In the pending bankruptcy appeal in Ultra Petroleum, the Fifth Circuit will consider whether noteholders of a solvent debtor may recover a make-whole amount plus postpetition default interest until payment in full. That issue has arisen because of two bankruptcy court decisions that linked—incorrectly, in some people's view—the right to receive a make-whole with the acceleration-upon-default provision. The upshot is that the Fifth Circuit likely will decide this issue under New York contract law, which provides little guidance, yet the result will impact contractual damage provisions in debt documents—and their application both inside and outside of bankruptcy—going forward.

'Ultra Petroleum' and the “Make-Whole”

Before bankruptcy, Ultra Resources (OpCo) issued unsecured notes that contained a make-whole provision. In re Ultra Petroleum, 575 B.R. 361, 363 (Bankr. S.D. Tex. 2017). That provision provided that OpCo “may, at its option, upon notice … prepay … [the] Notes … at 100% of the principal amount so prepaid, plus the Make-Whole Amount determined for the prepayment date ….” Id. at 363-64. For discussions sake, the “Make-Whole Amount” essentially equaled the stream of future interest payments after the prepayment date, discounted to present value at a rate of 0.5 percent over the yield to maturity of U.S. Treasury obligations. Id. at 364.

The notes also contained an acceleration provision, which provided that upon an Event of Default, the principal, accrued and unpaid interest, and the Make-Whole Amount shall immediately become due and payable. Id. An Event of Default occurred when OpCo filed for bankruptcy, which thereby triggered the acceleration clause. Id. Thus, on the petition date, the noteholders claimed an amount due of principal, accrued interest, and the Make-Whole Amount. Id.

Because OpCo became solvent during its bankruptcy case, the debtors proposed Chapter 11 plan sought to “unimpair” the noteholders' claims by paying them “in full and in cash”—including postpetition interest—with any excess to be up-streamed to OpCo's debtor-parent company. Id. at 364-65. OpCo and the noteholders disagreed, however, about whether the plan payments to the noteholders must include the Make-Whole Amount and disagreed over the rate for payment of postpetition interest. The debtors asserted that any postpetition interest should be at the Federal Judgment Rate while the noteholders argued that postpetition interest should accrue at the (much higher) contractual default rate. Id. at 365. Of particular importance, the debtors argued that, if the bankruptcy court were to award the Make-Whole Amount and postpetition interest at the default rate, then it must reduce the interest award to the extent necessary to avoid a double recovery. Id. at 365.

The bankruptcy court ruled for the noteholders; it awarded them an allowed claim for principal, accrued interest and the Make-Whole Amount and allowed postpetition interest to accrue at the contractual default rate. Id. at 370. It reasoned that under the documents all components of the claim—principal, accrued interest and the Make-Whole Amount—came due on the petition date by operation of the acceleration clause. Id. Because OpCo did not pay those amounts on the petition date, additional postpetition interest should accrue until the amounts were paid per the plan. Id.

On appeal to the Fifth Circuit, which remains pending, the debtors have argued that allowance of the Make-Whole Amount compensates the noteholders for any postpetition interest because it provides them with the discounted value of the future interest payments—thus additional postpetition interest would lead to a double recovery. (See Opening Brief for Appellants at 35, Ultra Petroleum v. Ad Hoc. Comm. Of Unsecured Creditors of Ultra Resources (In re Ultra Petroleum), Case No. 17-20793 (5th Cir. Feb. 26, 2018)). They contend that the make-whole formula functions appropriately only when the principal and accrued interest are actually prepaid—that is, the noteholders receive principal and interest in cash and are entitled at that time to an additional make-whole payment to compensate them for the discounted value of future interest payments from prepayment to maturity. Id. at 36. The problem here, they argue, is that the Make-Whole Amount came due on the petition date by operation of the acceleration clause, but the actual payment would not be made until months later on the plan effective date. Id. Thus, the noteholders would receive a double recovery: the Make-Whole Amount as a proxy for postpetition interest, and actual postpetition interest. Id.

