Institutional lenders and bondholders won big and lost big in an October 14 opinion from the Fifth Circuit. If you’re an unsecured lender with a “make-whole” and “default interest” owing by a solvent debtor, you won. If an insolvent debtor owes you a “make-whole,” you lost.
Unanimously, the Fifth Circuit panel decided that a so-called make-whole is “the economic equivalent of unmatured interest” and is therefore disallowed by Section 502(b)(2). The opinion may or may not have created a cert-worthy circuit split.
In a 2/1 ruling, the majority upheld the bankruptcy court’s decision that the so-called solvent-debtor exception to the disallowance of post-petition interest was not abrogated by the adoption of the Bankruptcy Code in 1978. The decision in this regard does seem to give rise to a circuit split.
The lenders in the Fifth Circuit lost on make-wholes as a stand-alone issue, but they walked away with victory because the majority decided that the solvent-debtor exception survives. Consequently, the majority awarded the lenders both the make-whole plus default interest at the higher contract rate. The majority’s holding on the solvent-debtor exception created a split of circuits.
The dissent and the circuit splits invite the debtor to file a petition for rehearing en banc or a petition for certiorari to the Supreme Court, or both.
Ultra Resources, a ‘Massively’ Solvent Debtor
Ultra Resources, an oil and gas producer, was forced into chapter 11 in 2016 when the price of petroleum imploded. Insolvent on filing, both the bankruptcy court and the Fifth Circuit said that the debtor became “massively solvent” when oil prices rose. The solvent debtors proposed a plan where creditors were unimpaired and thus not entitled to vote on the plan.
The bondholders’ loan agreement included a make-whole premium, which compensates a lender for being forced to reinvest at a lower interest rate if the loan is paid before maturity. The plan did not pay the make-whole, contending that it was unmatured interest disallowed under Section 502(b)(2).
The bondholders’ and the revolving credit lenders’ loan agreements both called for interest after default of about 2 percentage points higher than the contract rate. The plan, however, only proposed paying post-petition interest at the federal judgment rate, not at the higher default rate called for by the loan agreements.
Although not entitled to vote on the plan, the noteholders and revolving-credit lenders objected to the plan. To confirm the plan without resolving the objection, the bankruptcy court set aside $400 million to compensate the bondholders and the revolving-credit lenders if the court were later to decide that their claims for the make-whole and the default rate must be paid for the claims to be unimpaired.
Later, the bankruptcy court ruled that the claims must be paid in full under state law for the lenders to be unimpaired. The bankruptcy court did not decide whether make-wholes are prohibited under Section 502(b)(2) or whether the solvent-debtor exception persisted after the adoption of the Code.
The lenders appealed, and the bankruptcy court certified a direct appeal to the Fifth Circuit.
For now truncating the procedural history, suffice it to say that the Fifth Circuit reversed, holding in November 2019 that disallowing the make-whole 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.
The circuit court said that the bankruptcy court was “best able” to rule in the first instance on the allowance of make-wholes 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.
Back in bankruptcy court on remand, Bankruptcy Judge Marvin Isgur of Houston ruled that make-wholes were not the equivalent of unmatured interest and should be allowed for the creditors to be unimpaired. Likewise, he concluded that the solvent-debtor exception was not abrogated by the adoption of the Bankruptcy Code. He therefore allowed both the make-whole and the default rates of interest. In re Ultra Petroleum Corp., 624 B.R. 178 (Bankr. S.D. Tex. Oct. 26, 2020). To read ABI’s report, click here.
For a second time, the Fifth Circuit agreed to hear a direct appeal.
Make-Wholes Aren’t Allowed
On the allowance of make-wholes, the lenders lost the battle as a general principle but won the war because the majority, as we shall discuss later, decided they were entitled to makes-wholes and default interest given to a solvent debtor.
Writing the opinion for the panel on make-wholes, Circuit Judge Jennifer Walker Elrod first analyzed whether make-wholes are a disguised form of unmatured interest to be disallowed as a matter of law under Section 502(b)(2). That section disallows a claim “to the extent that . . . such claim is for unmatured interest.”
In substance, Judge Elrod saw her panel as being bound by In re Pengo Indus., Inc., 962 F.2d 543, 546 (5th Cir. 1992), where the Fifth Circuit held that original-issue discount is disallowed as unmatured interest as a matter of “economic fact.” Interpreting Pengo, she said, “What matters in this context is the underlying ‘economic reality’ of the thing — not dictionary definitions or formalistic labels.”
