Make-Whole Claims in Bankruptcy

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.

Fifth Circuit’s Ultra Petroleum Decision Suggests Make-Wholes are Unenforceable in Bankruptcy, Questions Collectability of Contract Rate Postpetition Interest

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By Donald S. Bernstein, Timothy Graulich, Marshall S. Huebner, Darren S. Klein, Brian M. Resnick, Christopher Robertson, Damian S. Schaible, Eli J. Vonnegut and Jacob Weiner (Davis Polk & Wardwell LLP).

In In re Ultra Petroleum Corp., No. 17-20793, 2019 WL 237365 (5th Cir. Jan. 17, 2019), the U.S. Court of Appeals for the Fifth Circuit issued a decision strongly suggesting that (i) make-whole premiums are not payable in bankruptcy to unsecured and undersecured creditors and (ii) unsecured creditors in solvent-debtor Chapter 11 cases are entitled to postpetition interest only at the federal judgment rate—not the higher full contract rate.  The Fifth Circuit found “compelling” the debtors’ argument that a make-whole premium owed to certain unsecured noteholders under the prepetition notes purchase agreement should be disallowed as a claim for unmatured interest pursuant to section 502(b)(2) of the Bankruptcy Code, departing from the majority view.  While distressed companies may rejoice in this decision, creditors—particularly unsecured and undersecured creditors—will need to reconsider the likelihood of collection of make-whole premiums for distressed companies that are able to file for bankruptcy protection in Texas, Louisiana, or Mississippi, and to evaluate the risk that courts in other circuits follow the Fifth Circuit’s reasoning.  Importantly, the UltraPetroleum decision will likely create additional incentives for distressed companies to file for bankruptcy in the Fifth Circuit if potentially large make-whole premiums are payable to unsecured or undersecured creditors.

In addition, the Fifth Circuit’s guidance on rates of postpetition interest owed to unsecured creditors in solvent-debtor Chapter 11 cases may influence courts in other jurisdictions in solvent-debtor Chapter 11 cases.

The full article, which describes the make-whole analysis in the context of the recent Momentive and Energy Future Holdings decisions and the postpetition interest rate dispute, is available here.

Momentive: Law Firm Perspectives

On October 28, 2017, the United States Court of Appeals for the Second Circuit handed down its decision in In re MPM Silicones, L.L.C., holding that where an efficient market exists, the appropriate cram-down interest rate in Chapter 11 cases is the market rate, distinguishing the formula rate applied by the Supreme Court in Till v. SCS Credit Corp. in Chapter 13 cases. The Second Circuit wrote that “the market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.” The Second Circuit also disallowed the senior creditors’ claim for a make-whole payment, although the Third Circuit had allowed such a claim in In re Energy Future Holdings Corp.

Law firms have so far reacted unanimously that this decision is a win for secured creditors as it ameliorates the risk that unsecured creditors could extract value from the debtor at the secured creditors’ expense. Weil writes that “it seems like the Bankruptcy Court, now freed from Till, will find that an efficient market exists, and will adjust the interest rate on the replacement notes accordingly.”

Nevertheless, some firms predict that there may still be areas future controversy. Davis Polk warns that this decision “could result in expensive litigations between debtors and secured creditors as to whether there exists an efficient market and, if so, what the efficient market rate should be.” Norton Rose Fulbright also emphasizes that the next step for secured creditors is to focus on when an efficient market exists.

Firms have also noticed the decision’s implication for debtor-side strategy. Baker McKenzie suggests the possibility that “a debtor may engage in forum shopping to file its case in a jurisdiction that applies the formula approach,” or “be even more sensitive to the potential for exit financing quotes to be used as evidence against [debtors] in establishing a market rate.”

On the issue of the make-whole premium, Davis Polk highlights that the circuit split may increase forum shopping for distressed issuers with potentially significant make-whole obligations. It expects future issuers to draft clearly around the issue of make-whole obligation to provide for future Chapter 11 cases.

(By Jianjian Ye, Harvard Law School, J.D. 2018.)