(Originally published in the New York Law Journal on February 22, 2016.)

There is a growing body of case law on the enforcement of make-whole provisions in debt instruments in Chapter 11. Below, we discuss the key takeaways from the cases and suggest contract language to add certainty to the issues.

In review, a make-whole provision generally provides that if debt is paid before maturity, the premium is added to the obligation. This premium generally represents the net present value of the remaining interest payments at the time of early payment.

Make-whole provisions recognize that a lender has committed to the transaction based on an expectation of receiving an investment return over a period of time. Such provisions attempt to provide the lender the benefit of its bargain, recognizing lost opportunity cost. Put another way, the make-whole protects the lender while providing the borrower the ability to repay debt before maturity.

A U.S. bankruptcy filing adds a wrinkle to the issue because it automatically accelerates unmatured debt, regardless of the language in the underlying agreement (although agreements typically do as well). Consequently, courts have had to address whether make-whole provisions should be honored or viewed as an unenforceable penalty or as unmatured interest disallowed under the Bankruptcy Code.

A number of court decisions over the last few years address these issues. One thing that is very clear from the decisions is that careful drafting of make-whole provisions is critical to enforcement.

‘School Specialty’

In In re School Specialty, 2013 Bankr. LEXIS 1897 (Bankr. D. Del. April 22, 2013) (School Specialty), a Delaware bankruptcy court upheld a make-whole payment that the debtors had stipulated to before the Chapter 11 case and again at the beginning of the Chapter 11 case. Pre-bankruptcy, the debtors entered into a forbearance agreement with their lender where they agreed the make-whole was due. When the debtors subsequently filed their Chapter 11 petition, their debtor-in-possession (DIP) financing arrangement with the same lender stipulated that the amount due to the lender included the make-whole amount.

After the interim DIP order was entered, the creditors’ committee filed a motion that challenged the make-whole, arguing that it was an unenforceable penalty and it was not permissible liquidated damages under New York law, but unmatured interest disallowed under §502(b)(2) of the Bankruptcy Code.

Looking to New York law to determine whether the make-whole provision was permissible liquidated damages or an unenforceable penalty, the court noted that New York courts will enforce a prepayment premium as permissible liquidated damages when “(i) actual damages are difficult to determine, and (ii) the sum stipulated is not ‘plainly disproportionate’ to the possible loss.” Id. at *7. The committee argued the prepayment premium was grossly disproportionate to the lender’s loss.

According to the court, “whether a prepayment penalty is ‘plainly disproportionate’ to a lender’s probable loss [requires consideration of] (i) whether the prepayment fee is calculated so that the lender will receive its bargained-for yield, and (ii) whether the prepayment fee is the result of an arms-length transaction between represented sophisticated parties.” Id. at *10-11. Examining the facts, the court held that the make-whole payment was not plainly disproportionate to the lender’s probable loss because the payment was calculated so that the lender would receive its bargained-for return after discounting future interest payments, and the prepayment terms were the result of an arm’s-length negotiation.

The court then turned to whether the make-whole payment was impermissible unmatured interest. The committee argued that the make-whole payment was intended to compensate the lender for lost future interest resulting from the prepayment making it impermissible unmatured interest. The court rejected the unmatured interest argument and followed what it cited as the “majority” approach, holding that the make-whole payment was not a claim for unmatured interest but liquidated damages. Critical to this conclusion was the view that liquidated damages, including prepayment premiums, fully mature when the contract is breached, and therefore do not represent unmatured interest.

‘Momentive’

In In re MPM Silicones, 2014 Bankr. LEXIS 3926 (Bankr. SDNY Sept. 9, 2014) aff’d 531 B.R. 321 (SDNY 2015) (Momentive),¹ the Bankruptcy Court for the Southern District of New York refused to enforce the make-whole provision. Indenture trustees argued their holders were entitled to a make-whole payment as a result of the repayment in the form of replacement notes they would be receiving under the terms of the debtors’ plan.

