On October 26, 2020, the U.S. Bankruptcy Court for the Southern District of Texas issued a long-awaited ruling on whether natural gas exploration and production company Ultra Petroleum Corp. ("UPC") must pay a make-whole premium to noteholders under its confirmed chapter 11 plan and whether the noteholders are entitled to postpetition interest on their claims pursuant to the "solvent-debtor exception." On remand from the U.S. Court of Appeals for the Fifth Circuit, the bankruptcy court answered "yes" on both counts, adding yet another chapter to a debate that has long occupied bankruptcy and appellate courts in this and other chapter 11 cases. See In re Ultra Petroleum Corp., 2020 WL 6276712 (Bankr. S.D. Tex. Oct. 26, 2020).
In particular, the bankruptcy court held that: (i) the contractual make-whole premium was not disallowed under section 502(b)(2) of the Bankruptcy Code as "unmatured interest" or its "economic equivalent" but, rather, represented liquidated damages enforceable under New York law; and (ii) the noteholders were entitled to interest on their claims at the contractual default rate, rather than the federal judgment rate, in accordance with the "solvent-debtor exception," which "has been widely recognized, both before and after adoption of the Bankruptcy Code" and is "rooted in the principle that the solvent debtor must pay its creditors in full before the debtor may recover a surplus."
UPC issued approximately $1.5 billion in unsecured notes from 2008 to 2010. The note agreement, which was governed by New York law, provided that UPC had the right to prepay the notes at 100% of principal plus a make-whole amount. The make-whole amount was calculated by subtracting the accelerated principal from the discounted value of the future principal and interest payments. Events of default under the agreement included a bankruptcy filing by UPC. In that event, failure to pay the outstanding principal, any accrued interest, and the make-whole amount immediately triggered the obligation to pay interest at a higher default rate specified in the note agreement.
UPC filed for chapter 11 protection in April 2016. Improving business conditions during the course of the case allowed UPC to seek confirmation of a chapter 11 plan that provided for the payment in cash of all unsecured claims in full. The plan designated the noteholders' claims as "unimpaired" but did not provide for the payment of the make-whole amount and would pay postpetition interest on the notes at the federal-funds rate rather than the default rate. UPC contested the noteholders' right to receive the make-whole amount. The parties agreed that postpetition interest should be paid on the noteholders' claims, but they disagreed on the appropriate rate. The plan distributed new common stock in the reorganized entity to UPC's existing shareholders.
In its plan confirmation ruling, the bankruptcy court decided that under New York law, the make-whole amount was an enforceable liquidated damages provision, rather than an unenforceable penalty. The court rejected UPC's arguments that the make-whole amount was "conspicuously disproportionate to foreseeable losses at the time the parties entered" into the note agreement because it would result in a double recovery.
The court also held that UPC's chapter 11 plan impaired the noteholders' claims because the plan failed to provide for the payment of the make-whole amount and postpetition default-rate interest. The court rejected UPC's position that, because the make-whole amount represented "unmatured interest" and was not allowable under section 502(b)(2), the plan left the noteholders' rights under the Bankruptcy Code unaltered, and the noteholders' claims were therefore unimpaired under section 1124(1).
The bankruptcy court certified a direct appeal of its order to the Fifth Circuit, which agreed to hear the appeal.
In In re Ultra Petroleum Corp., 913 F.3d 533 (5th Cir. 2019) ("Ultra I"), the Fifth Circuit ruled that the make-whole premium constituted "unmatured interest" disallowed by section 502(b)(2) and that, because the Bankruptcy Code, rather than UPC's chapter 11 plan itself, disallowed the noteholders' claim for a make-whole premium and postpetition interest at the contractual default rate, the noteholders' claims were not "impaired" for purposes of confirming the plan.
However, the Fifth Circuit acknowledged in Ultra I that the noteholders' claim for a make-whole premium might still be allowed because UPC was solvent. According to the court, "the creditors can recover the Make-Whole Amount if (but only if) the solvent-debtor exception survives Congress's enactment of § 502(b)(2)."
Prior to the enactment of the Bankruptcy Code, the Fifth Circuit explained, there existed a "solvent-debtor exception" to the disallowance of interest accruing after the filing of a bankruptcy petition derived from English law. The exception provided that interest would continue to accrue on a debt after a bankruptcy filing if the creditor's contract expressly provided for it and that interest would be payable if the bankruptcy estate contained sufficient assets to pay it after satisfying other debts. According to the Fifth Circuit, in such cases the post-bankruptcy interest was treated as part of the underlying debt obligation, as distinguished from interest "on" a creditor's claim that might be allowed by the provisions of a bankruptcy statute.