In other words, Judge Elrod said, a claim is disallowed if it “is really just the functional equivalent of unmatured interest.”
Applying Pengo’s principles, Judge Elrod said that a make-whole “compensates Creditors for the future use of their money. . . . This is simply another way of saying that the interest is unmatured. And unmatured interest is still interest.” [Emphasis in original.]
Judge Elrod rejected the notion that make-wholes are liquidated damages, which some lower courts have allowed. She held that a make-whole “is indeed a claim for unmatured interest or its economic equivalent [and is] disallowed under 11 U.S.C. § 502(b)(2).”
The Solvent-Debtor Exception
Although defeated on unmatured interest, the lenders had another route to victory: the solvent-debtor exception to the disallowance of interest in bankruptcy cases. Here, they won.
Ordinarily, Judge Elrod said, a make-whole would be disallowed. “But this is not an ordinary case,” she said, because the debtor was solvent.
Judge Elrod traced the 300-year history of the solvent-debtor exception. Generally, English common law disallowed interest on creditors’ claims after bankruptcy or the equivalent. The solvent-debtor exception allowed claims for interest when the debtor was solvent.
Judge Elrod cited the Supreme Court for saying that the exception was imported into the U.S. from England and was embraced by the Bankruptcy Act of 1898.
The debtor argued that the exception had been abrogated by the adoption of the Bankruptcy Code in 1978 and the absolute language in Section 502(b)(2). Judge Elrod cited the First and Sixth Circuits for holding that interest is disallowed under the Code even if the debtor is solvent.
Addressing the seemingly absolute language in Section 502(b)(2), Judge Elrod said, “[O]ne would expect [Congress] to have expressly abrogated the judicial exception if it intended to do so.” [Emphasis in original.] She supported her notion of statutory interpretation by alluding to Supreme Court authority, which she interpreted to mean that “[w]e must defer to prior bankruptcy practice unless expressly abrogated.”
Because the alleged abrogation of the solvent-debtor exception was not “absolutely clear,” Judge Elrod held that the exception “is alive and well.” For that reason, she said that the debtor must pay the make-whole, “even though . . . it is indeed otherwise disallowed unmatured interest.”
The Make-Whole Is Enforceable
So far, Judge Elrod had been working on the assumption that the make-whole was enforceable under New York law governing the loan agreements. The debtor contended that it was an unenforceable penalty.
To be a penalty under New York law, the make-whole must be grossly disproportionate to the probable loss. Because it wasn’t, Judge Elrod held that the make-whole was enforceable under New York law. Therefore, she said, “§ 502(b)(1) does not stand in the way of the solvent-debtor exception.”
Post-Petition Interest
The debtor conceded that the creditors were entitled to some post-petition interest because the estate was solvent. But the debtor also argued that the lenders were only entitled to the lower federal judgment rate in 28 U.S.C. § 1961(a), not the higher default rates in the loan agreements.
To find the answer, Judge Elrod studied the concept of impairment and the requirements of cramdown.
Section 726(a)(5) was seemingly relevant because cramdown requires proving that the creditors were being treated no worse than they would have been in a chapter 7 liquidation. As fifth priority when the debtor is solvent, the section requires “payment of interest at the legal rate from the date of the filing of the petition.”
At that juncture, Judge Elrod was confronted by In re Cardelucci, 285 F.3d 1231 (9th Cir. 2002), where the Ninth Circuit held that Section 726(a)(5) mandates the federal judgment rate. However, she was able to avoid deciding, like Cardelucci, whether the reference to “the legal rate” in Section 726(a)(5) means the federal judgment rate in 28 U.S.C. § 1961(a).
Instead, Judge Elrod pointed out that Section 1129(a)(7)(ii) does not require paying the “legal rate” in a hypothetical chapter 7 case. Rather, it says that the creditor must receive an amount “that is not less than the amount that such holder would so receive” in chapter 7. In other words, she said that Section 726(a)(5) only sets a “floor,” not a “ceiling.”
Although Judge Elrod disagreed with the bankruptcy court regarding the allowance of a make-whole, the other considerations in her opinion led her to affirm the judgment of the bankruptcy court by giving the lenders “what they bargained for with this solvent debtor.”
