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Recovery of Make-Whole Premiums in Bankruptcy After Momentive Performance and Energy Future Holdings

Navigating Varying Court Interpretations of Prepayment Premium Provisions; Guidance for Drafting Loan Documents and Indentures

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific TUESDAY, MAY 3, 2016

Melinda Franek, Vice President & Deputy General Counsel, CNH Partners, Greenwich, Conn. Jennifer Harris, Special Counsel, Milbank Tweed Hadley & McCloy, Los Angeles Melainie K. Mansfield, Partner, Milbank Tweed Hadley & McCloy, Los Angeles

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Recovery of Make-Whole Premiums in Bankruptcy After Momentive Performance and Energy Future Holdings

Disclosures

The views and opinions expressed herein are those of the authors and do not necessarily reflect the views of AQR Capital Management, CNH Partners, Milbank, Tweed, Hadley & McCoy LLP, or their respective affiliates and employees.

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General Considerations

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Topics To Be Covered

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• Differing approaches taken by bankruptcy courts in analyzing enforceability of

make-whole provisions

• Momentive Performance and Energy Future Holdings guidance on

enforceability of make-whole provisions

• Best practices for lenders and bondholders to protect their entitlement to make-

whole premiums

Premise of Make-Whole / Yield-Maintenance Provisions

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• Make-whole provisions require a borrower to include a premium when prepaying debt, in

addition to principal and accrued interest. The premium is intended to compensate lenders for the lost income stream from future interest that would have accrued but for early repayment (i.e., to make lender whole).

• Also referred to as “prepayment penalties,” “prepayment premiums,” “prepayment fees,”
• r “optional redemption” clauses.
• Lender Protection: Rather than prohibiting repayment, make-whole provisions are

designed to discourage borrowers from repaying debt as soon as credit markets move in their favor.

• Historically, more prevalent in bond markets and on other long term debt where investors

seek long term deployment of capital at fixed rates. Now, becoming more common in loan market.

Premise of Make-Whole / Yield-Maintenance Provisions

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• Examples of types of make-whole provisions:

– Fixed Percentage: premium is expressed as a fixed, certain dollar amount or, more typically, a fixed percentage of the principal amount to be repaid (e.g. 103%). – Net Present Value: formula-based make-whole premium that measures the difference between the lender’s expected return through a specified date (which could be maturity) and a hypothetical, alternative investment stream (formula could include a minimum rate of return to ensure make-whole premium is not zero or a negative value).

Other Protections Designed to Protect Lender Against Early Repayment of Debt

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• No call – an express provision prohibiting prepayment of bonds until maturity. (Note,

“perfect tender” rule (NY) common law.) No-call provisions are generally unenforceable in bankruptcy (conflicts with Chapter 11 inhibiting restructuring), although damages claims are sometimes permitted for breach of contract.

• “Hard” call – sets a specific date after which the borrower can repay the bonds with

premium in all circumstances.

• “Soft” call – does not prevent the bonds from being repaid but pays the investor a

premium for repricing or refinancing events.

• Change of control or fundamental change premiums.
• OID (original interest discount): difference between the face amount of the debt issued

and the cash actually received by the debt issuer. – This amount amortizes over the term of the debt and thus resembles interest accrual. Often treated as interest in bankruptcy. Not a make-whole per se, but raises related issues.

Considerations for Drafting

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• Time period over which make-whole premium applies? Is it a make-whole to maturity or
• nly through a shorter period of time (e.g., to the end of the first year)?
• What is the amount and how is it calculated? Beware of computation issues if a floating

rate loan; NPV discount.

• Triggers for make-whole payment, e.g., does a repayment or refinancing in bankruptcy

qualify as a voluntary prepayment or redemption under the terms of the debt documents? What effect does mandatory vs. voluntary pre-payment have?

• Market practice.

Bankruptcy Considerations for Make-Whole Premiums

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Bankruptcy Considerations for Make-Wholes

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Acceleration Analysis

• In bankruptcy, debt is automatically accelerated to the date the company filed for
• bankruptcy. In addition, contracts typically provide for automatic acceleration of debt

following a bankruptcy filing.

• If the debt is accelerated, is there still a valid claim for payment of a make-whole premium

under the agreement (which protected a lender’s expectation of future income streams)? – Example: “Acceleration. If an Event of Default . . . occurs and is continuing, the Trustee by notice to the Company . . . may . . . declare the principal of, premium, if any, and accrued and unpaid interest, if any, on all the Securities be due and payable. Upon such a declaration, such principal, premium and accrued and unpaid interest shall . . . be immediately due and payable”

Bankruptcy Considerations for Make-Wholes

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Interest Analysis:

• Is the make-whole premium merely a proxy for a claim for unmatured interest? Or is it

simply liquidated damages?

• RULE: A claim for “unmatured interest” is disallowed under the Bankruptcy Code. See 11

U.S.C. § 502(b)(2). – “Unmatured interest” is defined as interest that has not yet accrued as of the date a debtor filed for bankruptcy. – However, most courts view make-whole premiums as liquidated damages, subject to Section 506(b) of the Bankruptcy Code.

