Modern loan agreements often provide for compensation when a loan ends prematurely and interest rates have moved unfavorably. These are called "make-whole" clauses. (1) Litigation over such clauses has become increasingly common, and the amount in controversy is often in the hundreds of millions of dollars. Appellate courts will soon need to decide whether such a loss is either a claim for "unmatured interest" within the meaning of 11 U.S.C. [section] 502(b) that is not allowable or an ordinary, prepetition claim that is. (2) This essay attempts to provide some perspective on this question. (3)
This essay begins by identifying the legal attributes of make-whole clauses and then discussing the various legal issues that make-whole provisions have raised in bankruptcy apart from the question of whether they should be disallowed under 11 U.S.C. [section] 502(b). The essay then explores the origins of the principle that creditors are not entitled to recover for interest that accrues after the filing of the petition. The next part ties this history to first principles to suggest that make-whole premiums should not be considered "unmatured interest" within the meaning of the bankruptcy code. They are instead best understood as prepetition claims for contract damages that are routinely allowed when a party to a favorable contract files a claim.
The final part of the paper, however, shows that the same first principles that suggest make-whole claims should be allowed, also suggest that they should be enforced only to the extent that they compensate a creditor for the loss of a favorable rate of interest. A clause that awards the lender the difference between the contract rate and something close to the risk-free rate is over-compensatory and should not be enforced, quite apart from whether such a clause would be enforceable as a matter of nonbankruptcy law. Even if a court outside of bankruptcy would find such a clause to be for liquidated damages and not a penalty, a bankruptcy court should not enforce it.
MAKE-WHOLE CLAUSES OUTSIDE OF BANKRUPTCY AND INSIDE
PREPAYMENT CLAUSES AND MAKE-WHOLE CLAUSES
Outside of bankruptcy, a loan can come to an early end for either of two reasons. The borrower's circumstances may change, and it may want to repay the loan sooner than expected. Alternatively, the lender may want to terminate the loan early in the wake of a default on the part of the borrower. Some make-whole clauses treat the two situations identically. It is important to understand, however, that as a legal matter, a make-whole provision serves radically different functions in the two contexts.
Assume that Lender extends a $100 loan to Borrower, and Borrower promises to repay the loan in five years at 10 percent interest each year. In the ordinary run of things, Borrower makes the annual interest payments and returns the $100 after five years. But either Borrower or Lender may want to end things early. For example, Borrower might be flourishing and want to take on a new project. To do this it needs new financing. It finds another lender willing to make a new loan that is large enough both to retire the debt to Lender and fund the new project as well. Alternatively, if Borrower fares poorly, Lender might want to end the relationship early if Borrower trips up one of the covenants in the loan. These two sorts of termination events raise distinct legal issues.
Ordinarily, a borrower has no ability to pay before the original maturity date. (4) If borrower wants such a right, it must bargain for it at the time of the original loan. In the final decades of the last century, many borrowers began to do just this. They acquired the option to end the loan early in return for the payment of a fixed amount in addition to the principal, costs, and accrued interest. (5)
When borrowers first bargained for the right to call their loans, they did so to protect themselves from shifts in the market rate of interest. They transferred this risk from themselves to the lender. In recent years, a different sort of option to prepay a loan early has emerged. It requires the borrower to compensate the lender for any loss it will suffer as a result of the loan being repaid early. Prepayment clauses that require the borrower to make the lender whole provide the borrower with no protection against a change of interest rates.
Such prepayment clauses are, in effect, call options that give the borrower the ability to terminate the loan to take advantage of a new opportunity. For example, as the termination of the loan approaches the borrower might want to refinance early. The borrower might have ready access to credit markets six months before maturity, and it may want to guard against the risk that the economy will turn and this access will disappear. (6) As a practical matter, such clauses merely give the borrower a range of choices over how to repay the loan and are generally enforceable regardless of the form that they take. (7)
The picture is quite different when it comes to the ability of the lender to terminate the loan. Nonbankruptcy law gives a lender a right to terminate its loan early if there is a material breach. In this event, the lender can also bring a damages action for a return of principal and whatever else it needs to return to the position it was in after the borrower made its promise, including the loss of a favorable interest rate if conditions have changed since the time of the original loan. These damages may be hard to measure, so parties are entitled to make a good faith estimate. The make-whole clause in this context is merely an enforceable liquidated damages clause. It might take the same form as a clause that gives the borrower the right to pay early, but its legal character is altogether different. Outside of bankruptcy, courts will enforce such liquidated damages clauses in lending agreements the same as any other. The only qualification is that they cannot be penalty clauses in disguise. (8)
No particularly exotic legal ideas are at work here. Contracting parties cannot demand more than compensatory damages. (9) Of course, contracting parties can always agree to take less, and lenders do sometimes agree to give up the right to recover more than principal, accrued interest, and costs. Even though the borrower must pay a price over and above principal, accrued interest, and costs to exercise a call option when it terminates a loan early, it might be obliged to pay nothing beyond principal, out-of-pocket costs, and accrued interest if the lender demands immediate repayment of the loan after a default.
The lender's willingness to give up the right to pursue damages when there is an early default should not be surprising. When interest rates are relatively stable, as they largely were before the mid'1970s, damages over and above principal, out-of-pocket costs, and accrued interest are likely to be small to nonexistent. Moreover, turning away the chance to recover more may also reassure borrowers who fear that the lender will be too quick to pull the trigger in the wake of default. At the same time, the lender for its part may have little fear that the borrower will be too prone to default. The borrower already has substantial incentives to keep its promises. Among other things, default on one loan typically triggers a default on all the borrower's other loans. This could have catastrophic consequences if it happens at a time when the borrower cannot access credit markets.
Nevertheless, even a lender who does not bargain for damages from the loss of a favorable rate of interest in the event of default may still insist that the loan agreement include a substantial prepayment fee if the borrower wants to terminate the loan early. Providing a greater payment obligation when the borrower chooses to terminate and another when the lender asserts a right to damages in the wake of breach, of course, creates the potential for strategic behavior. If the borrower faced no collateral consequences from breaching, a borrower that wanted to terminate its loan early faces a temptation. It might arrange its affairs to appear that it breached its contract (and thus is obliged only to return principal with accumulated interest) rather than chose to end the relationship voluntarily (and thus be obliged to pay the higher amount set by the prepayment clause). Courts police such gamesman' ship. When a debtor asserts that it has not triggered the prepayment clause because it breached and thus owes only contract damages, courts will look to substance. If the debtor is in effect choosing to end the relationship, then the court can use its equitable powers to order the borrower to pay the makewhole premium. (10)
MAKE-WHOLE CLAUSES IN BANKRUPTCY
It is against this backdrop that bankruptcy courts confront make-whole clauses. In the first instance, courts must decide whether the make-whole clause has been triggered at all. These disputes present issues of contract interpretation. The debtor can argue that the make-whole clause in its loan agreement is simply a prepayment clause that operates only in the event of a voluntary prepayment of a loan. It has no effect on its obligations in the event of bankruptcy. By its nature, bankruptcy accelerates the obligations a debtor owes to this and every other creditor. At this point, there can no longer be a "prepayment" within the meaning of the loan agreement. (11) As a result, the debtor argues, the creditor is entitled only to recover principal, accumulated interest, and costs. (12) For its part, the creditor will argue that the make-whole, in addition to being a prepayment clause, also serves as a liquidated damages clause. It is triggered whenever a repayment that is made before the scheduled maturity date, whether it is at the borrower's option or as a result of a default.
In response to a number of opinions that interpreted make-wholes narrowly and found that they applied...