Make-Whole Claims in Bankruptcy
by | posted in: Bankruptcy Roundtable Updates, Statutory Interpretation | 0

By Sam Lawand (White & Case LLP)

The well-established “perfect tender in time rule” dictates that debt must be repaid only upon maturity, and no earlier. Under this rule, early repayments of debt are prohibited absent a contrary provision under the debt instrument. Debt instruments bar early repayments altogether through a “nocall” provision or permit early repayments through a “make-whole” provision. By modifying the “perfect tender in time rule,” make-whole provisions allow debtors to repay debt in advance of stated maturity, in exchange for a predetermined premium, usually based on the discounted value of the stream of future scheduled interest payments.

To determine whether make-whole claims are allowed in bankruptcy, courts undertake a two-pronged analysis. Because make-whole provisions are contractual, courts rely on contract construction principles to determine whether the debt instrument contains a make-whole provision, and, if so, the circumstances in which such provision is triggered. If a make-whole provision is triggered, courts then proceed to determine whether such provision is enforceable under state law.

If the make-whole provision is enforceable under state law, courts proceed to determine whether such provision is enforceable under bankruptcy law. Section 101(5)(A) of the Bankruptcy Code defines “claim” as a “right to payment,” which encompasses make-whole claims. Section 502(a) provides that “claims” are allowed, except to the extent disallowed under section 502(b). In turn, section 502(b)(1) disallows “claims” that are “unenforceable . . . under any agreement or applicable law,” and section 502(b)(2) disallows “claims” on account of “unmatured interest.” In certain circumstances, section 506(b) allows “secured claims” to include “interest” and “any reasonable fees, costs, or charges provided for under an agreement or State statute.” The confluence of these Bankruptcy Code provisions is murky.

Given that make-whole provisions, in essence, liquidate damages arising out of the loss of future scheduled “interest” payments, which by definition are “unmatured,” the allowance of make-whole claims in bankruptcy compels a demanding analysis.

In resolving whether make-whole claims are allowed in bankruptcy, this article examines the application of contract construction principles, reconciles conflicting precedent on such  principles, and construes applicable Bankruptcy Code provisions. This article recognizes that, in applying the provisions of the Bankruptcy Code, bankruptcy courts are courts of equity and that considerations of bankruptcy and commercial policies, including practicality and predictability, bear on the application of such provisions. This article concludes that make-whole claims are generally not allowed in bankruptcy, unless (1) the default or “early repayment” by the debtor is “voluntary”; or (2) the debt instrument contains a “clear and unambiguous” provision calling for a make-whole payment in all circumstances of early repayment.

In accordance with this two-pronged analysis, the first-half of this article covers the state-law analysis, and the second-half of this article covers the bankruptcy-law analysis.

The complete article is available for download here.

“Trade Away!”—Bankruptcy Court for the Southern District of New York Decides That Original Issue Discount From Fair Value Exchanges Is Allowable in Bankruptcy
by | posted in: Claims Trading | 0

Authors: Richard L. Wynne and Lance Miller, Jones Day

Debt exchanges have long been utilized by distressed companies to address liquidity concerns and to take advantage of beneficial market conditions.  A company with burdensome debt obligations might seek to exchange existing notes for new notes with the same outstanding principal but with borrower-favorable terms (a “Face Value Exchange”).   Alternatively, the company could attempt to exchange existing notes for new notes with a lower face amount (a “Fair Value Exchange”).  Under either scenario, a debt exchange will create “original issue discount” (“OID”) equal to the difference between the face amount of the new notes and the value generated by the exchange for the company (i.e., the fair market value of the old notes).  For tax and accounting purposes, OID is treated as interest that is amortized over the life of the note, with the face amount scheduled to be paid on maturity.

When a company files for bankruptcy, however, unaccrued OID should arguably be disallowed under section 502(b)(2) of the Bankruptcy Code as “unmatured interest.”  However, to encourage out-of-court restructurings, both the Second and Fifth Circuit Courts of Appeal have ruled that unaccrued OID from Face Value Exchanges should not be disallowed.  In In re Residential Capital , LLC, 501 B.R. 549 (Bankr. S.D.N.Y. 2013), the court expanded that rationale to apply to Fair Value Exchanges.  If interpreted broadly and adopted by other courts, the decision will bring certainty to the markets that OID resulting from a debt-for-debt exchange will be allowed in bankruptcy, regardless of how the exchange is structured.

A more detailed discussion of the ruling is available here.