So You Think Your Make-Whole and No-Call Rights Will Protect Yields? Think Again

Loan agreements and indentures frequently contain make-whole or no-call provisions, which are intended to protect the lenders’ and the bondholders’ expectation of receiving an uninterrupted stream of future interest payments. As borrowers seek to refinance their debt at today’s historically low interest rates, disputes regarding a lender’s or a bondholder’s right to make-whole or prepayment premiums ¹A “make-whole premium” is sometimes commonly referred as a “prepayment premium.” For purposes of this article, these terms are used interchangeably. have been occurring with greater frequency. Recent decisions demonstrate that when courts analyze the enforceability of make-whole and no-call provisions, they rely heavily upon the plain meaning of the loan agreement or indenture.

The Energy Future Holdings Corp.
²In re Energy Future Holdings Corp., No. 14-10979-CSS (Bankr. D. Del. filed April 29, 2014). bankruptcy case now pending in the District of Delaware involves, yet again, a dispute over the enforceability of make-whole provisions in the indentures governing approximately $6 billion in outstanding secured bonds. The secured bondholders assert, and the EFH debtors dispute, that the applicable indentures entitle the secured bondholders to approximately $1.4 billion in make-whole premiums. Without the need to analyze the relative strengths of the positions of the respective parties, one thing is clear—a set of better drafted indentures could have easily clarified whether the make-whole premiums are due.

This case and others ³See, e.g., In re Denver Merchandise Mart, Inc., 2014 BL 21331, 740 F.3d 1052 (5th Cir. 2014); In re AMR Corp., 2013 BL 243610, 730 F.3d 88 (2d Cir. 2013) cert. denied, 134 S. Ct. 1888 (U.S. 2014); In re MPM Silicones, LLC, Case No. 14-22503-RDD (Bankr. S.D.N.Y. Aug. 26, 2014) (bench ruling); In re Madison 92nd Street Associates LLC, 2012 BL 138889, 472 B.R. 189 (Bankr. S.D.N.Y. 2012); In re South Side House, LLC, 2011 BL 168699, 451 B.R. 248 (Bankr. E.D.N.Y. 2011) aff’d sub nom. U.S. Bank, N.A. v. South Side House, LLC, 2012 BL 26024 (E.D.N.Y. Jan. 30, 2012); In re Chemtura Corp., 2010 BL 249386, 439 B.R. 561 (Bankr. S.D.N.Y. 2010); In re Premier Entertainment Biloxi LLC, 2010 BL 206064, 445 B.R. 582 (Bankr. S.D. Miss. 2010); HSBC Bank USA, N.A. v. Calpine Corp., (S.D.N.Y. Sept. 15, 2010) (“Calpine II”); In re Solutia Inc., 2007 BL 146252, 379 B.R. 473 (Bankr. S.D.N.Y. 2007). illustrate the critical importance of carefully and precisely drafted make-whole and no-call provisions. Lenders and bondholders should take note of the lessons that can be learned from these cases that directly impact their rights and abilities to enforce make-whole provisions and to recover damages for breaches of no-call provisions. The following is a brief summary of these lessons.

1. OVERVIEW :

A no-call provision is a contractual reaffirmation of the common law rule known as the “perfect tender in time” rule. This rule provides that, unless otherwise expressly stated in the financing documents, a borrower is prohibited from prepaying its loan before its stated maturity because it would deprive the lender of its expected return on its investment. ⁴Northwestern Mutual Life Insurance Co. v. Uniondale Realty Associates, 816 N.Y.S.2d 831, 835 (N.Y. Sup. Ct. 2006). In some states, like New York, the “perfect tender in time” rule has been modified by statute for certain types of loans. See N.Y. General Obligations Law § 5-501(3)(b). No-call provisions are generally enforced against a borrower outside of bankruptcy by awarding damages to the lender. ⁵See Teachers Insurance & Annuity Association of America v. Butler, 626 F.Supp. 1229 (S.D.N.Y. 1986) (enforcing no-call provision in commitment letter, when borrower failed to negotiate in good faith the corresponding provisions in credit agreement).