The Fifth Circuit further explained that the Bankruptcy Code contains several exceptions to the general principal that upon a bankruptcy filing, unmatured interest is disallowed under section 502(b)(2). For example, section 506(b) provides that an oversecured creditor is entitled to interest during the bankruptcy case at the contract rate. Further, in a chapter 7 case, the distribution scheme set forth in section 726 designates as fifth in priority of payment interest on allowed unsecured claims "at the legal rate" (which has been interpreted to mean the federal statutory rate for interest on judgments set by 28 U.S.C. § 1961). Thus, if the estate in a chapter 7 case is sufficient to pay claims of higher priority, creditors are entitled to postpetition interest before the debtor can recover any surplus.
In a chapter 11 case, the chapter 7 priority scheme can apply under section 1129(a)(7). Referred to as the "best interests" test, section 1129(a)(7) mandates that, unless each creditor in an impaired class accepts a chapter 11 plan, the creditor must receive at least as much under the plan as it would in a chapter 7 liquidation of the debtor.
The Fifth Circuit emphasized, however, that each of these provisions is a statutory grant of postpetition interest "on a claim," rather than an allowance of postpetition interest accruing as part of the claim itself. According to the court, disallowance of the latter type of interest is absolute pursuant to section 502(b)(2), unless the pre-Bankruptcy Code solvent-debtor exception allowing postpetition interest as part of a claim survived the enactment of section 502(b)(2).
The Fifth Circuit doubted that it survived. Even so, the court noted, the bankruptcy court's resolution of the Bankruptcy Code versus chapter 11 plan impairment question prevented it from considering whether "Congress chose not to codify the solvent-debtor rule as an absolute exception to § 502(b)(2)" or whether lawmakers' silence on that score in 1978 should be presumed as an indication that certain long-established bankruptcy principles should remain undisturbed. The Fifth Circuit accordingly remanded the case below to make that determination. It also remanded the case to the bankruptcy court for additional findings regarding the appropriate rate of postpetition interest.
After agreeing to rehear the case, the Fifth Circuit partially vacated its decision in Ultra I. See In re Ultra Petroleum Corp., 943 F.3d 758 (5th Cir. 2019) ("Ultra II"). In Ultra II, the court reaffirmed its previous ruling regarding impairment but again remanded the case below to determine whether the make-whole premium was disallowed under section 502(b)(2) as unmatured interest, whether the noteholders were entitled to postpetition interest under the "solvent-debtor exception," and, if so, at what rate.
The Bankruptcy Court's Ruling on Remand
At the outset of its opinion on remand, the bankruptcy court framed the issues before it as: (i) "does the Bankruptcy Code disallow a contractual claim for [a make-whole premium] when an interest-bearing obligation is prepaid?"; and (ii) "does the Bankruptcy Code permit a solvent debtor to forego contractual obligations to an unimpaired class of unsecured creditors, but still pay a distribution to its shareholders?" The courts answered "no" on both counts.
The Make-Whole Premium Was Liquidated Damages Rather than Unmatured Interest. Addressing the first issue, the bankruptcy court explained that, because the Bankruptcy Code defines neither "interest" nor "unmatured interest" (as used in section 502(b)(2) or elsewhere), those terms must be defined according to their ordinary meanings under applicable nonbankruptcy law. According to the court, the ordinary meaning of "interest" is "consideration for the use or forbearance of another's money accruing over time," and "unmatured interest" means "consideration for the use or forbearance of another's money, which has not accrued or been earned as of a reference date." In bankruptcy, the reference date is the date of entry of the order for relief (which is the petition date in voluntary cases).
The court rejected the noteholders' argument that the make-whole premium matured due to acceleration. In this case, the court explained, "whether interest is matured at the moment of filing is determined without reference to acceleration clauses triggered by a bankruptcy petition."
However, the bankruptcy court concluded that the make-whole premium was not interest because it did not compensate the noteholders for UPC's use or forbearance of the noteholders' money but, instead, "compensate[d] the [noteholders] for the cost of reinvesting in a less favorable market." It further explained that, in an unfavorable market, UPC's decision not to use the noteholders' money would cause them to suffer damages, which the make-whole premium liquidated. The court also wrote that "[t]he Make-Whole Amount is not unmatured interest simply because it could equal zero when reinvestment rates are high." Moreover, the make-whole premium did not accrue over time but, rather, "is a one-time charge which fixes the [noteholders'] damages when it is triggered."
Because the make-whole premium was not interest, the court wrote, "it is also not unmatured interest" or its "economic equivalent," which the court defined as "in economic reality, … the economic substance of unmatured interest," such as unamortized original issue discount on bonds. Instead, the bankruptcy court ruled that the make-whole premium was an enforceable liquidated damages clause under New York law, and accordingly, "it forms part of the [noteholders'] allowed claims."
