Delaware Bankruptcy Court Enforces Prepetition “Make Whole” Payment Provision in School Specialty, Inc.

April 26, 2013

Publication| Bankruptcy & Corporate Restructuring

In In re School Specialty, Inc., Case No. 13-10125 (KJC) (Bankr. D. Del. Apr. 22, 2013), the United States Bankruptcy Court for the District of Delaware denied a motion brought by the Official Committee of Unsecured Creditors (the “Committee”) which sought to disallow a $23.7 million “early payment fee” (the “Make Whole Payment”) in a prepetition credit agreement. The Court enforced the Make Whole Payment provision because such payment was not “plainly disproportionate” to the lender’s probable loss, was reasonable under Bankruptcy Code section 506(b), and was not a claim for unmatured interest under Bankruptcy Code section 502(b)(2).

On January 28, 2013, School Specialty, Inc. and its affiliated debtors (the “Debtors”) filed voluntary chapter 11 petitions with the Court. On May 22, 2012, the Debtors entered into a term loan credit agreement (the “Credit Agreement”) with Bayside Finance, LLC (“Bayside”) that provided the Debtors with up to $70 million in term loan credit (the “Term Loan”). The Term Loan matured on October 31, 2014 (the “Initial Maturity Date”), but the maturity date could be extended until December 31, 2015 (the “Extended Maturity Date”) if the Debtors refinanced certain convertible notes (the “Convertible Notes”) prior to the Initial Maturity Date.

Upon the prepayment or acceleration of the Term Loan, the Debtors were required to pay an early payment fee. If the prepayment or acceleration occurred during the first 18 months of the Term Loan, the early payment fee was calculated by discounting the future stream of interest payments between the date on which the prepayment or acceleration was made and the Extended Maturity Date.1 The applicable discount rate was the Treasury rate plus 50 basis points.

On January 4, 2013, Bayside entered into a forbearance agreement (the “Forbearance Agreement”) with the Debtors wherein the Debtors acknowledged a breach of a minimum liquidity covenant in the Credit Agreement. The Forbearance Agreement also provided for the acceleration of the Term Loan, which consequently made all outstanding principal and unpaid interest under such loan, including the Make Whole Payment, due and payable.

In its decision, the Court first examined applicable state law to determine whether the Make Whole Payment is enforceable in bankruptcy. Under applicable New York law governing the Credit Agreement, prepayment provisions are analyzed similarly to liquidated damages provisions. New York law provides that a liquidated damages provision is enforceable when (i) actual damages are difficult to determine, and (ii) the amount is not “plainly disproportionate” to the possible loss as determined with reference to the facts and circumstances in existence on the date the agreement was entered into. The Court further noted that New York courts have cautioned against interfering with parties’ agreements absent overreaching or other unconscionable conduct.

The Committee’s main argument in support of its motion was that the Make Whole Payment was plainly disproportionate to Bayside’s possible loss. To examine this issue in accordance with New York law, the Court considered whether (i) the prepayment fee was calculated so that the lender would receive its bargained-for yield, and (ii) such fee was the result of an arm’s-length transaction between represented, sophisticated parties.

As to the first prong, the Committee argued that the Make Whole Payment inflated Bayside’s bargained-for yield because it included discounted interest payments through the Extended Maturity Date. In the Committee’s view, the Make Whole Payment should only include discounted interest payments through the Initial Maturity Date because it was unlikely that the Convertible Notes would be refinanced prior to the Initial Maturity Date (and thus that the maturity date would be extended). The Court rejected this argument because (i) the likelihood that such notes would be refinanced was irrelevant because Bayside was obligated to keep adequate funds available through the Extended Maturity Date and such commitment necessarily impacted Bayside’s lending activity, and (ii) the Make Whole Payment was calculated using a discount rate that was tied to Treasury Note performance and New York courts have held that such a calculation method supports the conclusion that a prepayment fee is not plainly disproportionate to a lender’s possible loss. Further, while the Make Whole Payment was 37% of the Term Loan and such percentage gave the Court pause, the Court noted that the applicable standard governing the validity of the Make Whole Payment was whether such payment was plainly disproportionate to Bayside’s possible loss and not whether such payment was plainly disproportionate to the amount of the Term Loan.

As to the second prong, the Court concluded that the Term Loan was an arm’s-length transaction. While it was undisputed that the Debtors were in financial distress when they entered into the Credit Agreement, the Court found that, under the facts and circumstances, there was no credible evidence to suggest overreaching by Bayside.

The Committee also argued that the Make Whole Payment must be reasonable under Bankruptcy Code section 506(b).2 Bayside argued that the reasonableness standard under such section did not apply given that such payment came due prepetition and, in its view, such standard only applies to post-petition fees, costs and charges. The Court did not rule on the applicability of this standard but concluded that, even if such standard applies, the Make Whole Payment was reasonable because, under New York law, it was not plainly disproportionate to Bayside’s possible loss.

The Committee further argued that the Make Whole Payment was intended to compensate Bayside for lost future interest resulting from the prepayment and, therefore, should be disallowed under Bankruptcy Code section 502(b)(2) because it was a claim for unmatured interest.3 The Court, following the reasoning in In re Trico Marine Servs., Inc., 450 B.R. 474 (Bankr. D. Del. 2011), concluded that the Make Whole Payment was akin to a claim for liquidated damages rather than a claim for unmatured interest because the Make Whole Payment fully matured at the time of the breach (i.e., when the Debtors entered into the Forbearance Agreement).

Finally, the Committee contended that Bayside had a duty to mitigate the damages that it suffered as a result of the breach. The Court also rejected this argument because, under New York law, courts have held that a valid liquidated damages claim obviates the duty to mitigate. 

* * *

The School Specialty opinion provides lenders, investors and borrowers, among others, with guidance regarding how to structure prepayment and other early termination fees so that such fees are enforceable in bankruptcy. The opinion is also noteworthy because it suggests that the Delaware Bankruptcy Court is trending toward the majority position that a prepayment or early termination fee should not be disallowed as a claim for unmatured interest pursuant to Bankruptcy Code section 502(b)(2).

1 The amount of the early payment fee decreased to 6% of the outstanding principal amount of the Term Loan if the prepayment or acceleration was made after the first 18 months of such loan and was further decreased to 1% of such amount if such prepayment or acceleration was made after the first 30 months of such loan.
2 Bankruptcy Code section 506(b) provides:
To the extent that an allowed secured claim is secured by property the value of which, after any recovery under [Bankruptcy Code section 506(c)], is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose. 
3 Bankruptcy Code section 502(b)(2) provides:
[If an] objection to a claim is made, the Court, after notice and a hearing, shall determine the amount of such claim . . . as of the date of the filing of the petition, and allow such claim in such amount, except to the extent that . . . such claim is for unmatured interest. 

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