Avoiding a circuit split, the Second Circuit joined the Third, Fifth and Ninth Circuits by holding on December 14 “that a claim is impaired under Section 1124(1) only when the plan of reorganization, rather than the [Bankruptcy] Code, alters the creditor’s legal, equitable, or contractual rights.”
Consequently, an unsecured creditor of an insolvent debtor is not entitled to post-petition interest even though the claim is unimpaired by the plan. In other words, an unsecured creditor remains unimpaired because Section 502(b)(2) disallows post-petition interest as being unmatured on the petition date.
The Second Circuit did not reach the question of whether unsecured creditors of a solvent debtor are entitled to post-petition interest. That question is going to the Third Circuit on direct appeal.
The Plan
The debtor was a holding company for several Latin American airlines. All were in chapter 11. With an equity infusion of more than $5.4 billion, the debtor proposed a plan where the unsecured claims of a Brazilian subsidiary would not be impaired.
More specifically, the plan said that the unsecured creditors would receive the full allowed amount of their claims or whatever treatment was necessary for them to be unimpaired. The debtors interpreted the plan to mean that it would pay $300 million on the subsidiary’s unsecured claims, but not an additional $150 million in post-petition interest.
The creditors objected to confirmation, contending that they would not be unimpaired under Section 1124(1) without post-petition interest. The creditors also argued that their debtor was solvent and that they should be paid post-petition interest under the so-called solvent-debtor exception to the general rule that interest for unsecured creditors ceases on filing.
The debtors contended that the relevant debtor was insolvent. A valuation battle ensued where the creditors posited evidence and argument to show solvency. The debtors countered with an analysis showing insolvency.
Bankruptcy Judge James L. Garrity, Jr. of New York sided with the debtors and found insolvency. He also overruled the creditors’ objection and confirmed the plan. The district court affirmed. LATAM Airlines Grp. S.A., 20-11254, 2022 WL 2206829 (Bankr. S.D.N.Y. June 18, 2022), as amended, 2022 WL 2541298 (Bankr. S.D.N.Y. July 7, 2022); aff’d In re LATAM Airlines Grp. S.A., 643 B.R. 741 (S.D.N.Y. 2022).
The creditors appealed to the Second Circuit.
No Circuit Split
Circuit Judge Pierre N. Leval began his analysis of the merits by stating the general rule that interest ceases to accrue on a bankruptcy filing. Before enactment of the Bankruptcy Code in 1978, the Second Circuit had adopted the solvent-debtor exception allowing post-petition interest to creditors of a solvent debtor before a surplus is returned to the debtor.
Judge Leval said that “the rule against post-petition interest is codified at 11 U.S.C. § 502(b)(2).” He described the subsection as disallowing “unmatured interest.”
Unlike the Fifth and Ninth Circuits, which recently ruled that the solvent-debtor exception did not survive adoption of Section 502(b)(2), Judge Leval said that his court had “not yet addressed” the question. See Ad Hoc Committee of Holder of Trade Claims v. Pacific Gas & Electric Co. (In re Pacific Gas & Electric Co.), 46 F.4th (9th Cir. Aug. 29, 2022); and Ultra Petroleum Corp. v. Ad Hoc Committee of OpCo Unsecured Creditors (In re Ultra Petroleum Corp.), 51 F.4th (5th Cir. Oct. 14, 2022). To read ABI’s reports, click here and here.
[Note: After ruling that the exception did survive the Code, a bankruptcy judge in Delaware recently certified the same question for direct appeal to the Third Circuit. See Wells Fargo Bank NA v. Hertz Corp. (In re Hertz Corp.), 21-50995 (Bankr. D. Del. Nov. 21, 2021). To read ABI’s report, click here.]
For the notion that they were entitled to post-petition interest, the creditors relied primarily on Section 1124(1) and its description of the requisites of unimpairment. The section says a claim is unimpaired “under a plan” if it “leaves unaltered the [creditor’s] legal, equitable, and contractual rights” and “does not otherwise alter the legal, equitable, or contractual rights to which such claim or interest entitles the holder of such claim or interest.”
