Loan agreements and bond indentures often contain “make-whole” provisions, which provide yield protection to lenders and investors in the event of a repayment prior to maturity. They accomplish this by requiring the borrower to pay a premium for pre-payment of a loan. This allows lenders to lock-in a guaranteed rate of return when they agree to provide financing. Borrowers also benefit since the yield protection allows lenders to offer lower interest rates or fees than they would absent such protection.
As contractual provisions, lenders and investors expect make-whole provisions to be enforceable according to their terms. But, what happens if the borrower files a bankruptcy petition?
In the current low interest rate environment, the enforceability of make-whole provisions in bankruptcy has been the subject of litigation as debtors have sought to refinance higher-interest debt, and lenders and investors seek to maintain their contractual rates of return. This litigation has recently produced several decisions about the lender’s entitlement to early termination premiums.
The basic issues regarding the enforceability of make-whole provisions were addressed by a Delaware bankruptcy judge applying New York law in In re School Specialty, Inc., No. 13-10125, 2013 WL 1838513 (Bankr. D. Del. Apr. 22, 2013). The court held that a make-whole provision was an enforceable liquidated damages provision which satisfied the reasonableness standard under Bankruptcy Code § 506(b), even though it amounted to 37% of the outstanding principal balance of the loan. The court also rejected an argument by the creditors’ committee that the payment constituted unmatured interest, which would not be allowable under Bankruptcy Code § 502(b)(2). Critically, the loan agreement provided that the debtors were required to pay an “Early Payment Fee” upon either prepayment or acceleration of the loan.
Several subsequent decisions have found that acceleration-upon-default provisions did not trigger prepayment obligations.
In Bank of NY Mellon v. GC Merchandise Mart, LLC (In re Denver Merchandise Mart, Inc.), 740 F.3d 1052 (5th Cir. 2014), the Fifth Circuit ruled that, under Colorado law, acceleration of a note due to the borrower’s pre-petition default did not trigger the prepayment obligation, since the note’s plain language did not require the borrower to pay prepayment consideration absent actual prepayment and there was no language in the note equated acceleration with prepayment.
In In re AMR Corp., 730 F.3d 88, 98-105 (2d Cir. 2013), the Second Circuit, applying New York law, held that the Chapter 11 debtors’ obligations under an indenture had been accelerated automatically as a result of their bankruptcy filing and, therefore, the repayment of the debt was in the nature of post-maturity-date repayment, rather prepayment. By the express terms of the indenture, the repayment did not trigger their obligation for a “make-whole” payment, even though the payment was made voluntarily so that the collateral could be released and pledged to a post-petition lender. More recently, a New York Bankruptcy Judge, following the Second Circuit’s reasoning, observed that the credit documents must contain express language that clearly triggers a pre-payment premium upon acceleration. In re MPM Silicones, LLC, No. 14-22503 (Bankr. S.D.N.Y. Sept. 9, 2014) (bench ruling).
Bankruptcy law only requires that a make-whole provision be “reasonable.” Aside from that overlay, bankruptcy courts will enforce make-whole provisions in accordance with the applicable state law; but, they will be strictly interpreted particularly if they do not clearly provide for consideration to be paid upon an acceleration of the debt. For example, New York provides that the parties can contract for a right of the borrower to prepay the debt in return for an agreed consideration which compensates the lender for the early termination of the stream of interest payments. Without that contractual option, the New York rule of perfect tender would preclude early payment. But, the lender forfeits the right to the pre-payment consideration if the lender accelerates the loan unless the loan documents contain “a clear and unambiguous clause” that requires the payment even in the event of acceleration. See In re MPM Silicones, LLC, supra.
Thus, the lender’s right to its make-whole premium hinges on whether the relevant provisions of their notes or loan documents provide, with sufficient clarity, for the payment of such premium after the maturity of the notes has been accelerated. Drafters should ensure that make-whole provisions (i) have a clear trigger for the payment and (ii) expressly provide that it is payable upon any early payment, regardless of whether it is the result of acceleration or enforcement actions taken by the lender.