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.
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 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.
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.
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.
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.
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.
Remains Inconclusive
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. •
