In an age of historically low interest rates, lenders rely on fee income and other devices to enhance their returns. One of these mechanisms -- and one that can have dramatic consequences for a borrower -- is the inclusion of a prepayment or make-whole premium in the loan agreement. These types of provisions require a borrower, upon prepayment or acceleration of a loan, to pay the lender an additional sum usually calculated to capture the net present value of the remaining interest payments on the loan. This serves as a disincentive for the borrower to prepay or refinance at a lower interest rate and leads to payment requirements above and beyond the loan balance.

Lenders argue that make-whole provisions ensure they receive the benefit of their bargain and compensate them for the opportunity cost of not having capital to loan elsewhere or for hedging against interest rate fluctuations. In some cases, however, these provisions can have disastrous consequences for the borrower.

In re School Specialty, Inc., Case No. 13-10125 (KJC) (Bankr. D. Del. Apr. 22, 2013) concerns a routine forbearance agreement that triggered a make-whole premium equal to 37 percent of the loan. The fact that such a dramatic result was blessed by a Delaware bankruptcy court, a leading venue whose decisions are followed closely by other jurisdictions, shows that borrowers cannot rely on the equitable nature of bankruptcy proceedings to protect them from these significant claims when things turn south.

In School Specialty, the Creditors Committee moved to disallow a $23.7 million make-whole payment contained in School Specialty's prepetition credit agreement. The credit agreement provided for a $70 million term loan from Bayside Finance, LLC. Upon either a prepayment or acceleration of the Loan, School Specialty was required to pay a Make-Whole Premium calculated by discounting the future stream of interest payments. The loan agreement had an optional early payment date, but School Specialty was never likely to meet that date.

Just two weeks before its bankruptcy, School Specialty entered into a forbearance agreement. School Specialty acknowledged breaching a financial covenant. The forbearance agreement provided for the acceleration of the Loan. As a result, all outstanding principal and unpaid interest on the Loan, including the Make-Whole Premium, became due and payable.

On January 28, 2013, School Specialty filed a chapter 11 case and sought post-petition financing from Bayside. Bayside insisted that the Debtors' acknowledge Bayside had a valid claim to the Make-Whole Premium, even though the premium totaled 37 percent of the Loan. This left the Creditors Committee as the only party with standing to challenge the validity of the Make-Whole Premium.

The Creditors Committee objected to the Make-Whole Premium, arguing (i) that it was an unenforceable penalty under New York law, which governed the Agreement; and (ii) that the Bankruptcy Code prohibits including unmatured interest as part of a creditor's claim. For its part, Bayside argued that the Make-Whole Premium was not a penalty but rather a form of liquidated damages calculated to compensate it for its lost stream of interest payments. The Creditors Committee responded that the formula used to calculate the Make-Whole Premium was disproportionate to Bayside's probable loss as of the time the parties entered into the Agreement because Bayside had calculated the premium based on the later maturity date. The Creditors Committee argued that that the formula for calculating the Make-Whole Premium unreasonably inflated Bayside's bargained-for yield by including discounted interest payments through an extended maturity date when the bargain originally was calculated based on the earlier, optional prepayment.

The Delaware Court first determined that, under applicable New York law, prepayment provisions in a loan agreement are enforceable when "(i) actual damages are difficult to determine, and (ii) the sum stipulated is not 'plainly disproportionate' to the possible loss." In re School Specialty, Inc. at 5. Further, the reasonableness of the stipulated damages is determined at the time the agreement is executed and not when it is breached. Id. Finally, the Court noted that New York courts have consistently cautioned against interfering with parties' agreements absent elements of fraud, over-reaching or unconscionable conduct. Id.

Applying the law to determine whether the Make-Whole Premium could stand, the Court looked to whether the Make-Whole Premium was calculated so that Bayside would receive its bargained-for yield and whether it was the product of arm's length negotiations between the Debtors on one hand, and Bayside on the other hand. The court determined it was.

The Court also dismissed the contention that calculating the premium to the later payment date was inappropriate. The Court noted that whether or not an extension of the Loan was likely was irrelevant to the calculation of the Make-Whole Premium. In addition, the Court found that prepayments calculated on the basis of U.S. Treasury bonds -- like the Make-Whole Premium here -- supported, rather than detracted from, the conclusion that the premium here was not "plainly disproportionate" to Bayside's loss.

Of great interest, the Court also noted that while the Make-Whole Premium was 37 percent of the principal balance of the Loan, the applicable standard guiding the Court's analysis was not whether the premium was plainly disproportionate to the size of the loan but, rather, whether it was plainly disproportionate to Bayside's possible loss. In other words, the Court left open the door to finding that even make-whole premiums in excess of 37 percent of a loan's balance will pass muster so long as that payment is not disproportionate to the bank's claimed loss.

Lastly, and most importantly, the Court disagreed that the Make-Whole Premium was a claim for unmatured interest and thus disallowable under section 502(b)(2) of the Bankruptcy Code. The question of whether make-whole or other prepayment premiums qualify as unmatured interest for purposes of the Bankruptcy Code has been the subject of much litigation, with courts coming down on both sides of the question. A minority of courts have held that, absent an actual prepayment of the loan, whether by the borrower or through a refinancing, make-whole payments are not enforceable in bankruptcy. For example, the bankruptcy court in In re Ridgewood Apts. Of Dekalb County, LTD., 174 B.R. 712 (Bankr. S.D. Oh. 1994) denied a claim for a prepayment fee predicated on the lender's acceleration of the note despite language in the loan agreement to the contrary. The Court reasoned that a pre-payment provision was just that, and required an actual payment and not just an acceleration of the loan. The court noted that "the essence of a bankruptcy reorganization. . . is to restructure debt [and] decelerate accelerated debts. . . . It would be anomalous for acceleration of an obligation to be construed as a prepayment which triggered the application of a penalty." Id. at 720. Based on that analysis, the Ridgewood court concluded that, absent actual prepayment by the debtor, the creditor's claim was a contingent one for unmatured interest and thus not allowable pursuant to section 502 of the Bankruptcy Code.

The School Specialty court, however, chose to follow the majority view and adopted the reasoning articulated in In re Trico Marine Servs., Inc., 540 B.R. 474 (Bankr. D. Del. 2011), holding that the Make-Whole Premium was not a claim for either a penalty or unmatured interest but rather a form of liquidated damages. In other words, courts taking the majority view presume that arm's length agreements between lenders and borrowers should be enforced according to their terms consistent with applicable state law governing liquidated damages and not equitable or policy-animated notions that favor reorganization. Moreover, the Court took the exact opposite view of the importance of a make-whole premium predicated on, among things, acceleration of the debt, construing the Forbearance Agreement to have made the debt due and payable upon acceleration and thus the Make-Whole Premium fully matured at the time of the breach.

The School Specialty decision provides strong support for enforcing aggressive make-whole provisions, even where the amounts charged would seem excessive. Delaware bankruptcy judges, whose decisions have influence across jurisdictions, now follow the majority view that make-whole and similar premiums will not be found unenforceable as claims for unmatured interest but rather analyzed as liquidated damages under applicable state law.