Make-Whole Clauses under German Law - Legal Issues of Application (As at: Dec. 2023)

Make-whole clauses grant the issuer the right to call the bond at any time, thereby enabling it to redeem the bond early. This can be particularly advantageous for the issuer if the general market interest rate level falls. Make-whole clauses are particularly common in the terms and conditions of US bonds. In the European legal area, these clauses are only very popular in bonds for professional investors.

However, in the case of retail bonds with small denominations (e.g., nominal amounts of €1,000), there is legal uncertainty in the market as to whether their offering requires the provision of basic information sheets (KIDs) in accordance with the PRIIP Regulation, which led to a collapse in the trading volume of corporate bonds among private investors. In addition, make-whole clauses raise further legal questions, such as the scope of privileges from product governance, as well as issues under general terms and conditions law.

How Make-Whole Clauses Work

From a legal point of view, bonds are bearer bonds in which the issuer makes a performance promise by virtue of a deed which must be fulfilled vis-à-vis the respective holder. The performance obligations are defined in the bond terms and conditions. These typically govern the issue volume and price, interest rate, term, repurchase and termination options, repayment and collateralization. In addition, high-yield bonds regularly contain special provisions, for example on special covenants, subordination, call or repurchase options, and breaches by the issuer that may lead to the bond being called in or called due (events of default). The terms and conditions of the bond generally regulate termination rights for both creditors and the issuer.

The make-whole clause grants the issuer an ordinary right of termination (known as early redemption), which it can in principle exercise at any time (known as make-whole call). In return, the bondholder is compensated for exercising the early redemption right (so-called make-whole premium), as he will miss out on future coupon payments (interest payments). According to the legal definition, the make-whole premium is the sum of the net present value of the remaining coupon payments expected until maturity and the principal amount of the bond to be redeemed. In practice, an additional premium is often also provided for (usually 1%). A reference value, such as the yield on German government bonds, is used to determine the net present value of remaining coupon payments.

From the issuer's perspective, the make-whole call may result in an improvement of its rating and subsequently more favorable refinancing opportunities, especially if lower market interest rates are achievable depending on the market environment. In general, an early termination makes sense from the issuer's point of view if the costs of refinancing and make-whole premium are lower than the costs resulting from the continuation of the bond. Depending on the individual case, the issuer can also use a make-whole call to get rid of possible disadvantageous covenants that it has given in the bond terms and conditions, such as restrictions on further borrowing. In contrast, the bondholder is exposed to a reinvestment risk resulting from the reinvestment of the repaid capital. If market interest rates fall, the investor will be able to invest with a lower interest rate expectation. The make-whole clause is intended to strike an appropriate balance between the fundamentally conflicting interests.

Privileging Product Governance

The WpHG's conduct of business requirements reveal a number of special features for bonds with make-whole clauses. Conceptual designers and distributors (i.e. securities service companies that design and distribute financial instruments for sale) must comply with regulations on product governance, among other things. "Product governance" describes a complex of behavioral and organizational obligations. Conceivers of financial instruments must carry out an internal product approval procedure, in the context of which, among other things, an abstract target market must be determined and it must be ensured that the financial instruments meet the needs of this target market. For the target market, the group of customers must be determined with whose needs, characteristics and objectives the financial instrument must be in line. Any negative target market must also be determined, i.e. groups of customers with whose needs, characteristics and objectives the financial instrument is not compatible. The target market is determined in accordance with the more detailed specifications of ESMA and BaFin on the basis of the characteristics of customer type as well as knowledge and experience, financial situation including loss-bearing capacity, risk-profit profile including risk tolerance, and customer objectives and needs. After the concept developer has determined the abstract target market, the sales company determines the concrete target market with a view to its customers. It assesses the compatibility of the financial instruments it recommends or offers with the needs of its customers, also taking into account the abstract target market.

