Make-whole premiums and ‘cram-up’: A glass half full?

Think your fully secured bond is fully secure? Think again. The New York and Delaware bankruptcy courts are once again divided on an issue of key importance not only to secured bondholders, but also to creditors directly below them in the priority chain. The dispute has two distinct parts: (1) the enforcement of “make-whole” yield-protection premiums on bonds redeemed before maturity and (2) low-interest notes “crammed up” on secured creditors to refinance higher-interest notes. The first problem can be easily solved; the other eludes easy resolution, though it might be possible to kill both birds with one carefully directed stone.

A familiar scenario and an extremely liberal U.S. bankruptcy law give rise to the problem.  Company borrows millions of dollars by issuing secured bonds when interest rates are relatively high. Years later, interest rates have fallen, so Company would like to refinance at a lower interest rate. The bond indenture, however, has foreseen this possibility, and it protects the holders’ investment expectations with a yield-maintenance clause, imposing on Company a large prepayment premium obligation to cover, at least in part, the interest lost over the remaining life of the bonds. Company thus faces a Hobson’s choice between prepayment penalty or high interest payments, making the refinancing option much less attractive.

Company might turn this Hobson’s choice back on its bondholders, however, by reorganizing its debt under U.S. bankruptcy law. Unlike most other world insolvency regimes, the U.S. Bankruptcy Code does not require the debtor to be insolvent to take advantage of a restructuring. While some degree of at least anticipated financial distress likely must be established, this is a simple matter for most companies in the volatile global market today. Thus, the ability to turn the tables on secured bondholder might present itself with some frequency in a time of falling interest rates.

Company’s restructuring offer might resemble the ones proposed by MPM Silicones (a.k.a. Momentive) in its Chapter 11 case filed in New York, or the one made in Energy Future Holdings’ case in Delaware, both in April 2014. Both of these companies offered bondholders full payment in cash, but they had to waive the prepayment “make-whole” premium, amounting to several hundred million dollars. If bondholders refused, the debtors would ask the bankruptcy court to deny the make-whole premium claim and force bondholders to accept full payment of their claims in the form of replacement bonds. Worse yet, these new bonds would bear a below-market interest rate artificially established using a formula approach developed by the U.S. Supreme Court; that is, a 1 to 3 percent risk premium over the rate on similar maturity U.S. Treasury bonds. Because such replacement bonds meet the minimum requirement of paying secured creditors in full, the debtors anticipated that the courts would confirm this “cram-up” plan, so called because of its similarity to a cram-down plan imposed on unsecured creditors, but directed “up” at senior secured creditors.

This strategy paid off for both Momentive and Energy Future, though to differing degrees. Both convinced the courts to deny the make-whole premium claim and to cram up the formula-interest refinance bonds on their senior secured holders. Secured creditors have few options for avoiding the imposition of low-interest but full-payment replacement refinancing bonds if a Chapter 11 case proceeds to confirmation of a restructuring plan.

If the make-whole premium obligation remained intact, the sting of forced refinancing could be dulled, but the courts in both New York and Delaware originally allowed the debtors to double down and avoid the make-whole payments, as well. Luckily for senior secured bondholders, the Third Circuit Court of Appeals recently reversed that holding in Delaware, potentially setting up another stark conflict between the restructuring rules in the two most prominent U.S. fora.

In November 2016, the Third Circuit held that in Delaware, arguments to avoid the make-whole payment went too far in construing the standard language of bond indentures. At the outset, the court noted that Energy Future had publicly announced in an 8-K form its intention to take advantage of the bankruptcy process to refinance its notes without paying any make-whole premium. This veiled criticism of Energy Future’s manipulation of the bankruptcy law, even while it was presumably fully solvent, foreshadowed the court’s evaluation of the arguments for achieving Energy Future’s announced goal.

The lower courts had denied the make-whole payment based on the language of the indenture, which required the premium only upon an “optional redemption” of the bonds before a certain date. A separate acceleration clause made the bonds automatically due in full upon the debtor’s bankruptcy filing, making the full redemption of the bonds now no longer optional, the lower courts reasoned, and the acceleration clause made no reference to any make-whole premium.

The Third Circuit dismantled the linguistic detours that supported Energy Future’s evasion of the premium by focusing not on the acceleration clause, but on a natural reading of the “optional redemption” clause. As to whether the redemption was optional in light of the forced acceleration, the Third Circuit needed to look no further than Energy Future’s 8-K public admission that it was engaging the bankruptcy process voluntarily to refinance its bonds, consensually engaging the acceleration and redemption. The court then rejected the approach taken in Momentive’s case, in which the New York courts implicitly equated redemption with prepayment and had demanded express and explicit mention of a premium due in the acceleration clause. Even if a make-whole payment is in essence a pre-payment deterrent, and the acceleration clause made the bonds due in full at or before the time of payment, “redemption” is not so time-sensitive a concept as “prepayment,” the court observed. It is entirely clear what sort of premium would be due upon such a redemption, the Third Circuit held, also challenging the New York courts’ position requiring greater specificity with respect to what “premium, if any” might be due upon bankruptcy-triggered acceleration.

The Second Circuit is likely to agree with the Third Circuit’s forceful reasoning and reject Momentive’s parallel attempt in New York to evade the make-whole premium. Even if it does not, at least that aspect of the debtor’s gambit can be avoided by careful advance drafting of bond indentures to describe quite specifically that a premium is due upon redemption of bonds even following acceleration, and even if that acceleration is triggered by a bankruptcy filing. As for the cram-up of low-interest replacement notes, it is not so easy to deny debtors the arbitrage benefit of paying a formula-based interest rate rather than market rates. While the principal of a fully secured debt is fully secure even in bankruptcy, future interest – a bond investor’s primary source of return – is not, unless the forced refinancing can be factored into the calculation of a carefully drafted make-whole premium.

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Jason Kilborn

Professor Jason Kilborn teaches business and commercial law at John Marshall Law School in Chicago.  His primary focus is on the comparative analysis of insolvency systems for individuals, though his interest extends to international bankruptcy as well. He recently co-authored a book on international co-operation in cross-border insolvency cases, published by Oxford University Press.

Jason Kilborn
Professor of Law
John Marshall Law School, Chicago
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T: +1 (312) 386 2860+1 (312) 386 2860
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