Make-Whole Premiums and the Agency Costs of Debt

Richard Squire is Professor of Law at Fordham University School of Law. This post is based on his recent book chapter, forthcoming in the Elgar Research Handbook on Bankruptcy Law.

A make-whole premium is a contractual penalty a borrower must pay for prepaying a loan. In several recent bankruptcy cases, the court ruled that the debtor triggered its make-whole obligations by voluntarily filing for bankruptcy and thereby accelerating all of its debts. In such cases, the questions then arise whether, and at what level of priority, the make-whole premium is recoverable as a statutory matter from the bankruptcy estate.

In a forthcoming book chapter, I argue that a make-whole premium automatically triggered by a bankruptcy filing shifts risk onto the debtor’s general creditors and thus increases the agency costs of debt. Risk-shifting occurs because a make-whole that is automatically triggered by a bankruptcy filing is an instance of correlation-seeking: the incurring of a contingent liability whose risk of being triggered correlates positively with the debtor’s insolvency risk. Correlation-seeking generates social costs that reduce the joint surplus from lending arrangements. The anticipation of it induces creditors to incur monitoring costs and debtors to incur bonding costs. When correlation-seeking is undeterred, it encourages overinvestment: the committing of capital to projects that are expected to benefit the firm’s shareholders only because they are subsidized by a transfer of value away from general creditors.

The positive function of a make-whole premium is to discourage a borrower from opting to prepay a loan solely to refinance at a lower interest rate. This function is served regardless of whether a make-whole is automatically triggered by a bankruptcy filing. Put another way, a make-whole will deter strategic refinancing even if it cannot reduce general creditor recoveries and is recoverable only to the extent the debtor is solvent. Its deterrence function requires that it be recoverable ahead of shareholder interests, not that it cut into the recoveries of other creditors.

A subordination rule for make-wholes—which permitted them to be recovered only to the extent a debtor is otherwise solvent—would be consistent with the text of the Bankruptcy Code. The Code generally disallows claims for unmatured interest, and this is exactly what most make-wholes premiums are: they are penalties set to equal the present value of the interest payments a borrower avoids by prepaying a loan. Several courts have reasoned that make-wholes are claims not for unmatured interest but rather for liquidated damages. However, as Judge Schmetterer of the Northern District of Illinois accurately observed in a 2014 case, a make-whole is both of these things: it is liquidated damages set to equal unmatured interest, and for this reason is excludable from a creditor’s bankruptcy claim unless the debtor is solvent. Moreover, most make-wholes overcompensate the lender by ignoring the opportunity to re-invest the prepaid principal. For this reason, bankruptcy courts should deem most of a claim for a make-whole unreasonable and thus unrecoverable even if the lender is oversecured, again unless the debtor proves solvent.

As with other forms of risk-shifting, general creditors can anticipate the dilutive impact of make-whole premiums and charge higher interest rates ex ante. In this way, interest-rate adjustments can prevent a net redistribution of wealth from some creditors to others. But ex ante interest-rate adjustments do not reduce the agency costs of debt, because they do not prevent parties from incurring monitoring and bonding costs or from engaging in overinvestment. By analogy, moral hazard causes insurers to charge drivers more for collision coverage, but the higher insurance premiums do not encourage the drivers to drive more carefully unless the premiums adjust ex post, after an accident occurs. Similarly, interest-rate adjustments do not reduce the agency costs of debt unless creditors also insist on loan covenants prohibiting risk-shifting conduct and monitor for compliance before bankruptcy occurs. Yet such monitoring is itself expensive. Automatic subordination of bankruptcy-triggered make-wholes by operation of the Bankruptcy Code would be more efficient, reducing the agency costs of debt (including monitoring costs) while preserving make-wholes’ positive function of deterring opportunistic refinancing.

A lender that can use a bankruptcy-triggered make-whole to augment its bankruptcy recovery will be willing to charge less interest on the underlying loan. This reduction in the loan’s interest rate benefits the borrower’s shareholders, and it may also leave more assets available for creditors if the borrower becomes bankrupt. However, it can be readily shown mathematically that, if a contingent liability’s triggering risk correlates positively with the debtor’s insolvency risk, then the liability’s expected cost to the debtor’s general creditors will exceed the expected benefit to them from this augmentation of the estate. In essence, the borrower uses the contingent liability to sell the lender a share of the borrower’s future bankruptcy estate that would otherwise go to other creditors. The borrower’s shareholders pocket most of the upside from the sale but bear little of the expected burden, which falls primarily on the borrower’s general creditors.

A bankruptcy-triggered make-whole is an example of what in the chapter I call a distress-triggered liability: a contingent claim against a debtor that tends to be triggered by the debtor’s own financial distress. Other examples include loan default penalties and intragroup guarantees, as well as prepayment fees generally. Because of the high correlation between the risk that such liabilities will be triggered and the debtor’s insolvency risk, all distress-triggered liabilities increase the agency costs of debt if recoverable at the expense of the debtor’s general creditors. By consistently applying a subordination rule to such liabilities, bankruptcy courts could reduce debt’s agency costs while preserving the arrangements’ positive functions.

The latest version of the chapter, forthcoming in the Elgar Research Handbook on Bankruptcy Law (Barry Adler, ed.), can be downloaded here.

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