In re School Specialty: Delaware Bankruptcy Court Enforces 37% Make-whole Premium

Practical Law Legal Update 3-526-8426 (Approx. 6 pages)

In re School Specialty: Delaware Bankruptcy Court Enforces 37% Make-whole Premium

by PLC Finance and Practical Law Bankruptcy & Restructuring

Background

On May 22, 2012, School Specialty, Inc. and certain of its affiliates (Debtors) entered into a loan agreement with Bayside Finance, LLC (Bayside) under which Bayside made a $70 million secured term loan to the Debtors. The loan was to mature on October 31, 2014, but if the Debtors refinanced certain existing bond debt the loan would mature on December 31, 2015.

Under the agreement, the Debtors were required to pay an early payment fee on either prepayment or acceleration of the loan. If the loan was repaid or accelerated during the first 18 months, the Debtors would be required to pay an early payment fee equal to a make-whole payment. The make-whole payment was calculated by discounting the future stream of interest payments between the prepayment or acceleration date and December 31, 2015, at the Treasury rate plus 50 basis points. However, after the 18th month, this amount would be reduced to 6% of the outstanding principal of the loan, and further reduced to 1% if the loan was prepaid or accelerated after the 30th month.

In January 2013, the Debtors defaulted under the loan agreement and entered into a forbearance agreement with Bayside. The forbearance agreement accelerated the loan, thereby triggering the make-whole provision. Under the forbearance agreement, the Debtors acknowledged that Bayside was entitled to a make-whole payment exceeding $25 million (later recalculated to be $23.7 million), reflecting the present value of interest payments through December 2015. This amount represented 37% of the loan balance.

On January 28, 2013, the Debtors filed for bankruptcy protection. The Committee filed a motion to disallow Bayside's make-whole claim, arguing that the make-whole provision was unenforceable.

Key Litigated Issues

At issue before the Court was whether the make-whole premium was enforceable under applicable state law (in this case, New York law), and if so, whether it was enforceable as a matter of federal bankruptcy law. In making its determination, the Court considered whether:

The make-whole premium was an enforceable liquidated damages provision under New York law.
The "reasonableness" standard of section 506(b) of the Bankruptcy Code was met.
The make-whole premium was a claim for unmatured interest under section 502(b)(2) of the Bankruptcy Code.
Bayside had a duty to mitigate damages.

Decision

The Court denied the Committee's motion and allowed Bayside's entire make-whole claim, for the reasons explained below.

The Make-whole Premium is an Enforceable Liquidated Damages Provision

The Court began by applying the New York liquidated damages test which requires that:

Actual damages are difficult to determine.
The sum stipulated is not "plainly disproportionate" to the possible loss, determined as of the time the parties entered into the agreement, not the time of the breach.

The Committee disputed the second prong of the test, claiming that the formula used to calculate the make-whole payment was not aligned with usual market practices, and therefore resulted in a prepayment premium that was "grossly disproportionate" to Bayside's possible loss. While the Committee's argument that the make-whole payment amounted to 37% of the principal of the loan gave the Court "pause," it stressed that the applicable standard is whether the payment is "plainly disproportionate" to the amount of the loss, not the principal amount of the loan.

Emphasizing that New York law generally discourages judicial interference with parties' agreements absent some element of fraud, exploitation or unconscionable conduct, the Court proceeded to analyze whether the prepayment premium was plainly disproportionate to Bayside's possible loss.

To determine whether a prepayment penalty is plainly disproportionate to a lender's possible loss, courts interpreting New York law consider whether the prepayment fee is:

Calculated so that the lender will receive its bargained-for yield.
The result of an arms-length transaction between represented sophisticated parties.

The Committee argued that the make-whole provision inflated Bayside's actual losses and should have included discounted interest payments for only the first 18 months because the odds of a possible refinancing before October 31, 2014 were slim. However, because the refinancing option was available through the life of the loan, the Court held that Bayside was obligated to keep the funds available through 2015 and was justified in using December 31, 2015 as the maturity date to calculate the make-whole payment. The Court also noted that New York courts have held that prepayment premiums calculated based on US Treasury bond interest rates are not plainly disproportionate to a lender's potential loss.

The Court held that the second prong of the test was also met as evidence presented at trial showed clearly that the loan was the result of an arms-length negotiation.

