And the Hogs Just Get Fatter Can They Be Put on a Diet?

31 st Annual National CLE Conference Vail, Colorado, January 8-12, 2014 And the Hogs Just Get Fatter Can They Be Put on a Diet? Make Whole Premiums and Other Lender Fees, Default Interest and Penalties Jason S. Brookner Looper Reed & McGraw, P.C. Dallas, Texas jbrookner@lrmlaw.com David M. Neff Perkins Coie LLP Chicago, Illinois dneff@perkinscoie.com

What Is a Make-Whole Premium?

What Is a Make-Whole Premium? A make-whole premium is a contractual right of a lender to obtain an agreed-upon amount upon acceleration or prepayment of the loan. Make-whole premiums are calculated based on a fixed fee, a yield maintenance formula, or both. In today s market, it is typical for a make-whole to be calculated as a factor of the Treasury rate. For example, in GMX Resources, the make-whole was calculated as (i) a specified redemption price (outstanding principal plus a certain percentage) plus (ii) all remaining interest payments through a specified date, multiplied by (iii) Treasury (0.21%) plus 50 basis points (which in GMX was 0.71%).

What Is a Make-Whole Premium? The purpose of a make-whole premium is to compensate the lender for the loss of its bargained-for yield upon a prepayment or default.

Make-Whole v. Other Prepayment Penalties Make-whole premiums generally arise upon acceleration caused by the borrower s default (e.g. bankruptcy). Prepayment penalties are generally triggered upon the borrower s voluntary prepayment of the indebtedness, in violation of a no call provision. Under the perfect tender in time rule, a commercial borrower has no right to pay off his obligation prior to its stated maturity date in the absence of a prepayment clause. Arthur v. Burkich, 520 N.Y.S.2d 638 (N.Y. App. Div. 1987). Make-whole provisions memorialize this common-law concept by liquidating a lender s future loss upon a borrower s early repayment.

Can Make-Whole Amounts Be Disallowed as Unmatured Interest under Section 502(b)(2)?

A Split of Authority The validity of make-whole premiums in bankruptcy is subject to a split of authority. The Majority View: amounts due under makewhole provisions are not unmatured interest and are allowable as liquidated damages. The Minority View: amounts due under makewhole provisions are disallowable as unmatured interest under section 502(b)(2).

The Majority View: Liquidated Damages The majority of courts considering this issue have concluded that make-whole premiums are in the nature of liquidated damages rather than unmatured interest. Reasoning: 502(b)(2) does not apply to makewhole premiums because the premium matures only upon acceleration.

Selected Cases Adopting Majority View In re Skyler Ridge, 80 B.R. 500 (Bankr. C.D. Cal. 1987). Liquidated damages, including prepayment premiums, fully mature at the time of breach an do not represent unmatured interest... If secured lenders and borrowers want to contract to protect a secured lender s interest rate through the payment of reasonably calculated liquidated damages, there is no bankruptcy policy to prohibit the enforcement of such a provision. In re Outdoor Sports Headquarters, Inc., 161 B.R. 414 (Bankr. S.D. Ohio 1993). Prepayment amounts, although not often computed as being interest that would have been received through the life of a loan, do not constitute unmatured interest because they fully mature pursuant to the provisions of the contract.

Selected Cases Adopting Majority View In re 360 Inns. Ltd., 76 B.R. 753 (Bankr. N.D. Tex. 1987). Prepayment penalty was not unmatured interest inasmuch as the prepayment penalty was activated and matured when the debtors proposed to repay the secured debt. In re Trico Marine Servs. Inc., 450 B.R. 474 (Bankr. D. Del. 2011). Noting that the substantial majority of courts considering this issue have concluded that make-whole or prepayment obligations are in the nature of liquidated damages rather than unmatured interest. In re School Specialty, Inc., Case No. 13-10125, 2013 WL 1838513 (Bankr. D. Del. Apr. 22, 2013) (KJC). In re AMR Corp., 485 B.R. 279 (Bankr. S.D.N.Y. 2013).

The Minority View: Unmatured Interest As nothing more than a prepayment penalty, make-whole premiums constitute an improper attempt to recover unmatured interest directly prohibited by section 502(b)(2). Legislative History of 502(b)(2): Whether interest is matured or unmatured on the date of bankruptcy is to be determined without reference to any ipso facto or bankruptcy clause in the agreement creating the claim. H.R. Rep. No. 595, 95 th Cong., 1 st Sess. 352 (1977).

