Renée M. Dailey Partner Bracewell & Giuliani
Renée M. Dailey
Bracewell & Giuliani
Katherine L. Lindsay Associate Bracewell & Giuliani
Katherine L. Lindsay Associate
Bracewell & Giuliani

In the past year there have been a number of cases involving the payment of make-whole premiums in bankruptcy. Make-whole premiums are intended to protect noteholders (or other debt holders) from the loss of future fixed coupon interest payments due to the early repayment of debt if market interest rates have declined between the date of issuance and the date of prepayment. Make-whole provisions typically require the issuer to pay the positive difference (if any) between 1) the amount of principal and interest currently due and 2) the net present value of the principal and interest payments that would have been made over time but for the prepayment.

Inclusion of make-whole in a bankruptcy claim is often a controversial issue between the debtor and the various creditor constituencies. Proponents of make-whole argue that the premium is simply a negotiated contractual right that seeks to compensate a noteholder for loss of expected profits. Objectors typically argue that make-whole, even when provided for in the underlying contract, should not be allowed as part of a bankruptcy claim under a variety of theories, with most of them boiling down to the “it’s not fair” argument. Arguments made in most make-whole cases, including the recent American Airlines and School Specialty cases, and the pending GMX Resources case,1 can be generally categorized into policy arguments and contractual arguments. The majority of courts view the policy arguments settled in favor of the payment of make-whole as part of a bankruptcy claim.

Policy Arguments

While every case is different, the typical policy positions asserted in a make-whole controversy include the arguments that 1) make-whole is unmatured interest and therefore disallowed under the Bankruptcy Code; 2) make-whole is unenforceable as a penalty; and 3) in the case of secured claims, make-whole is not reasonable under §506(b) of the Bankruptcy Code.

These arguments were made recently in School Specialty and rejected by that court.2 In that case, the relevant credit agreement provided that debtor-SSI would pay a make-whole premium upon prepayment or acceleration. The agreement set forth different premiums under different circumstances. SSI breached a minimum liquidity covenant in December 2012, thus permitting the lender to accelerate the loan and trigger the make-whole premium. At the same time, the lender and SSI entered into a January 4, 2013 forbearance agreement that acknowledged the outstanding amounts of principal, interest and make-whole premium. SSI filed Chapter 11 in January 2013. After additional negotiations, SSI stipulated that it owed the lender a $23.7 million make-whole payment on $67 million in outstanding principal amount. The Unsecured Creditors’ Committee objected to the inclusion of make-whole in the lender’s secured claim on the policy grounds outlined above. Similar arguments have been made by the Unsecured Creditors Committee in the pending GMX Resources case as well.

Proponents of the first argument assert that since a make-whole premium constitutes compensation for future interest payments that the borrower/issuer failed to make, the make-whole premium must take on the characteristics of the interest and be classified as unmatured interest. Section 506(b)(2) of the Bankruptcy Code prohibits claims for unmatured interest. The majority of courts disagree with this argument, however, and, instead, conclude that a make-whole premium is more akin to liquidated damages because it fully matures at the time of the breach or prepayment. See In re School Specialty, Inc., Case No. 13-10125, at 10-11 (Bankr. D. Del. April 22, 2013) citing In re Trico Marine Services, 450 B.R. 474 (Bankr. D. Del. 2011). Some courts in New York have taken the minority view that make-whole is unmatured interest. See In re Chemtura, 439 B.R. 561 (Bankr. S.D.N.Y. 2010) and HSBC Bank USA N.A. v. Calpine Corp., Case No. 07 Civ 3088 (S.D.N.Y. Sept. 14, 2010).

The next argument offered against the inclusion of make-whole premiums in bankruptcy claims is that the make-whole premium is not enforceable under state law (typically New York law) because the premium is “grossly disproportionate to any probable loss” and therefore constitutes an impermissible penalty. In evaluating whether a make-whole is disproportionate to the loss, New York law considers whether the make-whole formula is calculated so that the lender will receive its bargained-for yield, and also whether the parties in question were sophisticated parties who negotiated an arms-length transaction.

With this standard in mind, a number of courts have upheld make-whole formulas tied to comparable treasury rates. Most recently in the School Specialty case, the court noted that since the calculation in the underlying contract was clear “[t]he court cannot, with the benefit of hindsight, alter the agreement based on subsequent operational results and managerial decisions.”

