Make-Whole Provisions and Bankruptcy
Make-whole provisions may be unenforceable where a bankrupt company is trying to restructure its debts and reemerge from bankruptcy.
A “make-whole provision” is an obligation for a borrower under a loan that is being repaid early to reimburse the lender for the interest payments the lender will lose because the loan will not run for the full term.
The ability to enforce make-whole provisions may depend on where the bankrupt company is located.
A Delaware bankruptcy judge ruled in November 2022 that a make-whole premium owed by Hertz Global could not be enforced because the premium represented unmatured interest, which is statutorily disallowed under the US bankruptcy code.
The Hertz decision follows a string of decisions in other jurisdictions disallowing make-whole provisions.
For example, a US appeals court for the fifth circuit held in In re Ultra Petroleum Corporation in mid-October 2022 that claims rooted in make-whole provisions can be disallowed. The fifth circuit covers Mississippi, Louisiana, Texas and the Canal Zone. The bankruptcy courts are increasingly hostile toward make-whole provisions, particularly in the context of insolvent debtors.
Make-whole clauses are pervasive in high-yield financings and project bonds. They require payment by the borrower of a lump-sum premium to the lender upon an early redemption or prepayment of a loan. The premium is typically a sum calculated to provide the net present value of the interest payments that lenders forego because of an early redemption or prepayment.
The sums protected by make-whole clauses are not trivial. In the Hertz and Ultra Petroleum cases, the make-whole premiums were approximately $223 million and $203 million, respectively.
Arguments over the propriety of make-whole provisions are nothing new. US appeals courts in the second and third circuits have issued conflicting decisions concerning the validity of make-whole provisions in chapter 11 (bankruptcy restructuring) cases, but the decisions focused on the specific loan terms and not the US bankruptcy code aspects.
The fifth circuit court is the first US appeals court to assert the invalidity of make-whole provisions in insolvent-debtor bankruptcy proceedings on grounds that the premium is unmatured interest that is not allowed under the US bankruptcy code.
There will be significant consequences if other appeals courts adopt the same reasoning.
It could lead to forum shopping by distressed enterprises. 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 and project bondholders when the debtors they lend to become insolvent. Lenders may price in the probability of a borrower filing for bankruptcy in a jurisdiction that disallows make-whole provisions, raising the cost of credit for high-yield and project bond capital users.
It is important to note that make-whole provisions continue to be enforceable and valuable tools when bonds with call options or similar features are called before maturity. Thus, make-whole provisions are unlikely to see diminished use any time soon. The issue becomes how to protect lenders and fixed-rate investors from potential denial in bankruptcy proceedings.
Lenders and fixed-rate investors need to begin preparing now for the impact of the disallowance of make-whole provisions.
There are two ways for lenders and fixed-rate investors to protect themselves from make-whole disallowance risk.
Lenders could take make-whole disallowance risk into account in pricing. 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 be a more attractive solution if the market can be coaxed into offering it. The borrower 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.
Insurance offers two distinct advantages to raising rates across the board to compensate for make-whole disallowance risk.
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, insurance 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 the financial markets will provide a product like this.