• OID: Section 502(b)(2)’s legislative history makes clear that prepaid interest that

represents an original discounting of the claim may be included within the meaning of unmatured interest.

Bankruptcy Considerations for Make-Wholes

• Notwithstanding the general rule disallowing claims for unmatured interest, a claim for a

make-whole premium may still be enforced depending on whether the creditor is “over-secured,” “under-secured,” or “unsecured.”

• A lender is “over-secured” if the debt owed to such lender is less than the value of the

collateral securing that debt. Likewise, a lender is under-secured if the debt owed to such lender exceeds the value of the collateral securing that debt. A lender is unsecured if the debt owed to such lender is not secured by any collateral.

• Make-Whole premiums may be permitted if:

– The claim is not considered unmatured interest, but a reasonable fee or charge on the underlying principal (e.g., represents liquidated damages) and the lender is over- secured; or – Whether or not the lender is over-secured, if the debtor borrower is solvent upon emergence.

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Leading Cases: Southern District of New York

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Leading Cases: SDNY

• In re Calpine Corp. (Calpine I),

365 B.R. 392 (Bankr. SDNY 2007) (unsecured claim for breach of contract).

• In re Solutia Inc.,

379 B.R. 473 (Bankr. SDNY 2007) (bondholders gave up right to future income in exchange for immediate right to collect).

• In re Calpine Corp. (Calpine II),

2010 U.S. Dist. LEXIS 96792 (SDNY 2010) (no-call provisions are unenforceable in bankruptcy and damages cannot flow from unenforceable provision).

• In re Chemtura Corp.,

439 B.R. 561 (Bankr. SDNY 2010) (settlement met lowest range of reasonableness).

• In re AMR Corp.,

2013 Bankr. LEXIS 239 (Bankr. SDNY 2013) (“but for avoidance of doubt;” untimely motion to lift stay to decelerate) .

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Leading Cases: Delaware

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Leading Cases: Delaware

• In re Trico Marine Services,

450 B.R. 474 (Bankr. Del. 2011) (make-whole is not unmatured interest but at best an unsecured claim for damages).

• In re School Specialty, Inc.,

2013 WL 1838513 (Bankr. Del. 2013) (make-whole is enforceable where (a) there is express language, (b) actual damages difficult to determine, (c) sum is not plainly disproportionate to loss).

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Leading Cases: Other Jurisdictions

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Leading Cases: Other Jurisdictions

• In re Premier Entertainment Biloxi,

445 B.R. 582 (Bankr. SD Miss. 2010) (in a solvent debtor case damages for breach of no-call may be allowable).

• In re South Side House,

2012 BL 26024 (E.D.N.Y. Jan. 30, 2012) (mortgage note was subject to prepayment premium if debtor paid balance before termination; bankruptcy court disallowed, reasoning that debtor never attempted to tender).

• In re GMX Resources,

Case No. 132-11456 (Bankr. W.D. Okl. 2013) (unambiguous language in indenture provided for make-whole).

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Recent Matters

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Momentive Performance Materials

14-22503-RDD (Bankr. SDNY 2014)

• The debtors commenced an adversary proceeding against the indenture trustees for

the1L and 1.5L notes, seeking declaratory relief that the indentures did not require payment of a make-whole premium upon an automatic acceleration resulting from the bankruptcy filing.

• The trustees argued they were contractually entitled to a make-whole based on the

express terms of the indenture or, in the alternative, should be awarded damages for: (i) breach of the no-call provision, (ii) breach of the common law entitlement to repayment only on the agreed-upon maturity date (the “perfect tender” rule), or (iii) denial of their ability to rescind the automatic acceleration.

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Momentive Performance Materials

14-22503-RDD (Bankr. SDNY 2014)

• The Bankruptcy Court found that the indentures lacked language that clearly and

specifically provided for the payment of the make-whole, notwithstanding automatic acceleration of the debt.

• The Court concluded that the distributions to be made pursuant to the plan did not

constitute a voluntary prepayment or optional redemption of the notes.

• In addition, the noteholders forfeited their right to demand the debtors’ performance under

the common law “perfect tender” rule, as the relevant indentures provided for automatic acceleration on a bankruptcy filing, thereby altering that default common law rule as a matter of contract.

• The Court expressed frustration that the holders did not accept the settlement offer

embedded in the plan (par plus accrued in cash in exchange for waiving right to make- whole premium).

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Momentive Performance Materials

14-22503-RDD (Bankr. SDNY 2014)

• Any payment made after acceleration of the maturity was not considered a “prepayment”

absent specific language making the prepayment penalty applicable.

• To avoid this result under NY law, there must be clear and unambiguous language in the

relevant indentures providing that a make-whole premium is due upon (and notwithstanding) the automatic acceleration resulting from the bankruptcy filing. – However, this leaves lenders in the untenable position of either forfeiting yield protection or running afoul of the automatic stay.

• The Bankruptcy Court further held that, even assuming there was a breach of the no-call

provision and perfect tender rule (or based on denial of the noteholders contractual right to rescind acceleration), such claim would be barred by section 502(b)(2)’s prohibition against unmatured interest.

