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Recent Developments with Make-Whole Provisions in Chapter 11 Cases
August 01, 2018
A make-whole provision (also known as prepayment premium or call protection) in a loan agreement usually requires a debtor to pay a penalty based on a fixed percentage of the amount of a loan balance the debtor voluntarily prepays. The primary purpose of such provisions is to protect a creditor from the loss of interest-related profit resulting from a debtor’s prepayment of a loan. Although make-whole provisions are generally enforceable outside of bankruptcy, most courts have held that, absent specific terms in a loan agreement requiring the payment of a make-whole premium upon bankruptcy-induced debt acceleration, no make-whole premium is due as long as a debtor repays the underlying debt in while the debtor is in bankruptcy. See, e.g., Bank of N.Y. Mellon v. GC Merch. Mart, LLC (In re Denver Merch. Mart, Inc.), 740 F.3d 1052 (5th Cir. 2014) (affirming bankruptcy court’s disallowance of creditor’s $1.8 million claim for prepayment consideration under note).

U.S. Bank Tr. Nat’l Ass’n v. Am. Airlines, Inc. (In re AMR Corp.), 730 F.3d 88 (2d Cir. 2013) exemplifies the general rule. In AMR Corp., Chapter 11 debtor American Airlines, Inc.  (“American”) was party to three U.S. Bank-led secured prepetition financing transactions (the “prepetition financing”). Id. The Indentures governing the prepetition financing contained three provisions relating to a make-whole premium.

First, § 4.02(a)(i) of the Indentures provided that upon American’s default due to a voluntary bankruptcy, “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 . . . .” Id. at 94-95 (emphasis added).

Second, § 3.03 of the Indentures stated no make-whole amount was payable “as a consequence of or in connection with an Event of Default or . . . acceleration . . . .” Id. at 100.

Finally, the Indentures allowed American to redeem the notes at any time on condition that American paid the make-whole amount upon redemption. Id. at 103-04.

During the bankruptcy proceeding, U.S. Bank argued the make-whole amount was due immediately because (1) American had elected to redeem the notes voluntarily, as opposed to “as a consequence or in connection with” its default or acceleration and (2) the automatic acceleration provision upon a bankruptcy filing in § 4.02 of the Indentures was the result of an unenforceable ipso facto clause. Id. at 96-97. Relying on the plain language of the Indentures, the Bankruptcy Court rejected U.S. Bank’s arguments, holding that because American’s bankruptcy filing automatically accelerated the Notes, American did not have to pay the make-whole amount. Id. On appeal, the Second Circuit affirmed the Bankruptcy Court, noting that § 4.02 of the Indentures “made plain … [that] the debt was automatically accelerated by American’s bankruptcy filing.” Id. at 99.
Similarly, in In re MPM Silicones, LLC, the Second Circuit affirmed the majority viewpoint that an automatic acceleration of debt due to bankruptcy was not, in and of itself, a prepayment triggering the make-whole provisions of the underlying notes. 874 F.3d 787, 802-03 (2d Cir. 2017).

The current status of make-whole provisions in bankruptcy, however, is not quite so clear.  In In re Energy Future Holdings Corp., the Third Circuit held that, as an alternative to specific language in a loan agreement providing for the debtor’s payment of a make-whole premium upon bankruptcy-induced acceleration, a loan agreement may grant a creditor the right to an early redemption premium upon the debtor’s bankruptcy filing. 842 F.3d 247, 258-61 (3d Cir. 2016). Although an early redemption premium is effectively a make-whole premium, the court reasoned that it must “give effect to the words and phrases the parties chose.” Id. at 260 (internal quotation omitted). Further complicating the issue, a minority of courts have held that a claim for a make-whole premium is akin to a claim for unmatured interest, which is disallowed under § 502(b)(2) of the Bankruptcy Code. See, e.g., In re Ridgewood Apartments of DeKalb Cty., Ltd., 174 B.R. 712, 720 (Bankr. S.D. Ohio 1994) (“Absent actual prepayment by the Debtor, [the lender’s] claim for a prepayment penalty could be no more than a contingent liability. Further, because the contingent claim is for interest which is not yet due at the time the bankruptcy was filed (because prepayment had not occurred), it would not be allowed to an undersecured creditor [under § 502(b)(2)].”). However, the majority position is such a claim is akin to a claim for liquidated damages—not unmatured interest—and is thusly not disallowed under § 502(b)(2). See In re Trico Marine Servs., Inc., 450 B.R. 474, 480-81 (Bankr. D. Del. 2011) (holding that make-whole obligations are in the nature of liquidated damages, and are not unmatured interest disallowed under § 502(b)(2)); In re 360 Inns, Ltd., 76 B.R. 573, 576 (Bankr. N.D. Tex. 1987) (same); In re Lappin Elec. Co., 245 B.R. 326, 330 (Bankr. E.D. Wis. 2000) (same).

Section 506(b) of the Bankruptcy Code simply requires claims for make-whole premiums—like other allowed secured claims—be reasonable and provided for in the underlying agreement. Whether an agreement provides for the payment of a make-whole premium based upon a bankruptcy-induced acceleration is purely a matter of state law. Because the dispute is grounded in the interpretation of New York contract law, it is unlikely the Supreme Court will grant certiorari to resolve the circuit split. Rather, the New York Court of Appeals may resolve it in a certified question or the Second Circuit may do so if it grants a motion for rehearing in MPM Silicones, LLC. Where the preservation of make-whole payments is a central concern of secured creditors, those parties likely will attempt to steer debtors to file, if possible, in a jurisdiction bound by Third Circuit precedent, such as Delaware, whereas unsecured creditors looking for greater distributions may seek to persuade the same debtors to file, if possible, in a jurisdiction bound by Second Circuit precedent, such as New York.

Our seasoned team of bankruptcy attorneys can help you navigate through this and a host of other bankruptcy-related issues. Please contact us if you have any questions.
Bankruptcy & Creditors' Rights