Over a dissent, the majority on a Third Circuit panel held in the reorganization of Hertz Corp. that unsecured creditors of a solvent debtor are entitled to post-petition interest at the contract rate rather than the lower federal judgment rate.

Of greater significance, Circuit Judge Thomas L. Ambro held for the majority that a so-called make-whole premium is unmatured interest that is disallowed under Section 502(b)(2) in an ordinary bankruptcy where the debtor is insolvent.

Circuit Judge David J. Porter agreed with the two holdings stated above but disagreed with Judge Ambro’s most significant holding for the majority: Unsecured noteholders were entitled to their make-wholes because Hertz was solvent.

After adoption of the Bankruptcy Code, there has been an open question about the survival of the so-called solvent-debtor exception to the disallowance of unmatured interest under Section 502(b)(2). Rather than debate the topic, Judge Ambro reanimated the solvent-debtor exception by reading the Supreme Court’s Jevic opinion as expanding the absolute priority rule into areas beyond chapter 11 plan confirmation and thereby achieving the same effect as the solvent-debtor exception.

Judge Ambro’s Preface

Judge Ambro began his 43-page opinion by discussing how leverage “influences who gets paid.” Being able to pay creditors in full and thus deprive everyone of the ability to vote on a plan, Judge Ambro said that the debtor had leverage to deny unsecured noteholders more than $270 million “while giving lower priority equityholders four times that amount.”

In his opinion on September 10, Judge Ambro addressed the question of whether the Bankruptcy Code gave “the debtors enough leverage to do that.” With no controlling law in the Third Circuit, Judge Ambro found the answer by asking two questions: (1) Does the Section 502(b)(2) prohibition of unmatured interest cover make-wholes, and (2) does the Bankruptcy Code “as a whole” require unimpaired creditors to receive post-petition interest at the contract rate rather than the lower federal judgment rate?

Answering the first question, Judge Ambro said that a make-whole owed by an insolvent debtor “must be disallowed under § 502(b)(2), [because make-wholes] fit both the dictionary definition of interest and are its economic equivalent.” Regarding the second question, he said that the noteholders “have a right to receive contract rate interest and the [make-whole] because Hertz was solvent.”

Judge Ambro found support for his conclusions in opinions from the Fifth and Ninth Circuits that reached the same results. Ultra Petroleum Corp. v. Ad Hoc Comm. of Opco Unsecured Creditors (In re Ultra Petroleum Corp.), 51 F.4th 138 (5th Cir. 2022), cert. denied, 143 S.Ct. 2495 (2023); Ad Hoc Comm. of Holders of Trade Claims v. Pac. Gas & Elec. Co. (In re PG&E Corp.), 46 F.4th 1047 (9th Cir. 2022), cert. denied, 143 S.Ct. 2492 (2023). To read ABI’s reports on Ultra and PG&E, click here and here.

Although Judge Ambro reached the same result as the other two circuits, he said that the “primary support” for his conclusions came from his understanding of the absolute priority rule described by the Supreme Court in Czyzewski v. Jevic Holding Corp., 580 U.S. 451 (2017). To read ABI’s report on Jevic, click here.

As he would explain more fully later in the opinion, Judge Ambro summarized Jevic’s command of the result in the case before him by saying,

Allowing Hertz to cancel more than a quarter billion dollars of interest otherwise owed to the Noteholders, while distributing a massive gift to the Stockholders, would impermissibly “deviate from the basic priority rules . . . the Code establishes for final distributions of estate value in business bankruptcies.” Jevic, 580 U.S. at 455.

The Facts

After telling readers how his circuit was ruling, Judge Ambro laid out the facts.

Devastated by the pandemic, Hertz filed a chapter 11 petition in 2020. As the economy quickly rejuvenated, so did Hertz. Insolvent on filing, Hertz became solvent once more, owing $2.7 billion to unsecured noteholders.

The noteholders and all other classes of creditors were unimpaired by the Hertz plan and thus had no right to vote. Although the noteholders were to be paid in full on consummation, the plan gave them post-petition interest at the federal judgment rate of 0.15% rather than the higher contract rate. The plan also took away their make-whole, which was designed to compensate noteholders for early redemption and being forced to reinvest at lower rates of interest.