The third typical challenge to make-whole again focuses on the reasonableness of the amount, in particular under §506(b) that requires that to the extent a secured creditor is oversecured, if the underlying agreement so provides, the secured creditor may recover post-petition interest, fees, costs and charges but only if those amounts are reasonable. The flaws in this challenge are two-fold. First, §506(b) only applies to post-petition costs, and make-whole is earned as of the acceleration of the debt, in some cases by the bankruptcy filing itself. Second, to the extent that a premium is not an unenforceable penalty under state law, it is unlikely to be unreasonable under §506(b).

In School Specialty, the court did not need to reach the issue of whether §506(b) only applied to post-petition fees, costs and charges, and instead relied on its determination under New York law that the premium was not an unenforceable penalty and that such a determination compelled a parallel conclusion that the make-whole was therefore “reasonable” under §506(b).

Contractual Issues

As illustrated above, when courts disallow make-whole as part of a bankruptcy claim, it is not typically because of the policy arguments, but because of the language of the underlying contract.

In American, the United States Bankruptcy Court for the Southern District of New York approved debtor-American Airlines’ motion to enter into a secured financing transaction and repay certain pre-petition aircraft financing without paying make-whole premiums. This generated some concern in the bankruptcy world regarding the enforceability of make-wholes. The concern was unwarranted, the decision was not about the enforceability of make-whole as a policy matter. In fact, the court specifically noted that “[t]here is no dispute that make-whole amounts are permissible. The entitlement to such payments, however, is a matter of contract, not policy.” Instead, the decision focused on the underlying indentures and the inability of the indenture trustee to “undo” an automatic acceleration provision.
By way of brief background, American had issued various series of equipment notes under indentures. Each of the indentures provided that American’s voluntary bankruptcy filing in November 2011 constituted an event of default that automatically accelerated the notes and caused all amounts due thereunder to become immediately due and payable. The key fact is that the indentures carved out the payment of make-whole in these circumstances. Specifically, the indentures provided that where an event of default has occurred following a voluntary bankruptcy filing “the unpaid principal amount of the Equipment Notes then outstanding, together with accrued but unpaid interest thereon and all other amounts due thereunder (but for the avoidance of doubt, without Make-Whole Amount), shall immediately and without further act become due and payable. . .” Additionally in the priority of payment section, the indentures specifically provide that “no Make-Whole Amount shall be payable on the Equipment Notes as a consequence of or in connection with an Event of Default or the acceleration of the Equipment Notes.”

The indenture trustee argued that 1) it had not affirmatively accelerated the debt; 2) it had the right to decelerate the debt; and 3) the acceleration provision was an unenforceable ipso facto clause. The court dismissed all of these arguments, noting that the automatic acceleration provisions were explicit in the indentures. The court held that efforts to decelerate the notes would violate the automatic stay because doing so adversely affected American’s contractual rights under the indentures by triggering additional amounts owing. Further, the court noted that ipso facto clauses are only prohibited in connection with executory contracts and unexpired leases and that the parties had acknowledged that the indentures did not fall into either category.

A further contractual issue to be aware of is whether the underlying contract defines “maturity date.” This is an instance where defined terms matter, i.e., is the make-whole due anytime payment is made prior to the “maturity date” or the “Maturity Date”? The term “maturity date” could potentially be interpreted as the date on which payment becomes due following acceleration (i.e., it is an “acceleration of maturity”) instead of the fixed original stated maturity date of the notes when issued. The first interpretation results in a zero make-whole. Since bankruptcy accelerates the payment date (or the little “m” little “d” maturity date) of the debt, the underlying agreement should distinguish between the date used for purposes of make-whole calculation (the “Original Stated Maturity Date”) and the date that the debt may become due as a result of default or otherwise.

Renée M. Dailey is a partner with Bracewell & Giuliani and a member of the Financial Restructuring team.

Katherine L. Lindsay is an associate with Bracewell & Giuliani and a member of the Financial Restructuring team.

1. See In re GMX Resources Inc., Case No. 13-11456 (SAH) (Bankr. W. D. OK).
2. See In re School Specialty, Inc., Case No. 13-10125 (Bankr. D. Del. April 22, 2013).