In the case of bonds with make-whole clauses, special consideration had to be given to the fact that these are instruments with increased complexity when determining the target market. On the one hand, the return to be expected by the investor from the bond is unclear and, on the other hand, the issuer's right to make a make-whole call represents a derivative element. In addition, the risk indicators to be determined in accordance with the PRIIP Regulation or its Delegated Regulation regularly show higher values, i.e., a higher risk, than for traditional bonds. As a result, private customers had to meet at least higher requirements in terms of knowledge and experience. Depending on the business model, increased risk tolerance was also to be expected. Accordingly, bonds with make-whole clauses could regularly not be recommended or could only be marketed with a corresponding risk warning.

Since November 2021, there are now legally regulated privileges from these described complications. Specific product governance requirements no longer apply if investment services relate to bonds that do not have any embedded derivatives other than a make-whole clause. This privilege has been implemented across Europe. With this privilege, the European legislator wanted to improve the framework conditions for capital procurement by companies. According to the legislator, make-whole clauses are generally regarded as safe and simple products suitable for small investors. In the event of their early redemption, a bond with no embedded derivative other than a make-whole clause protects investors from loss by ensuring that those investors are paid an amount equal to the total net present value of the remaining coupon payments and principal amount of the bond that they would have received had the bond not been called early.

In practice, there are a large number of different make-whole clauses. With regard to the legal definition, new legal uncertainties arise. Depending on the design, the question arises as to whether the make-whole premium still falls within the definition. Due to aspects of investor protection, the definition is likely to be interpreted narrowly in cases of doubt. In principle, investors should not be placed in a particularly disadvantageous position as a result of a make-whole call. Ultimately, make-whole clauses must be examined on a case-by-case basis. Furthermore, the question also arises as to whether traditional bonds without a make-whole clause (so-called plain vanilla bonds) can also be subject to the privileged treatment. In any case, a first-right conclusion suggests that this is the case. If bonds with a derivative make-whole element are already exempt from product governance, this could also be assumed for pure plain vanilla bonds. In practice, comparable legal uncertainties also arise in the case of other clauses with an inherent derivative element.

Provision of a Key Information Document (KID) According to PRIIP Regulation?

A very relevant legal question in practice is whether a key information document (KID) must be prepared for bonds with a make-whole clause in accordance with the PRIIP Regulation. The decisive factor is whether or under what conditions affected bonds qualify as a packaged investment product (PRIP). According to the legal definition, a PRIP is an investment, including instruments issued by special purpose vehicles within the meaning of Article 13(26) of Directive 2009/138/EC or securitization special purpose vehicles within the meaning of Article 4(1)(an) of Directive 2011/61/EU of the European Parliament and of the Council, where, irrespective of the legal form of the investment, the amount to be repaid to the retail investor is subject to fluctuations due to the dependence on reference values or on the performance of one or more assets that are not acquired directly by the retail investor. Pure plain vanilla bonds are in any case not subject to this definition in principle. However, this is questionable in the case of bonds that contain a derivative element such as the make-whole clause.

In BaFin's current opinion, bonds with make-whole clauses are generally to be classified as PRIPs. This is because the calculation of the net present value and thus the amount to be paid is based on a reference value (e.g. the interest rate of German government bonds). However, make-whole clauses can also be designed in accordance with BaFin's legal opinion in such a way that the bond is not classified as a PRIP. The Joint Committee of the European Supervisory Authorities (ESAs) made a differentiated assessment in 2019. In their most recent opinion from April 2022, the ESAs emphasized to the European Commission the need to include explicit exemptions in the PRIIPs Regulation, including for bonds with make-whole clauses. One year later, in May 2023, the Commission responded and submitted a proposal to amend the PRIIPs Regulation to the European legislative process. This now expressly excludes instruments from the scope of the Regulation where the fluctuations are exclusively attributable to a make-whole clause within the meaning of MiFID II. As soon as this amending regulation has entered into force, the fundamental legal uncertainty regarding the preparation of a key information document will become partially redundant. What will remain for the time being are legal uncertainties regarding the specific structure of make-whole clauses.

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Kronsteyn advises concept developers and sales companies on the design of sales concepts for financial instruments. The range of services also includes the implementation of customer due diligence and product governance requirements through documentation and the preparation of customer documents.	​Dr Hendrik Müller-Lankow Attorney-at-law, LL. M. (UCL) mueller-lankow@kronsteyn.law