The enforcement of a lender’s claim for a make-whole premium in a chapter 11 case has created significant controversy among legal practitioners and the courts. Notably, the three circuit courts of appeal that have addressed make-whole claims, i.e. the Second, Third and Fifth Circuits, have issued conflicting decisions on the nature of these claims and their allowance under the Bankruptcy Code. In this post we provide a brief summary of make-whole premiums and address the controversy among the circuits.

Simply put, a make-whole provision is a yield maintenance provision that may be provided for in an indenture agreement, credit agreement or other form of debt instrument. It is designed to protect (at least in part) the lenders’ anticipated interest-rate yield, i.e. additional compensation to make up for the interest they would not receive if the debt instrument was redeemed prior to its maturity date. For example, an indenture may provide for an “Optional Redemption” that states when the make-whole premium is due:

At any time prior to maturity the company 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 . . . and accrued and unpaid interest. “Applicable Premium” is what is referred to as the make-whole, or yield-protection, contractual substitute for interest lost on the debt instrument redeemed before the expected due date.

See e.g., In re Energy Future Holdings Corp., Case No. 16-1351, at 7 (3d Cir. Nov. 17, 2016) (“EFH”). In contrast, the payment of the debt upon its stated maturity, or maturity resulting from acceleration, such as what occurs upon filing a voluntary bankruptcy petition, may not include a make-whole or yield protection payment.

Bankruptcy courts have struggled with whether to give effect to the make-whole provision in circumstances where plans of reorganization fail to provide for economic compensation to holders of make-whole claims. In such cases, allowance of the make-whole claim for a senior class reduces the distribution available to junior classes of creditors. For example, the amount of the claimed make-whole premium in the EFH case, if allowed by the bankruptcy court, would have reduced the distributions available to junior classes by $413 million. See EFH, at 9. In deciding whether to allow make-whole claims, courts have focused on whether to give effect to (i) the automatic acceleration and maturity provisions brought about by a bankruptcy filing and whether it would give rise to a make-whole claim, (ii) any redemption rights which provide for make-whole claims, or (iii) whether the make-whole claim is a claim for unmatured interest in violation of Bankruptcy Code Section 502(b)(2) which disallows claims for unmatured interest. In cases involving very similar fact patterns, the bankruptcy courts in the Southern District of New York and District of Delaware ruled in each instance, that the debtor’s bankruptcy filing itself accelerated the maturity of the debt and that no right to a make-whole premium was available upon maturity. See, e.g., U.S. Bank N.A. v. Wilmington Sav. Fund Soc’y (In re MPM Silicones, LLC), 531 B.R. 321 (S.D.N.Y. 2015); Del. Tr. Co. v. Energy Future Intermediate Holding Co. LLC (In re Energy Future Holdings Corp.), 527 B.R. 178 (Bankr. D. Del. 2015). Whereas the bankruptcy court for the Southern District of Texas agreed, but ruled that acceleration did not prevent payment of the make-whole premium. See, e.g., In re Ultra Petroleum Corp., 575 B.R. 361, 363 (Bankr. S.D. Tex. 2017).

In addressing the subsequent appeals, the Second, Third and Fifth Circuit Courts of Appeal each arrived at different conclusions. The Second Circuit in Momentive Perf. Materials Inc., et al. v. BOKF, NA, et al., Case No. 15-1682 (2d Cir. Oct. 20, 2017) (“Momentive”) decided that filing for bankruptcy does not trigger the obligation to pay a noteholder the make-whole premium because the debtor did not exercise a voluntary redemption of the note. On the other hand, the Fifth Circuit in Ultra Petroleum Corp. v. Ad Hoc Comm. of Unsecured Creditors of Ultra Res., Inc. (In re Ultra Petroleum Corp.), Case No. 17-20793 (5th Cir. Jan. 17, 2019) (“Ultra Petroleum”), avoided the redemption-vs.-accelerated maturity argument instead noting that make-whole premiums are the economic equivalent of unmatured interest and thus disallowed under § 502(b) of the Bankruptcy Code. The Third Circuit in EFH, however, held that a debtor’s decision to file for bankruptcy was a voluntary act that triggered the redemption provision of the subject indentures and required payment of the make-whole premium. We explore each decision and its implications in turn below.

A. Make-Whole Premiums Are Unenforceable

In Momentive, the plan of reorganization issued replacement notes to the Senior-Lien Notes holders, which did not account for the make-whole premium. These notes holders contended that the failure to include the premium violated the 2012 Indentures’ make-whole provision for three reasons: (i) they were entitled to the make-whole under the 2012 Indentures’ Optional Redemption clauses because the debtor “redeemed” the Notes “at its option” prior to maturity; (ii) they were entitled to it under the 2012 Indentures’ Acceleration clauses; and (iii) even if the indentures did not allow for a make-whole premium upon acceleration, they should not have been permanently barred from exercising their contractual right to rescind acceleration and thereby obtain the make-whole premium.

The bankruptcy court held that acceleration brought about by a bankruptcy filing changed the maturity date of the accelerated notes to the date of the petition. Therefore, any payment of the accelerated notes would be a post-maturity payment and not a redemption. The Second Circuit agreed, holding that the make-whole premiums were not enforceable because the filing of a voluntary bankruptcy petition did not trigger the indentures’ optional redemption clauses. The indentures provided for make-whole premiums only if Momentive “opted to redeem the notes prior to maturity.” Id., at 6. The court also noted that “[a] payment made mandatory by operation of an automatic acceleration clause is not one made at [Momentive’s] option.” Id., at 25.

