Make-Whole Premiums And OID In Bankruptcy

The recent Southern District Bankruptcy Court decision in In re AMR Corp., 485 B.R. 279 (Bankr. S.D.N.Y. 2013) ("American Airlines") raises again the challenges facing underwriters, initial purchasers, lenders and investors in the debt capital markets in assessing and minimizing the risks associated with the ability to recover make-whole compensation and original issue discount ("OID") in the event of a bankruptcy of an issuer.

Make-whole premiums and OID are common features in the bond and loan markets today. There is a risk that in the event of a bankruptcy filing by an issuer make-whole premiums and OID may be treated as unmatured interest. In a bankruptcy, the payment of unmatured interest is generally prohibited.

Make-whole premiums compensate the lender for the loss of future debt service payments and permit the issuer to pay off remaining debt early. In a loan agreement these are also referred to as prepayment penalties and prepayment premiums. In a bond indenture the issuer makes a lump sum payment derived from a formula based on the net present value of future coupon payments that will not be paid because of the call. In a loan agreement the premium payable is a percentage, usually set on a sliding scale and reduced over time.

OID refers to the difference between the stated principal amount of a debt instrument at maturity and the proceeds actually received by the issuer. OID has become more common since the 2007 credit crisis as a mechanism for increasing yield-to-maturity at a given coupon rate. For tax purposes, OID is deemed to accrue over time as though it were a stream of interest payments, but the issuer does not actually make any payments to amortize OID until maturity.

The most basic problem facing any claim in bankruptcy which may fairly be characterized as unmatured interest is a statutory bar (Section 502(b)(2)) to recovery of any interest that was not earned as of the filing date. Courts typically apply this provision to disallow the unearned portion of any OID. See, In re Solutia, 379 B.R. 473 (S.D.N.Y. 2007) ("Solutia"). Although Section 506(b) of the Code does permit payment of post-petition interest if a claim is oversecured, the courts have not yet harmonized that provision with 502(b) when dealing with a claim for OID. It is worth noting that the debtor in Solutia conceded that the lender was at least fully secured and that the case was settled prior to determination of an appeal.

Make-whole premiums have gotten...