Conflicting decisions by the 2nd, 3rd and 5th Circuit courts have created confusion over the status of make-whole claims in bankruptcy. Stephen Selbst analyzes the controversial cases and calls for a resolution either by a Supreme Court ruling or an amendment to the Bankruptcy Code.
The status of make-whole claims in bankruptcy proceedings is a muddle due to conflicting rulings by the 2nd Circuit, the 3rd Circuit and the 5th Circuit. This uncertainty has costs: investors use make-whole premiums as a hedge against refinancing risk and as part of their overall compensation package. If investors cannot be assured they will receive these payments, they will likely require higher current-pay interest rates, which will hurt borrowers with weaker credit.
Moreover, whether investors are able to receive make-whole amounts can have enormous financial consequences. The amount of make-whole premiums at issue in the Energy Future Holding case, for example, was $413 million. Given the commercial importance of this issue to borrowers and lenders, the imbroglio needs to be resolved by the Supreme Court or by an amendment to the Bankruptcy Code.
New York law, which governs many credit agreements and bond issues, provides that a debt cannot be paid before maturity without lender consent. Many debt instruments cannot be repaid prior to maturity unless the borrower pays a make-whole amount. A make-whole amount is generally expressed as the present value of the interest payments that would have been received if the debt had been paid at maturity. Make-whole provisions are common in bank credit agreements, investment-grade bonds, high-yield bonds, and equipment leases.
Energy Future Holdings
Energy Future Holdings Corp. (EFH) issued $4 billion in first-lien notes bearing interest at 10% in 2010 and then issued second-lien notes in 2011 and 2012. The indentures for all the issues required EFH to pay make-whole amounts if the notes were optionally redeemed. The indentures also contained a provision that automatically accelerated the debt if EFH filed a bankruptcy petition.
When interest rates declined, EFH considered refinancing its debt, but recognized that doing so would trigger substantial make-whole amounts. EFH believed it could avoid the make-whole premiums in Chapter 11, as it disclosed in an 8-K filing with the SEC in November 2013. In April 2014, EFH filed a Chapter 11 petition in Delaware.
In Chapter 11, the trustee for the first-lien bondholders sought a declaration that any refinancing would require payment of the make-whole amount. Alternatively, the trustee sought to de-accelerate the first-lien debt. The bankruptcy court first permitted EFH to refinance the first-lien and second-lien debt without payment of the make-whole amounts. But the court preserved the noteholders’ right to litigate the enforceability of the make-whole. The bankruptcy court then disallowed the payment of the make-whole.1 Its decision focused on the acceleration provision of the indenture; because that section made no mention of payment of the make-whole, the court concluded that payment of the make-whole was not required. The district court affirmed.
The 3rd Circuit reversed, finding that the noteholders were entitled to payment of the make-whole amounts.2 In the 3rd Circuit’s analysis, there was no conflict between the optional redemption provision of the indenture and the automatic acceleration provision; the two provisions could be read together, and the latter reading required payment of the make-whole amount. Applying New York law, it ruled that any payment of debt, whether at maturity or by an earlier acceleration, qualified as a redemption. It then held, based on the facts, EFH’s redemptions were optional, and highlighted EFH’s announced strategy of attempting to refinance the debt in bankruptcy to avoid the make-whole. Finally, it ruled that there was no conflict between the automatic acceleration provision and the make-whole.
Momentive Performance Silicones (MPM) was a producer of industrial silicone products that borrowed $1.1 billion in first-lien notes and $250 million in 1.5-lien notes in 2011. MPM had previously issued $500 million in subordinated unsecured notes and $1 billion in second-lien notes. When its business could not support its debt, MPM commenced a Chapter 11 proceeding in the Southern District of New York in 2014. The indentures under which the first-lien and 1.5-lien notes contained make-whole provisions that were similar to the make-whole provisions in the EFH indentures.
MPM’s Chapter 11 plan gave the senior noteholders the option of accepting the plan, waiving any make-whole claim, and receiving payment in cash in full, or rejecting the plan, preserving their make-whole argument and receiving replacement notes with a principal amount equal to their allowed claims but paying below-market interest rates. Both the first-lien and 1.5 lien noteholders voted overwhelmingly to reject the plan.