The "Reasonableness" Standard of Section 506(b) of the Bankruptcy Code

Section 506(b) of the Bankruptcy Code entitles oversecured creditors to reasonable postpetition fees, costs and charges provided for under the agreement or state statute under which their claim arose. Bayside argued that this "reasonableness" standard does not apply, because the make-whole amount arose prepetition. While the Court declined to rule on this issue, it held that, to the extent that the reasonableness standard applies, it was satisfied because the Court already determined that the prepayment premium was not an unenforceable penalty under New York law. By doing so, the Court assumed, without explaining, that the reasonableness inquiry is the same under federal bankruptcy law as it is under state law.

The Make-whole Provision is Not a Claim for Unmatured Interest

Section 502(b)(2) of the Bankruptcy Code generally prohibits the payment of unmatured interest. Unmatured interest is interest on prepetition debt not yet owing at the time of the bankruptcy filing. The Committee argued that the make-whole payment was a claim for unmatured interest because it was intended to compensate Bayside for lost future interest resulting from the prepayment of the debt. While noting that bankruptcy courts are split on the issue of whether make-whole payments are unmatured interest or liquidated damages, the Court ruled that make-whole payments are in the nature of allowable liquidated damage provisions rather than disallowable unmatured interest. In doing so, it followed the Delaware Bankruptcy Court's previous decision in In re Trico Marine Services, Inc., which held that make-whole payments are not claims for unmatured interest because they fully mature at the time of breach.

Duty to Mitigate Damages

The Court dismissed the Committee's argument that Bayside had a duty to mitigate any damages it suffered, noting that New York courts have held that a valid liquidated damages claim obviates any duty to mitigate damages.

Practical Implications

In this case, the Court followed the general trend of allowing make-whole claims when they are clearly provided for by the loan agreement, as courts are reluctant to interfere with agreements made among sophisticated parties. This opinion is consistent with a decision issued earlier this year by the US Bankruptcy Court for the Southern District of New York in US Bank Trust National Ass'n v. American Airlines, Inc. (In re AMR Corp.), which declined to enforce the make-whole provision solely because the agreement was explicit and unambiguous that no make-whole premium would be due under the circumstances at issue (see Legal Update, US Bank Trust National Ass'n v. American Airlines: Bankruptcy Court Relies on Language of Indentures to Reject Make-whole Claim). Therefore, to increase the chances that a court will uphold a make-whole provision in unforeseen circumstances, the agreement should clearly provide for the make-whole premium after acceleration for any reason, including a bankruptcy filing, and not just upon a prepayment before maturity. Absent this language, some courts have held that unless explicitly stated, debt automatically accelerated by a bankruptcy filing does not trigger a make-whole provision because acceleration of the debt advances the maturity date from the original stated maturity date to the acceleration date, which becomes the new maturity date (see In re Solutia Inc., 379 B.R. 473 (Bankr. S.D.N.Y. 2007) and Practice Note, Treatment of Make-whole and No-call Provisions in Bankruptcy: Solutia).

While this decision supports the argument that make-whole provisions are not claims for unmatured interest under New York law, the make-whole payment in this case was triggered by prepetition acceleration and had already matured before the petition date. Under these facts, it is harder to argue that the make-whole payment is a proxy for unmatured interest, which is disallowed under the Bankruptcy Code. In contrast, the SDNY Bankruptcy Court recently held that make-whole claims are proxies for unmatured interest in cases where the make-whole provisions were triggered by an automatic acceleration of the debt upon a bankruptcy filing (see In re Chemtura Corp., 443 B.R. 601 (Bankr. S.D.N.Y. 2011); HSBC Bank USA, Nat'l Assoc. v. Calpine Corp., , at *5 (S.D.N.Y. Sept. 15, 2010); Practice Note, Treatment of Make-whole and No-call Provisions in Bankruptcy: Calpine II and The Chemtura Roadmap). Therefore, this issue remains unresolved under New York law.

Finally, this decision supports the enforceability of make-whole provisions under New York law where the make-whole amount is not plainly disproportionate to the lender's potential loss, regardless of its size in relation to the principal amount of the claim. An appropriate discount rate, such as the Treasury rate, should be used to calculate the make-whole payment.

For more information on the enforceability of make-whole provisions in bankruptcy, see Practice Note, Treatment of Make-whole and No-call Provisions in Bankruptcy and Chemtura Roadmap: Analysis of Make-whole and No-call Provisions in Bankruptcy.

Court Documents

In re School Specialty, Inc., No. 13-10125, (Bankr. D. Del. Apr. 22, 2013).

In re School Specialty: Delaware Bankruptcy Court Enforces 37% Make-whole Premium | Practical Law