The recent Southern District Bankruptcy Court decision in In re AMR Corp., 485 B.R. 279 (Bankr. S.D.N.Y. 2013) ("American Airlines") raises again the challenges facing underwriters, initial purchasers, lenders and investors in the debt capital markets in assessing and minimizing the risks associated with the ability to recover make-whole compensation and original issue discount ("OID") in the event of a bankruptcy of an issuer.
Make-whole premiums and OID are common features in the bond and loan markets today. There is a risk that in the event of a bankruptcy filing by an issuer make-whole premiums and OID may be treated as unmatured interest. In a bankruptcy, the payment of unmatured interest is generally prohibited.
Make-whole premiums compensate the lender for the loss of future debt service payments and permit the issuer to pay off remaining debt early. In a loan agreement these are also referred to as prepayment penalties and prepayment premiums. In a bond indenture the issuer makes a lump sum payment derived from a formula based on the net present value of future coupon payments that will not be paid because of the call. In a loan agreement the premium payable is a percentage, usually set on a sliding scale and reduced over time.
OID refers to the difference between the stated principal amount of a debt instrument at maturity and the proceeds actually received by the issuer. OID has become more common since the 2007 credit crisis as a mechanism for increasing yield-to-maturity at a given coupon rate. For tax purposes, OID is deemed to accrue over time as though it were a stream of interest payments, but the issuer does not actually make any payments to amortize OID until maturity.
The most basic problem facing any claim in bankruptcy which may fairly be characterized as unmatured interest is a statutory bar (Section 502(b)(2)) to recovery of any interest that was not earned as of the filing date. Courts typically apply this provision to disallow the unearned portion of any OID. See, In re Solutia, 379 B.R. 473 (S.D.N.Y. 2007) ("Solutia"). Although Section 506(b) of the Code does permit payment of post-petition interest if a claim is oversecured, the courts have not yet harmonized that provision with 502(b) when dealing with a claim for OID. It is worth noting that the debtor in Solutia conceded that the lender was at least fully secured and that the case was settled prior to determination of an appeal.
Make-whole premiums have gotten more of a mixed reception. Some courts have disallowed them as unmatured interest, while others have found them to be enforceable under a liquidated damages theory. Most make-whole clauses are drafted to take effect only in the event of a voluntary pre-payment, so, arguably, the automatic acceleration which occurs on a bankruptcy filing (another standard feature of instruments of this nature to get around the need for a creditor to seek relief from the automatic stay in order to accelerate) would not trigger the make-whole right.
The problem in American Airlines centered around an unusual provision of the Bankruptcy Code which deals specifically with aircraft financing. In most situations, filing a bankruptcy petition stays all enforcement efforts by creditors, who must affirmatively seek relief from the court in order to pursue their individual remedies. Bankruptcy Code §1110, by contrast, provides the debtor a limited period (60 days) to cure defaults and agree to comply with the loan terms going forward; otherwise, the lenders are free to repossess their collateral. The debtor in American Airlines, with court approval, so agreed, and the lenders did not repossess the aircraft. However, the debtor subsequently sought to take advantage of favorable conditions in the aircraft finance market to refinance the aircraft at lower rates, prior to the originally scheduled maturity date of the loans.
The lenders argued that the refinancing constituted a voluntary repayment of the loans which triggered the application of the make-whole provisions. However, the American Airlines court held that the refinancing was not a prepayment because, under the plain language of the indentures, the loans were automatically accelerated when the debtor filed its bankruptcy petition. After that automatic acceleration, according to the court, the principal balance of the loans matured, and the debtor's repayment of the loans could not be a prepayment.
The court rejected the lenders' argument that repaying the loans without making make-whole payments was inconsistent with the debtor's undertaking under Bankruptcy Code §1110 to comply with the terms of the loans. The court noted that the §1110 requirement to cure non-bankruptcy defaults does not require reversal of acceleration that occurred as a result of a bankruptcy default. Therefore, according to the court, there was no prepayment even though the debtor elected to refinance loans that it could have kept outstanding.
The lenders also argued, to no avail, that the debtor's commencement of a bankruptcy case and repayment of the loans in that case should, when considered as a whole, be viewed as a prepayment, that the lenders should receive expectancy damages for the value of interest payments lost over the life of the loans. The court noted that providing such relief would require it to go beyond the plain language of the indentures.
American Airlines is the most recent installment in a series of cases in which courts have determined that automatic acceleration as a result of the debtor's bankruptcy filing prevents recovery of make-whole payments and similar compensation payable in connection with other adverse events, such as a change of control. However, even if automatic acceleration gets in the way, all is not necessarily lost for a creditor seeking compensation for the loss of its future stream of interest payments.
Much like in American Airlines, the court in In re Premier Entertainment Biloxi LLC, 445 B.R. 582 (S.D. Miss. 2010) ("Premier") determined that an automatic acceleration provision precluded the lenders from recovering a make-whole payment under the prepayment provisions of the indenture. The court also refused to specifically enforce a no-call provision in the indenture. However, the Premier court allowed the lenders an unsecured claim for expectancy damages for breach of the no-call provision, which was a meaningful remedy because the debtor in Premier was solvent.
In another solvent debtor case, the court in In re Chemtura Corp., 439 B.R. 561 (Bankr. S.D.N.Y. 2010) ("Chemtura") endorsed that approach in the course of approving a settlement with noteholders, reasoning that when the debtor is solvent there is no need to ensure fair treatment of competing creditors and the debtor should not be able to evade the economic effect of the no-call.
Notably, American Airlines, Solutia, Premier and Chemtura all involved loan documents that did not explicitly provide for payment of a make-whole payment upon automatic acceleration due to bankruptcy, and the holdings of those cases are narrowly based on that fact. If loan documents clearly provide that a make-whole provision is triggered by automatic acceleration due to bankruptcy, the lender can reasonably argue that it is entitled to a secured claim for the make-whole payment in bankruptcy.
As noted earlier, there currently is a split of authority as to whether make-whole payments should be disallowed under Bankruptcy Code §502(b)(2) as payments for unmatured interest or allowed under §506(b) as liquidated damages that can be characterized as "charges" under that statutory provision. Although the majority view has been that make-whole payments are enforceable liquidated damages, that view has been questioned – the Chemtura court observed in dicta that the minority view may be more appropriate for insolvent debtors. A case often cited for the minority view, In re Ridgewood Apartments of DeKalb County, Ltd., 174 B.R. 712 (Bankr. S.D. Ohio 1994), concluded that the prepayment penalty should be disallowed, at least when the lender is undersecured, because the penalty compensates the lender for loss of unmatured interest. A court faced with loan documents with a make-whole provision that clearly is triggered by bankruptcy would have to wrestle with that issue, and until one does lenders are well-advised to be wary.
Underwriters, initial purchasers and lenders should take care to ensure that the documents underlying their debt instruments are precisely drafted and should consider, among other things, including provisions that provide for the payment of make-whole premiums upon an automatic acceleration caused by a filing; provide that make-whole premiums are applicable whenever the debt is prepaid; and ensure that the make-whole provisions are drafted in such a way so that they will not be construed as unjustifiable penalties under state law. Participants in the debt capital markets should also be prepared to accept that OID will be recoverable only to the extent actually earned prior to the petition date, regardless whether the debt is secured and regardless of what the underlying documents say.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
