On April 22, 2013, the U.S. Bankruptcy Court for the District of Delaware in In re School Specialty upheld the enforceability of a make-whole premium triggered by the pre-petition acceleration of a secured term loan.1 The decision re-affirms that bankruptcy courts will respect properly drafted make-whole premiums that pass muster under applicable state law.
While the decision provides further comfort to creditors seeking to recover make-whole premiums against chapter 11 debtors, the enforceability of make-whole premiums in bankruptcy will continue to depend on a number of factors, including whether the make-whole premium is triggered upon acceleration, whether it is permissible as a liquidated damages clause under applicable state law, and whether the creditor seeks to recover a premium as part of its secured claim. Importantly, in School Specialty, the terms of the loan agreement specifically provided that a make-whole premium would also be triggered upon acceleration, which, in fact, occurred prior to the debtors’ chapter 11 filing. This fact pattern must be distinguished from other cases where the terms of the credit documents did not provide for a premium upon acceleration, but merely upon a prepayment prior to maturity. In these cases, courts have generally declined to enforce make-whole premiums on the ground that prepayment is not possible after the automatic acceleration of the maturity date upon the bankruptcy filing.2 Creditors must remain mindful of this when drafting make-whole premiums, if they intend to recover a make-whole premium in bankruptcy.
II. Factual Background
In May 2012, School Specialty, Inc. and certain of its affiliates entered into a credit agreement for a secured term loan in the aggregate principal amount of $70 million.3 The loan had an initial maturity date of October 31, 2014, unless the borrowers were able to refinance certain subordinated debentures, in which case the loan would mature on December 31, 2015.4 The credit agreement also provided that an early payment fee would be due upon prepayment or acceleration.5 During the first year and a half of the term loan, this early payment fee was equal to a make-whole premium, which was to be calculated by discounting the future stream of interest payments between the date on which the principal is prepaid or accelerated and December 31, 2015 (i.e., the maturity date in the event of a successful refinancing of the debentures), using the Treasury rate plus 50 basis points as the discount rate.6
In early January 2013, i.e., less than a year into the term of the loan, School Specialty defaulted on the loan and entered into a forbearance agreement with the lender.7 The forbearance agreement reflected the acceleration of the term loan which made all outstanding principal and unpaid interest, including the make-whole premium, due and payable.8 Shortly thereafter, on January 28, 2013, School Specialty and certain of its affiliates filed chapter 11 cases in the U.S. Bankruptcy Court for the District of Delaware.9
As part of first-day relief, the debtors requested an order approving interim debtor-in-possession financing, which the bankruptcy court granted.10 In the interim DIP order, the debtors also stipulated that they were liable to the lender in the aggregate amount of approximately $95 million, which amount reflected outstanding principal and interest, as well as a make-whole premium of approximately $23.7 million.11 The creditors’ committee opposed the stipulation as to the make-whole premium and filed a motion seeking to disallow such premium.12
III. Bankruptcy Court’s Ruling
The bankruptcy court denied the committee’s motion and held that the make-whole premium was enforceable as a matter of applicable New York law and federal bankruptcy law.
- Make-Whole Premium Is Enforceable Under New York Law
In the first part of its decision, the bankruptcy court concluded that the make-whole premium was a valid liquidated damages clause under applicable New York law.13 Generally, under New York law, a liquidated damages clause will be enforced if, at the time the parties entered into the agreement, (a) actual damages are difficult to determine, and (b) the sum stipulated is not “plainly disproportionate” to the possible loss.14 In its motion, the creditors’ committee had primarily argued that the make-whole premium failed under the second prong, i.e., it was grossly disproportionate to the lender’s possible loss, as reasonably projected at the time the credit agreement was entered into.15 The bankruptcy court, however, disagreed.
