The enforceability of “make-whole” premiums in bankruptcy has become a hotly contested issue in recent years given the significant financial stakes and the lack of clear legal guidance on how these provisions should be treated under chapter 11 of the United States Bankruptcy Code (the Bankruptcy Code). A make-whole provision is a clause in a credit agreement, indenture, or other debt instrument that mandates a borrower to pay a premium if it repays the loan before its maturity date. In the event of such prepayment, the borrower must typically make a lump-sum payment to compensate the lender for the interest income it would have earned over the life of the loan, a sum known as the “make-whole premium.” This provision ensures that lenders are protected from losing the expected yield on their investment when a borrower exercises its right to prepay the debt.
The treatment of make-whole premiums in chapter 11 proceedings has been notably inconsistent with variations driven by the specific language of loan agreements, the solvency of the debtor, whether the debtor voluntarily filed for bankruptcy, the lenders’ actions to accelerate the debt, the debtor’s willingness to reinstate the debt, and the jurisdiction overseeing the case. In the past decade, the stakes have risen given the amounts involved, and the circuit courts of appeal have weighed in on the scope and enforceability of make-whole claims. The Third Circuit’s landmark decision in In re Hertz ruled that a debtor is generally not obligated to pay a make-whole premium, as it is considered the economic equivalent of “unmatured interest,” which is disallowed under Section 502(b)(2) of the Bankruptcy Code. However, when the debtor remains solvent, equity principles may compel the borrower to fulfill the make-whole obligation.In re Hertz, 117 F.4th 109 (3d Cir. 2024), amended and superseded by 120 F.4th 1181 (3d Cir. 2024).
The Third, Second, and Fifth Circuits have analyzed the make-whole issue in the last eight years. In the 2016 Energy Future Holdings case, the Third Circuit held that debtors were contractually obligated to pay a make-whole premium when they refinanced the loan during their chapter 11 case, after the loan was accelerated by the borrower’s bankruptcy filing.
The Third Circuit’s analysis focused on “giv[ing] effect to the intent of the parties as revealed by the language of their agreement.”In re Energy Future Holdings, 842 F.3d 247, 261 (3d. Cir. 2016) (internal quotations and citations omitted). The agreements at issue were bond indentures, which contained an “optional redemption” provision and acceleration provision. To determine if the make-whole premium was payable, the court decided whether there had been an optional redemption before maturity. Judge Thomas Ambro distinguished between a “prepayment” and a “redemption,” which he found includes “both pre- and post-maturity repayments of debt” under New York and federal law.Id. at 254-56. Judge Ambro determined the redemption was optional because the debtors voluntarily filed for bankruptcy, and because it was the debtors’ decision to refinance the debt over the objection of the bondholders. Based on the interpretation of the term “redemption,” Judge Ambro concluded that the acceleration provision was not relevant. The Third Circuit did not address the unmatured interest issue because it did not arise in connection with the determination of the amount of the bondholders’ claim and such claim’s treatment under a plan.
In 2017, the Second Circuit grappled with a similar issue in In re MPM Silicones, LLC.874 F.3d 787 (2d Cir. 2017). The governing indentures contained a similarly constructed “optional redemption” provision and an acceleration provision. Despite the similar facts, the Second Circuit held that the debtors were not required to pay a make-whole premium after the debt had been accelerated by a chapter 11 petition. The Second Circuit’s analysis resulted in a different outcome because the court determined “redemption” only applied to a payment before the maturity, and the notes had been accelerated by the bankruptcy filing. The court also determined the language of the acceleration provision was not specific enough to conclude the make-whole premium was automatically triggered by the acceleration.Id.
