On Nov. 17, 2016, the United States Court of Appeals for the Third Circuit issued an important decision in favor of holders of more than $4 billion in secured first and second lien notes issued by Energy Future Intermediate Holding Co. LLC (EFIH), which unwillingly had their secured notes repaid ahead of schedule in bankruptcy without payment of the "make-whole" required under the indentures. In re Energy Futures Holding Co., No. 16-1351 (3d Cir. Nov. 17 2016). The decision, which reversed the bankruptcy and district courts and explicitly disagreed with another closely watched decision from the Southern District of New York, has important implications for borrowers and lenders grappling with refinancing in Chapter 11 cases. (Kramer Levin represents the EFIH second lien noteholders.)
Make-wholes, also variously referred to as "prepayment penalties" or "yield maintenance premiums," are contractual provisions in loan agreements or indentures requiring the borrower to pay an additional amount – generally either a fixed percentage of principle or a formula deriving the discounted value of the avoided future interest payments – if the loan is paid ahead of schedule. Such provisions ensure that lenders receive their bargained-for return on investment required to justify the risk associated with making the loan. Because lenders cannot call loans if prevailing interest rates rise, there would be an unfavorable asymmetry if borrowers could freely take advantage of falling interest rates to retire loans early (as is the case with residential mortgages).
Until reactions to recent cases, it was rare but not unheard of for loan documents expressly to address what happens to a contractual make-whole if a borrower seeks to make early payment during a Chapter 11 bankruptcy. It is common, however – indeed virtually universal – for indentures and loan agreements to provide that the act of filing for bankruptcy automatically accelerates the loan obligations and makes them immediately due and payable. The purpose of such automatic acceleration provisions is debatable. At first glance, they seem to exist for the benefit of lenders – the acceleration is usually waivable after it occurs, after all – but in practice any benefit is illusory; acceleration does not facilitate efforts to collect, which are prohibited by the automatic stay in bankruptcy.
Worse, borrowers have argued, often successfully, that because acceleration renders the loan obligations "mature," any payment in bankruptcy is not a "prepayment" and does not trigger the contractual make-whole. (Alert readers will note that we have therefore avoided using natural phrases like "prepayment" and "before maturity" above – for this reason.) Worse still, borrowers have also successfully invoked the automatic stay to protect their make-whole rights by preventing lenders from waiving acceleration.
EFIH, which redeemed all of its first lien notes and partially redeemed its second lien notes soon after filing for bankruptcy in the District of Delaware in April 2014, invoked this line of reasoning in an attempt to avoid hundreds of millions of dollars in contractual make-whole obligations. Both groups of secured bondholders sued.
Meanwhile, in a case presenting extremely similar facts, known as Momentive, Bankruptcy Judge Drain in the Southern District of New York rejected make-whole claims. In re MPM Silicones, LLC, No. 14-22503-RDD, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014), aff'd, 531 B.R. 321 (S.D.N.Y. 2015). The automatic acceleration provision there provided that upon bankruptcy, principal, interest and "premium, if any" became "due and payable immediately." Judge Drain held that this provision meant the notes were mature, had not been prepaid and obviated any make-whole obligation. While the words "premium, if any" might look like a reference to make-whole obligations, Judge Drain interpreted New York law to disfavor make-wholes after acceleration and to require that any reference to make-wholes in such circumstances be utterly explicit.
Presented with virtually identical language in EFIH, Bankruptcy Judge Sontchi followed Momentive and rejected the secured noteholders' make-whole claims. The District Court affirmed with little comment.
After more than two years of litigation, the Third Circuit reversed and reinstated the make-wholes. The Court of Appeals expressly rejected Judge Drain's interpretation of New York law as providing some presumption against make-wholes in bankruptcy, and held that there was no conflict between the acceleration provision and the make-whole provisions in the governing indentures; EFIH's early payment of the notes constituted "optional redemption," triggering the make-whole regardless of the automatic acceleration upon bankruptcy.
Importantly, the court stressed that the make-whole clauses at issue did not provide that the premiums were triggered by "prepayment" or payment "before maturity" (as indentures in some prior cases had), but rather provided that the make-wholes became due upon redemption prior to specified calendar dates. Because bankruptcy acceleration did nothing to change the calendar, it did not relieve the borrower of its make-whole obligations.
Thus, while the Third Circuit's decision in EFIH has potentially broad implications in rejecting the notion that there is some presumption against make-wholes in bankruptcy, it can also been seen as a narrow decision based on the use of specific calendar dates as triggers in the governing documents. The broader lesson of the case, of course, is that loan parties are well-advised to address the impact of bankruptcy on early payment in their agreements. As an economic matter, it is difficult to see why rational parties to a bargain would want to provide special prepayment rights to a borrower upon entering bankruptcy – but if they wish to do so, it should be done explicitly.
Note: As of this writing, the EFIH debtors have petitioned the Third Circuit for rehearing or en banc review of the panel's decision. In addition, the debtors have announced that they have reached a settlement in principle with the first and second lien make-whole claims; that settlement, which calls for termination of all further appeals and challenges to the make-whole claims in exchange for modest discounts on the full amounts, is expected to be presented to the bankruptcy court for approval in connection with confirmation of a plan of reorganization early next year. Finally, the Momentive decision from the Southern District of New York is currently under appeal to the Second Circuit; the matter has been argued and is awaiting decision.
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