A make-whole premium is a lump-sum payment that becomes due under a financing agreement when repayment occurs before the stated maturity date, thereby depriving the lender of all future interest payments bargained for under the agreement. Make-whole provisions, ubiquitous in the bond market, are becoming more prevalent in commercial loan transactions, including in the distressed context. That trend is spurred by favorable court rulings for lenders enforcing make-whole premiums when the borrower files for bankruptcy protection. Tight, unambiguous contracts with respect to the lender's rights are not being second-guessed by the courts. An example are recent decisions from the bankruptcy courts in Delaware in In re School Specialty, Inc., No. 13-10125, 2013 WL 1838513 (Bankr. D. Del. Apr. 22, 2013), the Southern District of New York in In re AMR Corp., 485 B.R. 279 (Bankr. S.D.N.Y. 2013) and the Western District of Oklahoma in GMX Resources, Inc., No. 13-11456 (filed Apr. 1, 2013). Nevertheless, lenders' claims to make-whole premiums continue to be challenged by unsecured creditors and equity committees, as in the bankruptcy case of In re Rotech Healthcare, Inc., No. 13-10741 (Bankr. D. Del. filed Apr. 8, 2013).
THE SCHOOL SPECIALTY DECISION
School Specialty entered into a credit agreement pre-bankruptcy to borrow $70 million from lender, Bayside Finance, LLC (Bayside). Under the terms of the parties' agreement, School Specialty was obligated to pay a make-whole premium to Bayside if the loan was prepaid or accelerated before the stated term. The parties' agreement calculated the make-whole premium as the present value of future interest payments that would have accrued between the date the principal was prepaid or accelerated and the loan's maturity date. The loan matured at the end of year 2014, but the maturity date could be extended to the end of 2015 under certain circumstances. School Specialty breached a covenant in the credit agreement that triggered its obligation to pay the make-whole premium. On January 4, 2013, School Specialty entered into a forbearance agreement with Bayside, acknowledging acceleration of the loan caused by the breach and the obligation to pay the make-whole premium in the approximate sum of $25 million.
The amount of the make-whole premium represented 37 percent of the loan principal, which was, in the court's words, large enough "to give the Court pause." 2013 WL 1838513, at *4. The premium was calculated based on interest payments that would have been due through the 2015 maturity date of the loan, at the U.S. Treasury rate plus 50 basis points.
On January 28, 2013, School Specialty and related entities (collectively School Specialty) filed voluntary petitions for Chapter 11 relief. School Specialty and Bayside entered into a debtor-in-possession financing arrangement, stipulating that School Specialty owed Bayside the principal of the loan and the make-whole premium of $23.7 million. Reacting to the magnitude of the premium that squeezed unsecured creditors out of the money, the Official Committee of Unsecured Creditors filed a motion to disallow the make-whole premium. Bayside opposed the Committee's motion.
The bankruptcy court conducted a trial, heard testimony and denied the Committee's motion. Applying the parties' choice of law under their agreement, which was New York, the court overruled all of the Committee's arguments.
First, the court found that New York law enforces make-whole premiums as liquidated damages. Id. at *2-*3. Liquidated damages provisions are enforceable when (1) actual damages are difficult to determine and (2) the sum stipulated is not "plainly disproportionate" to the possible loss. Id. To determine if a make-whole premium is plainly disproportionate to the lender's possible loss, courts consider whether the premium is (1) calculated to provide the lender with its bargained-for interest on the principal amount of the loan and (2) the result of an arms-length transaction between sophisticated parties represented by counsel. Id. Whether the premium is disproportionate to the loss is determined at the time the parties entered into the agreement and not at the time of the breach. The court determined that calculating the make-whole premium based on the extended maturity date was not plainly disproportionate to Bayside's possible loss, because the parties bargained for an extended repayment period. Id. at *3. In addition, the court found that the parties' transaction was arms-length and the U.S. Treasury bond interest rate applied in calculating the make-whole premium was appropriate. Id. at *4.
Second, the court ruled that applicable New York law did not require the make-whole premium to pass muster as "reasonable" under Bankruptcy Code section 506(b). Id. at *5. Section 506(b) of the Bankruptcy Code provides that where a secured creditor's collateral is worth more than the secured debt, reasonable fees, costs or other charges provided for under the parties' agreement may be added to the total indebtedness up to the value of the collateral. Even if the make-whole premium had to pass a "reasonable" test, the court would have approved it.
