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Friday, January 25, 2013

The AMR "Make-Whole" Decision


A couple of days ago, Bloomberg's "Bill on Bankruptcy" led with a segment in which their bankruptcy expert Bill Rochelle opined that the decision issued last week in the AMR bankruptcy by Judge Sean Lane, in which he denied investors a “make-whole payment” in connection with a refinancing was :"vulnerable on appeal".  I had also seen a story on Debtwire [very expensive paywall] in which the investors and their advisors made the same claim.   As the "make-whole" issue has been litigated a few times in the same court in the past decade, it seemed odd that the court would commit an error, but you never know, so I downloaded the opinion and read it.  I really can’t see how the appeal will succeed. The media seem to be missing at least half of the analysis.

Judge Lane’s analysis is very thorough, but I can boil it down for blog purposes to a few simple points; as in other posts on legal topics, I won’t burden the reader with case citations or the like – this is not a law review article, legal opinion or brief, just a blog post.

1)  A “make-whole” payment is a contractual provision that is meant to compensate an investor in some fashion for lost future income when a debt instrument is prepaid at a time when interest rates have declined such that the investor is presumed to earn less from reinvesting the proceeds than had the financing remained outstanding until maturity. One of the basic principles of “make-whole” litigation is you start by looking at the contract because it’s just a claim under a contract to begin with.  Generally, the burden is on the creditor to show a make whole payment was clearly intended under the contract.  Here, there are two separate contract provisions that speak to the “make-whole” issue:  in the case of a “voluntary redemption” the creditor clearly gets the additional payment;  in the event of a bankruptcy, although the contract says that the principal of the loan automatically comes due, the contract clearly says there is no “make-whole” in that case.  (For a contract to address the issue so clearly has not always been the case, but it has become more common, because of the number of cases in which the issue has arisen in the past decade.)  Normally, the specific language of the bankruptcy clause would be enough to end the dispute under prevailing case law.

2) Here, however, this debt had been made the subject of an “1110 election”. Section 1110 privileges asset-backed financings in airline bankruptcies, requiring the airline, if it wants to hold on to its equipment and keep operating, to make up any missed payments by the 60th day after the bankruptcy filing and agree to perform all its ongoing obligations under the financing as they come due, while preserving some optionality on the debtor’s part ultimately to stop doing so and surrender the aircraft to the financing parties.  The rationale for 1110 is that, by reducing potential bankruptcy losses to the financiers, it makes it easier for the industry to raise capital more cheaply (although if this really made a difference, it would make sense to give all industries a similar benefit, in which case, why not exempt all secured debt from chapter 11’s provisions? A topic for another day.)

3) Since the airline had agreed to perform all its obligations going forward, the investors argued in a variety of ingenious ways that it was now bound to honor the “make-whole” clause when it refinanced them out.  The section 1110 affirmation had created a state of affairs such that it was as if there were no bankruptcy in effect regarding the financing, so, they contended, the refi was in reality nothing more than a voluntary redemption to take advantage of lower rates.

4) Unfortunately for the investors, the argument failed (and fails) because, while it rests on one part of section 1110, it misses entirely another provision that appears to be directly relevant.  Section 1110(a)(2)(B) provides that, even when an airline hands out 1110 affirmations, it does not have to cure any default under its financing agreements resulting from its bankruptcy filing.  By negative implication, that means any bankruptcy default in the financing documents continues to exist after an 1110 affirmation.  Since the investors’ contract with the airline clearly said that there was no “make-whole” payable when a default resulted from a bankruptcy filing, the court simply gave effect to that provision of the contract and denied the claim for a make-whole.

5) This makes perfect sense to me.  Section 1110’s protections are so valuable to financing parties that assurance of section 1110 eligibility has become a staple component of asset-backed airline financings.  I doubt a major secured financing of an airline could be completed and sold to a sophisticated investor without comfort that it was protected by 1110.  So when the AMR financing was put in place and sold, section 1110 was an issue that had to have been addressed.  Therefore, when the AMR financing contained a specific statement about what was payable in a bankruptcy, that statement should be given effect even when the airline confers section 1110 protection on the financing.  Put another way, it’s inconceivable that anybody intended a provision in an 1110-protected financing to be interpreted differently if the airline afforded the financing the protections of section 1110.  This must have been the intended result when the contract was put together.

6.  In addition, there really is no such thing as a “voluntary redemption” of debt in chapter 11.  A “redemption” refers to a company paying off its debt before maturity, but most debt instruments, and most interpretations of the Bankruptcy Code, establish that, when a company files for bankruptcy, its debt matures and becomes payable that day. The Bankruptcy Code’s automatic stay protects it from creditor action to satisfy their debts outside of the bankruptcy process, but the debts are due and payable in full that day. So a “redemption” is not a meaningful concept in a bankruptcy case.  Even if it were, repaying debt is not a purely “voluntary” act for a debtor in bankruptcy.  It has to get court authorization to do so.  If the court says no, the debtor can't do what it wants. So it's an inapplicable concept in bankruptcy.

7.  The media also miss entirely the risk of appeal being mooted.  The decision approves a motion to enter into a replacement financing under section 364 of the bankruptcy code, and 364 contains a clause that moots any challenge to the financing unless a stay is obtained upon appeal, which rarely happens because it typically requires the appellant to post a multimillion dollar bond, which investors are loathe to do.  While the appellants will no doubt argue that their appeal only goes to collateral issues that can be resolved in their favor without disturbing the financing, it is a difficult, although not impossible argument to win as the debtor may be able to present evidence that the economics of the financing are premised upon a financial condition in which no “make-whole” is owing, in which case the issue may not be perceived as collateral and the appeal will be mooted.  I note that, in Calpine’s bankruptcy a few years ago in the same court, investors’ appeal of a “make-whole” ruling in the debtors’ favor was mooted, although for different reasons. So this is not a small risk.