The bankruptcy case of Energy Future Holdings (EFH) and its affiliates has already provided the Delaware bankruptcy court occasion to tackle a number of important bankruptcy questions, including the propriety of using tender offers to settle noteholder claims during the pendency of the case.1 On March 26, 2015, in a much-anticipated decision, the court has now ruled that a class of noteholders is not entitled to make-whole premiums under their indenture. Judge Christopher Sontchi held that the indenture plainly did not provide for payment of make-whole premiums upon the automatic acceleration of the notes due to the bankruptcy filing. The court rejected several arguments made by these noteholders seeking to enforce or otherwise collect on the make-whole provision, including the argument that EFH intentionally defaulted to avoid paying the make-whole premiums.

However, the court left open a narrow window for the holders to gain the right to the make-whole premium by demonstrating that “cause” exists to lift or modify the bankruptcy automatic stay. By lifting the stay, the indenture trustee could then exercise its contractual right under the indenture to waive the default and decelerate the notes. If granted, the holders would then have claims for the make-whole premium owed upon the “optional redemption” of the notes. In this next phase of litigation, the parties will have an opportunity to test the bankruptcy court’s willingness to grant such stay relief.

With the EFH decision, it appears that Delaware bankruptcy courts will interpret the make-whole premium issue consistently with the views expressed in the recent Momentive decision handed down by the Bankruptcy Court for the Southern District of New York. Momentive considered the enforceability of a make-whole provision in a different context — a proposed plan that would repay notes, versus using the proceeds of a DIP financing to do the same in EFH — but the analysis was substantially the same. If a contract does not specifically provide that a make-whole is payable upon acceleration due to a bankruptcy event of default, the bankruptcy court will not enforce the make-whole provision.

The Decision

In 2010, EFH subsidiaries Energy Future Intermediate Holding Company and EFIH Finance, Inc. (together, EFIH) issued $3.482 billion in principal amount of 10 Percent First Lien Notes due 2020 (Notes). Prior to the bankruptcy case, EFIH struggled with liquidity issues. In the prevailing favorable interest environment, EFIH negotiated and reached an agreement with some of its creditors to refinance its debt, repaying the outstanding principal and interest on the Notes, but not the make-whole premiums. EFH, EFIH, and their affiliates (collectively, Debtors) subsequently filed Chapter 11 petitions on April 29, 2014 (Petition Date) and EFIH requested approval of a $5.4 billion DIP financing to repay the notes and settle the noteholders’ claims pursuant to the prepetition agreement. EFIH repaid the outstanding principal and interest on the Notes on June 19, 2014 upon the court’s approval of the DIP Motion.

The Delaware Trust Company, as indenture trustee for the 10 Percent Notes (Trustee), i) objected to the DIP motion on the ground that it was entitled to full payment of the make-whole premium, in addition to principal and interest; ii) commenced an adversary proceeding to establish its right to secured claims for the make-whole premiums; and iii) sought declaratory relief that it could decelerate the notes without violating the automatic stay, or alternatively seeking to modify the stay. The court bifurcated the trial, first requiring the parties to litigate i) whether the holders had claims for make-whole premiums as a matter of contract interpretation or other applicable law (and the court assumed, for purposes of this issue, that the Debtors were solvent and could pay in full all allowed claims of their creditors); and ii) whether the Debtors intentionally defaulted to avoid paying the make-whole. The Trustee and the Debtors each moved for summary judgment, each maintaining that the indenture, analyzed under New York law, was clear and unambiguous.

The Trustee’s principal argument was that EFH’s early repayment of the Notes constituted an “Optional Redemption” triggering EFH’s obligation to pay the “Applicable Premium” — the make-whole premium — to the holders. Section 3.07(a) of the Indenture provides:

At any time prior to December 1, 2015 [the maturity date], the Issuer may redeem all or a part of the Notes at a redemption price equal to 100% of the principal amount of the Notes redeemed plus the Applicable Premium as of, and accrued and unpaid interest to, the date of redemption...

According to the Trustee, EFH’s repayment of the notes prior to maturity date on June 19, 2014 (following the court’s approval of the DIP Motion) was an “Optional Redemption.”

The court disagreed, holding that as a matter of plain meaning under New York law, the indenture did not provide for payment of the make-whole premium upon automatic acceleration of the Notes. For the make-whole to be payable, the indenture “must contain express language requiring payment of a prepayment premium upon acceleration.”  Indeed, the parties “certainly could have bargained for such a provision.” Absent such language, the Trustee’s emphasis on Section 3.07 was misplaced because an Optional Redemption is “an act separate and apart from automatic acceleration.” Under New York law, “a borrower’s repayment after acceleration is not considered voluntary” and thus not an Optional Redemption. Upon the Debtors’ bankruptcy filing and acceleration of the Notes, they became immediately due and payable as of the Petition Date — the new maturity date of the Notes. The court held that EFIH’s repayment of the Notes following acceleration could not have been an optional redemption prior to maturity that triggered the make-whole premium.

The Trustee also argued, citing the “intentional evasion” doctrine under New York law, that EFIH intentionally defaulted in order to avoid paying the make-whole premium. Not so, the court held, citing evidence that the Debtors filed for bankruptcy protection due to acute liquidity problems. The prospect of triggering a make-whole premium through a voluntary redemption was just one of many financial challenges facing the Debtors. The court declined to hold EFIH liable for pursuing a restructuring strategy that tapped into favorable debt market conditions to refinance the Notes before maturity. In short, EFIH is “no different than any other debtor that is forced into bankruptcy because of financial reasons but decides to use the tools provided by that bankruptcy, such as the power to reject unprofitable leases, for business reasons.” In addition, the court summarily rejected the Trustee’s other arguments that repayment of the notes breached a “no call” option in the Indenture and that the holders were entitled to damages for breach of the “perfect tender rule,” which prohibits borrowers from prepaying obligations in the absence of a prepayment clause.