The court found the underlying agreements lacked the specificity to create a claim for a make-whole premium following the automatic acceleration upon the bankruptcy filing. While the indentures referred to the “premium, if any” due on the notes upon an event of default (which included the debtors’ bankruptcy), the only place that the indentures referred to a specific premium being due was in the “optional redemption” sections. Id. at *33-34, *45. The court found that the lack of explicit language that the make-whole would be payable upon the acceleration or advancement of the original maturity date of the notes was fatal.

The trustees argued (alternatively) to lift the automatic stay to rescind the automatic acceleration caused by the bankruptcy filing. In declining to lift the stay, the court stated that lifting the stay to allow for a deceleration would significantly impact the estates and other creditors by hundreds of millions of dollars, and noted that other courts have routinely refused this relief.

‘EFH I’

In In re Energy Future Holdings, 527 B.R. 178 (Bankr. D. Del. 2015) (EFH I) the Bankruptcy Court for the District of Delaware denied the first-lien noteholders’ request for a make-whole payment.

In EFH I, certain noteholders who did not participate in a make-whole settlement separately pursued claims for the premium, arguing that the debtors’ refinancing of the notes through a DIP financing constituted a redemption triggering the premium. The indenture trustee also sought a declaration that it could decelerate the notes without violating the automatic stay.

The court held that the indenture’s acceleration provision (triggered by the bankruptcy) did not require payment of the make-whole premium. Instead, as in Momentive, the indenture’s optional redemption provision contained the make-whole language, and that provision had not been triggered. The court further noted that:

[a]cceleration moves the maturity date from the original maturity date to the acceleration date and that date becomes the new maturity date. Prepayment can only occur prior to the maturity date, and acceleration, by definition, advances the maturity date of the debt so that payment thereafter is not prepayment but instead is payment made after maturity.

Id. at 195. (internal citations and quotations omitted; emphasis added).²

The court then turned to the trustee’s request that it be permitted to decelerate the notes-to undo the automatic acceleration effective upon the bankruptcy filing. The court stated that if it were to lift the automatic stay allowing the trustee to waive the default and decelerate the notes, the debtors’ refinancing would then be an optional redemption triggering the premium. The court said a separate trial on the merits as to whether the trustee could establish cause to lift the automatic stay was required.

‘EFH II’

In In re Energy Future Holdings, 533 B.R. 106 (Bank. D. Del. 2015) (EFH II), the trial on the merits after the ruling in EFH I, Judge Christopher Sontchi refused to lift the automatic stay.

The indenture trustee argued that cause existed to lift the stay because the debtors were solvent. The court, however, said lifting the stay does not turn on a debtor’s solvency, but rather on a balancing of the harms and the totality of the circumstances. The court emphasized that the hardship to the non-debtor party by maintenance of the stay must “considerably outweigh” the hardship to the debtor were the stay to be lifted. Id. at 119.

The court held that the estate (including equity) would be greatly harmed if nearly half a billion dollars (and at least the amount of the applicable premium-$431 million) went to one subset of creditors substantially reducing the value of other stakeholder recoveries in Energy Future Intermediate Holding Company, LLC and EFIH Finance, Inc. (collectively EFIH).³ To the court, “the harm to the noteholders from maintaining the automatic stay is at most the amount of the applicable premium.” Id. at 122.

The court further stated that the movant failed to produce any evidence that the economic harm to the noteholders from maintaining the automatic stay exceeded the make-whole premium itself. Instead, all of the movant’s witnesses admitted the $431 million make-whole is a cap on the noteholder’s damages. Since the best case scenario of the harm to the noteholders was an equal amount of harm compared to the EFIH debtors, the hardship to the noteholders did not “considerably outweigh” the hardship to the debtors.

Analysis

Lending is facilitated if commercial laws, including the Bankruptcy Code, give parties the maximum degree of certainty in how their agreements will be enforced in default and bankruptcy. Less certainty regarding the enforcement of agreements in the bankruptcy context likely leads to more expensive borrowing.

