Judge Drain’s recent decision confirming the Momentive Performance Materials Inc. plan is just the latest in a series of recent cases involving “make whole” premiums. As in several of the recent cases, the lenders lost because the contract did not clearly enough provide for the make whole premium in the event of an acceleration rather than prepayment.
So what is a make whole premium? It is a type of prepayment penalty that is imposed if the loan is paid off early to compensate the lender for the interest that it was not able to earn over the remaining term of the loan. Normally it will be calculated to reflect the difference between the higher rate charged on the early-terminated loan and the lower current market rate since that is the lost expectation interest, or damages, the lender suffers as a result of early repayment. Make whole premiums are important to lenders in times like these when rates are very low and will diminish in importance if and when rates begin to rise.
Many of the recent cases have rejected the premiums by narrowly interpreting the contractual provisions. That has allowed them to avoid the very difficult issue of whether such fees constitute unmatured interest. That classification is important because the Code disallows any claim to the extent that it is for unmatured interest. See 11 U.S.C. § 502(b)(2). The cases that have reached the issue are split – largely on the form vs. substance divide that we often see in the law.
On the form side, a make whole premium is not in the form of an interest charge. It is a fee charged for an option – the option to pay the loan off early – that is a fully matured obligation at the time of prepayment, and not a charge for the use of money that accrues over time. That view makes sense if you think of it as a fancy type of prepayment penalty. For example, a simple modest flat fee imposed for prepayment looks nothing like an interest charge.
However, the make whole premium is not a flat fee, but rather is calculated using approximately the same formula one would use to calculate the breach of contract damage claim for paying early. Note that under the “perfect tender in time” rule, a borrower has no right to pay a loan off early absent a contractual term permitting prepayment. Thus, prepayment would constitute a breach of contract entitling the lender to damages for its lost expectation of interest. In fact, the lenders inMomentive made that argument as a fall-back position. Judge Drain rejected that claim as violating the section 502(b)(2) prohibition on unmatured interest.
This brings us to the substance approach. If a damage claim for unearned interest would fail under section 502(b)(2), then how can a make whole provision that does the same thing pass muster? That view makes sense if you think of a make whole provision as a liquidated damages clause covering unmatured interest.
A deeper question is why the Bankruptcy Code doesn’t recognize a lender’s legitimate state law future interest expectation damages as part of its allowed claim, when the future expectation damages of most other contract counter parties are allowed. This forces lenders to absorb the losses they incur when a debtor ceases to perform, while other creditors get to recover at least part of their losses.
That appears, however, to be the result intended by section 502(b)(2) and it’s disallowance of unmatured interest. The legislative history suggests that it is designed to limit lenders’ claims in the way that section 502(b)(6 & 7) caps landlord and employee claims rather than to merely avoid the administrative difficulty of calculating pendency interest at varying rates on all claims from the filing date to the distribution date. Indeed the legislative history specifically rejects the formalistic approach in at least one situation by requiring that original issue discount be treated as unmatured interest and pro-rated.
With Delaware seen as a pro make whole jurisdiction and the Southern District of New York seen as a hostile jurisdiction, hopefully some deeper analysis by the courts will clarify the issue before rising interest rates cause it to fade from the radar.