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November 21, 2013 Articles

"Make-Whole" Claims Triggered by Automatic Acceleration

Courts are split over what to do when loan agreements fail to address this issue

by Brendan M. Gage

The lender makes money from the interest that the borrower pays on a loan. A typical loan agreement will require the borrower make interest payments during the life of the loan until the maturity date when the balance of the loan becomes due. If the borrower wishes to pay off the loan before the maturity date (i.e., "prepay" the loan), the lender will be deprived of anticipated interest payments. The lender's losses can be particularly acute if the borrower prepays the loan "in an environment where prevailing interest rates are lower than those the parties bargained for at the time the [loan agreement] was [entered]." In re Chemtura Corp., 439 B.R. 561, 596 (Bankr. S.D.N.Y. 2010).

To compensate for the loss of interest caused by prepayment, the lender may include a "make-whole" provision in the loan agreement. A make-whole provision will provide for a fee, premium, or penalty that "serves as a proxy for the lender's actual damages in the event of prepayment." In re S. Side House, LLC, 451 B.R. 248, 268 (Bankr. E.D.N.Y. 2011). The make-whole amount is typically based on a percentage of the principal balance at the time of prepayment or on a yield maintenance formula that approximates the lender's expected return on interest.

Sometimes the loan agreement does not address the effect of acceleration on the make-whole provision. This is problematic because often loan agreements provide that the filing of bankruptcy is an event of default that automatically accelerates the maturity date of the loan. See, e.g., Petroleum & Franchise Funding, LLC v. Dhaliwal, 688 F. Supp. 2d 844, 850 (E.D. Wis. 2010); Premier Entm't Biloxi LLC v. U.S. Bank Nat'l Ass'n (In re Premier Entm't Biloxi LLC), 445 B.R. 582, 631 (Bankr. S.D. Miss. 2010); In re Skyler Ridge, 80 B.R. 500, 507 (Bankr. C.D. Cal. 1987). As a result, courts disagree over whether the lender is entitled to a make-whole amount when the debtor repays the accelerated loan in bankruptcy.

Contractual Acceleration
When a loan is accelerated pursuant to a contractual provision, "the acceleration date becomes the maturity date of the loan and the entire loan balance becomes due."  S. Side House, 451 B.R. at 268. If the lender exercises an option to accelerate the loan, "the lender elects 'to give up [its] future income stream in favor of having an immediate right to collect [its] entire debt.'" Id. (quoting In re Solutia, Inc., 379 B.R. 473, 485 (Bankr. S.D.N.Y. 2007)). In this scenario, the lender is not entitled to a make-whole amount because the loan, by definition, was not prepaid; it was called in early. In re LHD Realty Corp., 726 F.2d 327, 330–31 (7th Cir. 1984). However, this is only the default rule.

The lender is entitled to a make-whole amount if the loan agreement expressly provides for one upon acceleration or an event of default. See, e.g., In re AE Hotel Venture, 321 B.R. 209, 218 (Bankr. N.D. Ill. 2005) ("Parties to loan agreements may . . . agree that prepayment premiums are due even after acceleration."); In re Fin. Ctr. Assocs., 140 B.R. 829, 834–35 (Bankr. E.D.N.Y. 1992). Consequently, a carefully drafted loan agreement can avoid the issue of whether the lender is entitled to a make-whole amount when the loan is automatically accelerated. For example, if the loan agreement provides that the make-whole amount "is payable as long as the loan's original maturity dates have not passed, any possible tension between the fee and acceleration evaporates." Scott K. Charles & Emil A. Kleinhaus, "Prepayment Clauses in Bankruptcy," 15 Am. Bankr. Inst. L. Rev. 537, 546 (2007). The following discussion addresses those cases where the parties have failed to specify the effect of acceleration on the loan agreement's make-whole provision.

Repayment of Accelerated Debt in Bankruptcy
At the outset, it is important to recognize the often-overlooked distinction between contractual acceleration and acceleration for the purpose of filing a claim in bankruptcy. The Bankruptcy Code permits the filing of claims for debts that are contingent and unmatured. See 11 U.S.C. § 502(b)(1) (overruling objections to these kinds of filed claims). Thus, "a claim for the principal amount of a loan is allowed against a debtor even if that amount is not yet due and owing." Charles & Kleinhaus, supra, at 545. Whether the entire loan is actually due and owing is dependent on what the loan agreement says.

Recent cases have barred the lender from recovering a make-whole amount when the debtor repays accelerated debt in bankruptcy and the loan agreement does not address the effect of automatic acceleration on the loan agreement's make-whole provision. See, e.g., U.S. Bank Trust Nat'l Ass'n v. Am. Airlines, Inc. (In re AMR Corp.), 485 B.R. 279, 300 (Bankr. S.D.N.Y. 2013); Solutia, 379 B.R. at 484. These courts hold that a make-whole amount is triggered by prepayment and that prepayment can only occur before the loan matures. AMR, 485 B.R. at 298; Solutia, 379 B.R. at 488. The filing of bankruptcy accelerated the debt and the maturity date. Therefore, the post-petition payment of a loan cannot constitute the prepayment of the loan, absent contractual language to the contrary.