The Fifth Circuit has dealt with the make-whole question many times in the chapter 11 cases of In re Ultra Petroleum Corp. The first instance was in 2017, when the Fifth Circuit concluded in a now-withdrawn opinion that the make-whole premium was unenforceable because it was the economic equivalent of unmatured interest and disallowed by Section 502(b)(2) of the Code.In re Ultra Petroleum Corp., 913 F.3d 533, 537 (5th Cir. 2019), vacated by In re Ultra Petroleum Corp., 943 F.3d 758 (5th Cir. 2019). Five years later, the case reached the Fifth Circuit again, and the court again concluded that since the “[make-whole premium] here is the economic equivalent of a lender’s ‘unmatured interest,’ the Code . . . disallows it.”In re Ultra Petroleum Corp., 51 F.4th 138, 143 (5th Cir. 2022). This time, though, the Fifth Circuit held that the debtors were required to pay the make-whole premium under the solvent-debtor exception.
The debtor-borrowers issued a series of unsecured notes before filing for bankruptcy following a drop in oil prices. After filing for bankruptcy, oil prices rose, and the debtors became solvent. The debtors proposed a plan that would pay the noteholders in full by paying the principal and post-petition interest at the federal judgment rate and thus the noteholders would be unimpaired. The noteholders objected to the plan, claiming they were impaired because, in addition to not paying the contract rate of interest, the plan would not pay the make-whole premium required by the indentures.Id. The noteholders argued they were entitled to the contractual make-whole premiums both because the claims allowed in the Bankruptcy Code and the full amount of the claim should be paid under the solvent-debtor exception, which is an equitable principle requiring payment of creditors when a debtor is solvent.
Judge Jennifer Elrod, writing on behalf of the Fifth Circuit, first evaluated whether the make-whole premium was in fact an allowed claim or whether it amounted to unmatured interest disallowed by Section 502(b)(2). After looking at the facts and circumstances, she concluded the make-whole premium was economically equivalent to unmatured interest because it was a payment of bargained-for, future interest payments the creditors had lost through the prepayment, and the make-whole premium did not come due until after the petition date.Id. at 145-46.
Judge Elrod then examined the solvent-debtor exception, chronicling its history since it first emerged in 18th-century English law.Id. at 150-51. She explained that the purpose of the exception is to handle the unique situation in which the debtor is solvent, and principles of equity mandate that such a debtor honor its contractual obligations.Id. at 150-52 (“Solvent debtors are, by definition, able to pay their debts in full on their contractual terms, and absent a legitimate bankruptcy reason to the contrary, they should. Unlike the typical insolvent bankrupt, a solvent debtors pie is large enough for every creditor to have his full slice. With an insolvent debtor, halting contractual interest from accruing serves the legitimate bankruptcy interest of equitably distributing a limited pie among competing creditors as of the time of the debtor’s filing.”). Even though Congress did not codify the solvent-debtor exception when drafting the 1978 Bankruptcy Code, Judge Elrod found that “Congress did not abrogate the longstanding judicial exception for cases involving solvent debtors. We thus hold that the solvent-debtor exception is alive and well.”Id. at 156. The Ninth Circuit also recently concluded that the solvent-debtor exception remains in force for similar reasons.See In re PG&E Corp., 46 F.4th 1047, 1064 (9th Cir. 2022) (“We find it implausible that Congress meant to abrogate the equitable solvent-debtor exception by recodifying § 63 of the Bankruptcy Act, under which that exception was widely applied.”).
Enter the Third Circuit’s decision in Hertz. In that case, the debtors filed for bankruptcy early in the COVID-19 pandemic, which crippled the rental-car industry. The business rebounded as the pandemic subsided, and the debtors were solvent when they filed their proposed plan. Hertz’s noteholders were set to receive the full amount of principal under the plan, but the debtors did not pay the make-whole premium or full contractual interest even though the debtors “committed to pay whatever was necessary to ensure [the noteholders] were unimpaired.”In re Hertz, 120 F.4th 1181, 1190-91 (3d Cir. 2024). The plan also proposed paying the equity holders US$1.1 billion — substantially more than the amount of the noteholders’ make-whole premium. The plan was confirmed over the noteholders’ objections because, as unimpaired creditors, the noteholders could not vote and were presumed to accept the plan.Id.
