Resolving a distribution dispute between four layers of senior lenders, District Judge Deborah A. Batts of Manhattan sidestepped a conflict of circuits on the so-called Rule of Explicitness but nonetheless applied the doctrine to direct payment of interest on bondholders’ claims, even though post-petition interest would not have been an allowable claim under Section 506(b).

Judge Batts’ Jan. 27 opinion is a handy primer on the Rule of Explicitness and how courts around the country disagree over its interpretation and application.

In the case before Judge Batts, the trustee for a chapter 7 corporate debtor handed over about $25 million to the collateral agent for holders of five bond issues. The intercreditor agreement called for paying interest pro rata to all of the tranches simultaneously before beginning to pay principal. Once interest was paid, the agreement provided for principal until the senior-most tranche was paid in full, and then to the second in line until it was fully paid, and on down the line.

If interest were to be paid pro rata, the junior-most lender would get 38% of the $25 million. If Section 506(b) barred paying any interest at all, the first in line would get everything and the junior-most lender would get nothing. Under Section 506(b), interest is an allowable claim only if the collateral is worth more than the secured debt.

Judge Batts decided that the exception to the Rule of Explicitness was applicable in this case, meaning that all tranches were entitled to pro rata payment from the $25 million.

In her opinion, Judge Batts recounts the pre-Code derivation of the Rule of Explicitness. Created by federal courts before the adoption of Section 506, it decreed that interest ceases to accrue at the initiation of bankruptcy. It was codified by Section 506(b), with the exception that interest is a valid claim if the collateral is worth more than the debt.

Also before the adoption of the Code, courts created an exception to the Rule of Explicitness by suspending the doctrine between creditors if their agreement “clearly” showed “an intent to suspend the rule.”

Usually, disputes about the Rule arise between senior and subordinated creditors. Judge Batts held that it also applies in disputes among tranches of senior lenders.

Adoption of the Bankruptcy Code arguably modified or eradicated the Rule in its original form because Section 510 makes subordination agreements enforceable in bankruptcy to the extent they are “enforceable under state law.”

Answering a question certified from the Eleventh Circuit, the New York Court of Appeals, the highest court in the New York State court system, said that the Rule is a substantive principle of New York contract law.

The First Circuit, on the other hand, held that New York’s highest court improperly intruded into federal law by making a bankruptcy specific rule declaring that the Rule is applicable in bankruptcy. The Second Circuit has yet to address the dispute.

In the most dubious part of her opinion, Judge Batts avoided deciding whether the New York Court of Appeals improperly intruded into federal bankruptcy law because she said that the case before her did not involve bankruptcy since none of the parties before her were in bankruptcy, nor was she dealing with property of a bankrupt estate.

Thus free to apply the unvarnished New York version of the Rule of Explicitness, Judge Batts said that the parties’ agreements gave “clear notice” that principal payments were subordinated to prior payment of post-petition interest. To reach her conclusion, she pointed to a provision providing for the payment of interest “regardless of whether such interest and fees are allowed in such [bankruptcy] proceeding.” Another said that interest is due and payable “regardless of whether” the debtor is in bankruptcy.

Judge Batts buttressed her decision to allow interest payments by noting that the documents in the case before her incorporated language similar to the American Bar Association’s model indenture designed for use when the parties intend to override the Rule.