This is the last entry in our four-part series analyzing Judge Drain’s widely read bench ruling issued on August 26, 2014 in connection with the confirmation hearing of Momentive Performance Materials and its affiliated debtors. In Parts I and II, we discussed Judge Drain’s conclusions regarding the appropriate calculation of cramdown interest rates for secured creditors. In Part III, we turned to his analysis of certain subordination provisions found in the indentures governing the Debtors’ senior subordinated notes. Today, in Part IV, we discuss Judge Drain’s rulings regarding the parties’ make-whole and third party release disputes.
What You Need to Know: Make-Wholes
Make-wholes have been a “trending” topic of late in the restructuring community. This is partly because it is difficult to find a consistent approach to the issue within the reported decisions. Therefore, even for those of us who have been closely following recent make-whole developments, a brief refresher on make-wholes is always helpful.
What are make-wholes? Make-wholes are contractual provisions found in indentures that typically permit a borrower to redeem or repay notes before maturity but require the borrower to pay a lump sum amount derived from a formula based on the net present value of future coupon payments that will not be paid as a result of early redemption or repayment. Make-wholes are usually available only during a “no-call” period, or a period of time specified in the indenture during which the borrower is prohibited from repaying the debt before maturity.
What is the purpose of make-wholes? The purpose of make-wholes is to determine the rights of the borrower and the creditor in the event repaying a debt before it matures becomes economically efficient for the borrower. From the creditor’s perspective, a make-whole provides yield protection. When debt is redeemed before maturity or repaid upon default, a make-whole or prepayment provision requires the borrower to pay an amount above the principal and interest due on the debt to compensate the lender for economic loss suffered as a result of the redemption or repayment. From the borrower’s perspective, a make-whole provides freedom to repay debt before maturity. Many jurisdictions, including New York, have adopted the “perfect tender in time” rule, which prohibits a borrower from repaying a loan before maturity in the absence of a specific contractual provision permitting early repayment.
When are make-wholes payable in a bankruptcy case? Outside of bankruptcy, whether a creditor is entitled to a make-whole is determined purely by looking to the underlying contract that governs the debt. In other words, the analysis is rooted in state law. Once a borrower is in bankruptcy, however, the Bankruptcy Code adds a layer of complexity that has, at times, led to contradictory decisions on a constellation of bankruptcy-related issues.
While different courts have taken different approaches, a general framework for determining whether a make-whole provision is allowable in bankruptcy has emerged. Bankruptcy courts have generally engaged in two layers of analysis. The first layer of analysis requires analyzing the debt document under state law to determine whether the (i) make-whole has been triggered and (ii) if so, whether the entire claim is enforceable under state law. The second layer of analysis requires considering whether enforceable state law claims are allowable under federal bankruptcy law. The following are typical questions that a bankruptcy court might address in such an analysis:
- Does the debt document explicitly provide for a make-whole? If so, when exactly is the make-whole triggered?
- Does a bankruptcy filing automatically accelerate the debt under the debt documents?
- Does automatic acceleration upon a bankruptcy event of default cause the debt to mature on the petition date under the debt documents?
- Does a repayment or refinancing in bankruptcy qualify as a voluntary prepayment or redemption under the terms of the debt documents?
- Does the debt document include a no-call provision prohibiting early repayment of the debt?
- Can the creditor decelerate the debt postpetition?
- Would the claim for make-whole be disallowed as a claim for unmatured interest under section 502(b)(2) of the Bankruptcy Code?
- Would the claim for make-whole or prepayment premium be allowed as a secured claim under section 506(b) of the Bankruptcy Code?
As we will explore in greater detail below, Judge Drain’s ruling in Momentive touches upon many of these questions.
The Make-Whole Dispute in Momentive
The indenture trustees for the holders of approximately $1.1 billion of First Lien Notes and $250 million of 1.5 Lien Notes (each discussed in greater detail in Parts I and II of this series) asserted that they were entitled to make-whole amounts under the terms of their respective indentures as a result of the repayment (in the form of the issuance of replacement notes) of the First Lien Notes and 1.5 Lien Notes before the original maturity date under the terms of the Debtors’ plan. The trustees also argued that, barring such claim, they could assert a common law claim for damages as a result of the debtors’ breach of the underlying debt documents or the “perfect tender” rule. Both indentures contained identical language with respect to the relevant provisions. As drafted, Momentive’s chapter 11 plan did not contemplate a distribution on account of the make-whole claims asserted. Thus, if the bankruptcy court allowed the make-whole claim, the amount of replacement notes to be issued under the plan to the holders of the First Lien Notes and 1.5 Lien Notes would increase, giving them a larger distribution (approximately $200 million more) under the plan.