• Relatedly, the Court held that the automatic stay prohibited the 1L and 1.5L noteholders

from rescinding the automatic acceleration and denied the trustees’ motion to lift the automatic stay as this would enhance the noteholders’ claims by hundreds of millions of dollars to the detriment of the estate and other creditors.

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Momentive Performance Materials – District Court Appeal

14-CV-07471 (SDNY 2015)

• On appeal, the SDNY rejected the noteholders’ arguments and affirmed the Bankruptcy

Court’s decision.

• Payment of a debt upon acceleration is not presumed to be a “prepayment” or early

redemption.

• Noteholders must explicitly and unambiguously contract for their desired result; language

that provided for payment of a “premium, if any” upon acceleration was ambiguous, at best.

• The District Court distinguished these circumstances from those in Chemtura, finding the

reference to a date certain (October 15, 2015) did not meet the explicitness requirement that was discussed in that case. The1L and 1.5L noteholders bargained for acceleration in the event of a bankruptcy filing, and must live with the consequences of that bargain.

• Finally, the Court noted that the automatic stay is part of the backdrop of bargained for

rights and, here, the fact that it prohibited the noteholders from rescinding the acceleration did not by itself constitute a breach of contract by the debtors.

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EFIH (TXU)

(Bankr. Del. 2014)

• The Bankruptcy Court bifurcated the make-whole litigation.
• First phase covered make-whole claims and any other potential redemption claims such

as breach of the no-call provisions or damages arising under the perfect tender rule.

• First phase also covered whether debtors intentionally defaulted in order to avoid a make-

whole.

• For phase one, the Court assumed the debtors were solvent and able to pay allowed

claims in full.

• If the notes were entitled to a redemption claim, phase two would cover the amount of the

claim and whether insolvency (if asserted by debtors) provides a basis for disallowing or limiting the redemption claim.

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EFIH (TXU)

(Bankr. Del. 2014)

• The Bankruptcy Court concluded that the notes automatically accelerated upon a

bankruptcy filing.

• Under the plain language of the indenture, EFIH’s repayment of the first lien notes did not

trigger a make-whole. In addition, the language in the second lien indenture was not sufficiently explicit.

• New York law requires “express language requiring payment of a prepayment premium

upon acceleration; otherwise, it is not owed.”

• Any attempt to decelerate the first lien notes would violate the automatic stay and “cause”

did not exist to lift the automatic stay to permit the indenture trustee to take these actions.

• The hardship to the noteholders by maintenance of the automatic stay was, at most, equal

to the hardship to EFIH from lifting the automatic stay.

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EFIH (TXU) – District Court Appeal

(D. Del. 2015)

• The District Court concluded that:

– Neither the first lien nor second lien indenture provided for payment of a make-whole after acceleration. – The Bankruptcy Court did not abuse its discretion in denying the request to lift the stay. – Took under advisement, but ultimately concluded that the bar imposed by the automatic stay (prohibiting the noteholders from rescinding acceleration) did not permit a claim for damages.

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Automatic Stay Issues

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Automatic Stay Issues

• Cause to lift the stay:

– Whether any great prejudice to either the bankrupt estate or the debtor will result from a lifting of the automatic stay; – Whether the hardship to the non-bankrupt party by maintenance of the automatic stay considerably outweighs the hardship to the debtor; and – The probability of the creditor prevailing on the merits.

• Issues for consideration:

– Competing creditor’s interests? – Equity’s interest? – Solvent debtor – does it change the analysis? – Absolute priority rule? – Possibility for inequitable results?

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Lessons From Precedent Cases

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Lessons from Precedent Cases

• The express language of the debt instrument is the single most important factor in the

analysis.

• Courts tend to enforce make-whole provisions that unambiguously state they apply

following a bankruptcy filing.

• Any ambiguity is generally decided against the lender or investor.
• Ways to increase likelihood of enforceability:

– Draft make-whole provision that by its specific terms survives automatic acceleration caused by a bankruptcy filing. – Draft make-whole provisions as penalties to be added to principal upon default. – Draft premiums using NPV discounts as a more reasonable measure of harm. – State explicitly that make-whole provisions are triggered upon every prepayment, even if during a no-call period or after early (accelerated) maturity. – Include a cumulative remedies provision if permitted by law.

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Lessons from Precedent Cases

• Other questions/considerations:

– Is the make-whole unmatured interest subject to disallowance under §502(b)(2) of the Bankruptcy Code and relevant case law? – Is the debtor solvent? – Does the stated premium amount to an impermissible penalty or is it a reasonable liquidated damages claim? – Can the payment be considered a voluntary “redemption” rather than payment following acceleration? – Timely enforcement of rights (AMR). – Is there any reason for the lender to be perceived as a bad actor (Momentive)?

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Thank You

Melinda Franek CNH Partners mfranek@cnhpartners.com Jennifer Harris Milbank Tweed Hadley & McCloy jharris@milbank.com Melainie K. Mansfield Milbank Tweed Hadley & McCloy mmansfield@milbank.com

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