The question then becomes whether the lender can regain the right to a make-whole amount by decelerating the loan. See LHD Realty, 726 F.2d at 331 n.4. Generally, lenders cannot decelerate a loan post-petition without violating the automatic stay under section 362(a) because the lender is attempting to increase the size of its claim against the estate to the detriment of the estate and creditors. AMR, 485 B.R. at 294; Solutia, 379 B.R. at 485. For this reason, courts have denied lenders relief from the stay for the purpose of decelerating loans.

Older cases have taken a different view. These cases hold that the lender is not prohibited from recovering a make-whole amount where the loan agreement automatically accelerates the loan due to a bankruptcy filing. See, e.g., Imperial Coronado Partners, Ltd. v. Home Fed. Sav. & Loan Ass'n (In re Imperial Coronado Partners, Ltd.), 96 B.R. 997, 999–1001 (B.A.P. 9th Cir. 1989); LHD Realty, 726 F.2d at 332; Skyler Ridge, 80 B.R. at 507–8. These courts reason that because the debtor has a right to decelerate the maturity date of an accelerated loan as part of a reorganization plan under section 1124(2), the debtor still retains the choice of whether to prepay the loan. Therefore, if the debtor decides not to decelerate the loan and instead elects to pay the loan before the original maturity date, the debtor should be liable for the make-whole amount. Whether the loan agreement specifically provides for the payment of a make-whole amount due to automatic acceleration is irrelevant.

Are Acceleration Clauses Ipso Facto Clauses?
A more fundamental issue is whether a bankruptcy default provision that automatically accelerates a loan constitutes an unenforceable ipso facto clause under section 365(e)(1). If such a provision is unenforceable in bankruptcy, then the debtor should be able to continue making payments under the original terms of the loan without incurring make-whole liability for having filed bankruptcy.

Section 365(e)(1) renders unenforceable contractual provisions that modify a debtor's rights based solely on the debtor's financial condition or the commencement of a bankruptcy case. By its terms, section 365 applies only to "executory contracts" and "unexpired leases." See 11 U.S.C. § 365. (This article does not address the issue of whether a loan agreement constitutes an "unexpired lease.") Although some courts have adopted a per se rule that ipso facto clauses in all contracts are unenforceable in bankruptcy, see, e.g., In re W.R. Grace & Co., 475 B.R. 34, 154 (D. Del. 2012); Riggs Nat'l Bank v. Perry (In re Perry), 729 F.2d 982, 985 (4th Cir. 1984), most courts hold that only ipso facto clauses in executory contracts are unenforceable. AMR, 485 B.R. at 296 (collecting cases).

The Bankruptcy Code does not define "executory." One broad definition of an executory contract is "a contract on which performance is due to some extent on both sides." NLRB v. Bildisco & Bildisco, 465 U.S. 513, 522 n.6 (1984) (internal quotations omitted). Courts have also applied a narrower definition formulated by Professor Vern Countryman, who defined an executory contract as one "under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other." Vern Countryman, "Executory Contracts in Bankruptcy: Part I," 57 Minn. L. Rev. 439, 460 (1973).

Generally, courts have concluded that a loan agreement is not an "executory contract" where the lender has made the loan to the borrower because the only remaining obligation is repayment by the borrower. In re Gen. Growth Props., Inc., 451 B.R. 323, 329 (Bankr. S.D.N.Y. 2011). In other words, the lender has no obligations that, if unperformed, could constitute a material breach excusing performance of the borrower. See Premier Entm't, 445 B.R. at 617–18 (undisputed that lender's continuing duty to tender notices of default to borrower did not make indenture "executory").

Nevertheless, a few courts have found (1) financing agreements to be "executory" and (2) automatic acceleration clauses within financing agreements to constitute unenforceable ipso facto clauses. See, e.g.,In re Texaco, 73 B.R. 960, 964–65 (Bankr. S.D.N.Y. 1987); In re Schwegmann Giant Super Mkts., 287 B.R. 649, 657–58 (E.D. La. 2002) (citing Texaco). For example, in Texaco, the court held that a note indenture was executory where the indenture trustee had, inter alia, the continuing obligations to replace lost securities to note holders and to tender notices of default to the debtor. 73 B.R. at 964. However, the court overlooked the fact that these were obligations owed by the indenture trustee to the note holders rather than material obligations of the debtor. Moreover, the court did not discuss how the failure to perform these obligations would excuse the debtor's obligation to repay the debt.

Notwithstanding Texaco, bankruptcy courts have generally enforced automatic acceleration provisions in loan agreements. However, courts are split over what to do when loan agreements fail to address the effect of automatic acceleration on make-whole provisions. The case law establishes that lenders and borrowers can avoid costly litigation by specifying in their loan agreement whether a make-whole amount will be due in the event the loan is automatically accelerated.

Keywords: litigation, commercial, business, loan agreement, automatic acceleration, make whole, bankruptcy, prepayment

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