Third, the court held that the make-whole premium could not be disallowed under Bankruptcy Code section 502(b)(2) because make-whole or prepayment premiums are not characterized as unmatured interest. Id. at *5 (citing In re Trico Marine Servs., Inc., 450 B.R. 474 (Bankr. D. Del. 2011)). Finally, the court found that there was no duty to mitigate a valid liquidated damages claim.
The School Specialty decision has been appealed to the district court. See Off. Comm. of Unsecured Creditors v. Bayside Finance LLC, 13 Civ. 1009 (D. Del.) (GMS). Shortly after the appeal, the parties scuffled over Bayside's refusal to accept tender of the make-whole premium, thereby obliging the School Specialty to pay interest at a 17-percent default rate. Bayside eventually accepted payment. The appeal is going forward, and the parties have set a briefing schedule ending in November 2013.
In AMR, discussed below, a Southern District of New York bankruptcy court, applying New York law, again strictly construed the parties' contract but determined that default did not trigger payment of the make-whole premium.
THE AMR DECISION
In AMR, American Airlines had issued prepetition equipment notes for the purchase of aircraft in three separate financing transactions with U.S. Bank, as indenture trustee. Upon voluntary redemption of the notes, the indenture entitled U.S. Bank to receive (1) 100 percent of the unpaid principal amount outstanding, (2) accrued but unpaid interest to the date of redemption and (3) a make-whole premium equal to the discounted future stream of interest payments. The indenture also provided that a voluntary bankruptcy filing was an event of default. Unlike voluntary redemption, an event of default entitled U.S. Bank to automatically accelerate the unpaid principal and accrued but unpaid interest payments, but did not entitle U.S. Bank to a make-whole premium.
In November 2011, American Airlines and related entities (collectively, American) filed a voluntary petition for Chapter 11 relief and sought debtor-in-possession financing from various lenders, the proceeds of which, at least in part, would be used to pay off prepetition indebtedness to U.S.Bank. U.S. Bank objected to the extent American sought to repay the indebtedness without the make-whole premium. U.S. Bank argued that the make-whole premium was due under the parties' agreement because the payoff was tantamount to the American voluntary redemption of the notes. American argued that their bankruptcy filing was an event of default, and therefore, under the indenture, it had no obligation to pay a make-whole premium.
The bankruptcy court agreed with American, and denied U.S. Bank the make-whole premium. The court did not hold an evidentiary hearing, finding that the plain language of the indenture stated a bankruptcy filing was an event of default that automatically accelerated the loan but did not entitle U.S. Bank to the make-whole premium. Id. at *289. The court further found that U.S. Bank could not waive the default, because a waiver would violate the automatic stay and obligate American to pay the make-whole premium when their contract provided otherwise. Id. at *294-95.
The court also rejected U.S. Bank's argument that the bankruptcy default clause in the indenture was an unenforceable ipso facto clause under the Bankruptcy Code, which invalidates a default occasioned by a debtor's insolvency or filing of a bankruptcy petition. Id. at *295. The court held that ipso facto clauses are not per se invalid except if contained in an executory contract or unexpired lease. Id. (citing In re Gen. Growth Props., Inc., 451 B.R. 323, 329 (Bankr. S.D.N.Y. 2011)). The court found that the bankruptcy default clause here was enforceable, because the contract at issue was an indenture, and was not subject to the Bankruptcy Code provisions applicable to executory contracts within the meaning of the Bankruptcy Code. Id. at *297. Likewise, the court found that the proposed new financing transaction was not a voluntary redemption, because American were paying notes that had matured due to acceleration under the indenture, which was triggered by their bankruptcy filing. Id. at *298. Payoff of the notes, therefore, was not a pre-payment, but rather was made post-maturity date. Id.
