million to $900 million in make-whole claims. According to Energy Future, New York’s highest court, the New York Court of Appeals, should decide the issue instead: “Until the panel’s decision in this case, all courts-including state and federal courts in New York-agreed that under New York law, a borrower that repays accelerated debt is not required to pay an additional premium unless the governing contract says so explicitly.”
Energy Future continued: “There needs to be a uniform approach to this critical question, and only one court can provide it. Accordingly, appellants respectfully request that this Court grant rehearing and certify this determinative issue to the New York Court of Appeals. At a minimum, the Court should hold this petition until the Second Circuit has issued its pending decision [in the Momentive bankruptcy case] addressing this same issue....” To date, the petition is still pending before the 3rd Circuit, although it will be later withdrawn pursuant to the recent settlement if that agreement is implemented.
Given the 3rd Circuit’s adverse November 2016 ruling, Energy Future shortly thereafter had seemingly reached a settlement in principle regarding the make-whole premiums. The settlement with certain first and second lienholders and certain other unsecured creditors, reached on December 16, 2016, would provide for modest discounts on the premiums owed for early repayment. Under that lienholder settlement, intercreditor litigation between trustees for the first and second lienholders would be dismissed.
While the potential concessions would have been relatively modest, certain lienholders were evidently willing, at that point, to settle the matter, given, among other factors, the risks, uncertainties, and costs of continued litigation. Notwithstanding that, weeks after this apparent settlement, the debtors backed out of this proposed deal and, instead, pivoted to a plan deal with the unsecured PIK noteholders reflected in a seventh amended plan filed in early January 2017. Among other plan provisions, the new deal, at that point, would protect the first and second lienholders by funded, interest-bearing claims reserves (against which the lienholders would have liens, subject to certain provisions and exceptions); a committee appointed by the unsecured noteholders, acting on behalf of the debtors, would decide how vigorously and in which manner to challenge the 3rd Circuit’s November 2016 ruling.
The amended plan basically contemplated a resolution of the make-whole litigation within three years-although this period had been referred to by the debtors as “generous.” In short, under the seventh amended plan, potentially even more protracted litigation and appeals would have been forthcoming in the Energy Future case.
Then, in the most recent interesting turn of events, the Energy Future case culminated in the eighth amended joint plan, which was confirmed by the Bankruptcy Court on February 17, 2017. (Certain parties have appealed the plan’s confirmation.) On the eve of the hearing on confirmation of the seventh amended plan, Energy Future, certain supporting first and second lienholders, and certain unsecured noteholders reached an agreement to settle all make-whole claims, which was reflected in the eighth amended plan.
The related make-whole settlement was approved by the Bankruptcy Court pursuant to an order entered on March 24, 2017. Together under the confirmed eighth amended plan and court-approved settlement, the first lienholders will be paid 95 percent of the make-whole claims; all interest (at the contract rate) on the make-whole claims accrued as of the date of repayment; all documented fees, expenses, and indemnification claims; and all additional accrued and unpaid interest (at the contract rate).
The second lienholders will be paid 87.5 percent of their make-whole claims; all interest (at the contract rate) on the make-whole claims accrued as of the date of repayment; all documented fees, expenses, and indemnification claims; and all additional accrued and unpaid interest (at the contract rate). Pursuant to the settlement order, all first and second lienholders and unsecured noteholders that did not otherwise enter into the settlement are bound by the settlement and the settlement order, because, among other things, the applicable requisite floor amounts for binding non-signing parties (under applicable documents and laws) had been met.
In addition to the nearly $1 billion in make-whole claims and interest that could become allowed as a result of the make-whole litigation, Energy Future had faced mounting legal fees and other expenses. The settlement will provide for payment of less than 100 percent of the make-whole claims, cut off the substantial run-rate for interest and litigation costs, and obviate the need to escrow billions of dollars pending resolution of the make-whole litigation.
It should be noted that the 3rd Circuit’s Energy Future decision appears to be impacting, at least to some extent, the ongoing make-whole litigation in the Momentive bankruptcy case (MPM Silicones, LLC, Case No. 14-22503-RDD, pending in the Southern District of New York), which is awaiting a ruling from the 2nd U.S. Circuit Court of Appeals. Various parties have made filings with the 2nd Circuit supporting or criticizing/distinguishing the Energy Future decision.
How much of an impact the Energy Future decision will have in the Momentive litigation may hinge on the apparent insolvency of Momentive. The Energy Future decision presumed the debtor was solvent. If the 2nd Circuit were to ultimately agree with the 3rd Circuit’s reasoning and if the debtor is solvent, state law would require strict enforcement of the governing indentures and likely payment of the full premiums. If Momentive is insolvent, the equities of the case may require the court to divide up the finite pie in a different manner.
The Energy Future decision may also incentivize noteholders in other bankruptcy cases, to try to further explore or push its limits. For instance, In re Bonanza Creek Energy, Inc., Case No. 17-10015-KJC, pending in Delaware, the debtors have proposed a prepackaged plan (consistent with a restructuring support agreement by and among the debtors, an ad hoc group of certain noteholders, and other key parties) under which, among other things, $52 million in prepayment premiums would be allowed as part of the noteholders’ claims, which claims would be equitized into new common stock rather than be paid in cash. Substantive briefing on the prepayment premium issues has not yet been filed (although, among other things, an ad hoc committee of equity security holders have expressly reserved its rights to challenge any make-whole premiums), but potentially, the plan proponents will try to rely on the Energy Future decision and try to portray the prepayment premium as a redemption premium.
Related issues may come up in Bonanza Creek Energy that did not arise in Energy Future, such as whether a real optional redemption premium is at issue, given that the noteholders will be given new common stock (instead of cash) and the transactions will be implemented through a reorganization plan. It will be interesting to see how this case and other bankruptcy cases involving arguably analogous indenture provision issues turn out.
Minimizing Investor Risk
As in the case of any important contractual provision, when examining a make-whole provision, investors and lenders should seek explicit and clear terms specifying the situations in which they are entitled to their bargained-for make-whole payment. Loan agreements should provide that a make-whole amount is due regardless of any acceleration or action taken by the lender to protect its rights. In current and future debt issuance negotiations, investors and lenders may very well want to demand redemption and related provisions like those in the Energy Future case.
Additionally, the manner of calculating the make-whole amount should be based upon actual damages accruing to the lender. Many make-whole calculations are based upon the present value of the difference between the agreed interest rate and an interest rate based on LIBOR, Treasury notes, or other similar formulations. Relatedly, the credit agreement should expressly state that the make-whole claim is a liquidated damages provision (not a claim for unmatured interest or a penalty) and explain the financial justification for such claim and that the make-whole amount represents a reasonable estimate of the damages caused by prepayment.