New investors were effectively buying Hertz. Existing shareholders were cashed out with a package of stock, warrants and cash worth $1.1 billion. In other words, the plan gave noteholders a $270 million haircut while lower-ranking shareholders were taking home $1.1 billion.

To make noteholders unimpaired, the plan gave them the right after confirmation to file a complaint contesting the loss of the make-whole and the contract interest rate. The bankruptcy court dismissed the claim for restoration of the contract rate of interest, concluding that noteholders were only entitled to the federal judgment rate for post-petition interest. The bankruptcy court also disallowed the noteholders’ claim for redemption fees, believing they were not triggered a matter of contract law.

After trial, the bankruptcy court concluded that the make-whole was the economic equivalent of interest and was therefore barred by Section 502(b)(2), which disallows claims for “unmatured interest.”

Sua sponte, the bankruptcy judge certified her decision for direct appeal. The Third Circuit accepted the appeal. To read ABI’s reports on the bankruptcy court’s two decisions, Wells Fargo Bank NA v. Hertz Corp. (In re Hertz Corp.), 21-50995, 2022 BL 426983, 2022 Bankr Lexis 3358 (Bankr. D. Del. Nov. 21, 2021); and Wells Fargo Bank NA v. Hertz Corp. (In re Hertz Corp.), 637 B.R. 781 (Bankr. D. Del. Dec. 22, 2021), click here and here.

No Early Redemption Fee

The notes gave holders a fee if the notes were redeemed before maturity.

Judge Ambro agreed with the bankruptcy court, holding that the fee was not triggered because the notes matured automatically when Hertz file bankruptcy, with redemption occurring one year later when Hertz confirmed the chapter 11 plan.

In short, there was no redemption before maturity and thus no fee.

Judge Ambro said the result was not “absurd” because it flowed from “extensive negotiations” over the terms of the notes. If noteholders believe the result was “unfair,” he said they “should not have agreed” to the terms of the notes, he said.

The Make-Whole

Although the language of the make-whole “appears complicated,” Judge Ambro said that the substance was not. He described a make-whole as seeking “to ensure that Noteholders receive the return they expected for their investment in the Notes Hertz redeemed before their Redemption Date.”

On appeal, Judge Ambro said that the question was whether the make-whole was interest or the economic equivalent of interest, as the bankruptcy judge had found. After analysis, he concluded that the make-whole was both interest and the economic equivalent of interest. More specifically, he said that the make-whole was “mathematically equivalent to the unmatured interest the Noteholders would have received had Hertz redeemed the Notes on their Redemption Dates.”

Judge Ambro held that “the Bankruptcy Court correctly disallowed the Noteholders’ claims for” the make-whole because “§ 502(b)(2) disallows a claim for unmatured interest if it is either definitionally interest or its economic equivalent.”

[Note: Judge Ambro’s holding appears to mean that make-wholes are disallowed under Section 502(b)(2) in ordinary chapter 11 cases where the debtors are insolvent. In the next section of the opinion, Judge Ambro discussed the effect of Hertz’s solvency on the disallowance of the make-whole. The dissenter did not join the following section of the majority’s opinion.]

Solvency, Make-Wholes and Post-Petition Interest

Despite the holdings he had just issued, Judge Ambro asked whether “the Bankruptcy Code as a whole nonetheless require[s] solvent debtors to pay unimpaired creditors interest accruing post-petition at the contract rate?” He rephrased the question “in a way that makes the answer predictable: Can Hertz use the Bankruptcy Code to force the Noteholders to give up nine figures of contractually valid interest and spend that money on a massive dividend to the Stockholders?”

Judge Ambro devoted the next 17 pages of his opinion to explaining why the “answer is no.”

Judge Ambro saw the Fifth and Ninth Circuits as having held that creditors of solvent debtors have an equitable right to the contract rate of interest before surplus value goes to shareholders. He noted how the Ninth Circuit “correctly noted” the solvent debtor exception “sprung from the pre-Code absolute priority rule” and said that the “absolute priority rule serves as an essential governor on the bankruptcy process to protect creditors.”