In bankruptcy, courts do not specifically enforce no-call provisions. These provisions are viewed as a hindrance to the reorganization of debtors. ⁶See, e.g., Calpine II, 2010 WL 3835200 at *3 (citing cases). While at least one bankruptcy court has awarded damages for a breach of a no-call provision as an unsecured claim even in the absence of a specific damages provision, ⁷See Biloxi, 445 B.R. at 636 (stating that “the unavailability of specific performance as a remedy and the lack of a stipulated liquidated damages provision in the indenture do not prohibit the allowance of an award of expectation damages to the claimants as an alternative remedy for breach of the No-Call Provision, as an unsecured claim”). other bankruptcy courts have found that a lender may be entitled to damages only if the damages are explicitly provided for in the financing documents. ⁸See In re Calpine Corp., 365 B.R. 392, 399 (Bankr. S.D.N.Y. 2007) (allowing damages for a breach of no-call provision as an unsecured claim), but see Calpine II, 2010 WL 3835200 at *4 (holding that no damages were due because the no-call provision was unenforceable in bankruptcy). Contra Chemtura, 439 B.R. at 604 (disagreeing with Calpine II’s holding and concluding that with respect to no call provisions, “[w]hile the notion of specific performance is generally repugnant to bankruptcy policy, bankruptcy courts allow claims for damages for breaches of contracts they won’t specifically enforce …”).

A make-whole provision is a contractual opt-out to the “perfect tender in time” rule. In return for permitting the prepayment, the borrower is required to pay the lender a premium to compensate the lender for the loss of its interest over the term of the loan. ⁹Madison 92nd Street Associates, 472 B.R. at 195 (“[a] lender has the absolute right to receive the bargained for income stream over the life of the loan. The prepayment premium is viewed as the price of the option exercisable by the borrower to prepay the loan and cut off the lender’s income stream”) (citations omitted). Make-whole provisions are generally enforced both in and outside of bankruptcy, subject to certain limitations, as more particularly described below.

2.
MAKE-WHOLE AND NO-CALL PROVISIONS
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SOME LESSONS LEARNED:

When analyzing the enforceability of a make-premium provision, courts will first consider

• (a)  the context in which the payment of the make-whole premium is being triggered, whether it is an optional redemption, ¹⁰Chemtura, 439 B.R. at 601 (the indenture clearly provided that the make-whole premium was due upon the exercise by the borrower of the option redemption). an acceleration (whether automatic or at the lender’s election), ¹¹Biloxi, 445 B.R at 631 (“[the lenders] gave up their expectation to a payment stream in the future [and] chose to forego any prepayment premium in favor of an immediate right to collect their entire debt after a bankruptcy event of default”). a foreclosure, ¹²See
  3C Associates v. IC & LP Realty Co., 137 A.D.2d 439 (N.Y. App. Div. 1988) (mortgagee was not entitled to prepayment premium after bringing foreclosure action); Northwestern Mutual Life Insurance, 816 N.Y.S.2d at 840 (mortgagee was not entitled to prepayment premium in foreclosure action). or a similar financing or restructuring event; and
• (b)  whether, in such context, the borrower is making a “voluntary” payment versus an “involuntary” payment. ¹³Northwestern Mutual Life Insurance, 816 N.Y.S.2d at 834.

When considering whether a payment is “voluntary” or “involuntary,” courts have relied heavily upon the plain meaning of the financing documents. A make-whole premium provision “is generally analyzed as an ‘option’ for alternative performance on the loan and any premium is deemed consideration … for the option.” ¹⁴Id. at 835. In the context of a default and acceleration, the general rule ¹⁵There is one exception to this general rule. Some courts have found that “[e]ven in the absence of an express agreement, prepayment consideration may be awarded upon a finding that the borrower defaulted intentionally in order to avoid a prepayment penalty, trigger acceleration, and repay the debt.” South Side House, 451 B.R. at 269. See also In re Granite Broad. Corp., 2007 BL 3657 at **24, 369 B.R. 120, 144 (Bankr. S.D.N.Y. 2007); Northwestern Mutual Life Insurance, 816 N.Y.S.2d at 836. To protect against this type of intentional default, some lenders have included a so-called “evasion clause” in their financing documents in which the parties expressly agree that any “repayment of the debt after acceleration, or in the context of a foreclosure proceeding, will be deemed an evasion of the parties’ prepayment agreement and the borrower will be required to pay prepayment consideration or an equivalent amount.” South Side House, 451 B.R. at 269-70. While an evasion clause provides some additional protection to the lender in that it eliminates the need for the lender to address the borrower’s intent, courts have narrowly interpreted such clauses and limited their application to their plain meaning. See South Side House, 451 B.R. at 270 (since the debtor did not attempt to prepay the loan prior to the foreclosure action, the evasion clause was inapplicable); Northwestern Mutual Life Insurance, 816 N.Y.S.2d at 839 (the evasion clause was inapplicable since there was no evidence that the mortgagor intentionally triggered acceleration). is that:

• a lender is not entitled to prepayment consideration after a default unless the parties’ agreement expressly requires it. This is because prepayment provisions generally address the consideration to be paid when the borrower voluntarily prepays the debt, but after a default the borrower’s repayment is neither voluntary nor in the nature of a prepayment. ¹⁶South Side House, 451 B.R. at 268 (citations omitted).

From the cases interpreting this general rule, some lessons have emerged that directly impact the ability and the right of a lender to enforce its make-whole premium when the debt is in default and has been accelerated:

(A) Lesson No. 1—“Maturity Date” Should Be A Fixed Date. In support of this general rule, some courts have concluded that unless otherwise expressly agreed to by the parties, a payment made after acceleration cannot be a prepayment since it is made after maturity. In Solutia, for example, the court found that, by the express terms of the promissory note, acceleration advanced the maturity date to the date of acceleration. ¹⁷Solutia, 379 B.R. at 487-488. Consequently, any payment made after acceleration was not made before “maturity” but was instead a post-maturity date payment. ¹⁸Id. at 488. As a result, the court held that no prepayment premium was due because there was no prepayment made before the “new maturity date.” ¹⁹Id. See also AMR, 730 F.3d at 103 (finding that no make-whole premium was due because the payments made after acceleration of the debt were not prepayments and that the indenture trustee’s attempt to rescind the automatic acceleration of the notes and to decelerate the debt violated the automatic stay).

Similarly, in Biloxi, the court pointed out that the commencement of the bankruptcy case automatically accelerated the debt. ²⁰Biloxi, 445 B.R. at 633-34. The court concluded that “[t]he effect of acceleration was to change the maturity date from [its stated maturity date] to the Petition Date, which then became the new maturity date.” ²¹Id. at 627. As a result, the court held that the debtor’s post-acceleration payment of the notes under a plan of reorganization did not trigger the lender’s right to a prepayment premium.

In contrast, in Chemtura
, the court found that, by the express terms of the promissory notes, the “maturity date” was defined as a fixed date (i.e., June 1, 2016). ²²Chemtura, 439 B.R. at 601 (Chemtura concerned the approval of a settlement, and thus was not a decision on the merits, but rather a holding that the proposed settlement was reasonable in light of the opposing arguments). The effect of acceleration did not change the “maturity date.” ²³Id. The promissory notes provided that: “[a]t any time and from time to time prior to the [m]aturity [d]ate, the [c]ompany may, at its option, redeem all or any portion of the [s]ecurities at the [m]ake-[w]hole [p]rice plus accrued and unpaid interest to the date of redemption.” ²⁴Id
. at 601, n.176. The court pointed to this specific language in support of enforcement of the make-whole premium provision since the payments at issue were made before this fixed date. ²⁵Id. at 601.

From this line of cases, it is clear that defining the “maturity date” as a specific fixed date may enhance a lender’s right to enforce and collect its make-whole premium.

(B) Lesson No. 2
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Financing Documents Should Expressly State That Make-Whole Premium Is Due Upon Any Unscheduled Payment Whether Voluntary Or Involuntary. Some courts have concluded that when a lender elects to exercise its right to accelerate the debt, it is in effect waiving its right to receive a make-whole premium. ²⁶Biloxi, 445 B.R at 631 (the lenders “gave up their expectation to a payment stream in the future [and] chose to forego any prepayment premium in favor of an immediate right to collect their entire debt after a bankruptcy event of default”). These courts have found that, in the absence of any express agreement, “a lender forfeits the right to prepayment consideration by accelerating the balance of the loan.” ²⁷U.S. Bank, N.A. v. South Side House, LLC, 2012 BL 26024 (E.D.N.Y. Jan. 30, 2012). See also In re Financial Center Associates of East Meadow, L.P., 140 B.R. 829 (Bankr. E.D.N.Y. 1992) (the mortgage note expressly provided for the payment of a prepayment premium, even if the lender elected to accelerate the debt).