The Dissent
Circuit Judge Andrew S. Oldham dissented in part. He agreed with the majority that “the Make-Whole Amount is unmatured interest in disguise.”
He parted company with the majority because he did not believe that the solvent-debtor exception survived adoption of the Bankruptcy Code. He read Section 502(b)(2) to mean that “all claims for unmatured interest are disallowed.”
Judge Oldman dissected the predecessors to the Bankruptcy Code and found that they prohibited “some” unmatured interest but did “not contain a blanket bar on all unmatured interest — unlike § 502(b)(2).” Specifically, he believes that unmatured interest was disallowed by a combination of Sections 63(a)(1) and 65(e) of the former Bankruptcy Act.
In contrast, Judge Oldham said that the Code “goes for the jugular by flatly disallowing ‘claim[s] for unmatured interest.’ 11 U.S.C. § 502(b)(2).”
Judge Oldham would have disallowed the make-whole and limited the lenders’ recovery to the federal judgment rate. He “respectfully” dissented.
Observations
The Fifth Circuit’s opinion also seems to raise a circuit split on the disallowance of make-wholes.
The Third Circuit allowed a make-whole 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 make-wholes 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). For some of ABI’s coverage of Energy Future and MPM, click here and here.
Bankruptcy Judge Isgur and some other courts believe that MPM’s disallowance of make-wholes was dicta. If the Second Circuit’s ruling was dicta, then there wasn’t a concrete circuit split until the Fifth Circuit came along.
But think for a minute. Was the Fifth Circuit’s decision dicta with regard to make-wholes?
The Fifth Circuit’s disallowance of make-wholes was not necessary to the opinion, because the New Orleans-based court found other reasons for allowing a make-whole when the debtor is insolvent. Some therefore might say that the Fifth Circuit’s opinion on make-wholes is dicta. The lack of a clear-cut circuit split on make-wholes doesn’t make the case an attractive candidate for a grant of certiorari by the Supreme Court.
On the other hand, there is a circuit split on the Bankruptcy Code’s abrogation (or not) of the solvent-debtor exception. To enhance the chance of a successful rehearing or a grant of certiorari, the debtor can also point to the dissent by Judge Oldham.
The Withdraw Opinion
We glossed over a curious procedural fact. The Fifth Circuit’s prior opinion in November 2019 was not the first.
In January 2019 on the first direct appeal, Judge Oldham wrote at length about the allowance of make-wholes. Ultra Petroleum Corp. v. Ad Hoc Committee of Unsecured Creditors (In re Ultra Petroleum Corp.), 913 F.3d 533 (5th Cir. Jan. 17, 2019). To read ABI’s reports on the original opinion, click here.
When the debtor moved for panel rehearing, Judge Oldham withdrew the January opinion and issued a shorter opinion in November 2019, eliminating pages of dicta about make-wholes and limiting the ruling to a declaration that disallowance of portions of a claim by the operation of provisions of the Bankruptcy Code does not amount to “impairment” of the claim entitling the creditor to vote for or against confirmation of a chapter 11 plan.
Now, we have a second opinion by the Fifth Circuit on make-wholes, but it too may be dicta.
Institutional lenders and bondholders won big and lost big in an October 14 opinion from the Fifth Circuit. If you’re an unsecured lender with a “make-whole” and “default interest” owing by a solvent debtor, you won. If an insolvent debtor owes you a “make-whole,” you lost.
Unanimously, the Fifth Circuit panel decided that a so-called make-whole is “the economic equivalent of unmatured interest” and is therefore disallowed by Section 502(b)(2). The opinion may or may not have created a cert-worthy circuit split.
In a 2/1 ruling, the majority upheld the bankruptcy court’s decision that the so-called solvent-debtor exception to the disallowance of post-petition interest was not abrogated by the adoption of the Bankruptcy Code in 1978. The decision in this regard does seem to give rise to a circuit split.
The lenders in the Fifth Circuit lost on make-wholes as a stand-alone issue, but they walked away with victory because the majority decided that the solvent-debtor exception survives. Consequently, the majority awarded the lenders both the make-whole plus default interest at the higher contract rate. The majority’s holding on the solvent-debtor exception created a split of circuits.
The dissent and the circuit splits invite the debtor to file a petition for rehearing en banc or a petition for certiorari to the Supreme Court, or both.