The Solvent-Debtor Exception Survives. Next, the bankruptcy court held that, because UPC was solvent, it was obligated to pay postpetition interest to the noteholders. It wrote that, according to the legislative history, "Congress gave no indication that it intended to erode the solvent debtor exception" when it enacted the Bankruptcy Code. Moreover, "[e]quitable considerations" continue to support it, including the policy against allowing a windfall at the expense of creditors to any debtor that can afford to pay all of its debts.
According to the court, this conclusion is also supported by post-Bankruptcy Code court rulings involving solvent debtors as well as the removal from the Bankruptcy Code in 1994 of section 1124(3), which did not require the payment of postpetition interest on claims to render a class of creditors unimpaired under a chapter 11 plan, and therefore deemed to accept it, even though more junior classes would receive value under the plan. In short, the court wrote, there is a "'monolithic mountain of authority,' developed over nearly three hundred years in both English and American courts, holding that a solvent debtor must make its creditors whole" (quoting Ultra II, 943 F.3d at 760).
The court explained that, standing alone, neither section 105(a) of the Bankruptcy Code (giving the bankruptcy court broad equitable power), section 1129(a)(7) ("best interests" test), nor section 1129(b)(1) (requiring a cram-down chapter 11 plan to be "fair and equitable" with respect to dissenting impaired classes of creditors) is a statutory source for the solvent-debtor exception. Instead, the court wrote, "piecing these Bankruptcy Code provisions together," the solvent-debtor exception flows through section 1124(1), which provides that, to render a class of claims unimpaired, a plan must leave unaltered the claimants' "legal, equitable, and contractual rights." According to the court, "[b]ecause an unimpaired creditor has equitable rights to be treated no less favorably than an impaired creditor and to be paid in full before the debtor realizes a recovery, a plan denying post-petition interest in a solvent debtor case alters the equitable rights of an unimpaired creditor under § 1124(1)."
Finally, the bankruptcy court held that the default contract rate was the appropriate rate of interest, rather than the federal judgment rate. The court explained that the noteholders' right to postpetition interest was based on "two key equitable rights"—the right to receive no less favorable treatment than impaired creditors and the right to have their contractual rights fully enforced. According to the court, if the noteholder class were paid interest at the federal judgment rate, it would be worse off than if it were impaired under UPC's plan because "even though the [noteholders] would receive identical interest as a hypothetical impaired class, as an unimpaired class the Claimants were deprived of the right to vote for or against the plan." In addition, the court noted, limiting the noteholder class to interest at the federal judgment rate would contravene the purpose of the solvent-debtor exception, which dictates that when a debtor is solvent, "a bankruptcy court's role is merely to enforce the contractual rights of the parties."
The circuit courts of appeals have come to conflicting conclusions over the allowance of make-whole premiums in bankruptcy. The Third Circuit allowed a make-whole premium in Delaware Trust Co. v. Energy Future Intermediate Holding Co. LLC (In re Energy Future Holdings Corp.), 842 F.3d 247 (3d Cir. 2016). The Second Circuit disallowed one in BOKF NA v. Momentive Performance Materials Inc. (In re MPM Silicones LLC), 874 F.3d 787 (2d Cir. 2017), cert. denied,, 138 S. Ct. 2653 (2018), but because the make-whole never became payable under the relevant terms of the notes. In Ultra Petroleum, the bankruptcy court noted that MPM is distinguishable because the Second Circuit "was not presented with the question of whether a make-whole is unmatured interest." Therefore, it wrote, to the extent the Second Circuit appeared to say that make-whole premiums are disallowed, it is dicta.
The bankruptcy court's ruling regarding the solvent-debtor exception is notable. However, whether it will be embraced by courts adhering to a "plain language" approach to the relevant provisions of the Bankruptcy Code is an open question. Moreover, given the relative rarity of solvent-debtor chapter 11 cases, the issue may not be subject to extensive scrutiny.
Finally, the court's determination that the unsecured creditors of a solvent debtor are entitled to interest at the contract rate, rather than the federal funds rate, is controversial. Several other courts have ruled to the contrary. See In re Cardelucci, 285 F.3d 1231 (9th Cir. 2002); In re Beguelin, 220 B.R. 94 (B.A.P. 9th Cir. 1998); In re Cuker Interactive LLC, 2020 WL 7086066 (Bankr. S.D. Cal. Dec. 3, 2020); In re Pacific Gas & Electric Co., 610 B.R. 308 (Bankr. N.D. Cal. 2019).
The bankruptcy court certified a direct appeal of his ruling on remand to the Fifth Circuit on November 30, 2020. As such, the Fifth Circuit will have yet another opportunity to consider whether the make-whole premium in Ultra Petroleum should be allowed.