Judge Isgur Sides with the Third Circuit and Allows Makewhole Premiums

In a masterful opinion, Bankruptcy Judge Marvin Isgur of Houston answered two questions assigned to him by the Fifth Circuit. He held that (1) creditors of a solvent debtor are entitled to payment of a so-called makewhole, and (2) the solvent-debtor exception survived adoption of the Bankruptcy Code and allows affected creditors to recover interest at the higher default rate.

Although the case involved a “massively solvent” debtor, the analysis in Judge Isgur’s October 26 opinion would seem to allow makewhole claims even if the debtor is insolvent.

The circuits are split on the allowance of makewholes. The Third Circuit allowed makewholes in Delaware Trust Co. v. Energy Future Intermediate Holding Co. LLC (In re Energy Future Holdings Corp.), 842 F.3d 247 (3d Cir. 2016), but the Second Circuit seemingly disallowed makewholes in BOKF NA v. Momentive Performance Materials Inc. (In re MPM Silicones LLC), 874 F.3d 787 (2d Cir. 2017), cert. den. sub nom BOKF N.A. v. Momentive Performance Materials Inc., 138 S. Ct. 2653 (2018).

Judge Isgur said that the Second Circuit’s MPM opinion was dicta to the extent it appeared to say that makewholes are disallowed. For some of ABI’s coverage of Energy Future and MPM, click here and here.

Plan Doesn’t Pay Makewholes and Default Interest

Oil and gas producers, the debtors in Judge Isgur’s case were forced into chapter 11 in 2016 when the price of petroleum collapsed. Insolvent on filing, Judge Isgur said they became “massively solvent” when the price of oil rose. The debtors proposed a plan where all classes of creditors were unimpaired.

The bondholders’ loan agreement included a so-called makewhole premium. A makewhole compensates a lender for being forced to reinvest at lower interest rates if the loan is paid before maturity. The debtors did not propose to pay the makewhole, contending that the makewhole would be unmatured interest disallowed under Section 502(b)(2).

The loan agreements for both the bondholders and the revolving credit lenders called for interest after default about 2 percentage points above the contract rate. The plan, however, proposed to pay post-petition interest at the federal judgment rate, not at the higher default rate imposed by the loan agreements.

Noteholders and revolving credit lenders 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 default rate must be paid to render their claims unimpaired.

Skipping over some of the appellate history, the Fifth Circuit held in November 2019 that disallowing the makewhole and default interest under provisions of the Bankruptcy Code by itself did not render the claims impaired. Ultra Petroleum Corp. v. Ad Hoc Committee of Unsecured Creditors (In re Ultra Petroleum Corp.), 943 F.3d 758 (5th Cir. Nov. 26, 2019). To read ABI’s report, click here.

In a decision that was on appeal, Judge Isgur had not ruled on whether default interest or the makewhole were disallowed by Section 502(b)(2). The circuit court said that Judge Isgur was “best able” to rule in the first instance on the allowance of makewholes and default interest. Id. at 765. Nonetheless, the appeals court went on to say, “Our review of the record reveals no reason why the solvent-debtor exception could not apply.” Id.

Makewholes Are Allowed

With regard to the two questions given to Judge Isgur on remand, the result turned the interpretation of Section 502(b)(2), which disallows a claim for “unmatured interest.”

Although unmatured interest is not defined by the Code, Judge Isgur said that interest is “widely understood as consideration for the use or forbearance of another’s money accruing over time.” The question therefore required Judge Isgur to decide whether a makewhole is unmatured interest.

First, Judge Isgur said that a makewhole is enforceable under New York law, the parties’ choice of law. Next, he analyzed whether a makewhole is interest or unmatured interest.

Judge Isgur said that unmatured interest “is interest that has not accrued or been earned as of a reference date,” or “compensation for the future use of another’s money.”

Judge Isgur concluded that a makewhole is neither interest nor unmatured interest because it does not compensate the bondholders for the use or forbearance of the use of money. Rather, he said, it compensates the bondholders for a “breach of a promise to use money” or “the cost of reinvesting in a less favorable market.”

Likewise, a makewhole is not the economic equivalent of unmatured interest and is distinguishable from original issue discount. Furthermore, Judge Igur said that a makewhole is “not an example of clever attorneys drafting around the provisions of Section 502.”

Judge Isgur analyzed the Second Circuit’s MPM decision. He said the New York-based appeals court “was not presented with the question of whether a makewhole is unmatured interest.” Any statement about the characterization of a makewhole “was dicta,” he said.

