Disallowing Part of a Claim Doesn’t Make the Claim Impaired, Fifth Circuit Says

Siding with the Third Circuit, the Fifth Circuit held that a chapter 11 plan by itself, not state law, determines whether a claim is unimpaired. In other words, a claim is not impaired if some element of the claim, disallowed under the Bankruptcy Code, would be enforceable under state law.

Consequently, a creditor whose claim is otherwise paid in full has no right to vote on a chapter 11 plan just because part of the claim has been disallowed, perhaps because it represents unmatured interest.

The January 17 opinion by Circuit Judge Andrew S. Oldham primarily dealt with claims for a so-called makewhole premium, which chiefly arises under bond indentures when debt is repaid before maturity. The makewhole is designed to compensate bondholders for being forced to reinvest at a lower interest rate if rates have fallen.

Significantly, Judge Oldham did not delve into the split between the Second and Third Circuits regarding the allowance of makewholes. See Delaware Trust Co. v. Energy Future Intermediate Holding Co. LLC (In re Energy Future Holdings Corp.), 842 F.3d 247 (3d Cir. 2016), and BOKF NA v. Momentive Performance Materials Inc. (In re MPM Silicones LLC), 874 F.3d 787 (2d Cir. 2017).

Splitting with the Third Circuit, the Second Circuit held in 2017 that makewholes are not allowable in chapter 11. A year earlier, the Third Circuit held that bondholders have a valid makewhole claim in chapter 11. To read ABI’s discussion of those decisions, click here and here.

In the appeal before the Fifth Circuit, neither the Second nor the Third Circuit’s opinion would be definitive, because both prior cases dealt with insolvent debtors. On the other hand, Judge Oldham was dealing with solvent debtors.

Judge Oldham focused on the so-called solvent-debtor exception to a long-standing rule disallowing post-petition interest. If the exception survived adoption of the Bankruptcy Code, the makewhole might be allowable against a solvent chapter 11 debtor, he said.

Although he did not rule on the survival of the solvent-debtor exception, Judge Oldman hinted that makewholes are not allowable, regardless of whether the debtor is solvent or insolvent.

The Facts

The debtors were oil and gas producers that filed chapter 11 petitions in 2016 after the price of petroleum collapsed, rendering the companies insolvent. Later, however, the price of oil rose, making the debtors solvent once again.

The debtors proposed a chapter 11 plan where none of the creditors were impaired, thus theoretically barring them from voting on the plan.

Creditors included holders of unsecured bonds, whose indenture contained a makewhole premium. The plan did not propose to pay the makewhole.

The debtors also proposed to pay revolving credit lenders in full. However, the plan offered post-petition interest at the federal judgment rate, not the higher default rate called for in the loan agreement.

Because the plan did not pay the makewhole or the higher default interest rate, the creditors objected to the plan. To permit confirmation, the debtors set aside almost $400 million to compensate the bondholders and the revolving credit lenders if their claims for the makewhole and the default rate must be paid to render their claims unimpaired.

The Decision in Bankruptcy Court

The parties conceded that the makewhole and the default interest rate were both enforceable under state law.

After confirmation, Bankruptcy Judge Marvin Isgur of Houston ruled that the creditors must receive everything under state law to render their claims unimpaired.

The debtors appealed. Judge Isgur certified the questions for direct appeal to the Fifth Circuit. The Court of Appeals accepted the direct appeal.

Oral argument on November 5 was a clash of appellate titans, with Paul D. Clement for the debtors and Dennis F. Dunne for the creditors. We can’t say yet who came out on top, because the case was remanded for Judge Isgur to anoint the winners, subject to whatever Judge Oldham might say on the next appeal.

The outcome of the next appeal may tell us for sure whether the Fifth Circuit sides with the Second Circuit or the Third Circuit on the allowance of makewhole premiums in chapter 11.

Judge Oldham’s Opinion

In substance, Judge Oldman held that a claim is not impaired just because some portion of the claim is disallowed under the Bankruptcy Code.

For that proposition, he agreed with In re PPI Enterprises (U.S.) Inc., 324 F.3d 197 (3d Cir. 2003), where the cap in Section 502(b)(6) of the Bankruptcy Code reduced the allowed claim of a landlord to an amount lower than it would have been outside of bankruptcy under state law. The Third Circuit held that the landlord’s claim was not impaired, because the amount of the claim outside of bankruptcy “is not the relevant barometer for impairment.” Id. at 204.

Judge Oldham said that the Collier treatise and every reported decision all agree that impairment arises from what the plan does, not from disallowance of a portion of a claim under the Bankruptcy Code.

