Contributed by Doron P. Kenter.
In our previous posts, we have devoted extensive discussion to “make-whole” provisions. We have asked whether a debtor may repay debt prior to its maturity where the debt instrument prohibits such prepayment and whether prepayment penalties pursuant to “make-whole” provisions entitle the lenders to a claim over and above principal and accrued interest. Yet the question still remains: what is a “make-whole” provision? Yes, a make-whole provision may provide for a prepayment premium – a charge for prepaying debt, designed to compensate lenders or noteholders for the loss of future interest that would have been earned had the debt not been paid down early. But what is that payment? Is it interest? A penalty? Neither? Both?
Though the answers to those questions are not necessarily fully settled in all jurisdictions, Judge Shannon of the United States Bankruptcy Court for the District of Delaware recently provided further guidance in construing the fundamental nature of prepayment penalties pursuant to make-whole provisions, holding that make-whole payments are not payments of unmatured interest, but should, instead, be construed as liquidated damages.
In In re Trico Marine Servs., Inc., the debtor, Trico Marine International, Inc. issued approximately $18.9 million in notes to finance the construction of two supply vessels. The indenture for those notes provided that payments thereunder were subject to an optional redemption premium (i.e., a make-whole premium) that would mature if and when the debtor elected to redeem the notes “in whole or in part, at any time, at the redemption prices.”
The notes were not secured by any of the debtor’s property, but to induce the extension of this facility to the debtor, the United States Secretary of Transportation guaranteed the notes on behalf of the Maritime Administration, which administers a financial program to develop and promote the U.S. Maritime Service and other programs in furtherance of national maritime defense. Specifically, the Maritime Administration guaranteed payment of any unpaid interest or principal on the Trico notes. In exchange, the debtor granted the Maritime Administration a promissory note secured by a first priority lien on the vessels.
After commencing its chapter 11 case, the debtor sold the vessels. In exchange for its consents to the sale, the Maritime Administration demanded that the debtor use the proceeds to repay the outstanding notes (so as to ensure that the guarantee would not be called). Following the sale, the debtor paid the indenture trustee’s claims for outstanding principal and accrued interest under the indenture, but disputed the indenture trustee’s claim for make-whole premiums relating to the payoff. The debtor argued, among other things, that the make-whole premium should be disallowed as unmatured interest pursuant to section 502(b)(2) of the Bankruptcy Code, or, in the alternative, that the make-whole premium was a general unsecured claim that was not covered by the guarantee. Implicitly conceding that the make whole premium was unmatured interest, the indenture trustee argued that the make-whole premium was covered by the guarantee and that it could, therefore, look to the Maritime Administration for payment of the make-whole premium. Not surprisingly, the Maritime Administration contended that the make-whole premium was not “interest” and thus, not covered by its guarantee.
Judge Shannon observed that courts have disagreed on the proper understanding of make-whole provisions and whether payments pursuant to those provisions should be characterized as unmatured interest or as liquidated damages. Judge Shannon agreed with the apparent majority view that prepayment premiums should more properly be construed as liquidated damages, noting that a majority of courts to have faced the issue have held similarly. Although Judge Shannon did not devote extensive discussion to the issue, the cases cited in Trico had reached that conclusion largely because make-whole payments constitute fully matured obligations pursuant to a contract and are not unmatured obligations that simply would have been incurred had the loan not been prepaid. In other words, because the obligation itself comes due at the time of prepayment, any such prepayment penalties are not deemed to be “interest” simply because the amounts of such payments are based on calculations of future interest obligations that would have been incurred.
A significant implication of the Trico decision is that, according to that holding, make-whole premiums cannot be disallowed pursuant to section 502(b)(2) of the Bankruptcy Code because they are not unmatured interest. What is a make-whole payment? The answer may not yet be fully clear for all purposes, but, at least under Trico, it is not unmatured interest.
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