The first appeals court to decide a question where the lower courts are split, the Ninth Circuit ruled in a 2/1 opinion that unimpaired, unsecured creditors in a chapter 11 case are presumptively entitled to interest at the contract rate or the default rate for judgments under state law, rather than the lower federal judgment rate.

Like every circuit to consider the issue, the Ninth Circuit also held that the judge-made, solvent-debtor exception survived adoption of the Bankruptcy Code in 1978.

The dissent would have held that unimpaired, unsecured creditors are entitled to no interest whatsoever, be it the contract rate or the judgment rate under federal law. Believing that the solvent-debtor exception did not survive adoption of the Bankruptcy Code, the dissenter would have given no interest to unimpaired creditors, although impaired creditors in a cramdown would receive interest from a solvent debtor.

The PG&E Plan

California power company Pacific Gas & Electric Co. filed a chapter 11 petition to deal with overwhelming claims stemming from wildfires caused by defective equipment. At filing and on confirmation of its plan, the company was and remained solvent, according to the August 29 opinion for the majority by Circuit Judge Carlos F. Lucero, sitting by designation from the Tenth Circuit.

Claims resulting from damage by wildfires were impaired by the plan, but PG&E’s general unsecured creditors were deemed unimpaired by the plan. Overruling objections by holders of trade claims, the bankruptcy court ruled that unimpaired, unsecured creditors were only entitled to interest at the federal judgment rate of 2.59%. Trade creditors had wanted interest either at the rates provided in their contracts or at the 10% default rate under California law.

PG&E estimated that the higher rates of interest for general, unsecured creditors would cost about $200 million.

The district court affirmed, and trade creditors appealed to the circuit. The appeal was argued in December.

History of the Solvent-Debtor Exception

Judge Lucero framed the question as: “[W]hat rate of postpetition interest must a solvent debtor pay creditors whose claims are designated as unimpaired pursuant to § 1124(1) of the Bankruptcy Code?” He said that no other circuit had decided the question and that the lower courts are split.

Judge Lucero cited a bankruptcy court in Houston for holding that unimpaired creditors are entitled to the contract rate. One bankruptcy court in Delaware called for the court to rely on “equitable principles,” while another Delaware bankruptcy court decided that the federal judgment rate applied to unimpaired creditors.

To begin answering the question, Judge Lucero traced the history of the so-called solvent-debtor exception. In the eighteenth century, English courts adopted the exception to the general rule that interest cuts off at filing. The exception meant that unsecured creditors received interest on their claim from the filing date until the date of distribution, before returning the surplus to the debtor.

U.S. courts, Judge Lucero said, adopted the solvent-debtor exception and continued its application following adoption of the Bankruptcy Act of 1898, even though it was not codified in the words of the statute. Quoting the Seventh Circuit, he said that “multiple circuit courts” adopted the exception “‘simply to enforce creditors’ rights according to the tenor of the contracts that created those rights.’” It was, he said, “well established under the Bankruptcy Act.”

Judge Lucero then turned to the question of whether the Bankruptcy Code continued or abandoned the exception. He said, “No provision of the Code specifies the rate of postpetition interest a creditor must receive from a solvent debtor to be unimpaired.”

The starting point was Section 1124(1), which provides that a claim is impaired unless it “leaves unaltered the [creditor’s] legal, equitable, and contractual rights . . . .” Section 1129(a)(7)(A)(ii) contains the so-called best-interests test applicable in a cramdown. It says that creditors must receive not less than what they would have received in a chapter 7 liquidation.

In a cramdown, Section 726(a)(5) means that unsecured, impaired creditors are entitled to the “legal rate” of interest, which the Ninth Circuit interpreted to mean the federal judgment rate in In re Cardelucci, 285 F.3d 1231 (9th Cir. 2002). “Conversely,” Judge Lucero said, “no Code provision applies § 726(a)(5) to unimpaired chapter 11 claims.” [Emphasis in original.]

Cardelucci involved the interpretation of Section 726(a)(5), which pertains in chapter 11 cases only when the best-interests test must be applied. Judge Lucero rejected the debtor’s contention that Cardelucci controlled and also imposed the federal judgment rate on unimpaired creditors.