The court disagreed with the indenture trustees and ultimately held that they were not entitled to their make-whole claims, that the debtors did not owe damages for breach of a no-call provision or the perfect tender rule, and, lastly, that the indenture trustees were not permitted postpetition to decelerate the already accelerated debt.
The Debt Documents Do Not Explicitly Provide for a Make-Whole After the Automatic Acceleration of the First Lien and 1.5 Lien Debt
At the heart of the make-whole dispute sits the explicit language of the governing contract: in this case, the indentures and notes. As Judge Drain noted, when considering the allowance of a claim in a bankruptcy case, the bankruptcy court should first consider whether the claim would be valid under applicable nonbankruptcy law. Accordingly, Judge Drain devoted a large part of his ruling to unpacking the relevant provisions of the indentures and notes to determine whether they gave rise to a valid make-whole claim under New York state law.
Judge Drain first laid the foundation for his analysis by noting that the New York “perfect tender” rule prohibits early repayment of a loan unless a borrower and creditor contractually agree to provide the borrower a specific option under the contract to permit the borrower to prepay the debt in return for agreed-upon consideration that compensates the lender for the cessation of the stream of interest payments running to the original maturity date of the loan.
He also noted that it is “well-settled” that the common law rule in New York is that a lender forfeits its rights to consideration for early payment if the lender is the party affirmatively accelerating the balance of the debt. This rule, however, is subject to two main exceptions: when a debtor intentionally defaults to trigger acceleration and avoid the make-whole, which was not applicable to the debtors, and when the contract clearly and unambiguously requires payment of the make-whole in the event of acceleration of, or the establishment of a new maturity date for, the debt.
In Momentive, the indentures provided for the automatic acceleration of the debt upon a bankruptcy event of default. The court agreed with the debtors and Second Lien noteholders (who supported the Momentive plan) that, as a result of the automatic acceleration provision, the maturity date of the First Lien and 1.5 Lien debt had been contractually advanced. In other words, the First Lien and 1.5 Lien noteholders had bargained for the early repayment of the notes upon Momentive’s bankruptcy and, therefore, forfeited their right to a prepayment premium, and the indentures lacked language that would otherwise “clearly and specifically” provide for the payment of the make-whole, notwithstanding the automatic acceleration.
Judge Drain distinguished Judge Gerber’s holding in In re Chemtura Corp., which the indenture trustees attempted to use to support their make-whole claim. In Chemtura, Judge Gerber was not asked to decide the merits of the make-whole claims asserted, but only to evaluate whether a settlement of the make-whole claims under a chapter 11 plan fell below the lowest level in the range of reasonableness. There, Judge Gerber expressed that, in his opinion, the bondholders asserting a make-whole claim had the “substantially” better argument and the debtors opposing the make-whole claim had a weak argument where the indenture defined “Maturity Date” as a date certain and “Maturity” separately, and indicated that a make-whole would be due upon early redemption of the debt before the “Maturity Date.” Unlike Chemtura, Judge Drain noted that, in Momentive, there were no provisions within the indentures that stated explicitly that a make-whole would be due if the debt was repaid prior to its original maturity.
Furthermore, Judge Drain dismissed the indenture trustees’ arguments that language referencing lower case “prepayment premiums” found throughout the indenture was sufficiently clear to warrant entitlement to the make-whole. For example, section 6.02 of each of the indentures provides for the payment of a “premium, if any” upon the automatic acceleration of the debt. Judge Drain held that each of the references highlighted by the indenture trustees to “other rights” or “premiums, if any” to be paid upon a prepayment were not specific enough to give rise to a make-whole entitlement under New York law.
