A Mississippi bankruptcy court has ruled that when a promissory note provides for automatic acceleration triggered by the borrower’s bankruptcy, under New York law oversecured noteholders cannot collect a prepayment premium. In re Premier Entertainment Biloxi, LLC, 445 B.R. 582 (Bankr. S.D.Miss. 2010). The ruling had significant financial consequences for the lenders, and although the impact of the case is unclear, lenders and investment bankers should take steps to avoid a similar result in future transactions.
In 2002, Premier Entertainment Biloxi, LLC and certain related entities undertook to construct the Hard Rock Hotel & Casino Biloxi, the plans for which included a 112-foot guitar sign. To finance construction, the Debtors issued 10.75% first mortgage notes in the principal amount of $160 Million, due on February 1, 2012, with $8.6 Million in interest due February 1 and August 1 each year beginning on August 1, 2004. U.S. Bank served as indenture trustee.
The notes provided for automatic acceleration of the maturity date upon the Debtors’ filing of a voluntary bankruptcy petition. The notes also provided that the Debtors could redeem the notes prior to maturity, but not before the end of the “no-call period” on February 1, 2008, by paying the principal plus a prepayment premium (100% to 105.375% depending on the remaining term). If the Debtors were to take any willful action during the no-call period with the intent of avoiding the prohibition on early redemption, the lenders would be entitled to higher prepayment premiums (106.719% to 110.75% depending on the remaining term).
The hotel and casino were completed on time and a certificate of occupancy as issued on August 26, 2005. Three days later, on August 29, 2005, Hurricane Katrina completely destroyed the resort’s casino, which was built upon two floating barges, and severely damaged other facilities. Thereafter, the Debtors negotiated with the indenture trustee and other parties to reconstruct the resort, this time on concrete piers, using remaining cash and insurance proceeds. However, the lenders eventually lost faith in the project and stopped all construction disbursements.
On January 6, 2006, the indenture trustee gave notice of certain defaults, which did not trigger automatic acceleration. Subsequently, a controlling stake in the Debtors was purchased by a new equity group, which made several offers to purchase the notes up to 101% of principal, far below the 105.375% required as of the expiration of the no-call period. At the time, the market price of the notes ranged from 105% to 106%.
The indenture trustee rejected the offers, and the Debtors commenced chapter 11 cases on September 19, 2006. The Debtors filed a reorganization plan providing for payment of the notes at par value plus accrued interest from new financing. Although the noteholders rejected the plan, all other classes of creditors voted in favor of the plan and it was “crammed down” over the noteholders’ objections. The plan was confirmed in June, 2007, and the resort opened to much fanfare just a few days later.
Thereafter, a trial was held on the noteholders’ entitlement to the contractual prepayment premiums that were denied under the plan. The bankruptcy court ruled in favor of the Debtors, holding that: “The reason [automatic acceleration] clauses exist is to allow lenders to accelerate the debt without first having to petition the bankruptcy court to lift the automatic stay.” In exchange for this advantage, the court held that the noteholders gave up their expectation of a prepayment premium: “The [noteholders] chose to forego any prepayment premium in favor of an immediate right to collect their entire debt after a bankruptcy event of default.”
The court’s rationale is dubious in that it is unlikely the noteholders actually preferred to exchange the significant economic benefits of the prepayment premium for the relatively minor procedural advantage of avoiding a motion for relief from the automatic stay. Moreover, there is authority questioning whether an automatic acceleration clause is barred by the “ipso facto” provisions of the Bankruptcy Code and is invalid in any case. See In re Crystal Properties, Ltd., L.P., 268 F.3d 743 (9th Cir. 2001). In other words, the court read a very bad bargain into the terms of the notes.
If the court’s holding were to become the rule, it would give rise to difficulties in determining the present value of corporate bonds and disrupt the corporate bond market. In fact, in this case the market priced the bonds significantly higher before the commencement of the case, and bondholders would have been better off selling out. This underscores the fact that the court’s ruling sharply reduced the real value of the notes.
It is unclear what impact this opinion will have, and investment banking counsel should take steps to reduce the risk of a similar result for their clients. Specifically, this result might be avoided by specifying that the prepayment premiums apply notwithstanding acceleration of the maturity date. In fact, the court commented that: “Contractual acceleration provisions are only limited in what they can do by the parties’ imaginations – in the absence of fraudulent, exploitative, overreaching, or unconscionable conduct.” Alternatively, lenders that are likely to be significantly oversecured should consider whether automatic acceleration upon bankruptcy confers any real advantage.
(Also seen on Insight Into Banking)