Earlier this year the U.S. Court of Appeals for the Fifth Circuit added another take on “make-whole provisions” in bankruptcy law when it held that, absent language to the contrary, prepayment penalties may not be included in the claims of lenders who accelerate their borrowers’ notes.1 “Make-whole provisions”, and related “no-call provisions”, are important mechanisms that provide protection for lenders seeking to ensure returns on their loans.2 While “no-call provisions” simply prohibit a borrower from paying a loan before its due date, “make-whole provisions” “permit prepayment only in conjunction with the payment of a premium as proxy for the anticipated yield.”3 Premiums are commonly calculated in one of two ways, either as a fixed percentage of the remaining balance, or as “an estimate of the lender’s loss of the remaining interest payment stream.”4
Whether “make-whole provisions” are allowable under the bankruptcy code is both a common issue in bankruptcy litigation, and also the source of a split among bankruptcy courts.5 Once filed, a bankruptcy petition automatically accelerates the debts of the petitioner.6 At the same time, Section 502(b)(2) of the Bankruptcy Code explicitly disallows a claim “to the extent that . . . such claim is for unmatured interest.”7 The intersection of these two bankruptcy provisions—the automatic acceleration of debts and the disallowance of unmatured interest—highlights the uncertain role of “make-whole provisions” in bankruptcy. In some instances, courts have held that the amount owing upon acceleration is only the principal of the loan, and any prepayment penalty represents disallowed unmatured interest.8. A majority of circuits, however, have held that “make-whole provisions” are simply allowable liquidated damages.9
Yet in In re Denver Merchandise Mart, the Fifth Circuit reminds lenders and those drafting lending agreements that thoughtful contract drafting can, in at least some jurisdictions, provide a way around the thorny issue of “make-whole provisions” and allowable bankruptcy claims. The note in Denver Merchandise included both a “make-whole provision” and an acceleration clause, wherein the debtor agreed to pay “all sums, as provided in [the] Note” or “all other moneys agreed or provided to be paid by Borrower in [the] Note.”10 When the debtor filed for Chapter 11 bankruptcy, the lender included in its claim a $1.8 million prepayment penalty as a sum “provided in the note”.11 The debtor challenged that amount as disallowed unmatured interest, giving rise to the recent litigation.12
In resolving this dispute, the Fifth Circuit turned to contract interpretation.13 Under “general Colorado law”, a lender who chooses to accelerate a loan is not entitled to a prepayment premium.14 However, a lender can avoid this result with the proper language—an outcome the Denver Merchandise court found “not difficult to achieve.”15 The court included the following language from a note in a separate case where a prepayment penalty was included in the lender’s claim: “The undersigned [borrower] agrees that if the holder of this Note [lender] accelerates the whole or any part of the principal sum . . . the undersigned waives any right to prepay said principal sum in whole or in part without premium and agrees to pay a prepayment premium.”16 Had the lender in Denver Merchandise included similar language in its note, upon acceleration of that note the prepayment penalty would have been similarly included.17
In sum, Denver Merchandise serves as a reminder that in some instances thoughtful contract drafting can serve to preempt otherwise challenging disputes. And, though business lenders such as the bank in Denver Merchandise are certain to take note of its holding, Denver Merchandise should have an impact wherever similar “make-whole provisions” arise.
In re Denver Merch. Mart, Inc., 740 F.3d 1052 (5th Cir. 2014). ↩
Ryan M. Murphy, Great Expectations: Chemtura Revisits the Treatment of “Make-whole” and “No-call” Provisions Under the Bankruptcy Code, 20 J. Bankr. L. & Prac. 6 Art. 6 (2011). ↩
Id. ↩
Matthew I. Knepper, Lipstick on a Pig: Disallowing Make-Whole Clauses as Unmatured Interest, 31-JAN Am. Bankr. Inst. J. 40, 40 (2013). ↩
Id. ↩
Daniel J. Carragher, When 100% is Not Enough: Post-petition Accruals on Oversecured Claim, 24-AUG Am. Bankr. Inst. J. 28, 28 (2005). ↩
11 U.S.C. § 502(b)(2) (2014). ↩
See In re Manville Forest Products Corp., 43 B.R. 293 (Bankr. S.D.N.Y. 1984), aff’d in part, rev’d in part, 60 B.R. 403 (S.D.N.Y. 1986); See also In re Ridgewood Apartments of DeKalb County, Ltd., 174 B.R. 712, 712 (Bankr. S.D. Ohio 1994). ↩
Knepper, supra note 3, at 40 (citing In re Trico Marine Services Inc., 450 B.R. 474, 480 (Bankr. D. Del. 2011) (“The substantial majority of courts . . . have concluded that make-whole . . . obligations are in the nature of liquidated damages rather than unmatured interest”). ↩
Denver Merchandise, 740 F.3d at 1052) (emphasis added) (internal quotation marks omitted). ↩
Id. ↩
Id. ↩
Id. ↩
Id. ↩
Id. ↩
Id. (quoting In re CP Holdings, Inc., 332 B.R. 380, 382 (Bankr. W.D. Mo.) (emphasis added) aff’d, 206 F. App’x 629 (8th Cir. 2006) ). ↩
Id. ↩