In Denver Merchandise Mart, for example, the lender exercised its right under the promissory note to accelerate the debt after the occurrence of a payment default. ²⁸Denver Merchandise Mart, 740 F.3d at 1054. In disallowing the prepayment premium, the court reviewed the plain language of the promissory note and concluded that the prepayment premium only became due upon an actual prepayment and not merely upon acceleration. ²⁹Id. at 1058-1059. The court found that “a lender’s choice to accelerate acts as a waiver of the right to prepayment penalty.” ³⁰Id. at 1056. When the lender exercised its right to accelerate the entire debt, it consequently waived its right to receive the prepayment premium.

To protect against this theory of implied waiver, it is important that the make-whole premium provision expressly provides that the premium is due upon any unscheduled payment, whether voluntary or involuntary. For example, in AE Hotel Venture, ³¹In re AE Hotel Venture, 321 B.R. 209 (Bankr. N.D. Ill. 2005). the court also looked to the plain language of the mortgage note when asked to consider whether a prepayment premium was due in connection with a foreclosure sale. However, in this case, the mortgage note expressly provided that:

• after an event of default, [the mortgagor] shall tender payment of an amount sufficient to satisfy the [d]ebt at any time prior to a sale of the [m]ortgaged [p]roperty by [the mortgagee] …, either through foreclosure or the exercise of the other remedies available to [the mortgagee] under the [m]ortgage, such tender by [the mortgagor] shall be deemed to be a voluntary prepayment. ³²Id. at 218 (italicized added).

Because the parties expressly agreed in the mortgage note that any “payment of the debt even after default was a ‘voluntary prepayment,’” and that the prepayment premium was due even after acceleration, the court found that the prepayment premium was due. ³³Id. at 219. The mortgage note clearly provided that the lender was not waiving the premium upon acceleration of the debt.

(C) Lesson No. 3—The Accelerated Amount Must Expressly Include Make-Whole Premium. It is critical that the amount due at acceleration expressly state, and include, the make-whole premium. General language as to the amount due at acceleration that seems to incorporate the make-whole premium may not be sufficient. For example, the following language was found not to be sufficiently specific for the prepayment premium due to be upon acceleration:

• “all other moneys agreed or provided to be paid by [b]orrower in this [n]ote, the [s]ecurity [i]nstruments or the other [s]ecurity [d]ocuments … shall without notice become immediately due and payable at the option of [l]ender” upon the occurrence of any event of default. ³⁴See Denver Merchandise Mart, 740 F.3d at 1057. See also In re MPM Silicones, LLC, Case No. 14-22503-RDD (Bankr. S.D.N.Y. Aug. 26, 2014) (Hearing Transcript at 36-43) (holding that no “Applicable Premium” was due upon acceleration when the indenture merely provided for the acceleration of the principal, interest and any “premium,” but did not specifically reference the “Applicable Premium” due upon a redemption of the notes).

In contrast, make-whole premiums were found to be due upon acceleration when the financing documents specifically provided for the following:

• “If the [l]oan is accelerated during the [l]ockout [p]eriod for any reason …, [b]orrower shall pay, in addition to all other amounts outstanding under the loan documents, a prepayment premium equal to five percent (5%) of the outstanding balance of the [l]oan.” ³⁵Madison 92nd Street Associates, 472 B.R. at 196.
• “If the maturity of any Series B Notes shall be accelerated … by reason of the occurrence of an [e]vent of [d]efault, there shall become due and payable (and the [c]ompany will pay), as compensation to the holders of such [n]otes for the loss of their investment opportunity and not as a penalty, a premium equal to the [m]ake-[w]hole [a]mount.” ³⁶In re Anchor Resolution Corp., 221 B.R. 330, 334 (Bankr. D. Del. 1998); See also In re Schaumburg Hotel Owner Limited Partnership, 97 B.R. 943, 953 (Bankr. N.D. Ill. 1989) (“The [[d]ebtor] agrees that the prepayment premium … shall be due and payable whether said payment is voluntary or the result of prepayment created by the exercise of any acceleration clause after a default provided for hereunder or under the [m]ortgage or [s]ecurity [d]ocuments.”) (emphasis omitted).

