Last November, Judge John Dorsey of the Delaware Bankruptcy Court held in the Mallinckrodt chapter 11 case that the debtors did not have to pay a $94 million “make-whole” premium that was provided for in an indenture governing first lien notes. The indenture provides for automatic acceleration following an Event of Default, which includes a bankruptcy filing. Acceleration makes “the principal of, premium, if any, and interest on all the Notes . . . immediately due and payable . . . .”
A “make-whole” premium is a loan provision to compensate a lender if a borrower repays the debt before maturity for the loss of the lender’s anticipated yield, and can also be called “yield maintenance,” or a “redemption” or “prepayment” premium. The make-whole amount is typically the net present value of the interest payments that the lender would have received if the debt was paid at maturity. While make-whole premiums are generally enforceable under state law outside of bankruptcy, courts have rendered conflicting decisions on their enforceability in chapter 11. Economics drives the continuing bankruptcy court litigation over make-whole payments. For large bond issues, the make-whole amounts can often exceed nine figures.
Mallinckrodt’s chapter 11 plan treated its first lien notes as unimpaired and did not provide for payment of the make-whole amount and its first lien noteholders objected to that treatment. In overruling their objection, Judge Dorsey characterized the Mallinckrodt make-whole premium as an improper “bankruptcy penalty” and the obligation to pay it as allowing a party to receive a “windfall merely by reason of the happenstance of the bankruptcy,” which the Supreme Court has cautioned against.
Judge Dorsey held that the make-whole premium “can be de-accelerated and paid if and when owing at a later time” and that section 1124(2), the section of the Bankruptcy Code that governs reinstatement of unimpaired claims, allows the debtors to “roll back the clock to the time before the asserted default” that gave rise to the make-whole premium.
In May 2022, the ad hoc first lien noteholders appealed the debtors’ confirmation order to the Delaware District Court. The noteholders’ appeal brief argues that Judge Dorsey’s decision “improperly substitutes the court’s notions of ‘policy’ for the plain language of the Bankruptcy Code” and conflicts with Supreme Court precedent rejecting “equitable” exceptions to the Bankruptcy Code’s plain language.
The brief also argues that to reinstate the first lien notes, the debtors needed to cure and reinstate them under section 1124. Even if the debtors were not required to cure their bankruptcy default, the brief reasons, the make-whole payment matured automatically upon the bankruptcy filing and nothing in the first lien notes indenture causes it to “unmature.” “Although the [indenture] allows the Debtors to undo the effects of some defaults, that is not the case with the [make-whole premium], which can only be waived by the noteholders themselves.”
On Judge Dorsey’s conclusion that reinstatement under section 1124(2) operates not only to “de-accelerate the debt” but also to “rol[l] back the clock to the time before the default existed,” the brief quips that nothing in the provision supports the “conclusion that reinstatement operates as a time-travel machine.”
The brief further argues that even if the debtors did not need to pay the make-whole premium, “[a]t a minimum, the Debtors must pay interest on the Applicable Premium for the more than 19 months that their chapter 11 cases have been pending,” which was approximately $15 million as of the date of the brief.
The Third Circuit’s leading case on the enforceability of make-whole provisions in bankruptcy is In re Energy Future Holdings Corp., where the court reversed the decisions of the bankruptcy court and the district court and enforced the payment of a make-whole premium. In Energy Future Holdings, the Third Circuit emphasized the importance of interpreting a contract, including a make-whole provision, in accordance with the parties’ intent. Third Circuit considered what happens when an indenture accelerates debt upon bankruptcy. In Mallinckrodt, the noteholders’ appeal brief argues that the indenture clearly provides for payment of the make-whole in the event of a bankruptcy filing, and is thus even stronger for their position than the Energy Future Holdings indenture.
Given the magnitude of the amount in dispute in Mallinckrodt, it is safe to assume that the District Court appeal will not be the last stop for this litigation.