The AMR decision was directly appealed to the United States Court of Appeals for the Second Circuit. On September 12, 2013, the Second Circuit affirmed the bankruptcy court's decision in full. See In re AMR Corp., No. 13-1204, slip op. (Sept. 12, 2013) (ECF No. 109). Based upon the plain language of the indentures, the Second Circuit determined that filing the bankruptcy petition triggered a default, which accelerated the debt but did not require payment of a make-whole amount. Id. at 19-22. The Second Circuit further agreed with the bankruptcy court's reasoning that payoff of the notes was not a voluntary redemption, because the notes were accelerated and hence mature, id. at 31-32, and the indentures were not executory contracts and, therefore, the bankruptcy default clause was unenforceable as an ipso facto clause. Id. at 37-38. The Second Circuit rejected the argument that ipso facto clauses in non-executory contracts are per se prohibited, finding that such a conclusion is not supported by the Bankruptcy Code. Id. at 39-40.
THE GMX AND ROTECH HEALTHCARE CASES
Following the decisions in School Specialty and AMR, disputes between unsecured creditors and debtors over the enforceability of make-whole premiums are becoming a more consistent feature in the restructuring landscape. In the bankruptcy case of In re GMX Resources, Inc., No. 13-11456 (Bankr. W.D. Ok. filed Apr. 1, 2013), for example, the bankruptcy court ruled in an oral decision on August 27, 2013, that the first-lien lenders' claim properly included a make-whole premium in the amount of $66 million, rejecting a challenge by the Official Committee of Unsecured Creditors. Following the reasoning in School Specialty and AMR, the court relied chiefly on the unambiguous language of the governing credit agreement. Applying New York law, the court reasoned that the lenders' anticipated losses were difficult to estimate at the time the indenture was drafted; calculating the rate tied to U.S. Treasury bonds was not disproportionate to the anticipated losses; the make-whole premium was in the nature of liquidated damages and not unmatured interest subject to disallowance under section 502(b)(2) of the Bankruptcy Code; and Bankruptcy Code section 506(b)'s reasonableness standard did not apply. Unlike School Specialty, however, the court took testimony on whether the calculation of the make-whole premium followed industry practice.
In the bankruptcy case of In re Rotech Healthcare, Inc., No. 13-10741 (Bankr. D. Del. filed Apr. 8, 2013), the Official Committee of Equity Security Holders filed a motion to interdict any claim of the second lien noteholder to a make-whole premium in the amount of $57 million. The Equity Committee made the now familiar, but unsuccessful, arguments that the Creditors' Committee made in School Specialty, arguing that the make-whole premium was an unenforceable penalty under New York contract law, unenforceable unmatured interest under section 502(b)(2) of the Bankruptcy Code, and was improperly based on a reinvestment rate tied to U.S. Treasury bond yields that overestimate the potential loss from the prepayment. Guidance from this case is limited, however, given that the Equity Committee was disbanded prior to resolution of its motion.
The AMR decision, as affirmed by the Second Circuit, and the School Specialty and GMX decisions are in accord that the right to payment of a make-whole premium is governed by applicable state law and the plain language of the parties' agreement. The courts discussed above, it appears, made limited or no factual findings as to whether the premium was disproportionate to the lender's loss.
The School Specialty and AMR decisions could potentially shape the market for interest protection in distressed loans. Conventionally, bond indenture provisions lack the clarity the School Specialty and AMR Courts found conclusive. Lenders across the board, however, may take advantage of the favorable case law and the prospect of limited litigation cost and demand make-whole premiums, especially where the costs of negotiating detailed, unambiguous terms are relatively low and the potential upside is high. Enabling more restructuring and greater access to credit market may persuade courts to follow the lead of School Specialty and AMR and defer to the bargained-for agreement between sophisticated parties.
No doubt, unsecured creditors and equity holders will continue to battle against outsized make-whole premium payments by insolvent debtors, as did the Equity Committee in the Rotech bankruptcy. However, in jurisdictions where the premiums are viewed as liquidated damages, resort to Bankruptcy Code provisions applicable to unmatured interest and reasonableness, among other arguments rejected in School Specialty and AMR, may be a losing battle. One such battle may present itself if Energy Future Holdings, the troubled power company formerly known as TXU, files for bankruptcy protection to avoid payment of a make-whole premium called for under its indentures in an insolvency event.
The legal precedents governing make-whole provisions are being created now. Lenders and borrowers in distressed markets would be wise to monitor the legal landscape in this developing area.