Triumph for Energy Future Noteholders in Third Circuit Make-Whole Decision

Background

Shortly after Energy Future Holdings Corp. and certain of its affiliates (the Debtors) filed for Chapter 11 protection in the Bankruptcy Court for the District of Delaware, sets of noteholders under a First Lien Indenture and a Second Lien Indenture (collectively, the Noteholders) commenced actions seeking a determination that they were entitled to so-called “make-whole payments” when their notes were repaid through bankruptcy court-approved refinancings in the bankruptcy cases. Make-whole payments generally provide for a lender to receive an agreed upon additional payment if its debt is repaid early to compensate the lender for the interest yield bargained for at the inception of the loan.

The make-whole provision in the Indentures was in a section captioned “Optional Redemption,” and provided that “[a]t any time prior to December 1, 2015, [the Debtor] may redeem all or a part of the Notes at a redemption price equal to 100% of the principal amount of the Notes redeemed plus the Applicable Premium . . . and accrued and unpaid interest[.]” The Indentures each provided for automatic acceleration upon a bankruptcy filing (albeit with slightly different wording),^[1] and that Noteholders were permitted to “rescind any acceleration [of] the Notes and its consequences[.]” Neither of the indentures expressly provided for payment of a make-whole amount upon the acceleration of the Notes due to a bankruptcy filing.

The Debtors argued that the make-whole payments sought by the Noteholders were “prepayment premiums” and that, under the plain language of the Indentures, no prepayment premiums were due. This is because, among other things, the debt was automatically accelerated on the bankruptcy filing date, so there was no “prepayment” triggering the make-whole clause and the refinancing was not “optional” because the Notes had matured as a result of the automatic acceleration. In other words, you cannot prepay a debt that is already due because of acceleration.

The Bankruptcy Court and, on appeal, the District Court, agreed with the Debtors. In so doing, the courts cited a line of cases that stand for the proposition that where an indenture does not expressly specify that a prepayment premium is owed following automatic acceleration upon a bankruptcy filing, such premium is simply not owed. Precise drafting is required. In addition, the courts found that repayment by a borrower after acceleration cannot, by definition, be voluntary.

The Third Circuit’s Opinion

The prepayment premiums at issue in the Energy Future Indentures were contractually triggered by “Optional Redemptions” – redemptions of all or part of the Notes on or prior to a date certain. Thus, in determining whether the make-whole payments were due, the Third Circuit had to consider two things (i) was the repayment made by the Debtors “optional” and (ii) was there a redemption prior to a date certain? The Third Circuit held in the affirmative on both counts.

According to the Third Circuit, on these facts a “redemption” occurs upon any repayment of the Notes on or before December 1, 2015, even if such repayment occurred post-maturity. In so holding, the Third Circuit disregarded the Debtors’ arguments that, in the make-whole context, the term redemption is intended to capture a voluntary “repurchase of a bond before maturity.” Decision at 14 (citations omitted) (emphasis added). Instead, the court cited to “New York and federal courts” which have held that ‘redemption’ [can] include both pre- and post-maturity repayments of debt.” Id. (citations omitted).  In an effort to distinguish state law precedent governing prepayments, the decision rests on a distinction by the court between “prepayments,” which occur pre-maturity, and “redemptions,” which (according to the Third Circuit) can occur any time, including after acceleration. Under the Third Circuit’s view of the difference between a “prepayment” (which connotes a payment before “maturity”) and a “redemption” (which, according to the Third Circuit’s view of New York law, can occur at any point in time regardless of maturity), if the make-whole premium in the indenture is triggered by a “prepayment,” the make whole payment would not be due upon a maturity date that was triggered by an acceleration unless the language of the indenture clearly provided that the make whole was payable even though the debt had matured.  This is because, absent the clarifying language, there cannot be a “prepayment” of debt that is contractually due and owing. Under this linguistic formulation, the payment is not a “pre” payment; it is simply a required payment. Significantly for the Third Circuit, however, the indentures at issue in Energy Futures did not tie the debtor’s obligation to pay the make whole to the debtor’s making a “prepayment” of the debt, but instead, tied the make whole to a “redemption” payment that occurred within a certain window of time. When the redemption occurred within that window, at least according to the Third Circuit, the acceleration of the maturity date of the debt upon bankruptcy was irrelevant to the issue of whether the make whole was due. In other words, under the indentures, the redemption was simply a payment that was made during a window of time that triggered a make whole, regardless of whether the “maturity date” had been accelerated.

On the second point, the Third Circuit determined that the refinancing of the Notes proposed by the Debtors were “voluntary” because the Debtors, of their own volition: (i) chose to file for bankruptcy protection, and (ii) opted to promptly refinance the Notes at a more favorable rate rather than delaying the refinance or preserving the option to be able to seek to reinstate the Notes at some later point in the case. In addition, nothing in the Bankruptcy Code compelled the Debtors to refinance the Notes and, in contrast to a situation where an indenture trustee is seeking to enforce its rights post-default, the Noteholders had sought to decelerate the Notes and were actively discouraging the “early” payment.^[2] The Third Circuit held that these facts, coupled with statements the Debtors had made in their public filings pre- and post-bankruptcy regarding their decision to redeem the Notes, clearly evidence that the refinancing was “voluntary.” The Debtors had a choice, and made it. However, the Third Circuit did not analyze the facts and circumstances precipitating the chapter 11 filing, or whether those circumstances compelled the chapter 11 filing as a matter of fiduciary duty, or otherwise, rendering the chapter 11 filing not voluntary. Nor did the Third Circuit discuss whether a cure and reinstatement pursuant to Section 1124 of the Bankruptcy Code was possible. This decision is a marked departure from a line of jurisprudence, cited to by the Debtors, which provides that post-bankruptcy payments of accelerated debt are not “voluntary redemptions or prepayments” because the debt is then due and payable by its terms.

Final Words

Regardless of whether the Third Circuit’s ruling in Energy Future is the right one, the decision emphasizes, once again, that precise drafting is critical. If the objective of the parties is for no prepayment premium to be charged in the event of automatic acceleration or other remedy following an event of default (bankruptcy or otherwise), best practices recommend that the indenture should explicitly state that the prepayment premium is not triggered in such circumstances. Prior to this ruling, the presumption was that no prepayment premium would be awarded upon acceleration unless expressly reserved for in the indenture. Following this decision, courts may be much more inclined to find a prepayment premium due by a chapter 11 debtor, notwithstanding the existence of ambiguous language or the fact that the debt has already matured due to automatic acceleration as a result of the bankruptcy filing, provided that the indenture (i) uses the term “redemption” rather than “prepayment” and (ii) permits deceleration or reinstatement.