Although other circuits have held that the section “sweeps broadly,” Judge Leval said:
[T]he Third, Fifth, and Ninth Circuits have noted a significant caveat: Because Section 1124(1) refers to impairment imposed by a “plan,” these circuits have held it inapplicable to modifications which occur by operation of the Code.
The creditors implored Judge Leval not to follow the three circuits but instead to adopt the rationale of two bankruptcy courts in the late 1990s that held that post-petition interest must be allowed to render a claim unimpaired. Judge Leval declined the invitation in favor of following the three circuits.
Finding the three circuits’ opinions to be “persuasive,” Judge Leval held “that a claim is impaired under Section 1124(1) only when the plan of reorganization, rather than the Code, alters the creditor’s legal, equitable, or contractual rights.” In other words, creditors’ “claims are not impaired simply because they did not receive post-petition interest.”
Creditors’ Arguments Rejected
The creditors posited arguments based on statutory language, the same arguments that did not persuade the three circuits.
The creditors pointed to the statute’s use of “claims” rather than “allowed claims.” Like the three circuits, Judge Leval said the section does not state that “claims” are unaltered but that “instead, it protects ‘the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest.’ 11 U.S.C. § 1124(1) (emphasis added).”
Judge Leval also rejected the creditors’ argument based on statutory history and, in particular, the elimination of Section 1124(3). He explained that it was deleted in response to In re New Valley Corp., which read the subsection to mean that solvency alone wasn’t enough to require post-petition interest for unsecured creditors.
Judge Leval cited the legislative history for the subsection’s repeal to “ensure that solvent debtors pay post-petition interest on their claims.”
Solvent or Insolvent?
On a different line of attach, the creditors argued that the debtor was solvent, not insolvent as the bankruptcy court had found. On appeal in the circuit, the creditors did not advance arguments about the facts, but rather about legal issues underpinning the proper method of valuation.
The creditors argued that the absolute priority rule invokes the solvent-debtor exception. In particular, they relied on the Supreme Court’s Consolidated Rock opinion from 1941 and its statements about absolute priority. In response, Judge Leval cited the Second Circuit for having said in 1998 that the Code did not codify any pre-Code version of the absolute priority rule.
Looking at absolute priority as it reads today in Section 1129(b)(2)(B), one of the alternatives says that cramdown requires creditors to receive “the allowed amount of such claim.”
Because the creditors are receiving the allowed amount of their claims, Judge Leval said that they “cannot insist on compliance with the absolute priority rule. Because such a plan satisfies Section 1129(b)(2)(B)(i), there is no need for it to satisfy Section 1129(b)(2)(B)(ii).”
Judge Leval concluded by saying:
We therefore do not believe that the absolute priority rule provides the relevant test for solvency. We accordingly reject the argument that the Bankruptcy Court was required, as a matter of law, to apply the solvent debtor exception under these circumstances.
Judge Leval ruled that the bankruptcy court had correctly found the debtor to be insolvent and had correctly ruled that the creditors were not impaired because the plan did not impair the claims. He affirmed.
Avoiding a circuit split, the Second Circuit joined the Third, Fifth and Ninth Circuits by holding on December 14 “that a claim is impaired under Section 1124(1) only when the plan of reorganization, rather than the [Bankruptcy] Code, alters the creditor’s legal, equitable, or contractual rights.”
Consequently, an unsecured creditor of an insolvent debtor is not entitled to post-petition interest even though the claim is unimpaired by the plan. In other words, an unsecured creditor remains unimpaired because Section 502(b)(2) disallows post-petition interest as being unmatured on the petition date.
The Second Circuit did not reach the question of whether unsecured creditors of a solvent debtor are entitled to post-petition interest. That question is going to the Third Circuit on direct appeal.