Make-whole provisions

Make-whole clauses are pervasive in high-yield financings and are designed to protect the anticipated interest-rate yield that lenders bargain for when extending credit over a specified term (or a part of such term). These clauses provide protection by compensating lenders for interest payments lost on debt redeemed or prepaid before the stated maturity date. The compensation is usually in the form of a lump-sum premium that is paid by the borrower upon an early redemption or prepayment.

Arguments in US chapter 11 cases over the propriety of make-whole provisions are nothing new, but two recent decisions in the Hertz and Ultra Petroleum chapter 11 cases have cast doubt on the enforceability of these provisions against bankrupt entities. See Wells Fargo Bank N.A. v. The Hertz Corp. (In re The Hertz Corp.), Case No. 1:21-ap-50995, Dkt. No. 71 (Bankr. D. Del. Nov. 21, 2022); In re Ultra Petroleum Corp., 51 F. 4th 138 (5th Cir. 2022). In November 2022, a Delaware bankruptcy judge presiding over the Hertz case ruled that the make-whole premium was statutorily disallowed as "unmatured interest" under the US Bankruptcy Code. Similarly, in October 2022, the Fifth Circuit Court of Appeals in Ultra Petroleum found that claims rooted in make-whole provisions can be disallowed as "unmatured interest" in a bankruptcy proceeding of an insolvent debtor.¹ The decisions in Hertz and Ultra Petroleum point to a bankruptcy system that is increasingly hostile toward make-whole provisions.

A brief history of make-whole provisions in chapter 11 cases

Prior chapter 11 cases involving allowance of make whole provisions focused on a contractual interpretation of the loan agreement. These cases, including cases out of the Second and Third Circuit Courts of Appeal, resulted in conflicting decisions concerning the validity of make-whole provisions, with a focus on specific contract terms rather than the import of the US Bankruptcy Code. In the Momentive and AMR cases, for example, the Second Circuit found that the make-wholes were not payable under the contract terms where the debtors' bankruptcy filings triggered defaults that automatically accelerated the debt, preventing an optional note redemption under the contracts. See, e.g., Momentive Performance Materials Inv. v. BOKF, N.A. (In re MPM Silicones, LLC), 874 F.3d 787 (2d Cir. 2017); U.S. Bank Trust Nat'l Ass'n v. AMR Corp. (In re AMR Corp.), 730 F.3d 88 (2d Cir. 2013). By contrast, the Third Circuit in the EFH case held that the debtor made an optional redemption under the contractual language by refinancing, rather than reinstating, the notes, therefore triggering the make-whole provision. See In re Energy Future Holdings Corp., 842 F.3d 247, 251 (3d Cir. 2016). While addressing enforceability of make-whole provisions pursuant to the terms of the relevant contracts, none of these cases evaluated allowance under the US Bankruptcy Code.

Recent chapter 11 decisions disallowing make-whole premiums

In Ultra Petroleum, the Fifth Circuit took a different approach, first considering whether the make-whole premium was the "economic equivalent" of "unmatured interest," which is disallowed by section 502 of the US Bankruptcy Code. In determining that it was, the Fifth Circuit commented that the make-whole provision at issue was "both liquidated damages and the 'economic equivalent of unmatured interest"—as the very purpose of the make-whole provision is to "liquidate fixed-rate lenders' damages" resulting from a default. The Fifth Circuit therefore held that make-whole premiums are unenforceable in an ordinary case against an insolvent debtor. In conducting its analysis under the US Bankruptcy Code, the Fifth Circuit was the first appellate level court to directly assert the invalidity of make-whole provisions on the grounds that the premium constitutes unmatured interest that is not allowed under the US Bankruptcy Code.²

The Delaware bankruptcy court in the Hertz case reached the same decision as the Fifth Circuit after evaluating the "economic substance" of the make-whole provision, rather than the "formalistic labels or dictionary definitions of the terms used." The Delaware bankruptcy court, noting that its decision was fact-intensive and not controlling in all circumstances, found that the make-whole provision was the "equivalent of unmatured interest" and, therefore, not allowable against Hertz under the US Bankruptcy Code. However, the Delaware bankruptcy court agreed to certify an appeal of its decision directly to the Third Circuit, so the effect of this ruling remains uncertain during the pendency of that appeal.

Practical effects and possible solutions

The material sums that make-whole provisions protect (over US$200 million in both Hertz and Ultra Petroleum), combined with their ubiquity, means that uncertainty regarding the validity of make-whole provisions in chapter 11 cases could significantly impact lending practices, particularly if other courts begin to follow the Hertz and Ultra Petroleum decisions.

Debtors and lenders would be wise to evaluate jurisdictional differences when considering where a chapter 11 case may be filed. Well advised insolvent-debtors will choose to file for bankruptcy in jurisdictions that disallow make-whole provisions. Concentrating bankruptcy proceedings in jurisdictions that disallow make-whole provisions will lead to smaller recoveries for high-yield lenders when the debtors they lend to become insolvent.

It is important to note that make-whole provisions continue to be enforceable and valuable tools when bonds with a call option or similar feature are called before maturity. Thus, make-whole provisions are unlikely to see diminished use any time soon. The issue becomes how to prepare lenders and fixed-rate investors for the impact of the disallowance of make-whole provisions. Lenders could, for example, price-in the risk of a bankruptcy court disallowing the recovery of a make-whole premium, raising the cost of credit for high-yield capital users. Lenders might use probability of insolvency to calculate precise interest rate adjustments for each borrower, but a more likely outcome is across the board increases in rates for high-yield borrowers.

Alternatively, an insurance-like product might represent a more attractive solution if the market can be coaxed into offering it. Third parties could step in and insure against make-whole disallowance risk. The debtor would pay a premium upfront to cover the cost of insurance, and the lender would be protected in the event of an insolvent-debtor bankruptcy in a jurisdiction that disallows make-whole provisions. Lenders would seek make-whole premiums directly from the insurer rather than the debtor or seek payment of compensation if the premium is disallowed. This solution offers two distinct advantages to raising rates across the board to compensate for the risk of disallowance. First, an insurer could tailor the cost of its product to the unique risk profile that each debtor presents. This would allow for more competitive pricing of loans. Second, this solution would limit the impact of bankruptcy courts on high yield financing. Lenders and fixed rate investors would no longer be subject to as much uncertainty with respect to bankruptcy courts and make-whole provisions. The question is whether financial markets will provide a product like this.

Stay tuned for further case law on this important topic and potential market reactions.