Ninth Circuit Holds that the Solvent-Debtor Exception Survived Passage of the Bankruptcy Code

If a solvent chapter 11 debtor designates creditors as unimpaired, what rate of post-petition interest must the debtor pay those creditors? That question has divided bankruptcy courts. Some have held that a plan must pay unimpaired creditors post-petition interest at the contract rate. [1] Others have held that, “under equitable principles,” a plan must pay post-petition interest at a rate “the Court deems appropriate.” [2] Yet another line of cases holds that unimpaired creditors are entitled only to the much lower federal judgment rate. [3]

This fall, the Ninth Circuit answered that question, becoming the first circuit court to do so. In a divided opinion, the Ninth Circuit held that under the “solvent-debtor exception,” unimpaired creditors possess an equitable right to post-petition interest at either the contractual rate or the state statutory rate of default interest, subject to any other equitable considerations that might exist in the case. [4]

After wildfires ravaged Northern California, Pacific Gas & Electric Company (PG&E) filed a chapter 11 petition to address potential liability for the damage. Despite facing tens of billions of dollars in liability to fire victims, PG&E was otherwise “solvent” at the time of its petition, meaning its assets exceeded its known liabilities by almost $20 billion.

Under its chapter 11 plan, PG&E classified its general unsecured creditors separately from the wildfire claimants. The plan then designated those general unsecured creditors as “unimpaired,” proposing to pay them the full principal amount of their claims plus post-petition interest at the federal judgment rate of 2.59%. [5]

That rate was far lower than what certain of the general unsecured creditors were entitled to under state law — some of which had higher contractual rates, while others were entitled to California’s statutory default rate of 10%. [6]

Certain creditors objected to confirmation of the plan, arguing that, to be “unimpaired,” PG&E was required to pay them postpetition interest at the contract or state statutory rate, as applicable. By using the federal judgment rate, the creditors argued that the plan would underpay these creditors by around $200 million.

The bankruptcy court [7] and district court [8] disagreed with the objecting creditors, holding that the Bankruptcy Code limited recovery to the much lower federal judgment rate. Both courts held that they were bound by Cardelucci v. Cardelucci (In re Cardelucci), 285 F.3d 1231 (9th Cir. 2002), which they interpreted as holding that unsecured creditors of a solvent debtor are entitled only to post-petition interest at the federal judgment rate — regardless of how those creditors are classified. The Ninth Circuit reversed, holding that unimpaired creditors of a solvent debtor have an “equitable right” to postpetition interest at the contractual or state law rate under the longstanding and judge-made “solvent-debtor exception.”

Generally, creditors are not entitled to interest after the petition date. [9] Otherwise, payment of post-petition interest would diminish the estate, resulting in disparate treatment among creditors. [10] But that concern does not exist when a debtor is solvent. As a result, beginning in the eighteenth century, English courts created and began applying the “solvent-debtor exception” to the general rule. That exception required bankrupt debtors to pay interest to creditors before the debtor would be permitted to retain value from the estate. [11]

American courts adopted the exception and applied it under the Bankruptcy Act of 1898. [12] Notably, the exception had not been codified in the Bankruptcy Act and instead remained a judge-made exception to the Act’s prohibition on post-petition interest, “flowing from the purpose of bankruptcy law to ensure an equitable distribution of assets.” [13] In applying the exception, American courts held that creditors of a solvent debtor were entitled to post-petition interest under their contractual or statutory rate of interest under applicable state law.

But did the Bankruptcy Code abrogate the exception? Not according to the Ninth Circuit. Courts “will not read the Bankruptcy Code to erode past bankruptcy practice absent a clear indication that Congress intended such a departure.” [14] In addition, the Ninth Circuit found no “clear indication” that Congress intended to abrogate the solvent-debtor exception. Instead, the majority found that the Bankruptcy Code’s language compelled the opposite result.

The Ninth Circuit focused on the concept of “impairment” under § 1124(1). That section provides that a claim cannot be considered “unimpaired” unless a chapter 11 plan “leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest.” [15] Pre-Code practice granted unimpaired creditors an equitable right to contractual post-petition interest. In enacting § 1124(1), it appeared that Congress intended that equitable right to remain and, in fact, required that it be “unaltered” when a chapter 11 debtor is solvent.

The Ninth Circuit also disagreed with the lower courts that Cardelucci controlled. The lower courts had opined that Cardelucci “established a broad rule that all unsecured claims in a solvent-debtor bankruptcy are entitled only to post-petition interest at the federal judgment rate, regardless of impairment status.” [16] But the Ninth Circuit recognized that Cardelucci’s holding was limited. In that case, the court was interpreting the phrase “interest at the legal rate” under § 726(a)(5), holding that the phrase referred to the federal judgment rate. But § 726(a)(5) applies only to impaired creditors, not to unimpaired creditors of a solvent debtor. Thus, the Ninth Circuit dismissed Cardelucci as irrelevant to the question presented to it.

Ultimately, the Ninth Circuit held that because PG&E was solvent, the general unsecured creditors had an equitable right to post-petition interest under the solvent-debtor exception. The Ninth Circuit reversed the decision below and remanded to the bankruptcy court for a determination as to how much post-petition interest the general unsecured creditors were entitled to under the equities of the case.

Notably, the Ninth Circuit emphasized that the solvent-debtor exception “does not give bankruptcy judges free-floating discretion to redistribute rights in accordance with [their] personal views of justice and fairness.” [17] Instead, “absent compelling equitable considerations, when a debtor is solvent, it is the role of the bankruptcy court to enforce the creditors’ contractual rights.” [18] In most cases, “the equitable role of the bankruptcy court will be simply to enforce creditors’ rights according to the tenor of the contracts that created those rights.” [19] To be sure, there may be the occasional case “where payment of contractual or default interest could impair the ability of other similarly situated creditors to be paid in full, or where other compelling equitable considerations could counsel in favor of payment of post-petition interest at a different rate. [20] But the Ninth Circuit found no such considerations in PG&E’s case, so there was a “presumption that [the general unsecured creditors were] entitled to contractual or default postpetition interest.” [21]

The Ninth Circuit may have been the first circuit to decide the issue, but it certainly will not be the last. Given the division in the lower courts, it is perhaps likely that the other circuits will decide the issue differently, ultimately requiring the Supreme Court to weigh in.