(D) Lesson No. 4
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Make-Whole and No Call Provisions Should Specify Method of Calculating Damages in the Event of a Breach. Even if the make-whole premium provision is clearly drafted, the premium can still be denied if it is not allowed under applicable state law. ³⁷If the borrower has filed for bankruptcy protection, there are two provisions of the Bankruptcy Code that may limit or disallow a make-whole premium. First, Section 502(b)(2) of the Bankruptcy Code specifically disallows any claim for unmatured interest. See 11 U.S.C. § 502(b)(2). While the majority of courts view make-whole premiums as a claim for liquidated damages and not for unmatured interest, See In re School Specialty, Inc., 2013 BL 107127 at *5 (citing cases) (Bankr. D. Del. April 22, 2013); In re Trico Marine Services, Inc., 2011 BL 110253 at **6, 450 B.R. 474, 481 (Bankr. D. Del. 2011); In re Skyler Ridge, 80 B.R. 500, 508 (Bankr. C.D. Cal. 1987), some New York courts have questioned this view, believing that “make-whole premiums and damages for breach of a no-call are proxies for unmatured interest.” Chemtura, 439 B.R. at 604. Second, under Section 506(b) of the Bankruptcy Code, the amount of any make-whole premium must be “reasonable.” See 11 U.S.C. § 506(b). Section 506(b) provides that, to the extent that the lender is oversecured, the lender will be entitled to receive, among other things, any “’reasonable’ fees, costs or charges” incurred after the filing of the bankruptcy petition. Id.. While only a few courts have found that a certain amount of prepayment premiums to be “unreasonable,” See In re Duralite Truck Body & Container Corp., 153 B.R. 708, 714-15 (Bankr. D. Md. 1993) (a prepayment charge was “unreasonable” because it did not account for changes in market interest rate and was not discounted to present value); In re Kroh Brothers Development Co., 88 B.R. 997, 1000-02 (Bankr. W.D. Mo. 1988) (applying both state law and the 506(b) reasonableness standing holding that prepayment penalty of approximately 25% of the principal amount was unreasonable because it was not discounted to present value), at least one court has hinted at the possibility, noting that “although the pre-payment charge may pass [the New York state law], the resulting actual charge may be so large and so unjust to the estate and its creditors, that it may be avoided based on the 506(b) reasonableness standard.” Financial Center Associates, 140 B.R. at 839. For instance, under New York law, courts will analyze whether as “a question of law,” a make-whole premium is meant to impose an unenforceable penalty upon the borrower or instead is intended to liquidate the damages sustained by the lender due to the borrower’s breach. ³⁸JMD Holding Corp. v. Congress Financial Corp., 2005 BL 1088 at ****3, 4 N.Y.3d 373, 379 (2005).

Under New York law, a make-whole premium will be enforced as liquidated damages if “(1) actual damages may be difficult to determine and (2) the sum stipulated is “not plainly disproportionate” to [a lender’s] possible loss.” ³⁹United Merchants and Manufacturers, Inc. v. Equitable Life Assurance Society of the United States., 674 F.2d 134, 142 (2d Cir. 1982) (quoting Walter E. Heller & Co., Inc. v. American Flyers Airline Corp., 459 F.2d 896, 899 (2d Cir. 1972)). See also In re School Specialty, Inc., 2013 BL 107127 at *2 (Bankr. D. Del. Apr. 22, 2013); Madison 92nd Street Associates, 472 B.R. at 196. Whether the make-whole premium is “plainly disproportionate” requires the court to consider “(i) whether the prepayment fee is calculated so that the lender will receive its bargained for yield, and (ii) whether the prepayment fee is the result of an arms-length transaction between represented sophisticated parties.” ⁴⁰School Specialty, 2013 BL 107127 at *3 (citing South Side House, 451 B.R. at 270-71). The courts analyze liquidated damages not with hindsight but “in light of the circumstances existing as of the time that the agreement is entered into.” ⁴¹United Merchants and Manufacturers, 674 F.2d at 142 (quoting Walter E. Heller & Co., 459 F.2d at 898). See also Madison 92nd Street Associates, 472 B.R. at 196 (“The party seeking to avoid the liquidated damages clause bears the burden of proving that it is a penalty, and must demonstrate either that the damages flowing from prepayment were readily ascertainable at the time the parties entered into the lending agreement or the prepayment premium is ‘conspicuously disproportionate’ to the lender’s foreseeable losses.”) (citing JMD Holding, 4 N.Y.3d at 380). As a result, the liquidated damages may be higher or lower than the actual damages suffered. ⁴²United Merchants and Manufacturers, 674 F.2d at 142.

