By its very nature, the world of distressed investing is
constantly changing. However, significant trends have recently
emerged in the sector that will affect fund managers.
The first is a shift in the legal status of make-whole call
provisions ("make-wholes") due to a pair of court
rulings. Make-wholes typically allow the borrower in a bond
issuance to prepay the remaining fixed-rate term debt using an
additional lump-sum payment based on the net present value of
future coupon payments. The provisions are standard inclusions in
both investment-grade and high-yield indentures, yet they are
seldom invoked, since the potential cost to the borrow can be
prohibitive.
However, since distressed debt – and the potential for large
returns – is a popular investment target for hedge funds and
other private investment funds, make-whole provisions remain an
important consideration for fund managers.
Two recent bankruptcy court decisions have cast a significant
measure of doubt over the continued viability of make-wholes. In
the first, the U.S. District Court for the Southern District of New
York rejected lenders' appeals of a bankruptcy court decision
that approved the Chapter 11 plan to reorganize MPM Silicones. In
doing so, the court upheld the previous decision that senior
secured lenders of the private equity-backed company would be
denied approximately $200 million in make-whole payments they
believed they would be owed. The decision stated that the bond
indenture did not include language that was specific enough
outlining the terms or circumstances that would warrant a
make-whole payment in the event of a bankruptcy acceleration.
In another prominent case, the judge overseeing the restructuring
of Energy Future Holdings ("EFH") ruled that the
repayment in full of senior secured notes in that case did not
trigger a requirement to pay a make-whole premium. Bankruptcy Judge
Christopher Sontchi's ruling stated that "under New York
law, an indenture must contain express language requiring payment
of a prepayment premium upon acceleration; otherwise, it is not
owed."
Essentially, these decisions established that make-wholes must be
clearly and explicitly described in indentures, representing a
departure from the previous discussions in decisions related to the
provisions. This apparent shift in the state of the law raises
several issues that warrant careful consideration for debtors and
creditors alike when evaluating the reliability of such provisions.
First, is the make-whole clearly payable under the indenture? Put
another way, is it clear and unambiguous that a make-whole is
payable even after an acceleration? Furthermore, is the make-whole
reasonable? There are two levels of analysis used to establish this
– under state law and the Bankruptcy Code; however, the
matter ultimately comes down to whether the amount of the make
whole is a reasonable approximation of the harm suffered by the
prepayment. There is also the potential for double counting of a
make- whole, based on the language of the indenture
agreement.
The second issue that has emerged relates to post-position
interest ("PPI"), which accrues after the commencement of
a bankruptcy, insolvency or reorganization case, as outlined in the
Bankruptcy Code. The evolution of this subject again comes out of
the EFH proceedings. Previously, it was fairly well-settled in
numerous cases that in a solvent debtor case, unsecured creditors
are entitled to PPI. While there was a split in how the interest
should be calculated, creditors generally assumed that if debtors
were solvent, they would receive interest. However, that belief has
recently been turned upside down.
Judge Sontchi's ruling held that PPI is not an essential part
of an unsecured creditor's claim under a Chapter 11 plan.
Specifically, he held that (i) the allowed amount of the claim
under 502(b) does not include PPI; (ii) to the extent 726(a)(5)
applies, "the legal rate" means the federal judgment
rate; (iii) unimpairment does not require paying any PPI; and (iv)
the "fair and equitable" requirement in 1129(b) does not
require payment of PPI to unsecured creditors just because a junior
class is receiving a distribution. He also held, however, that the
court has the discretion in its equitable power to require the
payment of PPI at some rate to be determined by the court. This
decision flips the presumption: Now the creditor is required to
prove that it is entitled to PPI payments.
These decisions highlight that the law related to make-wholes and
PPI remains unsettled and many long-held assumptions are now being
challenged as a result. Indentures written prior to these decisions
were likely based upon the previous understanding of the law. Now
that it is changing, distressed investors should take note.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
