Background on Enforceability of Make-Whole Provisions in Bankruptcy
In New York and Delaware, make-whole premiums are generally construed as liquidated damages because they are designed to compensate for costs incurred in connection with early payment on a long-term loan/bond, in recognition of the fact that such early payment deprives lenders/bondholders of their bargained-for right to rely on a stable flow of funds over a known period.4
But some courts, including the Fifth Circuit in its recent Ultra decision, have strongly suggested that make-whole premiums are in effect unmatured interest, which is generally disallowed under section 502(b)(2) of the Bankruptcy Code. In Ultra, the Fifth Circuit, reversing the bankruptcy court decision described in a prior Sidley Restructuring Update,5 (i) found that the make-whole premium contained in the note agreement was the “economic equivalent of ‘interest,’” compensating for interest that was “unmatured” when the debtors filed for chapter 11 protection and (ii) remanded to the bankruptcy court on the question of whether the unsecured bondholders were entitled to the make-whole amount and postpetition interest based on the “solvent debtor” exception.6
Nevertheless, most courts, including in the Second and Third Circuits, have found that make-whole premiums are potentially allowable liquidated damages, not unmatured interest, and can be enforceable in accordance with the applicable contractual terms.
Several circuit courts have closely examined make-whole provisions to determine whether they were enforceable against the borrower in bankruptcy. In 2013, the Second Circuit held in AMR7 that the make-whole premium was not enforceable in part because (i) the indenture expressly stated that upon an event of automatic acceleration triggered by the borrower’s bankruptcy filing, no make-whole premium was due, and (ii) the make-whole provision was framed as a voluntary “prepayment” and thus could not be due and payable postacceleration, as a prepayment can occur only prior to the maturity date — which was advanced by acceleration to the date of the borrower’s bankruptcy filing.
However, the Third Circuit held in EFH8 that the secured noteholders were entitled to an “optional redemption” make-whole premium even after acceleration, finding that (i) payment of a “redemption” could occur before or after maturity, and (ii) the borrower’s decision to repay the notes constituted “optional” redemption because the borrower could have reinstated the notes under its chapter 11 plan. In contrast, the Second Circuit held in Momentive that a similar optional redemption premium equated to a prepayment premium and thus, as in AMR, could not become due postacceleration and that repayment of the notes postacceleration was not optional because the payment obligation arose automatically upon acceleration.
Factual Background to the 1141 Realty Decision
1141 Realty Owner LLC (the Debtor) is the current owner of the Flatiron Hotel and had entered into a secured loan evidenced by, among other things, a loan agreement and two promissory notes secured by a mortgage on the Flatiron Hotel. Nearly a year before the Debtor’s chapter 11 filing, the loan trustee sent a notice of default and acceleration to the Debtor based on events of default under the loan documents. The trustee then proceeded to commence foreclosure proceedings against the Debtor.
On July 31, 2018, the Debtor commenced its chapter 11 case. The trustee filed a proof of claim for the secured loan, asserting an entitlement to a “Yield Maintenance Default Premium” (make-whole) under the loan documents. The Debtor objected to allowance of this premium, arguing, among other things, that the trustee’s acceleration of the debt required its disallowance as a matter of law. The Debtor further contended that such premiums could be allowed after acceleration only if the contract expressly provided that the premium was due following acceleration and used the word “acceleration” or some other variant thereof.
The bankruptcy court rejected these arguments, holding that the premium was enforceable under New York state law despite the fact that the trustee had accelerated the debt.
The 1141 Realty Decision Clarifies That Make-Whole Premiums Can Still Be Enforced in Bankruptcy Postacceleration
Consistent with precedent in the Second Circuit and the Third Circuit, the bankruptcy court in 1141 Realty focused its analysis of the enforceability of a make-whole provision on the contractual terms in the loan documents, with particular attention to the provision governing payment of the premium at issue, which provided:
If, following an Event of Default which occurs prior to Free Window Date, 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 ....
The court also considered the purpose and rationale for make-whole provisions, noting that these premiums were designed to permit borrowers to pay loans in advance of their original maturity in exchange for payment of the lender’s expected income stream over the term of the loan.
The court recognized that a make-whole premium — which is often styled as a premium owed in the event of a “prepayment” — is typically not enforceable after a loan has been accelerated because acceleration advances the maturity date and a loan cannot be prepaid after it has matured.
However, the court nevertheless enforced and allowed the Yield Maintenance Default Premium, finding that the parties in 1141 Realty had expressly contracted to require payment of the make-whole premium in the event of any postdefault payment, which, unlike a prepayment, could occur either before or after an event of default.