The Minority View: Unmatured Interest In re Allegheny Int l, Inc., 100 B.R. 247(Bankr. W.D. Pa. 1989); In re Oahu Cabinets, 12 B.R. 160 (Bankr. D. Haw. 1981). [T]he clear legislative history to section 502(b)(2) declares that determination of the maturity of interest shall be make without reference to any ipso facto or bankruptcy clause in the agreement creating the claim. Charles & Kleinhaus, Prepayment Clauses in Bankruptcy, 15 ABI L. Rev. 537 (Winter 2007). Reading section 502(b)(2) to disallow a claim for unmatured interest, but not a claim for the present value of that interest is difficult to defend. A better reading of section 502(b)(2) is that it disallows unsecured claims for interest or its equivalent are unmatured as of the petition date.

In re Ridgewood Apartments 174 B.R. 712 (Bankr. S.D. Ohio 1994) Bankruptcy court refused to allow Fannie Mae s claims for a prepayment penalty. Fannie Mae is not entitled to be protected against a postpetition loss of interest income. Any claim for a prepayment penalty in this circumstance would violate that prohibition and would fly in the face of the legislative history to section 502(b)(2).

In re Ridgewood Apartments (cont d) The clear purpose for a prepayment penalty is to compensate the lender for the risk that market rates of interest at the time of prepayment might be lower than the rate of the loan being prepaid. Such a provision would compensate the lender for anticipated interest that would not be received if the loan were paid prematurely.

A Temporal Gap?

A Temporal Gap? Claims are determined as of the moment in time that the petition is filed. See, e.g., In re Francisco, 390 B.R. 700 (B.A.P. 10 th Cir. 2008). Indenture Language from GMX Resources: If an Event of Default occurs and is continuing [then] the principal of, premium, if any, and interest on all the Notes will become and be immediately due and payable.... (emphasis added). If/then language creates a temporal gap between the time a bankruptcy petition is filed (default triggered) and the time acceleration took place.

A Temporal Gap? Gap means that the make-whole premium accrued postpetition, and thus, constitutes unmatured interest at the moment of filing. Rejected by court in In re GMX Resources, Inc. See Transcript of Proceedings, No. 13-11456 (Bankr. W.D. Okla. Aug. 27, 2013). Possibly undercut by In re AMR Corp., Inc. Indenture contained same If/then language and Court upheld make-whole provision.

Impermissible Ipso Facto Clause?

Impermissible Ipso Facto Clause? The Bankruptcy Code prohibits enforcement of ipso facto clauses only in very narrow circumstances i.e. the modification or termination of an executory contract or unexpired lease but does not broadly proscribe the enforcement of such clauses in all circumstances. In re AMR Corp., 485 B.R. 279 (Bankr. S.D.N.Y. 2013): subject indenture s ipso facto clause that accelerated make-whole premium upon filing bankruptcy was not prohibited.

Other Potential Challenges to Make-Whole Clauses

Section 502(b)(1): Unenforceable Penalty Under State Law When a clear and unambiguous clause which calls for payment of the prepayment premium of a sum equal thereto at any time after default and acceleration is included in a loan agreement, such clause is analyzed as liquidated damages and is generally enforceable. Nw. Mut. Life Ins. Co. v. Uniondale Realty Assocs., 816 N.Y.S.2d 831 (N.Y. Sup. Ct. Nassau Cnty. 2006). Generally, a liquidated damages clause is enforceable under state law if (1) damages are difficult to determine and (2) the award is not plainly disproportionate to the possible loss.

Unenforceable Penalty? Probably Not. First Prong: Courts have acknowledged that fixing damages related to complex debt instruments is difficult. Walter E. Heller & Co., Inc. v. Am. Flyers Airline Corp., 459 F.2d 896 (2d Cir. 1972). See also Transcript of Proceedings, In re GMX Resources, Inc., No. 13-11456 (Bankr. W.D. Okla. Aug. 27, 2013); JMD Holding Corp. v. Cong. Fin. Corp., 828 N.E.2d 604 (N.Y. 2005). Second Prong: Courts generally consider (i) whether the negotiated damages are calculated so that the lender will receive its bargained-for yield and (2) whether the provision is a result of an arms-length transaction between adequately represented sophisticated businessmen. In re South Side House, LLC, 451 B.R. 248 (Bankr. E.D.N.Y. 2011).