Lastly, the debtors and Second Lien noteholders argued that the repayment of the First Lien and 1.5 Lien debt under the terms of the Momentive chapter 11 plan did not constitute an elective or voluntary prepayment as contemplated by the indentures. Judge Drain noted that, under the terms of the debt documents, the debtors could elect to “redeem” under sections 3.02 and 3.03 of the indentures and paragraph 5 of the notes, but under section 1124 of the Bankruptcy Code, the debtors could choose to reinstate the First Lien and 1.5 Lien debt rather than pay with substitute consideration. Ultimately, however, Judge Drain restrained himself from further considering this particular argument in light of his agreement with the Debtors that the plain language of the Indentures failed to give rise to a valid make-whole claim.
No Claim for a Breach of the No-Call Arises Under the First Lien and 1.5 Lien Notes
Judge Drain turned next to the indenture trustees’ alternative argument that they were entitled to a claim for damages as a result of the debtors’ breach of the no-call provision found in the First Lien and 1.5 Lien notes. Paragraph 5 of the notes stated, “Except as set forth in the following two paragraphs, [which discuss the contractual make-wholes] the Note shall not be redeemable at the option of MPM prior to October 15, 2015.” Siding again with the debtors and the Second Lien noteholders, Judge Drain held that this sentence was not a contractual no-call provision; instead, it was a framing device to introduce the notes’ elective redemption provisions that provide for a make-whole under certain circumstances, which were not triggered here.
The indenture trustees also argued, however, that, under New York’s “perfect tender” rule, which was contractually preserved by a general reservation of rights and remedies set forth in section 6.03 of the indentures, prepayment itself constituted a breach of that rule and entitled the First Lien and 1.5 Lien noteholders to a damages claim. Although Judge Drain acknowledged that New York law would, in fact, provide a claim for a breach of the “perfect tender” rule, the Bankruptcy Code would prohibit such a claim. First, Judge Drain noted that a prohibition on early repayment of debt is not specifically enforceable in bankruptcy. Second, he reiterated that the debt documents did not explicitly provide for an additional premium to be paid post-acceleration. Accordingly, the claim could not be allowed under section 506(b), which allows oversecured creditors to recover fees and charges under the parties’ agreement up to the value of their collateral. Lastly, he concluded that a claim for breach of the “perfect tender” rule would be barred by section 502(b)(2)’s prohibition against claims for unmatured interest. Any damages for breach of the perfect tender rule or a no-call provision that does not provide for liquidated damages would be calculated by taking the difference between the present value of the interest to be paid under the First Lien and 1.5 Lien notes through their stated maturity and the present value of their interest under the replacement notes to be issued under the Debtors’ plan, which difference would equate to unmatured interest.
The Automatic Stay Bars Deceleration of the First Lien and 1.5 Lien Debt
Realizing that the Debtors’ arguments against allowing the make-whole claims largely hinged on the automatic acceleration of the debt upon a bankruptcy event of default, the indenture trustees separately sought permission from the bankruptcy court to rescind the automatic acceleration of the notes. The indenture trustees made three arguments. First, the automatic stay does not apply to any rescission notice. Second, even if the automatic stay under section 362(a) of the Bankruptcy Code applied, rescission is excepted from the stay by section 555. Finally, they contended that even if the automatic stay applied, they should be granted relief.
Consistent with other similar cases, such as AMR and Solutia, Judge Drain concluded that the automatic stay did bar the issuance of a rescission notice and the deceleration of the debt under sections 362(a)(3) and 362(a)(6). According to Judge Drain, the purpose of the rescission notice would be to “resurrect” the right to the make-whole claim by decelerating the debt, and the effect of rescission would be to increase the size of the indenture trustees’ claims by approximately $200 million. This act thus constituted an act to control property of the estate by exercising a contract right to the estate’s detriment and attempting to recover, by deceleration, a claim against the debtors.
The indenture trustees further attempted to argue that the automatic stay was not implicated because it affected solely the rights of third parties, as any additional distribution under the Momentive plan on the incremental make-whole claim would simply reduce distributions to the Second Lien holders and trade creditors. As such, this was simply an intercreditor dispute. Judge Drain quickly dismissed this argument, noting that a proper reading of section 362(a) did not impose the additional limitation that acts barred needed to provide economic value to the estate, and moreover, this argument ignored the applicability of section 362(a)(6).