Importantly, the court distinguished AMR and Momentive, reasoning that in both cases, the triggers for the make-whole premium had not — and could not have — occurred. The indenture in AMR stated that no make-whole premium would be due upon automatic acceleration of the debt — which had been triggered by the bankruptcy filing, and the indenture in Momentive stated that a make-whole premium was due only in the event of an optional redemption — which the Second Circuit held could not occur postacceleration and postbankruptcy. In distinguishing these cases, the court in 1141 Realty confirmed that make-whole premiums can be enforceable in bankruptcy, postdefault and postacceleration if there is clear and unambiguous contract language to that effect.
The court in 1141 Realty continued the trend in Second and Third Circuit case law regarding the enforceability of make-whole premiums in bankruptcy of primarily focusing on the express language of the debt documents. The court’s decision provides useful guidance for determining whether a given make-whole provision is likely to be enforceable after acceleration in a bankruptcy case, including the following:
- A provision that expressly states that the make-whole premium is due after, or regardless of, acceleration is in the best position to be enforceable after acceleration; for example, a provision that states that the premium is due even after acceleration or that states the premium is due upon any postdefault payment of debt, as in 1141 Realty.
- A make-whole provision should be clear and unambiguous. At the hearing on the make-whole dispute in 1141 Realty, the court inquired about the existence of any extrinsic evidence that would be relevant in interpreting ambiguous contract provisions. As this experience illustrates, taking care to ensure that the make-whole provision is clear and unambiguous will serve to reduce the likelihood of expensive evidentiary disputes.
- The debt documents should expressly state that the creditor’s rights and remedies are cumulative and not exclusive of any other right under the debt documents to ensure recovery of the make-whole premium, especially when the lender had already taken other remedial actions. Although this point is not reflected in the 1141 Realty decision, the court expressed an interest in these provisions at the hearing in light of the fact the trustee had already accelerated the loan and commenced foreclosure proceedings.
- A make-whole premium could be unenforceable if it is a “penalty” — that is, if the damages from prepayment were readily ascertainable when the parties entered into the agreement or if the premium is “conspicuously disproportionate” to the lender’s foreseeable losses. However, if the premium is pegged to the lender’s expected yield through the original maturity date, the premium likely will not be found to be an unenforceable penalty.
While the 1141 Realty decision provides meaningful guidance on enforceability of make-whole premiums under New York law, there are some open issues.
The court in 1141 Realty did not consider whether a make-whole premium would constitute disallowed unmatured interest under section 502(b)(2) of the Bankruptcy Code and in fact held that the make-whole provision was a liquidated damages clause without citing or addressing Ultra. It remains to be seen whether the recent Ultra decision on this issue will affect the allowance of make-whole premiums in the Second Circuit and Third Circuit — especially with respect to unsecured debt or debt that is automatically accelerated upon a borrower’s bankruptcy filing.
The court in 1141 Realty also noted that a make-whole premium may potentially be enforced after acceleration, even absent clear and unambiguous language in a contract, if a borrower intentionally defaults to trigger acceleration and thereby evade payment of the make-whole premium. However, the court found it unnecessary to decide this issue in light of the court’s finding that loan documents mandated payment of the make-whole premium. While the intentional-default theory has been applied in only a few cases in New York,9 it may provide a separate ground for enforcing make-whole premiums in circumstances where the borrower’s default arose from its “voluntary” actions as opposed to so-called “involuntary” actions such as filing for bankruptcy.
1In re MPM Silicones, LLC, 874 F.3d 787 (2d Cir. 2017) (Momentive).
2In re Ultra Petroleum Corp., No. 17-20793, 2019 WL 237365 (5th Cir. January 17, 2019).
3In re 1141 Realty Owner LLC, No. 18-12341 (SMB), 2019 WL 1270818 (Bankr. S.D.N.Y. Mar. 18, 2019). Sidley Austin acted as counsel for the trustee and secured lender in connection with this decision.
4See In re MarketXT Holdings Corp., 376 B.R. 390, 417 (Bankr. S.D.N.Y. 2007); In re Sch. Specialty, No. 13-10125, 2013 WL 1838513, at *2 (Bankr. D. Del. April 22, 2013).
6On February 5, 2019, the noteholders petitioned for a rehearing en banc of the Ultra decision on, among other things, whether a make-whole premium constitutes unmatured interested disallowable under section 502(b)(2). As of April 25, 2019, the petition remains pending.
7In re AMR Corp., 730 F.3d 88 (2d Cir. 2013).
8In re Energy Future Holdings Corp., 842 F.3d 247 (3d Cir. 2016).
9See Wilmington Sav. Fund Soc’y v. Cash Am. Int’l, Inc., 15-CV-5027 (JMF), 2016 WL 5092594 (S.D.N.Y. Sept. 19, 2016); Sharon Steel Corp. v. Chase Manhattan Bank, N.A., 691 F.2d 1039 (2d Cir. 1982).
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