United States: Court Decisions Signal Shifting Landscape For Make-Whole Provisions

By its very nature, the world of distressed investing is constantly changing. However, significant trends have recently emerged in the sector that will affect fund managers.

The first is a shift in the legal status of make-whole call provisions ("make-wholes") due to a pair of court rulings. Make-wholes typically allow the borrower in a bond issuance to prepay the remaining fixed-rate term debt using an additional lump-sum payment based on the net present value of future coupon payments. The provisions are standard inclusions in both investment-grade and high-yield indentures, yet they are seldom invoked, since the potential cost to the borrow can be prohibitive.

However, since distressed debt – and the potential for large returns – is a popular investment target for hedge funds and other private investment funds, make-whole provisions remain an important consideration for fund managers.

Two recent bankruptcy court decisions have cast a significant measure of doubt over the continued viability of make-wholes. In the first, the U.S. District Court for the Southern District of New York rejected lenders' appeals of a bankruptcy court decision that approved the Chapter 11 plan to reorganize MPM Silicones. In doing so, the court upheld the previous decision that senior secured lenders of the private equity-backed company would be denied approximately $200 million in make-whole payments they believed they would be owed. The decision stated that the bond indenture did not include language that was specific enough outlining the terms or circumstances that would warrant a make-whole payment in the event of a bankruptcy acceleration.

In another prominent case, the judge overseeing the restructuring of Energy Future Holdings ("EFH") ruled that the repayment in full of senior secured notes in that case did not trigger a requirement to pay a make-whole premium. Bankruptcy Judge Christopher Sontchi's ruling stated that "under New York law, an indenture must contain express language requiring payment of a prepayment premium upon acceleration; otherwise, it is not owed."
Essentially, these decisions established that make-wholes must be clearly and explicitly described in indentures, representing a departure from the previous discussions in decisions related to the provisions. This apparent shift in the state of the law raises several issues that warrant careful consideration for debtors and creditors alike when evaluating the reliability of such provisions. First, is the make-whole clearly payable under the indenture? Put another way, is it clear and unambiguous that a make-whole is payable even after an acceleration? Furthermore, is the make-whole reasonable? There are two levels of analysis used to establish this – under state law and the Bankruptcy Code; however, the matter ultimately comes down to whether the amount of the make whole is a reasonable approximation of the harm suffered by the prepayment. There is also the potential for double counting of a make- whole, based on the language of the indenture agreement.

The second issue that has emerged relates to post-position interest ("PPI"), which accrues after the commencement of a bankruptcy, insolvency or reorganization case, as outlined in the Bankruptcy Code. The evolution of this subject again comes out of the EFH proceedings. Previously, it was fairly well-settled in numerous cases that in a solvent debtor case, unsecured creditors are entitled to PPI. While there was a split in how the interest should be calculated, creditors generally assumed that if debtors were solvent, they would receive interest. However, that belief has recently been turned upside down.

Judge Sontchi's ruling held that PPI is not an essential part of an unsecured creditor's claim under a Chapter 11 plan. Specifically, he held that (i) the allowed amount of the claim under 502(b) does not include PPI; (ii) to the extent 726(a)(5) applies, "the legal rate" means the federal judgment rate; (iii) unimpairment does not require paying any PPI; and (iv) the "fair and equitable" requirement in 1129(b) does not require payment of PPI to unsecured creditors just because a junior class is receiving a distribution. He also held, however, that the court has the discretion in its equitable power to require the payment of PPI at some rate to be determined by the court. This decision flips the presumption: Now the creditor is required to prove that it is entitled to PPI payments.

These decisions highlight that the law related to make-wholes and PPI remains unsettled and many long-held assumptions are now being challenged as a result. Indentures written prior to these decisions were likely based upon the previous understanding of the law. Now that it is changing, distressed investors should take note.

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.

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