After tracing the history of absolute priority back to Northern Pacific Railway Co. v. Boyd, 228 U.S. 482 (1913), Judge Ambro said that “the absolute priority rule [today] is housed in § 1129(b).” Citing Jevic as authority for interpreting the contours of absolute priority, Judge Ambo said that a “creditor is impaired if its treatment violates the absolute priority rule because every creditor has a right to treatment consistent with that principle.”

Reversed by the Supreme Court in Jevic, Judge Ambro said that the Third Circuit had approved a so-called structured dismissal that violated priorities in bankruptcy distribution. He explained the significance of the Jevic reversal as follows:

Whereas our Court saw the absolute priority rule as a procedural protection that applied only when § 1129(b) is invoked (where the Code explicitly mentions it), the Supreme Court concluded it applied everywhere absent a clear statement authorizing a departure. . . . In other words, the Bankruptcy Code entitles every creditor — not just the dissenting impaired creditors who can invoke § 1129(b)19 — to treatment consistent with absolute priority absent a clear statement to the contrary.

Interpreting Jevic to require application of absolute priority everywhere, Judge Ambro said that “the Noteholders’ right to treatment consistent with absolute priority must be honored to leave them unimpaired.” Pre-Code practice, he said, “required solvent debtors to pay contract rate interest before making distributions to equity.” Stitching the principles together, he said that “the absolute priority rule requires creditors’ obligations be paid in full before owners, with junior rights to the business, take anything at all.”

In sum, Judge Ambro held that a make-whole is a form of interest that a solvent debtor must pay in full before distributions to shareholders.

Ordinarily, Judge Ambro said the circuit court would remand for the bankruptcy court to decide whether there were any equitable exceptions to disallow the make-whole, but “we do not do so here,” for two reasons.

First, the debtor never sought a remand. Second, the shareholders had already received $1.1 billion. “So,” Judge Ambro said, “our equitable calculus must reflect that the Stockholders already took their dividend. Therefore, the equities demand the Noteholders recover post-petition interest at the contract rate.”

Ending his opinion, Judge Ambro affirmed in part and reversed in part, ruling that Hertz must pay noteholders’ post-petition interest at the contract rate along with the make-whole.

The Dissent

Judge Porter “respectfully” concurred except in the last part of the majority opinion requiring payment of the make-whole and post-petition interest under the Jevic interpretation of the absolute priority rule. Citing Section 502(b)(2), he said that “the Bankruptcy Code plainly disallows claims ‘for unmatured interest’ like the Noteholders’ claims for the [make-whole] and post-petition interest.”

Judge Porter gave two reasons for his dissent. First, he said that application of absolute priority is not a “right” protected under Section 1124(1), which describes how a claim must be treated if it is to be unimpaired. Like the dissenter in the Ninth Circuit, he said that absolute priority is a “procedural protection” and not a substantive right to payment.

Second, Judge Porter assumed that Section 1124(1) requires “treatment consistent with absolute priority.” Nevertheless, he said that the noteholders were unimpaired “because it is the Code that alters the Noteholders’ right, not the Plan.”

For two other reasons, Judge Porter disagreed with the notion “that Jevic requires Hertz to pay contract-rate interest.”

First, Judge Porter said that the bankruptcy court had violated the absolute priority rule in Jevic by exercising power “without any express basis in the Code.” In the Hertz case, he said that “the Code expressly disempowers courts from allowing claims for post-petition contract-rate interest over an objection. § 502(b)(2).” [Emphasis in original.]

Second, Judge Porter assumed the majority was correct that “Hertz violate[d] the common law absolute priority rule.” In Jevic, he said that structured dismissal “violated the codified absolute priority rule.” [Emphasis in original.] In the Hertz plan, he said that the debtor “has not violated the codified absolute priority rules because it has paid the Noteholders’ allowed claims in full.”

In sum, Judge Porter said that Jevic “does not apply to the facts here.” He “would not use the common law absolute priority rule as an ‘extratextual supplement’ to supplant § 502(b)(2),” because “the Code’s disallowance of the Noteholders’ claims is clear and unambiguous.”