Treatment of make-whole provisions in AMR Corp. Chapter 11 case raises new concerns for lenders
March 2013 | SPECIAL REPORT: DISTRESSED M&A AND INVESTING
Financier Worldwide Magazine
Make-whole premiums are intended to compensate financiers, typically bondholders under an indenture, for the loss of future interest payments in situations where, due to declining market interest rates, a debtor elects to repay its debt obligations early. Without such protection, bondholders would suffer losses in reinvesting the prepaid funds at the lower prevailing market interest rates. Thus, trust indentures typically contain make-whole protections to prevent a borrower from refinancing debt as interest rates drop without compensating bondholders for lost interest.
However, trust indentures typically draw a distinction between a borrower’s voluntary early redemption and acceleration of principal due to a borrower’s default, either by a missed payment or automatically upon the borrower’s filing of a bankruptcy petition under an ‘ipso facto’ clause. In the latter case, a make-whole premium may not be due since the financiers, and not the borrower, are forcing early repayment.
The issue becomes murkier where a United States Chapter 11 borrower chooses to pay off debt early, not because it is required to do so as it liquidates its assets, but rather to refinance its debt at lower interest rates. In such circumstance, bondholders and borrowers frequently litigate over the scope of the make-whole protection with varying outcomes.
In the US Airways, Solutia, and Calpine reorganisations, the courts held that automatic acceleration of debt under an ipso facto clause negates any right to a make-whole premium absent any clear contractual language to the contrary. This is true even if the bondholders had the ability to decelerate payment of principal. The Solutia court held such an attempt by a creditor to exercise the deceleration clause following the automatic acceleration upon a bankruptcy filing would violate the automatic stay. The Solutia court explained that such an attempt would, in effect, increase a creditor’s claim contrary to the clear contractual language that negated payment of a make-whole premium.
The Bankruptcy Court’s decision in American Airlines
Last October, American sought authority in its reorganisation to refinance $1.5bn in enhanced equipment trust certificate (EETC) debt secured by aircraft, with interest rates ranging between 8.6 and 13 percent, in favour of lower rates now available in the market. The financed aircraft were all subject to elections made pursuant to section 1110(a) of the Bankruptcy Code that required American to ‘agree to perform’ certain obligations under the EETC financings, namely, pay current debt service and comply with other current obligations, such as aircraft maintenance, to keep the automatic stay in place. American sought to use the proceeds from the new EETC financing to repay the prepetition aircraft obligations without payment of the prepayment premium, or ‘make-whole’ amount. American believed it would save over $200m in interest costs due to the lower interest rates obtained through the refinancing.
Not surprisingly, the indenture trustees for the EETC financings objected to repayment of the prepetition financings without payment of the make-whole amount, arguing that American’s election to refinance at lower interest rates was a ‘voluntary’ redemption which required payment of the make-whole premium.
On 17 January 2013, the American Airlines bankruptcy court followed the US Airways, Calpine, and Solutia line of cases and held that the debtors were not required to pay a make-whole premium upon refinancing of $1.5bn in aircraft debt.
In particular, the bankruptcy court noted that the clear language of the indentures provided that the voluntary bankruptcy filing acted to automatically accelerate the debt and, that upon such acceleration, no make-whole payment was due. The court dismissed the argument that American’s refinancing amounted to a ‘voluntary’ redemption under the terms of the indenture. Although American sought refinancing to take advantage of more favourable interest rates, American only did so after its debt obligations were already automatically accelerated. Accordingly, American’s repayment would be a ‘post-maturity date repayment’, and not a ‘prepayment’ of the debt obligations.
Following the rationale in Solutia, the bankruptcy court also dismissed the argument that the indenture trustees could elect to waive the event of default and decelerate the debt. The court stated that any deceleration of the notes would be barred by the automatic stay. Moreover, the court found that lifting the stay to allow such a deceleration would not be appropriate where the sole purpose of the creditor appears to be to increase the size of its claim and where the creditor already has adequate protection.
Furthermore, the bankruptcy court held that the automatic acceleration clause was not an unenforceable ipso facto clause. Following the recent decision by the district court in the General Growth Properties reorganisation, the American Airlines court held that whether a default clause should be invalidated as an ipso facto clause depends on whether the contract at issue is ‘executory’. The court found that the indentures were not ‘executory contracts’, a point conceded by the indenture trustees, and accordingly, 365(e) did not apply to invalidate the default provision in the indenture.
Finally, the court disagreed that American’s election pursuant to section 1110 of the Bankruptcy Code mandated payment of the make-whole amount. The court noted that while section 1110 provides aircraft financiers with special protections if a debtor elects to continue using collateral, section 1110 “does nothing to interfere with the operation of the controlling provisions of the [i]ndentures”.
On 8 February 2013, the indenture trustees appealed the court’s ruling. The trajectory of this appeal, however, may be wed to the appeal of the GGP decision, which is currently pending before the appellate court. If the appellate court overturns the GGP decision, and determines that ipso facto clauses are not enforceable in all contracts, including trust indentures, then the ipso facto provision in the EETC indentures may also be invalidated. Without an automatic acceleration, the indenture trustees could resurrect their argument that American Airlines, through the refinancing, is seeking to prepay the EETC, not a post-maturity date repayment for which no make-whole payment is due.
While this potential argument may be subject to challenge, it does highlight contractual language borrowers may want to use in future indentures to avoid imposition of a make-whole payment. Borrowers who expect to avoid make-whole payments upon the voluntary filing of a bankruptcy petition may seek clear contractual language providing that no make-whole premium is due if the obligations are repaid following a voluntary bankruptcy filing irrespective of an acceleration under an ipso facto clause. Whether financiers will accept such language is a different issue.
Regardless of the outcome on appeal, the bankruptcy court’s decision in American Airlines serves as an important reminder to financiers that they must draft clear provisions in indentures that require payment of a make-whole premium after both an event of default and acceleration. For example, lenders may seek contractual terms requiring payment of a make-whole amount, even after automatic acceleration of the debt, if the debtors make an election pursuant to section 1110 of the Bankruptcy Code or otherwise make a payment after the bankruptcy filing but prior to claim resolution.
Absent such clear language, financiers will be unwise to rely solely on statutory and policy arguments to avoid losing the benefit of make-whole protection in a declining interest rate environment.
John K. Lyons and Felicia Gerber Perlman are partners and Jennifer Madden is an associate at Skadden, Arps, Slate, Meagher & Flom LLP. Mr Lyons can be contacted on +1 (312) 407 0860 or by email: email@example.com. Ms Perlman can be contacted on +1 (312) 407 0758 or by email: firstname.lastname@example.org. Ms Madden can be contacted on +1 (312) 407 0983 or by email: email@example.com. The authors currently represent the Official Committee of Unsecured Creditors in the AMR Corp. bankruptcy case.
© Financier Worldwide
John K. Lyons, Felicia Gerber Perlman and Jennifer Madden
Skadden, Arps, Slate, Meagher & Flom LLP