An important decision by Judge Kevin Carey of the United States Bankruptcy Court for the District of Delaware recently focused the distressed debt market (and financial creditors in general) on the proper legal characterization of a common financing provision — the “make-whole premium.”1 Judge Carey allowed a lender’s claim in bankruptcy for the full amount of a large make-whole premium, after denying a motion by the Unsecured Creditors’ Committee to disallow the claim.
WHY DOES THIS DECISION MATTER?
The decision is important to distressed bond and loan investors because they seek to predict a return on investment based upon (i) the “allowed amount” of a financial claim, (ii) the ultimate recovery from a bankrupt debtor, and (iii) the timing of any such recovery. Working backward from those predications — and adding a discount rate to reflect their desired rate of return — a rational purchase price for the claim can be calculated.
What is the allowed amount of a bond or loan claim? In addition to the principal outstanding on the day of the bankruptcy filing as well as interest accrued to that date, bond indentures and loan agreements routinely contain clauses that require an issuer or borrower to pay an additional amount to bondholders or lenders if the bond or loan is prepaid or accelerated before the expected maturity date. These “early payment fees” or “make-whole premiums” are intended to compensate bondholders and lenders for the net present value of future interest payments that will not be made because of the prepayment or acceleration.
Investors and courts have struggled to decide whether make-whole premiums should be recognized as an allowed portion of a bondholder or lender’s aggregate financial claim in bankruptcy.
Outside of the bankruptcy context, under state law, contracts that require the payment of make-whole premiums are generally considered binding and are routinely enforced according to their terms so long as (i) the contract is explicit in requiring payment of a premium in the applicable scenario, (ii) actual damages would have been difficult to determine at the time of contract execution, and (iii) the make-whole premium is not “plainly disproportionate” to the amount of probable loss. Within the bankruptcy context, an obligation to pay a make-whole premium is allowed if, in addition to satisfying any state law requirements, the make-whole premium can be further characterized as “liquidated damages” as opposed to “unmatured interest.”
Bankruptcy Courts are split on whether a make-whole premium should be considered liquidated (or stipulated) damages or unmatured interest. To date, a minority have held that the economic effect of a make-whole premium is compensation to a lender for future interest — or interest not yet due — and therefore the makewhole premium should be disallowed as unmatured interest under Section 502(b)(2) of the Bankruptcy Code. But the growing majority of Bankruptcy Courts have held that make-whole premiums should be considered contracts to pay liquidated damages if the contract is breached and should be allowed in bankruptcy, if they are enforceable under applicable state law.
WHAT ARE THE UNDERLYING FACTS IN THE CASE?
In May, 2012, School Specialty, Inc. borrowed $70,000,000 from Bayside Finance, LLC under a term loan agreement. The loan was due to mature in October 2014, unless borrower refinanced certain convertible subordinated debentures, in which case the loan would mature in December 2015. The term loan agreement required borrower to pay a make-whole premium if the loan was prepaid or accelerated before maturity.
In January 2013, borrower defaulted under the term loan agreement and entered into a forbearance agreement with Bayside.
Later that month, borrower filed for bankruptcy and the Court approved debtor-in-possession financing. Bayside received a super-priority lien and adequate protection for the full amount of its claim, including (i) outstanding principal ($67,000,000), (ii) interest ($1,605,208.33) and (iii) a make-whole premium calculated using the later, December 2015, maturity date ($23,700,000). Calculation of the make-whole premium assumed that borrower could have refinanced the convertible subordinated debentures before October 2014, and therefore the later (conditional) maturity date for the loan was applicable.2
The Unsecured Creditors’ Committee moved to disallow the make-whole premium, arguing that the calculation inflated Bayside’s actual loss, was inconsistent with market precedent and in any event should have applied the shortest possible maturity date — October 2014 — because it was not certain borrower would have been able to refinance the convertible subordinated debentures.
The Court approved Bayside’s calculation of the makewhole premium and allowed the claim, finding it was not “plainly disproportionate” to Bayside’s loss even if the make-whole premium was more than one-third as large as the principal amount of the loan. Judge Carey reasoned that, under New York law (the law governing the term loan agreement), the test was whether the premium was disproportionate to the probable loss, not whether it was disproportionate to the principal amount of the loan. Judge Carey found that because the convertible subordinated debentures might have been refinanced, Bayside was committed to fund the loan through December 2015, and Bayside was required to plan its lending activity to account for an extension of the maturity. Therefore, it was appropriate to use the December 2015 maturity date to calculate the (increased) make-whole premium. Judge Carey also determined that borrower and Bayside negotiated the terms of the term loan agreement at arms-length, based on the fact that borrower received lending proposals from multiple lenders and ultimately chose Bayside and specifically negotiated the loan’s prepayment terms.
WHAT IS THE PRACTICAL EFFECT OF THE CASE?
Perhaps most importantly for the distressed debt market, Judge Carey sided with the evolving majority view of Bankruptcy Courts — that make-whole premiums are not unmatured interest — and found that the makewhole premium at issue was best characterized as a properly drafted liquidated damages provision that should be allowed under Section 502(b)(2) of the Bankruptcy Code.
At the heart of Judge Carey’s decision is a judicial reluctance to interfere with the provisions of a credit agreement bargained for by sophisticated parties — the Court followed this “freedom of contract” reasoning to its ultimate conclusion — (i) the characterization of the make-whole provision as a contract to pay liquidated damages upon the breach of the term loan credit agreement, and (ii) the allowance of a very substantial claim based on that make-whole premium.
The well-reasoned decision from an influential Bankruptcy Court is good news for lenders and bondholders and should provide additional guidance to distressed debt investors evaluating the likely return on a make-whole premium claim. While the substantial amount of the premium in this case may have led another court to conclude that the make-whole premium was disproportionate to the lender’s loss, Judge Carey’s decision effectively re-focuses the legal analysis on the calculation of the potential economic loss to the lender, not the relation of the make-whole premium to the outstanding principal amount the claim.