In addition, the indenture trustees raised a novel argument, which was not previously raised in AMR or Solutia, that the sending of the rescission notice merely served to liquidate a securities contract as permitted by section 555 of the Bankruptcy Code. Judge Drain, however, disagreed. He expressed serious doubts that the indentures qualified as “securities contracts” as defined in section 741(7)(A) of the Bankruptcy Code. The indentures were not contracts for the purchase, sale or loan of a security, but instead reflected the terms under which outstanding debt would be governed. Furthermore, sending a notice of rescission would not, in Judge Drain’s opinion, qualify as an act to liquidate the make-whole claim. It would, rather, constitute an act to increase the overall claims against the debtors by creating an altogether new and different claim.
Lastly, Judge Drain exercised his discretion and determined that relief from the stay was not warranted under these circumstances after application of the Second Circuit’s Sonnax case. Here, permitting the indenture trustees to send a rescission notice and decelerate the debt would significantly affect other creditors and the debtors’ collective estate, potentially enhancing the claims of the First Lien and 1.5 Lien noteholders by hundreds of millions of dollars.
The Third Party Releases Dispute in Momentive
Before we conclude, we will take a moment to briefly discuss Judge Drain’s ruling regarding the third party release provisions provided for under the Momentive plan. Only the indenture trustees for the First Lien and 1.5 Lien noteholders objected to the third party releases. The indenture trustees objected to the inclusion of third party releases for parties named or identified in state court lawsuits brought by the First Lien and 1.5 Lien indenture trustees to enforce the terms of an intercreditor agreement as against the Second Lien holders. In that litigation, the First Lien and 1.5 Lien holders alleged that the Second Lien noteholders’ support of the Momentive plan and the plan’s contemplated distribution of proceeds to the Second Lien noteholders before payment to the First and 1.5 Lien noteholders constituted a breach of the intercreditor agreement between the parties.
As a result of concerns Judge Drain expressed at the confirmation hearing, however, the debtors amended their releases to carve out the release of rights with respect to the intercreditor litigation. What remained of the third party releases, he upheld. Applying Deutsche Bank AG v. Metromedia Fiber Networks, Inc. and the case law interpreting it in the Second Circuit, the court found that the third party releases satisfied the Metromedia test because the Second Lien holders who were covered by the releases were providing substantial consideration to the debtors under the Momentive plan. The released Second Lien noteholders had agreed to different treatment of their unsecured deficiency claim from the unsecured claims of trade creditors (who would be paid in full under the plan), were committing to backstop a $600 million equity investment under the plan and had consistently supported the debtors’ reorganization efforts, starting with the execution of a prepetition plan support agreement. The court also found that the third party releases were an important part of the debtors’ plan. Without the third party releases, there existed a “reasonable risk” that the Second Lien noteholders would withdraw their support of the plan, and the court found this risk was “especially significant” given all that the Second Lien noteholders had committed to do under the plan.
Judge Drain’s rulings regarding the indenture trustees’ make-whole claims are notable because they provide additional clarity in an otherwise murky area of law. Prior to Momentive, the core cases discussing make-wholes largely examined contractual provisions that either clearly entitled a party to a make-whole claim or clearly denied a party a make-whole claim. On the drafting spectrum, the indentures and notes at issue in Momentive fell somewhere in between the two extremes. But exactly where it fell on the spectrum was a matter of rampant speculation. Particular attention was paid to the “premium, if any” language found in the automatic acceleration clauses of the debtors’ indentures, as that specific language, or similar language, could be found in many modern indentures. Debates spawned regarding whether the use of lower case “premium” would be sufficiently clear to trigger entitlement to a make-whole as a matter of contract law, sides were taken, and bets were placed. Judge Drain’s ruling — while not binding on other courts — provides yet another stake in the ground that telegraphs to creditors that their underlying contracts need to be more explicit regarding when they are entitled to a make-whole claim if they want to successfully seek allowance of such claim in bankruptcy. Furthermore, his denial of the indenture trustees’ request to modify the automatic stay to allow deceleration of the First Lien and 1.5 Lien debt buttresses the existing case law that prohibits creditors from attempting to resurrect a make-whole claim post-acceleration where the contract language itself does not give rise to such a claim.