Distressed Lending after Ultra Petroleum: When Does Risky Business Become Too Risky?

4 Min Read By: Nicole Fulfree

IN BRIEF

  • Lenders often include a prepayment premium provision—particularly in larger commercial loans with longer terms—to ensure a guaranteed return at the time they agree to provide the financing. This limits the unpredictability of a borrower’s decision to refinance or otherwise repay a loan.
  • The Fifth Circuit’s decision in Ultra Petroleum undoubtedly creates a valuable leverage point for corporate debtors, creditors’ committees, and other stakeholders seeking to avoid or reduce prepayment premium obligations in chapter 11 negotiations with prepetition lenders.
  • Although distressed lenders are, by nature, in the business of risky business, the decision’s immediate upside for corporate debtors, creditors’ committees, and other stakeholders must be measured alongside considerations of the lending market’s potential response in the longer term.

Prepayment Penalties in Commercial Loan Documents

Contractual prepayment premiums—also called make-whole provisions or prepayment penalties—offer yield protection to a lender in the event a borrower repays its loan prior to its scheduled maturity date. Such provisions are often found in higher-value loans with longer terms, including those offered to distressed companies trying to clean up their balance sheet or restructure debt in an attempt to avoid a bankruptcy filing. Some categorize prepayment premiums as a hedge against the risk of loss of future interest resulting from a borrower’s early payoff, whereas others describe the premium as the price a borrower pays for the autonomy to prepay or refinance its debt. Whichever way you put it, prepayment premiums endeavor to increase predictability for lenders.

Although these provisions are increasingly common in commercial loan agreements and bond indentures, and even more so where the borrower is distressed, that is not to say they are uncontroversial. In many cases, make-whole provisions compensate commercial lenders and bondholders in an amount significantly exceeding that which the name would imply, contemplating returns that often exceed the current fair value of the debt. In addition, because they are more common in larger loans, make-whole amounts are typically quite significant. Indeed, in In re Ultra Petroleum, 913 F.3d 533 (5th Cir. 2019), the value of the make-whole amount and postpetition interest at stake exceeded $380 million.

The Ultra Petroleum Decision

To be clear, the Ultra Petroleum decision is not the first to create uncertainty in the analysis of make-whole provisions under the Bankruptcy Code, and it is true that objectors seeking to avoid make-whole claims enjoyed their choice of several grounds of attack far before the Fifth Circuit’s ruling. For example, make-whole claims had been disallowed as unenforceable under applicable nonbankruptcy law (including based on arguments that the claims were a penalty as opposed to a reasonable and enforceable liquidated damages provision), as unreasonable under section 506(b) of the Bankruptcy Code (with respect to secured claims), or in a handful of cases, as unmatured interest under section 502(b)(2). In fact, prior to Ultra Petroleum, the Second Circuit in In re MPM Silicones, LLC, 874 F.3d 787 (2d Cir. 2017) and the Third Circuit in In re Energy Future Holdings Corporation, 842 F.3d 247 (3d Cir. 2016), had issued completely conflicting opinions on whether the automatic acceleration of debt caused by a bankruptcy filing triggers payment of a make whole.

In the January 2019 decision, the Fifth Circuit, albeit in dicta, sided with the small minority of bankruptcy courts that held that make-whole claims constitute unmatured interest because, in substance, they seek to compensate a lender for future interest payments due to early repayment of debt. Thus, the Ultra Petroleum ruling, which strongly suggests that section 502(b)(2) disallows any claim that is the economic equivalent of unmatured interest, bolsters arguments for the across-the-board disallowance of make-whole claims under the Bankruptcy Code.

The Post-Ultra Petroleum State of the Law

Although the successful recovery of make-whole amounts from a chapter 11 debtor was far from a foregone conclusion even pre-Ultra Petroleum, the decision unquestionably alters what had been at least a somewhat navigable legal landscape, and raises questions about the lending market’s response in the longer term.

The pre-Ultra Petroleum state of the law was marked by specific guidelines set forth in various cases that provided a playbook by which sophisticated bankruptcy counsel could surgically craft loan documents to avoid the pitfalls of make-whole provisions by including carefully bargained-for provisions on choice of law, yield maintenance formulas estimating the damages to lenders resulting from prepayment, and clearly defined conditions to payment, including explicit language indicating the make whole is payable on acceleration. Thus, notwithstanding the existing circuit split, lenders could draft to hedge against these risks and exert their control over borrowers to push for a favorable jurisdiction in the event of bankruptcy.

The ruling will undoubtedly have considerable impact on the allowability of a lender’s make-whole claim in courts within the Fifth Circuit. However, unless and until the Supreme Court offers guidance on how courts should approach the issue, the new, even less predictable landscape of make-whole claims in bankruptcy means significantly more uncertainty for lenders relying on make-whole recoveries. In a realm where lenders already exercise a great deal of control, the uncertainty caused by the ruling, coupled with the typically significant value of the make-whole claims at stake, may result in increased rigidity and tension in chapter 11 negotiations. To compensate for this risk, lenders may also resort to charging higher interest rates and fees on distressed deals, or even opting not to lend to distressed borrowers. Although the ultimate impact of Ultra Petroleum remains to be seen, the line between risky and too risky can be a thin (and expensive) one to tread.

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