The noteholders then filed a complaint seeking payment of the make-whole premiums and other fees relating to the early redemption. The bankruptcy court concluded the make-whole premium was akin to unmatured interest and determined the solvent-debtor exception did not require Hertz to pay the make-whole premium. The bankruptcy court then certified the issue for direct appeal to the Third Circuit.Id. at 1191.
The Third Circuit first dealt with the unmatured interest question, which hinged on whether the make-whole premium amounted to interest since it had clearly not matured as of the date of filing. To answer this question, the Third Circuit applied two tests: (a) “whether a make-whole fee best fits within the dictionary and caselaw definitions of interest” and (b) “whether the make-whole at issue is the economic equivalent of interest.”Id. at 1195.
Both tests led to the same conclusion. Under the definitional approach, the court concluded that the make-whole premium was interest because it was designed to compensate the lender for the use or forbearance of money, fitting squarely in the dictionary definition of interest.Id. at 1195 (citing Black’s Law Dictionary (12th ed. 2024) (“Black’s Law Dictionary says it is ‛[t]he compensation fixed by agreement or allowed by law for the use or detention of money, or for the loss of money by one who is entitled to its use; esp[ecially] the amount owed to a lender in return for the use of borrowed money.’”). Judge Ambro also concluded that the make-whole premium was economically equivalent to interest since “‘a dollar today is worth more than a dollar tomorrow’ . . . [and present value discounts] are applied to early payments to account for risk of default and the time value of money, thus making sure that lenders receive the benefit of their bargain—the value they would expect to receive through a scheduled, rather than premature, paydown.”Id. at 1197 (citing Ultra Petroleum, 51 F.4th at 148).
Like the Fifth Circuit, the Third Circuit looked to whether the make-whole premium was nonetheless payable under the solvent-debtor exception. The debtors argued that the solvent-debtor exception, without its formal codification, was “a mere ‘tool of construction’ relevant only when the Code is genuinely ambiguous.”Id. at 1198. Judge Ambro disagreed. His analysis focused on a holistic interpretation of the Bankruptcy Code, which should be done in a manner that produces a substantive result that comports with the basic structure of the Bankruptcy Code. The central issue was that the debtors’ plan violated the absolute priority rule because it paid the equity holders more than four-times the make-whole premium, which should have been paid to the supposedly unimpaired noteholders. Consequently, the Third Circuit held that the solvent-debtor exception required the debtors to pay the make-whole premium since the “Code’s careful design does not give [the debtors] enough leverage to subvert that law’s foundational goals.”Id. at 1206.
The Third Circuit’s ruling in In re Hertz marks a significant moment, with two of the most-trafficked circuits now aligning in their position that make-whole premiums are generally unenforceable in chapter 11 proceedings, as a matter of law. This development raises serious doubt about whether a bankruptcy court in the Third or Fifth Circuit would compel an insolvent debtor to pay a make-whole premium. Distressed borrowers should carefully review their debt documents to determine whether they contain make-whole provisions similar to those in Ultra Petroleum and Hertz. Similarly, creditors who bargained for make-wholes should remain vigilant, anticipating the strategic use of a bankruptcy filing by borrowers to seek to minimize exposure to make-whole premiums. At the same time, parties must consider that the two key cases holding make-wholes to be unenforceable required them to be paid. Both cases arose in the rare but possible scenario in which the debtor filed for bankruptcy as insolvent, but later emerged solvent.
Like many key document provisions, the existence and strength of the make-whole provisions will impact strategy of parties seeking to pursue liability management transactions. Even with these major circuit court decisions, however, uncertainty remains across circuits, and enforceability might come down to a question of valuation. Moreover, each of the court decisions in this area has turned on the specific language of the debt documents at issue. For creditors seeking to recover from early payment, the starting point is careful drafting and incorporating creative solutions in light of the court decisions to maximize lender protections.