Make-whole premiums are much more likely to be enforced in the Third Circuit following that court’s recent opinion in In re Energy Futures Holdings Corp.^[1] The court reversed the decisions of the district and bankruptcy courts in Delaware and rejected the recent trend against enforcing such premiums exemplified by the opinion of the Bankruptcy Court for the Southern District of New York in Momentive.^[2] In doing so, the Third Circuit vindicated the yield protection in most bondholders’ documents by closing a potential loophole when bonds are “automatically accelerated” upon the borrower’s bankruptcy. It also provided an important clarification of New York law that excuses the need to explicitly provide for a make-whole premium due on redemption (in contrast to a prepayment premium) at or after acceleration due to default.

Make-whole premiums are a common yield protection feature of fixed rate bonds that remove a borrower’s incentive to refinance the bonds if interest rates drop. Many lenders, and especially insurance companies and other institutional investors, bargain for such premiums because they must carefully match investment income to maturing liabilities. Reduced interest rates have put these provisions to the test in several recent cases.

When they entered Chapter 11, Energy Future Intermediate Holding Company LLC and EFIH Finance Inc. (collectively, EFH), had over $4 billion face value in 10 percent first-lien secured bonds issued in 2010, as well as second lien bonds outstanding. By April 2014, interest rates had declined to the point where EFH could refinance its bonds at 4.25 percent and save nearly $13 million in interest payments a month, if it could avoid the costly make-whole premiums due under each of its bonds.

Energy Futures Holdings Corporation sought to follow the strategy laid out in Momentive to refinance both series of bonds during bankruptcy. Momentive allowed a borrower to avoid paying an expensive prepayment premium by filing a strategic Chapter 11 bankruptcy in New York to automatically accelerate its indebtedness and then rely on the lack of an unambiguous requirement that the prepayment premium remains payable after acceleration. The Delaware bankruptcy court allowed EFH to refinance its bonds, but the declaratory judgment proceedings by the indenture trustees to determine the right to a make-whole premium remained pending. Until reaching the Third Circuit, it looked like the strategy had succeeded for EFH.

Both the bankruptcy and district courts followed the analysis of the Momentive decision, holding that EFH did not have to pay the make-whole premiums because the similarly worded bond indentures at issue did not unambiguously require payment of the premium following acceleration. They held that § 3.07 of the indentures, which governed the payment of the make-whole premium following an “optional redemption” of the bonds prior to stated maturity, did not apply following the automatic acceleration of the indebtedness under the bonds upon a bankruptcy filing under § 6.02 of the indentures. They accepted Momentive’s rationale that redemption of the bonds was no longer optional after such acceleration. They also accepted the rationale that a “redemption” only applied to repurchases of bonds before maturity. According to Momentive, repayments following acceleration were no longer payable prior to maturity.

The Third Circuit reversed and specifically rejected the rationale and holding of Momentive. First, the court was not persuaded that EFH’s voluntary bankruptcy rendered payment of its bonds to be involuntary rather than “optional.” It cited a series of SEC filings that EFH made several months before it filed for bankruptcy in which EFH laid out its strategy for avoiding the make-whole premiums. The court also noted that EFH had the option under Section 1124 of the Bankruptcy Code to reinstate the bonds and EFH resisted the bondholders’ attempt to avoid the make-whole by seeking relief from the automatic stay to de-accelerate the bonds postpetition. Second, the Third Circuit rejected EFH’s argument that a “redemption” had not occurred. The New York Court of Appeals had binding precedent that a redemption occurs when a debt security is prepaid both before and after it matured.^[3] This broader definition of redemption distinguished several cases that held that, when a creditor accelerates the debt after default, it gives up the right to collect a prepayment premium absent an explicit preservation of that right.^[4] The Third Circuit did not require explicit reference to “premium” in the acceleration provisions of the senior indenture. The Third Circuit found additional evidence of intent that the make-whole provisions for the second lien bonds was to remain applicable after acceleration because the second lien bond indenture referred to the obligation to pay “premium, if any” after acceleration. Finally, the court rejected the argument that the failure of EFH to refinance by following the specified redemption procedure created a loophole from paying the make-whole premium due on redemption. Accordingly, EFH was obligated to pay the make-whole premium on both series of bonds.

Ultimately, the Third Circuit was most concerned about preserving the benefit of the bondholders’ bargain. EFH had broadcast loud and clear its intention to refinance its debt while using the bankruptcy process to avoid paying the make-whole premium. Calling EFH’s refinancing anything other than optional would have been to miss the forest for the trees, and the court interpreted the bond indentures in that context.

After Energy Futures, holders of bonds issued under the older forms should rest easier knowing that a borrower will have a harder time avoiding a make-whole payment due on redemption by refinancing through a Chapter 11 proceeding. While some standard note purchase forms address the Momentive rationale,^[5] creditors seeking to preserve a prepayment premium should explicitly provide for the payment thereof after acceleration to avoid what the Third Circuit called a “linguistic paradox created by the idea of a prepayment following acceleration.”^[6] Explicit preservation of a make-whole or prepayment premium after default also may be useful in situations where New York law is not applicable.

^{[1] Delaware Trust Company v. Energy Future Intermediate Holding Company, et al. (In re Energy Future Holdings Corp.), Case No. 16-1351 (3rd Cir., November 17, 2016) (“Energy Futures”).}

^{[2] See, e.g., In re MPM Silicones, LLC, 2014 WL 4436335, No. 14-22503 (Bankr. S.D.N.Y., Sept. 9, 2014) (“Momentive”).}

^{[3] Energy Futures, Slip Op. at 15, citing Chesapeake Energy Corp. v. Bank of N.Y. Mellon, 773 F.3d 110, 116 (2d. Cir 2014).}

^{[4] Energy Futures, Slip. Op at 23, distinguishing Nw. Mut. Life Ins. Co. v. Uniondale Realty Assoc., 816 N.Y.S.2d 831 (N.Y. Sup. Ct. 2006) and other cited cases nullifying a prepayment premium after acceleration of notes.}

^{[5] For example, Model Form No. 2 (January 13, 2016) promulgated by the American College of Investment Counsel, explicitly provides for the payment of a make-whole premium if principal “has become or is declared to be immediately due and payable” following a default including a bankruptcy event that triggers automatic acceleration. See http://aciclaw.org/model-form/npa-model-form-no-2.}

^{[6] Energy Futures, Slip Op. at 25.}