Some term loans allow borrowers to redeem debt. But to protect a lender’s expected yield, such loans often impose a “make-whole premium” on redemption. That is, they require compensation to the lender for the borrower’s premature termination of interest payments.
A recent case asked the U.S. Court of Appeals for the Third Circuit to consider whether a make-whole premium must be paid on debt accelerated by the borrowers’ bankruptcy filing. Relying on the contractual language of the loans before it, the Third Circuit held that a make-whole premium must be paid on an accelerated debt when activation of an acceleration clause does not, by its terms, render a redemption clause inoperative.
In 2010, Energy Future Intermediate Holding Co. LLC and EFIH Finance Inc. (collectively, EFIH) borrowed roughly $4 billion. EFIH did so by issuing notes due in 2020 and secured by a first-priority lien on its assets. Later, in 2011 and 2012, EFIH obtained additional financing by issuing notes due in 2021 and 2022, respectively, which were secured by second-priority liens.
EFIH’s first- and second-lien notes are both governed by indentures that include optional redemption and acceleration clauses. The indentures’ optional redemption clause allows EFIH to redeem all or part of the notes at a price equal to 100 percent of the applicable premium amount plus a make-whole premium and accrued and unpaid interest. The indentures’ acceleration clause renders the amounts owed under the notes due and payable if EFIH files for bankruptcy. But the acceleration clause is not absolute: It permits noteholders to rescind acceleration.
In 2013, given favorable market conditions, EFIH considered refinancing its first-lien notes. Refinancing would have required EFIH to pay the make-whole premium. So instead, EFIH filed for bankruptcy in Delaware in an attempt to avoid that penalty (among other reasons). Specifically, EFIH asked the bankruptcy court to approve its borrowing of funds to pay off the first-lien notes and to settle with any noteholders who agreed to waive the make-whole premium. In a Securities and Exchange Commission (SEC) filing made shortly after its bankruptcy filing, EFIH reserved the right to redeem all or part of the second-lien notes but asserted that it was not under any obligation to do so.
Fearing loss of their expected yield, the first-lien noteholders filed an adversary proceeding against EFIH. That proceeding requested a declaratory judgment that (1) EFIH’s refinancing of its notes through bankruptcy would trigger the make-whole premium, and (2) the first-lien noteholders could rescind acceleration of the notes without violating the automatic stay. In light of EFIH’s SEC filing, the second-lien noteholders filed a similar lawsuit. When the bankruptcy court failed to rule, both sets of noteholders tried to rescind the acceleration of their notes.
In June 2014 and February 2015, the bankruptcy court granted EFIH’s requests to borrow funds and to refinance its debts. Pursuant to that authority, EFIH refinanced and paid off — less the make-whole premium — its first-lien notes and refinanced a portion of and paid down — less the make-whole premium — its second-lien notes. Then, in March and October of 2015, the bankruptcy court denied the first- and second-lien noteholders’ requests for declaratory judgments, ruling that EFIH did not have to pay a make-whole premium on its accelerated debt and that the noteholders could not rescind such accelerations. The district court affirmed these decisions, and the noteholders appealed to the Third Circuit.
The Third Circuit’s Holding and Rationale
In a largely textualist opinion, the Third Circuit vindicated the parties’ contractual language by reversing the decisions of the district court. The Third Circuit focused its analysis first on the indentures’ optional redemption clause, asking three questions: Was there a redemption by EFIH? Was the redemption optional? And, if yes to both, did that redemption occur before the optional redemption clause expired?
On the first question, because the indentures lacked a definition, the Third Circuit applied Black’s Law Dictionary and a long strand of New York cases to conclude that redemption encompasses both pre- and post-maturity payments. Thus, EFIH’s payment of its accelerated debt was a redemption under the indentures. On the second question, the Court of Appeals wrote that, although EFIH’s bankruptcy accelerated its debts, the company chose to file for bankruptcy. What’s more, a Chapter 11 debtor and a non-debtor have the same capacity to refinance their debts. So EFIH’s bankruptcies do not render its redemptions involuntary. On the third question, the Third Circuit simply noted that EFIH’s redemptions occurred before the optional redemption clause expired.
The Third Circuit next rebuffed EFIH’s argument that the indentures’ acceleration clause and optional redemption clause are incompatible. Each clause addresses a unique subject and is silent about the other, so it would be a false dichotomy to require the court to choose which to enforce. (EFIH’s second-lien notes bolstered this conclusion by including “premiums, if any” in the accelerated amount.) In this respect, the Third Circuit distinguished In re AMR Corp., 730 F.3d 88 (2d Cir. 2013), in which the Second Circuit — critically — considered a loan with an acceleration clause that explicitly obviated its make-whole clause in an event of default.
The Third Circuit also dismissed a New York state court case, Northwestern Mutual Life Insurance Co. v. Uniondale Realty Associates, 816 N.Y.S.2d 831, 836 (N.Y. Sup. Ct. 2006), as nonbinding, incompatible with decisions of New York’s highest court, and factually distinct. In Northwestern Mutual, the New York trial court found that a lender who chose to foreclose following a default on a mortgage loan was not entitled to a prepayment penalty. Redemption and prepayment are different, the Third Circuit noted. Namely — absent a clear clause to the contrary — redemption can occur at the point of a debt’s maturity but prepayment cannot.
Throughout its opinion, the Third Circuit stressed the actual contractual language of the indentures before it. That is no surprise, as federal courts strive “‘to give effect to the intent of the parties as revealed by the language of their agreement.’” 2016 WL 6803710 at *10 (quoting Chesapeake Energy Corp. v. Bank of N.Y. Mellon Trust Co., N.A., 773 F.3d 110, 113–14 (2d Cir. 2014)). For this reason, the Third Circuit’s opinion in Delaware Trust Co. v. Energy Future Intermediate Holding Co., LLC, is not as far-reaching as some commentators suggest. In short, if parties wish to avoid the incurrence of make-whole premiums on accelerated debt, the underlying contract must be clear on that point.