Accordingly, to avoid an argument by the borrower that the make-whole premium is an unenforceable penalty, it is important that the make-whole premium provision include a clause that specifies the method of calculating the damages sustained by the lender in the event of a breach. By way of examples:

• In School Specialty, the court held that a 35% make-whole premium was enforceable (i.e., a $23.7 million premium on $67 million of principal outstanding under the loan). In support of its decision, the court explicitly noted that the credit agreement stated that the premium was calculated by discounting the future stream of interest payments at applicable treasury rate plus 50 basis points from the date of prepayment or acceleration to the applicable maturity date, and included a “step-down” mechanism that further reduced the fee after 18 and 30 months. ⁴³School Specialty, 2013 BL 107127 at *1; see also Anchor Resolution, 221 B.R. at 341 (same formula—discounted at treasury plus 50 basis points).
• In AE Hotel Venture, the court concluded that an 18% premium was enforceable (i.e., a $1.2 million premium on $6.7 million of principal outstanding under the mortgage loan). The court found that the mortgage note expressly set forth a formula for calculating the premium using the larger of either (a) discounting the repaid amount based on the rate of certain U.S. Treasury securities of a similar maturity to the loan during the week preceding the prepayment, or (b) 1% of the outstanding balance on the prepayment date. ⁴⁴AE Hotel Venture, 321 B.R. at 213-14. See also Madison 92nd Street Associates, 472 B.R. at 197 (a 5% prepayment premium was not “conspicuously disproportionate” to the lender’s foreseeable losses at the time of contracting).

With respect to no-call provisions, it is similarly important to include in the financing documents a provision for liquidated damages. Some lenders who have failed to include such a provision have not been able to recover in bankruptcy damages for a breach of the no-call provisions. For example, in Calpine II, the court found that once the debtor had filed for bankruptcy, the no-call provisions in the notes were unenforceable and as a result, such provisions did not prevent the debtor from repaying its notes in bankruptcy. ⁴⁵Calpine II, 2010 WL 3835200 at *3. The court specifically pointed out that because the notes lacked any specific provision for damages in the case of acceleration, the lenders were not entitled to any damages when the debtors repaid in full the principal and interest under their notes. ⁴⁶Id. at *4. But see Biloxi, 445 B.R at 636 (even though the indenture did not contain any specific provision for liquidated damages, the court did grant the lenders an unsecured claim for damages for breach of the no-call provision, concluding that when “a borrower violates an explicit prohibition against prepayment, monetary damages are frequently a remedy.”).

3. CONCLUSION:

Lenders and bondholders should not expect make-whole and no-call provisions to be enforceable in all circumstances simply because these provisions are in the financing documents. Rather, as the above noted cases illustrate, the specific language of these provisions will ultimately determine whether and to what extent damages can be recovered in a default situation. Accordingly, lenders and bondholders should carefully scrutinize their financing documents to ensure, among other things, that:

• The “maturity date” is defined as of a specific fixed date.
• The make-whole premium provision expressly provides that the premium is due when any voluntary or involuntary unscheduled payment is made—regardless whether such payment is in connection with an optional redemption, after an acceleration (whether automatic or at the lender’s election), a foreclosure, or similar financing or restructuring event.
• The financing documents provide that the amount due at acceleration expressly includes the make-whole premium.
• The make-whole and no-call provisions specify a method for calculating the damages sustained by the lender in the event of a breach by the borrower.