The Fifth Circuit will have to decide between two competing yet meritorious views. On the one hand, the bankruptcy court faithfully applied the documents, which called for payment of principal, interest and the Make-Whole Amount upon acceleration on the petition date as well as continuing interest accrual until paid. On the other hand, the debtors have ably argued that allowing postpetition interest at the default rate in addition to the Make-Whole Amount provides two payments that relate to interest for the period from the petition date until payment. The standard that the Fifth Circuit should apply—is this an unenforceable penalty under New York law?—does not readily answer the question.

How Did We Get Here?

Let's drill down further to understand why debt documents today include a make-whole provision in the acceleration clause. Until a few years ago, a make-whole provision typically resided only in the redemption provision—and not in the acceleration provision. However, in the high-profile EFIH case, the debtors convinced a Delaware bankruptcy court that the acceleration clause must contain “express language requiring payment of a prepayment premium upon acceleration; otherwise, it is not owed.” Delaware Trust Co. v. Energy Future Intermediate Holding Co. (In re Energy Future Holdings), 527 B.R. 178, 192 (Bankr. D. Del. 2015), rev'd, 842 F.3d 247 (3d Cir. 2015). A New York bankruptcy court held likewise. See In re MPM Silicones, Case No. 14-25503-rdd, 2014 WL 4436335 at *14 (Bankr. S.D.N.Y. Sept. 9, 2014), rev'd on other issue, 874 F.3d 787 (2d Cir. 2017). The EFIH decision was more egregious, given that the bankruptcy court permitted the debtors to refinance their debt during their Chapter 11 case without paying the make-whole—a transaction that outside of bankruptcy would have unquestionably required payment of make-whole. In re Energy Future Holdings, 527 B.R. at 197.

The Third Circuit reversed, holding—correctly in the author's view, as counsel for the successful appellants—that the acceleration provision and the redemption provision addressed two different things: “[the acceleration] causes the maturity of EFIH's debt to accelerate on its bankruptcy, and [the redemption provision] causes a make-whole to become due when there is an optional redemption … .” Delaware Trust Co. v. Energy Future Intermediate Holding Co. (In re Energy Future Holdings), 842 F.3d 247, 257 (3d Cir. 2015). In other words, whether or not a make-whole amount constitutes part of the allowed claim does not turn on the provisions of the acceleration clause. Rather, one must consider whether the requirements for payment of the make-whole are satisfied, which in EFIH meant asking whether an “optional redemption” occurred.

Notwithstanding the Third Circuit's efforts to bring some order to make-whole jurisprudence, drafters of debt documents have implemented an easy fix to “EFIH-proof” their loans: They simply include the right to a make-whole amount in the acceleration provision. Thus, whenever the debt is accelerated—whether or not it has been paid—the make-whole amount becomes due as well. This approach has transformed the make-whole from a proxy for future interest upon prepayment to an additional component of damages upon default.

The problem is that the drafters may not have intended that the make-whole function as a new damages component that is entirely divorced from actual prepayment. Indeed, doesn't the default rate of interest already exist to compensate noteholders for non-payment after a default and acceleration? Perhaps the drafters were simply trying to respond to EFIH and never specifically considered the possibility of a double recovery for interest after an Event of Default until payment.

The bottom line is that the Fifth Circuit will likely have to resolve whether a claim for a make-whole calculated as of the acceleration date plus a claim for contractual default interest from acceleration until payment does—or does not—violate New York law concerning unenforceable penalties. That ruling will have sweeping effect given that, as a circuit-level pronouncement of New York law, it will have application beyond bankruptcy. If it is upheld, make-wholes plus additional contractual default interest may well become the damage formula for any and all defaults by the borrower. This all arises because of a couple questionable (and with respect to EFIH, reversed) decisions from bankruptcy courts trying to prevent noteholders from recovering make-wholes in bankruptcy cases. We expect the Fifth Circuit's decision in the coming months.

James H. Millar is a partner in the corporate restructuring group of Drinker Biddle & Reath in New York.