Both the MPM bankruptcy court3 and district court4 ruled against the noteholders on the make-whole premium. Both courts held that their debt was automatically accelerated as a result of MPM’s chapter filing, and that the make-whole would only have been due if the indentures “clearly and unambiguously” provided for it. Both courts determined that the “optional redemption” provision of the indentures did not clearly so provide, and that a refinancing in bankruptcy (even following a voluntary filing) is not “optional” because it is triggered automatically. The lower courts also refused to read a provision in the indentures’ automatic acceleration clauses, which provided for payment of a “premium, if any” upon acceleration, as providing for a make-whole because they ruled that no make-whole was due under the “optional redemption” clause.
On appeal, the noteholders contended that they were entitled to the make-whole, but the 2nd5 Circuit held that the repayment of the notes happened post-maturity because MPM’s Chapter 11 filing accelerated the maturity of the notes to the Chapter 11 petition date and the redemption occurred later.6 It also ruled that the notes were not voluntarily redeemed, but were redeemed as a result of the automatic acceleration of the debt upon bankruptcy.
The Chapter 11 case of Ultra Petroleum, which was filed in the Southern District of Texas in 2016, has further confused the status of make-wholes. Ultra issued $1.46 billion of notes in three tranches, the note agreements for which contained make-whole provisions in the event of optional redemptions. The note agreements also provided that the notes were automatically accelerated upon bankruptcy. The noteholders filed proofs of claim that included their make-whole amounts, to which the debtors objected. The parties agreed to permit the debtors to confirm their plan, which did not provide for make-whole payments, but preserved the noteholders’ make-whole objection.
At trial the debtors argued that the make-whole payments were disguised unmatured interest payments, and that under section 502(b) of the bankruptcy code, such claims were disallowed by operation of law. Because it was the bankruptcy code, and not the plan, that disallowed the claims, they argued, their plan was valid. The bankruptcy court disagreed, ruling that the noteholders were entitled to receive payment of their make-whole, which was approximately $201 million.7 The debtors appealed directly to the 5th Circuit.
On January 17, 2019, the 5th Circuit issued its first Ultra decision, holding that make-whole premiums are not enforceable in bankruptcy.8 The 5th Circuit found the debtors’ argument “compelling” that a make-whole premium should be disallowed as a claim for “unmatured interest” pursuant to section 502(b)(2) of the bankruptcy code. The 5th Circuit said that the analysis of make-whole payments needed to focus on their economic reality and not their contractual form. Prior courts had rejected similar unmatured interest arguments; while acknowledging that make-whole premiums are intended to compensate for future interest that would be received through the scheduled maturity date, those courts upheld their enforceability on the theory that because the make-whole is triggered by an optional redemption, it is fully payable pursuant to the terms of the debt instrument. Ultra also held that the noteholders were unimpaired because it was the bankruptcy code itself — and not the debtors’ plan — that disallowed their make-whole claims.
Because the first Ultra decision departed analytically from the EFH and MPM decisions, it had an enormous impact and led to further confusion. The Ultra noteholders appealed to the full 5th Circuit. On November 26, 2019, the same panel of the 5th Circuit issued a new Ultra decision, which reaffirmed that, to the extent a plan pays creditors all that they are entitled to under the bankruptcy code, such creditors are unimpaired.9 But critically, it withdrew the substance of its prior opinion, including its finding that make-whole premiums constituted unmatured interest and were per se disallowed. Instead, it held that whether a make-whole constituted unmatured interest was to be determined on a case-by-case basis and remanded the case to the bankruptcy court for further factual findings.
Although the controversial elements of the 5th Circuit’s Ultra decision have been withdrawn, the history of that litigation suggests that it is likely to be back before that court on a fuller factual record. More broadly, the starkly different decisions and analyses of the EFH, MPM Silicones and Ultra courts show that there is no consensus on this issue, even though the disputes in these cases run to hundreds of millions of dollars.
Make-whole provisions are standard in a variety of debt instruments and investors have made lending decisions in reliance on their protections. If they are held invalid, lenders will find other ways to be compensated. But given the magnitude of the problem, the differences in legal analysis, and the splits in the circuit courts, this is an issue that is ripe for adjudication by the Supreme Court. But if the Supreme Court cannot or will not rule, the institutional lending community needs to craft a legislative solution to this quandary. •