The court concluded that the make-whole premium was not “plainly disproportionate” to the lender’s possible loss because (a) the make-whole premium was calculated to ensure that the lender would receive its bargained-for yield and (b) the premium was the result of an arms-length transaction between represented sophisticated parties.16 The court specifically rejected the committee’s argument that the make-whole premium should be calculated based on the initial maturity date, i.e., October 31, 2014, because a refinancing of the debenture was unlikely.17 In the court’s view, because the refinancing option remained available throughout the life of the term loan, the lender was obligated to keep the funds available through December 2015 and therefore was justified in calculating the make-whole premium based on the later maturity date.18 The court refused to alter, with the benefit of hindsight, the terms of the agreement based on subsequent operational results and managerial decisions. 19 It was also irrelevant that the make-whole premium was sizeable in relation to the principal amount of the loan, as “the applicable standard by which the Court is bound to evaluate whether the lender is entitled to receive the Make Whole Payment is whether the payment is ‘plainly disproportionate’ to the possible loss—not whether the payment at issue is disproportionate to the principal of the loan.” 20 The court also found no issue with the use of the Treasury rate as the discount rate.21
- Make-Whole Premium Is Also Enforceable Under Bankruptcy Law
In the second part of its decision, the bankruptcy court addressed whether the make-whole premium is enforceable as a matter of federal bankruptcy law. The creditors’ committee argued that in order for the make-whole premium to be entitled to be treated as an allowed secured claim, it must pass muster under the reasonableness standard set forth in section 506(b) of the Bankruptcy Code.22 The lender countered that section 506(b) didn’t apply in the first place because the make-whole premium became due prior to the petition date.23 The bankruptcy court noted that the case law is divided on the question whether section 506(b) applied only to post-petition charges or both pre- and post-petition charges.24 The court, however, did not decide this issue and simply concluded that even if section 506(b) applied here, the make-whole premium was reasonable on the record before the court.25
Finally, the court also addressed the committee’s objection that the make-whole premium constitutes unmatured interest and should be disallowed under section 502(b)(2) of the Bankruptcy Code. After acknowledging a split in the case law, the court ultimately sided with the majority line of cases, including a recent Delaware decision in In re Trico Marine Services, Inc.,26 concluding that a make-whole premium is not a claim for unmatured interest, but rather akin to a claim for liquidated damages.27
The bankruptcy court’s analysis falls largely in line with recent case law concerning the enforceability of make whole premiums. Generally, make-whole premiums are to be subjected to a two-level analysis.28
First, courts evaluate whether the creditor is entitled to a make-whole premium as a matter of state law. As part of this inquiry, the court must determine whether the premium has, in fact, been triggered under the terms of the contract, as well as whether the premium is enforceable as a proper liquidated damages clause under applicable state law or constitutes an unenforceable penalty. This first level of inquiry is critical. Without an enforceable make-whole premium under applicable state law, there can be no allowable claim in bankruptcy in the first place.29 Creditors should therefore pay close attention to the trigger mechanism of the make-whole premium. To the extent they desire to recover a make-whole premium not merely upon prepayment, but also after acceleration, the credit documents should so specifically provide. In addition, creditors should be familiar with the applicable state law on liquidated damages. As evidenced by School Specialty, however, New York law (which is frequently the law of choice in credit transactions) poses a relatively low bar: a liquidated damages clause will be enforced as long as, at the time the parties entered into the contract, actual damages are difficult to determine and the stipulated amount is not plainly disproportionate to the possible loss. Moreover, as School Specialty highlights, it is irrelevant whether the amount of the make-whole premium may appear large in relation to the principal amount of the debt, as that is not the relevant test under New York law. Therefore, in practice, a properly drafted make-whole premium (e.g., the sum of the future stream of interest payments discounted by a proper discount rate) that was negotiated at arms-length between sophisticated parties is likely to be found enforceable under New York law.30 In that regard, it is also important to stress that the court approved of the Treasury rate (plus 50 basis points) as a proper discount rate for purposes of calculating the make-whole premium.
At the second level, and only if the premium is enforceable under applicable state law, courts will evaluate whether the premium is also enforceable as a matter of federal bankruptcy law. While the scope of the analysis may vary from case to case, courts typically take a number of considerations into account. For one, where an oversecured creditor seeks to recover a make-whole premium as part of its secured claim, that creditor must also show that the premium qualifies under section 506(b) of the Bankruptcy Code as a reasonable charge provided for under the agreement. Unfortunately, the case law is rather mixed on the impact of section 506(b). On the one hand, a number of cases have held that a prepayment fee will only be found reasonable under section 506(b) to the extent that the creditor can show that it actually incurred damages.31 Other courts, including School Specialty, do not subject make-whole premiums that are valid liquidated damages clause to much further scrutiny.32 As one court noted, the reasonableness standard of section 506(b) is a “safety valve which must be used cautiously and sparingly.”33 In School Specialty, section 506(b) did not pose any hurdle beyond the reasonableness requirements under applicable state law.34 Indeed, the court appeared to assume, without explanation, that if a charge is reasonable under state law it is also reasonable under section 506(b). Such an approach effectively renders section 506(b) mere surplusage.35
Moreover, a number of courts have also considered whether a make-whole premium should be disallowed as unmatured interest under section 502(b)(2) of the Bankruptcy Code.36 As noted, School Specialty sides with the majority line, which concludes that a make-whole premium is not unmatured interest.37 It should be cautioned, however, that the make-whole premium in School Specialty had already matured at the time of the petition date, as it was triggered by the pre-petition acceleration, and thus the decision does not speak to those circumstances where a make-whole premium is triggered at or after the petition date, e.g., by a repayment or refinancing during the course of a chapter 11 case. Moreover, there are at least two decisions in the Southern District of New York that would seem to question the ability to recover liquidated damages for lost yield.38 Thus, even though Delaware courts have now sided with the majority line of cases, it remains unresolved in the Southern District of New York.
The decision in School Specialty provides further comfort to creditors that bankruptcy courts will enforce properly drafted make-whole premiums. However, creditors must be vigilant to make sure that a make-whole premium is, in fact, triggered by acceleration (including upon a bankruptcy filing) and that the make-whole formula seeks to approximate the lost yield from the time of prepayment or acceleration through maturity, discounted by an appropriate discount rate, which may include the Treasury rate.