The circuits are split over the allowance of makewhole premiums in chapter 11 cases, and lower courts are divergent on the interest payable to unsecured creditors whose claims are unimpaired when the debtor is solvent.
The Bankruptcy Code adds to the confusion because its provisions address the questions only if the reader reads implications into sections addressing other circumstances.
In the wake of the confirmation of the Hertz Corp. chapter 11 plan, Bankruptcy Judge Mary F. Walrath of Delaware held most prominently in her December 22 opinion that unimpaired, unsecured creditors are entitled to post-petition interest at the federal judgment rate, not at the higher contract rate. She issued a split decision on the allowance of makewholes.
The Plan and the Bonds
The Hertz plan was simple in concept, and the facts were not complex.
Judge Walrath was dealing with unsecured notes under two bond issues whose indentures called for so-called makewhose premiums and higher rates of interest after default. Makewhole premiums are often characterized as indenture provisions that compensate debt holders for being required to reinvest at lower rates of interest when the obligation is paid before maturity.
After a year in chapter 11, Hertz ended up solvent.
The plan paid unsecured claims in cash, in full on the effective date. Shareholders received cash and new warrants or subscription rights. Judge Walrath called the plan “a fantastic result for all of their creditors and shareholders.”
The unsecured notes were categorized in the plan as being unimpaired. The plan gave noteholders post-petition interest up to the plan’s effective date at the federal judgment rate or whatever rate necessary for the notes to be unimpaired. The federal judgment rate was lower than the contract default rate.
Regarding $2.7 billion in principal and pre-petition interest on the two bond issues, the indenture trustees filed an adversary proceeding seeking (1) payment of makewhole premiums totaling about $147 million and (2) post-petition interest at the default rate in the contract, amounting to another $125 million.
The debtor filed a motion to dismiss for failure to state a claim. In her 46-page opinion Judge Walrath granted dismissal in part.
Makewholes
First, Judge Walrath dealt with makewholes. On the law and relevant provisions in the indentures, she laid out the arguments on both sides in minute detail.
The circuits are split on the allowance of makewholes. The Third Circuit allowed a makewhole 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).
More recently, Bankruptcy Judge Marvin Isgur of Houston held that (1) creditors of a solvent debtor are entitled to makewholes, and (2) the solvent-debtor exception survived adoption of the Bankruptcy Code and allows affected creditors to recover interest at the higher default rate. See In re Ultra Petroleum Corp., 624 B.R. 178 (Bankr. S.D. Tex. 2020). To read ABI’s report on Ultra Petroleum, click here.
If Judge Walrath were to follow Judge Isgur, it would be total victory for bondholders, but she didn’t.
Judge Walrath carefully analyzed the indentures and reached different results. On one, she concluded that the “redemption” was made via the plan after “maturity” resulting from the debtor’s chapter 11 filing. With regard to those bonds, she ruled that the makewhole was not invoked by the language of the indenture itself.
As to that issue, Judge Walrath granted the debtor’s motion to dismiss with respect to the makewhole.
With regard to the other, subtle language differences led Judge Walrath to the conclusion that the redemption via the plan plausibly occurred before maturity. She therefore declined to dismiss in respect of that bond issue.
Makewhole as Unmatured Interest
Next, Judge Walrath focused on the bonds where she had decided that the makewhole plausibly could be required by the language of the indenture. She turned to the question, dealt with in Energy Future, as to whether a makewhole is “unmatured interest” disallowed by Section 502(b)(2).
Judge Walrath read Energy Future as not saying whether a makewhole should be characterized as unmatured interest. Therefore, she was “not prepared to conclude, as a legal matter,” that makewholes are not disallowed as unmatured interest.
Saying that labels are not controlling, Judge Walrath asked whether the makewhole was the “economic equivalent of unmatured interest.” Whether the makewhole qualified as unmatured interest was a fact question, not a legal question, she said.
Focusing on the complaint, Judge Walrath said it made a plausible claim because the indenture trustee “may be able to present evidence that the redemption premium in the 2026/2028 Senior Notes is not, in fact, the economic equivalent of unmatured interest.” She therefore stood by her decision to dismiss the complaint as to one issue but not the other.