Following Momentive and EFH I, it is clear that make-whole claims are very unlikely to be upheld absent language that the make-whole premium is triggered by the automatic acceleration that occurs upon a bankruptcy filing. Furthermore, Momentive and EFH II in particular make it fairly clear that the automatic stay will not be lifted to undo the acceleration and treat the payment as a “voluntary/optional” redemption/prepayment.

To provide certainty to the payment of a make-whole premium in bankruptcy, adding clear language to the indenture or loan document is essential. The following recommendations apply to both indentures and loan agreements.

First, the document must state that if the obligation is accelerated as a result of an event of default (including a bankruptcy filing), the principal, accrued and unpaid interest, and premium on the notes that become due and payable shall equal the redemption price applicable with respect to an optional redemption of the notes.⁴

Second, it should provide that any payment after such acceleration will be treated as an optional redemption triggering the premium.

Third, the document should state that any premium payable is liquidated damages and a reasonable approximation of the damages to be suffered by the holder in the event of early payment.

Fourth, the document should include a waiver by the issuer regarding the provisions of any present or future statute that may prohibit the collection of the premium in connection with an acceleration.

Fifth, it would be useful to include the ability of the noteholders to rescind any acceleration (including one caused by a bankruptcy filing).

Sixth, and finally, the following stipulations on the part of the issuer/borrower should be made with respect to the make-whole provisions.

The issuer/borrower agrees that:

• The premium payable is reasonable and the product of an arm’s-length transaction;
• The premium shall be payable notwithstanding the then prevailing market rates at the time the payment is made;
• There was a course of conduct between the noteholders/lenders and issuer/borrower giving specific consideration for such agreement to pay the premium;
• The issuer/borrower’s agreement to pay the premium to the noteholders/lenders was a material inducement for the noteholders/lenders to purchase the notes/make the loan; and
• Any premium or make-whole payment is consideration for the transaction and part of an inducement to holders/lenders to purchase the notes/make the loan.

Many of the loan documents and indentures distressed debt buyers will be analyzing in the near future will most likely not yet contain the necessary carefully drafted language discussed herein. Ultimately, the plain meaning of the agreement between the parties needs to be clear that defaults based upon a bankruptcy petition filing will operate to accelerate maturity of the notes and will trigger the make-whole payment. The recent cases point to one unmistakable conclusion: Loan documentation or indentures that remain silent whether make-wholes apply upon a bankruptcy filing will result in the loss of the bargained-for make-whole payment.

If you have any questions concerning this article, please feel free to contact John R. Ashmead (212-574-1366) or Ronald L. Cohen (212-574-1515).

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¹ This decision is on appeal to the U.S. Court of Appeals for the Second Circuit.

² After this decision, in In re Energy Future Holdings Corp., 540 B.R. 96 (Bankr. D. Del. 2015), Judge Sontchi cited to this rationale in sustaining the debtors’ objection to the make-whole premium in the proof of claim of certain payment-in-kind notes. See also In re Energy Future Holdings Corp., 539 B.R. 723 (Bankr. D. Del. 2015) (denying the second-lien noteholders’ make-whole argument for the same reasons).

³ While stating it was unnecessary to reach this conclusion, the court noted that the harm to the EFIH Debtors from lifting the stay could eventually be much greater, as other EFIH noteholders elsewhere on the capital structure had already stated they were planning on filing their own motions to lift the stay. Moreover, the court stated that the loss of distributable value to EFIH’s equity holder (EFH) would significantly complicate and prejudice EFH’s proposed jointly administered restructuring, making EFIH’s own restructuring more difficult.

⁴ Alternatively the drafter of the document may consider making payment of the make-whole due specifically upon acceleration (including due to a bankruptcy filing), without tying the make-whole to the optional redemption provision. As the Second Circuit noted in In re AMR Corp., 730 F.3d 88 (2d Cir. 2013)., ipso facto clauses (i.e., acceleration provisions) are not per se unenforceable, and specific make-whole premiums solely triggered by acceleration provisions should be upheld without the need to tie the make-whole to the optional redemption provision.

Reprinted with permission from the “February 22, 2016” edition of the “New York Law Journal”© 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. ALMReprints.com – 877-257-3382 – reprints@alm.com.