Section 506(b): Unreasonable Postpetition Interest Section 506(b) permits an oversecured creditor to receive postpetition interest on its claim and reasonable fees, costs and charges pursuant to an agreement between the creditor and the debtor. Courts construing make whole provisions typically find that they do not constitute postpetition interest because the make-whole premium became due and owing upon the filing of the bankruptcy petition.

Section 506(b) (cont d) A court should allow contractually bargained for default interest rate[s] under 506(b) without examining the reasonableness of these rates provided they fall within the range of acceptable rates. In re Skyler Ridge, 80 B.R. 500, 511 (Bankr. C.D. Cal. 1987). In the absence of egregious or unfair circumstances, a valid liquidated damages clause is a reasonable fee or charge under 506(b). Reasonableness analysis under 506(b) is substantially similar to state law liquidated damages analysis.

In re School Specialty, Inc. Case No. 13-10125, 2013 WL 1838513 (Bankr. D. Del. Apr. 22, 2013) (KJC) Background Facts: Make-whole premium was 37% of the loan principal and discount rate was applicable Treasury rate plus 50 basis points aggressive enough compared to industry standards to give the Court pause The Debtor breached and triggered the make-whole premium prior to filing bankruptcy Committee challenged make-whole under sections 502(b)(1),(2) and 506(b)

In re School Specialty, Inc. (cont d) Held: The make-whole premium was enforceable 502(b)(1) did not apply: Make-whole was enforceable liquidated damages provision under New York law. Whether the premium is disproportionate to the loss is determined at the time the parties entered into the agreement and not at the time of the breach.

In re School Specialty, Inc. (cont d) 506(b) did not apply: Reasonableness standard did not apply under New York law, but even if it did apply, the make-whole met the reasonableness test. 502(b)(2) did not apply: Adopted majority view.

In re GMX Resources, Inc. Case No. 13-11456 (Bankr. W.D. Okla. Aug. 27, 2013). Background Facts: Make-whole premium was 29% of the loan principal Discount rate was applicable Treasury rate plus 50 basis points effectively 0.71%, resulting in present value very close to absolute value The Debtors voluntary chapter 11 filing triggered the make-whole premium. Committee challenged make-whole under sections 502(b)(1),(2) and 506(b)

In re GMX Resources, Inc. Held: The make-whole premium was enforceable 502(b)(1) did not apply: Make-whole was enforceable liquidated damages provision under New York law. 502(b)(2) did not apply: Adopted majority view 506(b) did not apply: Did not conduct reasonableness analysis because already determined make-whole was part of prepetition claim

The Moral of the Story

Make-Whole Provision Is Probably Enforceable If The premium has been triggered under the indenture s terms; The make-whole provision is a valid liquidated damages clause under applicable state law; and The premium is reasonable under 506(b).

Precise Drafting Is Necessary Courts rely heavily on the plain meaning of contract language when considering the enforceability of make-whole provisions. Where the [governing agreements] do not unambiguously require a payment premium upon acceleration and default, a claim for prepayment consideration must be disallowed. South Side House, 2012 WL 273119, at *7 (E.D.N.Y. Jan. 30, 2012). Does the contract require payment of the makewhole premium upon post-acceleration repayment or only upon pre-maturity prepayment?

In re AMR Corp. (2 nd Circuit) 2013 WL 4840474 (2d Cir. Sept. 12, 2013). Debtors sought to obtain post-petition financing to repay prepetition noteholder without payment of make-whole premium. Indenture provided for a make-whole premium triggered by a voluntary prepayment of the notes, but not in the event of a mandatory prepayment. Noteholder objected, arguing that debtors were voluntarily redeeming the notes via post-petition financing, triggering the make-whole premium.

In re AMR Corp. (cont d) Relevant indenture language: No Make-Whole Amount shall be payable on the [notes] as a consequence of or in connection with an Event of Default or acceleration of the [notes]. [Upon filing bankruptcy] the unpaid principal, together with accrued but unpaid interest thereon and all other amounts due thereunder (but for the avoidance of doubt, without Make-Whole Amount), shall immediately and without further act become due and payable

In re AMR Corp. (cont d) Held: Based on the plain language of the indenture, the secured noteholders did not have the right to collect makewhole premium.

Take Away for Secured Creditors Carefully review financing agreements to ensure they explicitly provide that the make-whole premium will be due upon acceleration (including bankruptcy filing). Check for exceptions to payment of make-whole amount (i.e. American Airlines).

Questions?