Poor Drafting of Loan Documents Leads to the Disallowance of Hundreds of Millions of Dollars in Make-Whole Claims

Make-whole premiums are a fixture of commercial loan agreements. Their purpose is to determine the parties’ respective rights in the event that prepayment becomes economically efficient for a borrower. Absent any limitation on prepayment, a borrower will repay its debt as soon as the benefits of refinancing exceed the transaction cost of procuring a new loan. In so doing, a lender will be deprived of all future interest payments bargained for under the agreement.

As debtors have looked to take advantage of current low interest rates to reduce or eliminate more expensive debt, disputes over the payment of make-whole premiums have become more prominent in chapter 11 cases over the last few years. Recent decisions by the U.S. Bankruptcy Court for the Southern District of New York in Momentive and the U.S. Bankruptcy Court for the District of Delaware in Energy Future Holdings Corp. reaffirm the importance of drafting make-whole provisions that will hold up to strict scrutiny of the contractual terms and give effect to the parties’ deal.

Momentive Decision

MPM Silicones, LLC (Momentive), a private-equity sponsored manufacturer of quartz and silicone products, commenced chapter 11 cases in the Southern District of New York in April 2014. At the time of its filing, Momentive had outstanding first-lien notes, 1.5-lien notes (notes junior to the first-lien notes but senior to Momentive’s other funded debt), second-lien notes and subordinated notes. Its reorganization plan proposed to equitize more than $1.3 billion in second-lien debt, and eliminate $380 million in senior subordinated notes. As to its holders of approximately $1.1 billion in first-lien notes and $250 million in 1.5-lien notes, the plan offered two choices: accept the plan and receive payment in full in cash of the face amount of the debt, not including any make-whole premium, or reject the plan and receive replacement notes at a cramdown rate, the principal amount of which would reflect the make-whole premium to the extent so determined by the court. The senior lienholders chose the latter.

They rejected the plan, and challenged Momentive’s proposed interest rate on the replacement notes by arguing that the plan violated the Bankruptcy Code’s requirement of “fair and equitable” treatment by forcing them to accept replacement notes yielding below-market interest. They also challenged Momentive’s attempt to avoid payment of their make-whole claim by arguing that Momentive triggered the make-whole provisions by effectively refinancing the notes before their stated maturity. In an Aug. 26, 2014, bench decision, which was later corrected and modified on Sept. 9, 2014, U.S. Bankruptcy Judge Robert D. Drain overruled the senior lienholders’ objections and confirmed Momentive’s plan, imposing a slightly increased rate on the replacement notes and denying the make-whole claim in its entirety.[1] With respect to the make-whole claim, Judge Drain made two key rulings.

First, the senior lienholders argued that the replacement notes issued under the plan constituted a prepayment and voluntary redemption of the notes that triggered their right to a make-whole payment. Judge Drain disagreed, and held that the loan documents did not explicitly provide for a make-whole after the automatic acceleration resulting from Momentive’s bankruptcy filing.

Second, realizing that Momentive’s arguments against allowing the make-whole claims hinged on the automatic acceleration of the debt upon a bankruptcy event of default, the senior lienholders sought permission to rescind the automatic acceleration of the notes. The purpose of sending a rescission notice, as found by Judge Drain, would be to “resurrect” the right to the make-whole claim by decelerating the debt, and the effect of rescission would be to increase the size of the trustees’ claims by approximately $200 million. Because this act constituted an act to control property of the estate by exercising a contract right to the estate’s detriment and attempting to recover, by deceleration, a claim against Momentive, Judge Drain ruled that the automatic stay barred the issuance of a rescission notice and the deceleration of the debt under §§ 362(a)(3) and 362(a)(6) of the Bankruptcy Code. The U.S. District Court for the Southern District of New York affirmed Judge Drain’s decision on May 4, 2015.[2]

Energy Future Holdings Corp. Decision

In Energy Future Holdings Corp., the indenture trustee commenced an adversary proceeding seeking to establish its right to secured claims for payment of a $665.2 million make-whole premium in connection with the repayment of the outstanding principal and interest on the notes upon the bankruptcy court’s approval of a debtor-in-possession financing facility, as well as a declaratory judgment allowing it to decelerate the notes without violating the automatic stay or, in the alternative, modifying the stay.

The indenture trustee’s principal argument was that the debtors’ early prepayment of the notes constituted an “optional redemption” triggering debtors’ obligation to pay the “Applicable Premium” — the make-whole provision — to the holders. In March 2015, U.S. Bankruptcy Judge Christopher S. Sontchi, following the reasoning of Judge Drain in Momentive, held that due to the automatic acceleration, the repayment of the notes did not constitute an optional redemption, and therefore, the debtors had no obligation to pay a make-whole premium.[3]

This did not fully resolve the issue, however. The indenture trustee also argued that even if the automatic acceleration could eliminate the debtors’ obligation to pay the make-whole premium, under the indenture agreement the trustee had the right to deliver, and in fact did deliver, a notice that rescinded the automatic acceleration. Judge Sontchi held that the automatic stay prevented the indenture trustee from issuing a notice of rescission. But he did not decide whether stay relief was appropriate, deferring that question pending additional factual development to determine whether “cause” exists to lift the automatic stay.

After holding an evidentiary hearing in April, Judge Sontchi rejected the indenture trustee’s arguments for lifting the automatic stay to decelerate the loan and pursue the make-whole premium.[4] While Judge Sontchi acknowledged the investors would likely prevail on the merits,[5] he concluded that the prejudice to the debtors’ estate, “in the form of the loss of hundreds of millions of dollars,” outweighed the hardship to the investors of the first-lien notes. In reaching his decision, Judge Sontchi made it clear that courts must consider the harm to the estate when assessing whether cause exists to lift the automatic stay, including any harm to the equity-holders of a debtor.[6]

Takeaway

Although Momentive and Energy Future Holdings Corp. have garnered significant attention, neither decision alters existing law. Make-whole provisions will generally be enforced by bankruptcy courts where the premium is triggered by the express contract terms, the make-whole provision is valid under applicable state law, and the premium is reasonable under § 506(b) of the Bankruptcy Code. These decisions, however, do serve as a reminder that in order to be enforced, make-whole provisions must explicitly specify if and when a make-whole premium is due following default and acceleration of the debt in a bankruptcy case. By way of example, courts have enforced make-whole premiums where the documents state that if the debt “is accelerated during the [period in which the premium would be due] for any reason other than casualty or condemnation, [the debtor] shall pay, in addition to all other amounts outstanding under the Loan documents, a prepayment premium.”[7] Likewise, courts have enforced make-whole premiums where the documents require the borrower to pay a make-whole whenever debt is repaid before its original maturity.[8]

More significantly, in analyzing a lender’s attempt to avoid the implications with the automatic acceleration of debt that occur upon a bankruptcy filing where the applicable documents do not expressly provide that the lender is entitled to a make-whole premium post acceleration, Momentive and Energy Future Holdings Corp. make it clear that seeking to terminate the automatic stay to “decelerate” a loan will be difficult, especially if the debtor is not solvent, which typically is the case.