Although the Cardelucci opinion did not say so, Judge Lucero said that the creditors were impaired. The two lower courts were therefore in error by making Cardelucci and its lower interest rate applicable to unimpaired creditors.

With no controlling precedent in the Ninth Circuit, Judge Lucero searched for the applicable rate in the Code or common law.

The Exception Was Not Abrogated by the Code

Judge Lucero cited the Supreme Court for the proposition that the Bankruptcy Code will not be read to “erode” past practice “‘absent a clear indication that Congress intended such a departure.’ Cohen v. de la Cruz, 523 U.S. 213, 221 (1998).” In that regard, he said, “No Code provisions — alone or together — unambiguously displace the long-established solvent-debtor exception or preclude supposedly unimpaired creditors from asserting an equitable right to contractual postpetition interest.”

For example, Judge Lucero said that Section 502(b)(2) excluded postpetition interest from “the amount of” a claim and did not ban interest entirely. Similarly, he pointed to the amendment that deleted former Section 1124(3) in 1994. Before deletion, that section had been interpreted to mean that an unimpaired creditor received no interest.

“In sum,” Judge Lucero said, “we agree with [trade creditors] that the Code lacks any ‘clear indication,’ Cohen, 523 U.S. at 221, that Congress meant to displace the historic solvent-debtor exception.” He therefore held, like “multiple sibling circuits,” that the “passage of the Code did not abrogate the solvent-debtor exception, any more than passage of the Bankruptcy Act did so.”

What Rate to Apply?

Next, Judge Lucero addressed the interest rate to apply to unimpaired, unsecured claims. He said that “no provision of the Code expressly provides for postpetition interest for unimpaired creditors.”

On the other hand, Judge Lucero said that the unimpaired creditors’ “equitable” rights under Section 1124(1) entitle them “to recovery of interest pursuant to their contracts.” Nonetheless, he did not specify the rate to impose on remand, be it the contract rate or the default rate under state law.

Judge Lucero called on the bankruptcy court “to weigh the equities and determine what rate of interest plaintiffs are entitled to in this instance.” Even so, he said that the bankruptcy court would not have “free-floating discretion.”

In “most cases,” the judge said, the court will enforce a creditor’s contractual right to interest, unless the “payment of contractual or default interest could impair the ability of other similarly situated creditors to be paid in full.” Although the record was “limited,” Judge Lucero saw “no sign of any ‘compelling equitable considerations’ in this case that would defeat the presumption that plaintiffs are entitled to contractual or default postpetition interest.”

For himself and Circuit Judge Lawrence VanDyke, Judge Lucero reversed and remanded in 28 pages.

The Dissent

Circuit Judge Sandra S. Ikuta dissented in a 21-page opinion that took an entirely different approach. She saw the Code as “clear” and that it “does not authorize an award of post-petition interest to unimpaired creditors.”

Under Section 502(b)(2), Judge Ikuta said, “there is no dispute” that claims stop accruing interest on filing. She said there must be a provision in the text of the Code to reinstate interest, and she found none in the case of unimpaired creditors.

Judge Ikuta saw the solvent-debtor exception as having been “implicitly incorporated” in several provisions of the Code, but none were applicable to unimpaired creditors. She pointed to Section 726(a)(5), which makes interest the fifth priority in a chapter 7 liquidation, but that section does not apply generally in chapter 11. It only comes into play when addressing best interests on cramdown of impaired creditors under Section 1129(a)(7)(a)(ii).

Addressing the majority’s “policy” argument that unimpaired creditors should be treated no worse than impaired creditors, Judge Ikuta said that policy considerations are for Congress to consider, not the courts.

Refusing to believe that the nonstatutory exception survived adoption of the Code, Judge Ikuta said that unimpaired creditors should be governed by the general rule disallowing postpetition interest.

Note: On appeal, the debtor did not argue, like Judge Ikuta would have ruled, that unimpaired creditors are entitled to no interest. The debtor advocated for the federal judgment rate.

Observation

The opinions do not speak of “plain meaning.” Still, the opinions demonstrate how radically different the results can be when judges use their common sense or when they struggle to find the answer only in the text of a statute on a question that Congress surely did not consider.