The Effect of Unimpairment
Regardless of everything else, the indenture trustees contended that the unimpaired status of the claims on the bonds and the so-called solvent debtor exception mean that everything in the indentures must be enforceable, including claims for makewholes and interest at the default rate.
The debtor took the position that the bonds’ unimpaired status makes no difference, because unmatured interest is disallowed under Section 502(b) even as to unimpaired, unsecured claims. At most, the debtor argued, the bondholders are entitled to interest the federal judgment rate under Section 726(a)(5).
Judge Walrath adopted the idea that Section 502(b) stripped the bondholders of the right to unmatured interest. Because the loss of rights stemmed from the Code, not from the plan, she decided that the bondholders were “unimpaired” even if the Code took away rights to makewholes and default interest. As authority for that rationale, Judge Walrath cited the Fifth Circuit’s Ultra Petroleum opinion. In re Ultra Petroleum Corp., 943 F.3d 758, 765 (5th Cir. 2019). To read ABI’s report, click here.
With regard to the solvent debtor exception, Judge Walrath said that the Bankruptcy Code “is silent on what treatment unimpaired creditors must receive in a solvent chapter 11 debtor case.”
In the 2020 decision in Ultra Petroleum, Bankruptcy Judge Isgur concluded that the solvent debtor exception survived adoption of the Bankruptcy Code. Judge Walrath said that Ultra Petroleum was “not persuasive” in view of Third Circuit and Supreme Court precedent.
Judge Walrath said that a “bankruptcy court cannot use equitable principles to modify express language of the Code,” and nothing in the Bankruptcy Code waives the disallowance of unmatured interest in Section 502(b)(2). Furthermore, she cited the Third Circuit for saying that Section 1124(1) “does not mandate that unimpaired creditors receive all of their contract rights where those rights are expressly disallowed by section 502(b) of the Code.”
As a general proposition, the solvent debtor exception did not survive adoption of the Bankruptcy Code, in Judge Walrath’s opinion.
What Do Unimpaired Creditors Receive?
Judge Walrath said she was
convinced that the solvent debtor exception survived passage of the Bankruptcy Code only to a limited extent. The Bankruptcy Code expressly codified the solvent debtor exception in section 506(b) as to oversecured creditors and in section 1129(a)(7) and 726(a)(5) as to unsecured creditors.
In the legislative history, Judge Walrath found “strong evidence Congress intended that unimpaired creditors in a solvent chapter 11 debtor case should receive post-petition interest only in accordance with sections 1129(a)(7) and 726(a)(5).”
To Judge Walrath, the legislative history accompanying the repeal of former Section 1124(3) “suggests that Congress believed that there is no legitimate reason when a debtor is solvent to distinguish between impaired and unimpaired unsecured creditors who are receiving payment of their claims in cash in full.”
Judge Walrath held that impaired and unimpaired creditors who are paid in full “both should receive the same treatment: payment of their allowed claim plus post-petition interest at the federal judgment rate in accordance with section 726(a)(5).”
Conclusion
In short, Judge Walrath dismissed the makewhole claim as to one issue. As to both issues, she dismissed the claims seeking default interest. Her rulings are eminently appealable, but not yet, because she did not dispose of all claims in the adversary proceeding.
The time for appeal may be long in the future, given that Judge Walrath is calling for a trial on plausible claims in the indenture trustees’ complaint.
If ever there was a case where a judge’s opinion begs the parties to settle, this is it.
The circuits are split over the allowance of makewhole premiums in chapter 11 cases, and lower courts are divergent on the interest payable to unsecured creditors whose claims are unimpaired when the debtor is solvent.
The Bankruptcy Code adds to the confusion because its provisions address the questions only if the reader reads implications into sections addressing other circumstances.
In the wake of the confirmation of the Hertz Corp. chapter 11 plan, Bankruptcy Judge Mary F. Walrath of Delaware held most prominently in her December 22 opinion that unimpaired, unsecured creditors are entitled to post-petition interest at the federal judgment rate, not at the higher contract rate. She issued a split decision on the allowance of makewholes.