The Trustee’s only argument to survive summary judgment centers on the holders’ contractual right to waive the default and to rescind the automatic acceleration of the notes. Section 6.02 provides:

The Holders of at least a majority in aggregate principal amount of the Notes by written notice to the Trustee may on behalf of all the Holders waive any existing Default and its consequences under the Indenture except a continuing Default in the payment of interest on, premium, if any, or the principal of any Note (held by a non consenting Holder) and rescind any acceleration with respect to the Notes and its consequences (so long as such rescission would not conflict with any judgment of a court of competent jurisdiction).

According to the Trustee, by waiving the default and decelerating the notes, the maturity date would remain December 1, 2015 and EFIH’s early repayment of the Notes would be an “Optional Redemption” triggering the obligation to pay the make-whole. The Trustee sought declaratory relief that it could decelerate the Notes without violating the automatic stay, or alternatively that the automatic stay should be modified to permit the Trustee to rescind the acceleration. In addition, the Trustee asserted a claim in the amount of the make-whole premium for denial of the holders’ rescission rights.

The court agreed with the Debtors that the automatic stay of Section 362 of the Bankruptcy Code prevented the trustee from issuing a notice of rescission. The Trustee also was not entitled to assert claims for violation of its Section 6.02 rescission rights because such damages were not specifically provided for in the indenture.

However, the court concluded that “[t]he only thing that stands in the way of owing the Applicable Premium is that the bankruptcy caused an automatic default that accelerated the debt.” The Trustee and the holders would be entitled to make-whole premiums if the stay was modified or lifted to allow the Trustee to exercise its contractual right to waive the default and decelerate the notes. The court did not decide whether stay relief was appropriate, deferring that question pending additional factual development to determine whether “cause” exists to lift the automatic stay under Bankruptcy Code Section 362(d)(1). Thus, the court granted summary judgment in favor of the Debtors, subject to revision if the holders succeed in persuading the court to lift the stay.

To determine whether stay relief is appropriate, the parties will now need to develop evidence on issues including the solvency of the EFIH Debtors and their estates, and whether they or their creditors would be harmed if stay relief is granted. However, if the Delaware bankruptcy court continues to follow Momentive’s lead, it may conclude that the automatic stay bars the Trustee’s issuance of a rescission notice to decelerate the debt because it would increase the amount of the Trustee’s claims and thus constitute an act to control the property of the Debtors’ estates.

Conclusion

The court’s decision brings Delaware into line with New York on the issue of enforceability of make-whole premiums. Like the decisions in MomentiveAMR Corp., and other cases, the Delaware bankruptcy court agreed that a make-whole premium could be payable if explicitly provided in the indenture, and that no “voluntary” prepayment triggering a make-whole obligation occurred as a result of acceleration due to a bankruptcy filing. It remains to be seen whether the Delaware bankruptcy court will also exercise its discretion to deny the holders’ efforts to lift the automatic stay in order to rescind deceleration and assert a claim for the make-whole premium.

EFH contrasts sharply with the result in School Specialty, the last major decision in which a Delaware bankruptcy court ruled on the make-whole issue. In School Specialty, the court approved payment of a make-whole premium valued at 37 percent of the loan amount. The loan agreement provided that a premium, in an amount set by contractual formula, was payable upon prepayment or acceleration of the loan during the first 18 months of the term. The borrower defaulted and entered into a forbearance agreement prior to the bankruptcy case, triggering the make-whole premium. In the bankruptcy case, the official committee of unsecured creditors objected that the premium was an unenforceable penalty under state law and should be disallowed as unmatured interest under Section 502(b)(2) of the Bankruptcy Code. The court held that the policy of respecting parties’ contractual arrangements counseled against interfering with even a 37 percent premium. Further, the court agreed with the majority view that a make-whole is a form of liquidated damages, not unmatured interest. Where, as in School Specialty, an agreement plainly provides for payment of a make-whole premium upon acceleration of the debt, it appears that Delaware courts will observe the terms of the agreement.

The lessons of EFH and other make-whole decisions are clear. To avoid litigation over the enforceability of a make-whole premium in bankruptcy, parties entering into indenture agreements should pay careful attention to drafting. In particular, holders and indenture trustees should ensure that the contract provides that repayment is impermissible prior to the maturity date, and that a make-whole premium is expressly payable upon an automatic acceleration of the notes caused by a bankruptcy default. Drafting an unambiguous contract, like the indenture at issue in EFH, will limit the uncertainty of a court’s consideration of extrinsic evidence of the parties’ intent with respect to the make-whole provision. However, bankruptcy disputes concerning make-whole provisions are likely to continue as litigants dispute imperfectly drafted indentures and litigate bankruptcy issues such as whether make-wholes are allowable interest under the Bankruptcy Code and whether holders can lift the automatic stay to decelerate the notes.

After a bankruptcy filing, the overlay of bankruptcy law to the contractual interpretation of make-whole provisions in an indenture can lead to unanticipated results. In negotiating indentures, parties should pay attention to the consequences of default, acceleration, and repayment of the notes in the context of bankruptcy. Holders negotiating with borrowers to refinance notes in the current low interest rate environment should also consider these consequences. Distressed debt investors should closely review the make-whole premium, default, and acceleration provisions of indentures, and should assume that those provisions will be read literally and strictly construed by bankruptcy courts.