In Ultra Petroleum, the Fifth Circuit stated that a make-whole payment was the economic equivalent of “unmatured interest” and therefore could be disallowed under § 502(b) of the Bankruptcy Code. The court reasoned that the make-whole amount claimed by the creditors was merely interest that had not yet accrued as of the petition date. Although the note agreement at issue in Ultra Petroleum included an acceleration provision, such provision acted as an unenforceable ipso facto clause. In fact, the Court stated, “[w]hether interest is considered to be matured or unmatured for the purposes of § 502(b)(2) is to be determined without reference to any ipso facto bankruptcy clause in the agreement creating the claims.” Id. at 21 (internal citations omitted). However, the Fifth Circuit noted that the pre-Bankruptcy Code solvent-debtor exception could operate as a carve-out from § 502(b)(2)’s general bar on unmatured interest. Therefore, it remanded to the bankruptcy court on the limited issue of whether the pre-Code solvent-debtor exception survived the enactment of § 502(b)(2).

B. Make-Whole Premiums Are Enforceable

The Third Circuit has taken a different tack, explicitly departing from the Momentive lower courts’ decisions. As in Momentive, in EFH, the bankruptcy court focused its attention on the acceleration provision in the indenture. In re Energy Future Holdings Corp., 527 B.R. 178 (Bankr. D. Del. 2015). Because the acceleration took effect when EFH entered bankruptcy, the bankruptcy court concluded that no make-whole payment was due, and the district court concurred. On appeal, the Third Circuit reversed and held that payment of make-whole premiums was enforceable because it was the debtor’s choice to file for bankruptcy in order to refinance its debt, effectively triggering the optional redemption clauses in the indentures. The court stated:

[EFH] contends nonetheless that any redemption was mandatory rather than optional. But this contention does not match the facts. Indeed a chapter 11 debtor that has the capacity to refinance secured debt on better terms . . . is in the same position within bankruptcy as it would be outside bankruptcy, and cannot reasonably assert that its repayment of debt is not ‘voluntary.’

EFH, at 15 (internal citation omitted). The Third Circuit also took issue with the lower courts’ interpretation of New York law arguing the EFH indenture provision’s default and redemption provision must be read together:

More specifically, [EFH]’s interpretation conflicts with the New York Court of Appeals’ statement that “[w]hile it is understood that acceleration advances the maturity date of the debt,” there is no “rule of New York law declaring that other terms of the contract not necessarily impacted by acceleration . . . automatically cease to be enforceable after acceleration.”

EFH, at 18 (citing NML Capital v. Republic of Argentina, 952 N.E.2d 482, 492 (N.Y. 2011)). The court expressed its disapproval of the Momentive bankruptcy and district court decisions (the EFH decision predated the Momentive circuit court’s opinion—which the Third Circuit likely would have taken issue with, as well) in their interpretation of the indenture’s default and redemption provisions. Key to the Third Circuit’s decision was the interpretation of the word “premium” in the indenture’s default clause, which provided that “all principal of and premium, if any, interest . . . [,] and any other monetary obligations on the outstanding [Second Lien] Notes [to] be[come] due and payable immediately.” EFH, at 19 (emphasis added). Accordingly, the Third Circuit ruled that a premium was due to the noteholders despite the ipso facto acceleration of the debt and the reference to the word premium in the default provision had to mean the make-whole premium referenced in the optional redemption clause. The Third Circuit acknowledged that, interpreting virtually the same exact default provision, the bankruptcy court in Momentive came to an opposite conclusion, noting that “[w]e believe, however, the result in Momentive conflicts with that indenture’s text and fails to honor the parties’ bargain. For these and additional reasons . . . , we find it unpersuasive.” EFH, at 20.

Perhaps the conflicting Second and Third Circuit decisions may be reduced simply to different facts. In EFH, the debtor was solvent and chose to file for bankruptcy for the explicit purpose of refinancing the notes. In Momentive, the debtor was insolvent. This may be a significant distinction because the EFH court relied on the debtor’s pre-bankruptcy SEC filings to show that the debtor voluntarily decided to file, triggering the acceleration and, thus, satisfying the “optional” redemption language of the indentures. But given the Third Circuit’s clear repudiation of the Momentive decision, such conclusions are far from clear.

C. Implications

The Fifth and Second Circuits appear aligned that make-whole premiums triggered by a bankruptcy petition are not enforceable, but come to that conclusion using completely different analyses. The Third Circuit held the opposite. However, a question remains. Had the debtor in EFH been insolvent and the redemption been inapplicable, would the Third Circuit have come out against enforcement of the make-whole premiums? Had the debtor in Ultra Petroleum been insolvent the make-whole premium would have been disallowed as unmatured interest and no remand would have been necessary. Now consider the question with inverse facts: would the Second Circuit have enforced the make-whole premiums as against a solvent debtor? This may be a distinction without a difference given the Third Circuit’s critique of the Momentive decisions where Momentive was insolvent. But the split exists. At least in the Third Circuit we can clearly state that it is important to include in a default provision in a debt instrument the language, “all principal of and premium, if any.” In any event, the U.S. Supreme Court has denied a writ of certiorari of the Second Circuit’s Momentive decision. Perhaps this is an area best addressed by Congress.