Because a makewhole is “not interest [and] also not unmatured interest,” Judge Isgur held that the makewhole “forms part of the Note Holders’ allowed claims.”

The Solvent-Debtor Exception

The allowance or disallowance of the default rates of interest turned on the survival of the solvent-debtor exception and its 300 years of history under English and U.S. law.

Following adoption of the Bankruptcy Act of 1898, the Supreme Court said that fundamental principles of English law carried over into U.S. bankruptcy law. One of those principles was the disallowance of interest after the filing date, as codified in Section 63 of the Bankruptcy Act.

Nonetheless, Judge Isgur said that courts “consistently” applied the solvent-debtor exception in cases under the Bankruptcy Act. The exception means that creditors are entitled to post-petition interest when the debtor is solvent.

Because the treatment of unmatured interest in Section 502(b)(2) of the Code was “nearly identical” to Section 63 of the Act, Judge Isgur cited the Fifth, First and Sixth Circuits for holding that the solvent-debtor exception was not abrogated by adoption of the Bankruptcy Code. Neither the statute nor its legislative history shows “clear Congressional intent” to dispense with the exception, Judge Isgur said.

Furthermore, Judge Isgur said, “[e]quitable considerations support the solvent-debtor exception.” It ensures “that the debtor does not receive a windfall at the expense of its creditors.”

Deciding that the creditors were entitled to post-petition interest left open the question of rate. The debtors opted for the federal judgment rate, but the creditors wanted the higher default rates prescribed by the loan agreements.

If the creditors only received the judgment rate, they would be “worse off” under the plan than impaired creditors. “Additionally,” Judge Isgur said, imposing the federal judgment rate would “contravene[] the purpose of the solvent-debtor exception.”

Judge Isgur allowed the claims for default interest, saying he would “not upset three hundred years of established law.”

Observations

Reading like a treatise, Judge Isgur’s opinion is the most comprehensive analysis so far of the nature of makewholes. In the Second Circuit, where makewholes were seemingly disallowed by MPM, his opinion opens the door for lower courts to follow the Third Circuit by saying the Second Circuit’s comments were dicta on allowance of a makewhole.

If the Fifth Circuit affirms Judge Isgur, there may be a petition for certiorari, but the Supreme Court declined to review MPM. Judge Isgur’s opinion could diminish the probability of “grant” because there is no circuit split, if he was correct in saying that the Second Circuit’s statements about makewhole were dicta.

There is an opening, however, for a different result. Appellate courts, especially those not steeped in the lore of bankruptcy law, are increasingly prone to follow what they perceive as the plain language of the statute.

Section 502(b)(2) is a blanket disallowance of unmatured interest. There is no hint about a solvent-debtor exception in its plain language. A court might say that Congress could have engrafted the exception onto the statute if it intended to do so.

Judge Isgur went to great pains to explain why a makewhole is not unmatured interest. Another court, however, might view a makewhole as interest that the lenders did not or will not receive.

The Supreme Court is drawing away from cases like Dewsnup, where the justices followed decisional law under the Bankruptcy Act by arguably disregarding Sections 506(a) and 506(d) to preclude a debtor from stripping down an undersecured mortgage. Dewsnup v. Timm, 502 U.S. 410 (1992).

The late Justice Antonin Scalia wrote a vigorous dissent in Dewsnup, accusing the majority of ignoring the plain language of the statute by adopting a policy contrary to decisions that Congress made by enacting the Bankruptcy Code.

Twenty-three years later, the justices seemed primed to revisit Dewsnup. At oral argument in Bank of America N.A. v. Caulkett, 135 S. Ct. 1995 (2015), several justices apparently thought Dewsnup was wrongly decided. Indeed, the unanimous opinion in Caulkett, written by Justice Clarence Thomas, said that a “straightforward reading of the statute” would allow a debtor to strip off an underwater mortgage.

The justices were given the opportunity to overrule Dewsnup, but the Court denied certiorari in Ritter v. Brady, 139 S. Ct. 1186, 203 L. Ed. 2d 256 (2019).

If the makewhole issue ever reaches the Supreme Court, the result may turn on how much the justices do or do not read into Section 502(b)(2).

Will the Supreme Court recognize the solvent-debtor exception just like it followed pre-Code law in Dewsnup? Or, will the Court refuse to look beyond Section 502(b)(2) and rule that the exception did not survive adoption of the Code?

For makewholes, there could be a middle ground. Some courts might allow them for solvent debtors but disallow them when the debtors are insolvent. The issue will test the reservoir of equitable powers that remain in bankruptcy courts.