Get Rich or Die Trying: Recent Developments of Make-Whole Provisions in Bankruptcy

Parties enter into contracts to get the benefit of their bargain. Loan agreements are no different.[1] If a credit facility has a term of five years, the borrower should expect to pay interest for five years. Unless negotiated, borrowers generally do not have an unfettered right to repay their debts early because this would deprive the lender of its bargained-for consideration. This concept, known as the “perfect tender in time” rule, precludes prepayment of a loan (or bond issue, or any other extension of credit) so that lenders can collect the interest contracted to earn through the maturity date of the loan. Further, many loan agreements contain prepayment penalties, exit fees and other provisions that allow lenders to recoup future consideration if a loan is repaid early. Such clauses are typically referred to as “make-whole” or “yield maintenance” provisions.[2] Bankruptcy law can change the rules for many financial arrangements, including loans containing make-whole provisions.

The Bankruptcy Code contains conflicting provisions addressing how to interpret make-whole provisions. For example, § 502(b)(2) explicitly disallows claims for unmatured interest, while § 506(b) allows oversecured creditors to recover “interest on such claim,” and § 726(a)(5) allows payment of interest “at the legal rate.” Moreover, bankruptcy courts must typically look to state law when determining whether (and how) to enforce contractual obligations.

To date, three circuits have reached different results regarding whether make-whole provisions are enforceable in bankruptcy. The Third Circuit[3] held that make-whole provisions are generally enforceable. The Fifth Circuit, although not squarely deciding the issue, has strongly indicated that they are never enforceable.[4] The Second Circuit has held that make-whole provisions are sometimes enforceable.[5] Applying these decisions, courts have considered several issues: (a) whether make-whole provisions are enforceable under state law, (b) whether the clause constitutes allowable liquidated damages under state law, (c) whether the debtor is solvent (at least as to the creditor’s claim), and (d) whether the compensation due is reasonable in light of its purpose.

In re 1141 Realty Owner LLC: Make-Whole Provisions Allowed if Properly Documented

Against this background, the U.S. Bankruptcy Court for the Southern District of New York (Bernstein, USBJ) recently decided In re 1141 Realty Owner LLC.[6] In this case, the debtor, a hotel owner, borrowed money secured by a mortgage containing a make-whole provision. Pre-petition, the creditor accelerated the mortgage for certain non-monetary defaults. The mortgage did not permit prepayment. Instead, it expressly provided that if there was an event of default and “payment of all or any part of the Debt is tendered by Borrower or otherwise recovered by Lender, such tender or recovery shall be deemed a voluntary prepayment by Borrower in violation of the prohibition against prepayment set forth in Section 2.3.1 and Borrower shall pay, in addition to the Debt, (i) an amount equal to the Yield Maintenance Default Premium….”[7] The creditor filed a proof of claim that included the make-whole payment — i.e., the Yield Maintenance Default Premium.

The debtor objected to the claim and argued that the make-whole provision should be disallowed under Momentive because “courts will only uphold prepayment premiums after acceleration where the applicable loan agreement expressly provides that the premium is due following an acceleration and uses the word ‘acceleration,’ or some other variant.”[8] Thus, the debtor claimed, because the debt was accelerated, there cannot be a prepayment penalty, Momentive applies, and the make-whole provision is not allowed.

The debtor argued that under New York law, a lender that accelerates a loan following a default forfeits the right to a prepayment premium because the acceleration advances the maturity date, and, by definition, the loan cannot be prepaid. But, as the court explained, there are exceptions. First, if a clear and unambiguous clause requires the payment of the prepayment premium even after default and acceleration, the clause will be analyzed as liquidated damages. Second, if the borrower intentionally defaults to trigger the acceleration and “evade” payment of the prepayment premium, a lender can enforce the prepayment premium.[9] Applying New York law, the court held that the mortgage contained a provision requiring payment of the make-whole provision both before and after acceleration: “It imposes the make-whole premium in connection with any payment made after an Event of Default, not just a prepayment made after an Event of Default but before acceleration…. As a result, the Yield Maintenance Default Premium must be analyzed as a liquidated damages provision.”[10]

Judge Bernstein distinguished Momentive, because in 1141 Realty Owner it did not matter when or how the default occurred, the debtor would always liable for the make-whole payment. The loan agreement defined every payment, even those made after acceleration, as a voluntary payment. This holding is more consistent with the Third Circuit’s Energy Future holding, which also applied New York law and essentially held that even imprecise make-whole provisions were enforceable. In sum, if a loan agreement is clear that the make-whole payment is due, regardless of acceleration, it will be enforced unless it is a penalty.[11]

Make-Whole Provisions as Liquidated Damages

Further applying New York law, 1141 Realty Owner also held that a make-whole provision cannot be a disguised penalty. Oddly, in 1141 Realty Owner, the debtor apparently did not argue with any force or analyze whether the make-whole provision was an unenforceable penalty as opposed to allowable liquidated damages.[12] The court held that a party seeking to avoid a liquidated-damages provision bears the burden of proving that it is a penalty. Thus, the debtor, was required to demonstrate that either the damages flowing from prepayment were readily ascertainable at the time the parties entered into the lending agreement, or that the prepayment premium is “conspicuously disproportionate” to the lender’s foreseeable losses.[13]

Reasonable liquidated damages are those that are “calculated so that the lender will receive its bargained-for yield….”[14] “[T]he test is the foreseeable damages at the time of contracting and not the actual damages at the time of the breach.”[15] Courts will exercise their discretion and carefully scrutinize liquidated-damages provisions.[16] Courts have held that liquidated-damages provisions tied to Treasury bond yields are reasonable.[17] However, a per diem amount with no relationship to actual economic loss is unenforceable.[18] In sum, the burden is on the debtor seeking to escape a liquidated-damages provision to show that the amount of liquidated damages is disproportionate to the lender's probable loss on account of the default. This issue was not fully litigated in 1141 Realty Owner.

Conclusions

The Fifth Circuit appears likely to diverge from the Second Circuit/Third Circuit view that make-whole provisions are generally enforceable, if properly drafted in accordance with state law. Because the Bankruptcy Code contains conflicting provisions (§ 502(b)(2) vs. § 506(b)), the potential split among circuits on this issue may need to be decided by the Supreme Court. However, the “right” answer to the enforceability of make-wholes is not entirely clear. Whether a make-whole provision provides proper business incentives to ensure that credit markets function efficiently, or bestows an inequitable windfall, is debatable. Regardless, borrowers need to make sure they understand how a make-whole provision will affect their financial prospects.

In bankruptcy, the enforceability of a make-whole provision may be the difference between paying unsecured creditors a meaningful distribution or nothing at all. Courts should also carefully scrutinize such provisions to ensure they are the product of meaningful negotiation, supply appropriate economic incentives, comply with state law, and are not cleverly disguised penalties. If the make-whole provision does not serve a legitimate business purpose, it should not be enforced.