Judge Oldham said his conclusion was based on the plain language of the statute, Section 1124(a), which says that a claim is not impaired “if the plan . . . leaves unaltered the [claimant’s] legal, equitable, and contractual rights.” The focus, he said, is on whether “‘the plan’ itself alters a claimant’s ‘legal, equitable [or] contractual rights.’”

Allowance of the Makewhole?

Ruling that the bondholders’ claim was not impaired did not end the inquiry. The question remained as to whether the bondholders were entitled to the makewhole to ensure they were unimpaired. The bankruptcy court had not reached that issue, having ruled that the bondholders were impaired and thus entitled to the makewhole for that reason alone.

Judge Oldham embarked on a lengthy exegesis of English bankruptcy law and how it was or was not adopted by the Bankruptcy Act of 1898 and modified by the Bankruptcy Code in 1978 together with its later amendments. In particular, he noted how English law from hundreds of years ago disallowed post-petition interest.

English law, however, had developed exceptions to the rule disallowing post-petition interest. One exception allowed post-petition interest against a solvent debtor. Judge Oldman therefore analyzed whether the solvent-debtor exception survived adoption of the Bankruptcy Code.

Judge Oldham said that something similar to the solvent-debtor exception appears in Section 726(a)(5), where creditors are entitled to interest if claims have been paid in full. Section 1129(a)(7) incorporates Section 726(a)(5) when applying the best interest test.

However, Judge Oldman pointed out that Section 1129(a)(7) applies to an “impaired class of claims.” He said that the “plain text does not apply to unimpaired claims.” [Emphasis in original.]

Therefore, Section 1129(a)(7) did not entitle bondholders to the makewhole.

Other Reasons to Allow the Makewhole

Judge Oldham said that the makewhole might still be allowable if “the solvent-debtor exception survives Congress’s enactment of Section 502(b)(2).” That section disallows claims for “unmatured interest.”

Judge Oldham did not leave a blank slate for Judge Isgur. Instead, he spilled a ream of dicta addressing the solvent-debtor exception.

Judge Oldham said the debtors had a “compelling argument” that a makewhole is the “economic equivalent” of disallowed, unmatured interest. Further, he said the claim for the makewhole arose on the filing of the bankruptcy petition, possibly thereby making it an unenforceable ipso facto clause.

On the other hand, Judge Oldham said that the bondholders’ “most persuasive response is that none of these arguments applies to a solvent debtor.” [Emphasis in original.] The solvent-debtor exception, he said, might “operate as a carve-out from Section 502(b)(2)’s general bar on unmatured interest.”

Did the solvent-debtor exception survive with regard to the makewhole? Judge Oldham said, “We doubt it,” but he remanded the case for Judge Isgur to decide.

On remand, the survival — or not — of the solvent-debtor exception is not the end of the inquiry. Should Judge Isgur decide that the exception is not viable under the Bankruptcy Code, he still must confront Energy Future, where the Third Circuit held that a makewhole is allowable in chapter 11 even if the debtor is insolvent. Of course, the Second Circuit disagreed in MPM Silicones.

The Revolver’s Default Interest Rate

But what about allowance of default interest on the revolving credit lenders’ claim? Judge Oldham said the answer “is even murkier.”

Both sides agreed that the revolver creditors were entitled to some post-petition interest. But how much? Should it be the lower federal judgment rate from 28 U.S.C. § 1961(a) or the higher contractual default rate?

Judge Oldham said that some courts have treated a bankruptcy claim as equivalent to a money judgment, thus invoking Section 1961(a). “Uniformity” would be a benefit of following Section 1961(a), he said. On the other hand, notions of equity might counsel for the allowance of the higher default rate.

Rather than rule, Judge Oldham again remanded the issue because Judge Isgur had not considered the rate of interest on the revolver debt.

Observations

This writer cannot recall an opinion of recent vintage using ancient English law to illuminate a complex question of modern U.S. bankruptcy law. Judge Oldham’s opinion was also reliant on the Bankruptcy Code’s legislative history.

The late Supreme Court Justice Antonin Scalia railed against reliance on legislative history and opposed the notion of enlightening U.S. law by the rules followed in other countries. For Justice Scalia, the statute was the beginning and the end of the discussion.

Judge Oldham, an ostensibly conservative jurist appointed by President Donald Trump, appears unbound by Justice Scalia’s prescripts with regard to statutory interpretation. Notably also, legislative history has been creeping back into Supreme Court opinions following Justice Scalia’s death, with “plain meaning” less often the basis for a high court ruling.