Dear constituency list members of the Insolvency Law Committee, the following is a case update written by Michael J. Riela, a senior investments attorney at Genworth North America Corporation, analyzing a recent case of interest:
In Ultra Petroleum Corp. v. Ad Hoc Committee of OpCo Unsecured Creditors (In re Ultra Petroleum Corp.), 51 F. 4th 138 (5th Cir. Oct. 14, 2022), the Fifth Circuit Court of Appeals held that:
- The “make-whole” amount that the debtors were required to pay their unsecured noteholders was the economic equivalent of unmatured interest, and thus generally is a disallowed claim under Section 502(b)(2) of the Bankruptcy Code;
- Nevertheless, because the debtors were solvent, the debtors were required to pay the make-whole amount to the noteholders in this particular case; and
- The debtors must pay the noteholders post-petition interest at the contractual rate of interest, rather than the significantly lower Federal Judgment Rate.
A copy of Ultra Petroleum Corp. can be found here.
The debtors were natural gas exploration and production companies. In 2014 and 2015, a sharp decline in natural gas prices drove the debtors into chapter 11. However, while the chapter 11 cases proceeded, commodity prices rebounded significantly, which propelled the debtors back to solvency.
Under the debtors’ chapter 11 plan (which the bankruptcy court confirmed), their unsecured noteholders were slated to receive a 100% distribution on account of their claims for outstanding principal and pre-petition interest, plus post-petition interest at the Federal Judgment Rate. The plan did not propose to pay noteholders any “make-whole amount.”
Certain noteholders contested the debtors’ plan, asserting that (i) the governing debt documents required the debtors to pay the make-whole amount to the noteholders, and (ii) the noteholders were entitled to receive post-petition interest at the rate specified in the debt documents, rather than the much-lower Federal Judgment Rate.
The debtors contended that (i) the claim for the make-whole amount was “unmatured interest,” and thus must be disallowed under Section 502(b)(2) of the Bankruptcy Code, and (ii) the noteholders’ claim for post-petition interest is to be calculated at “the legal rate” under Sections 1129(a)(7)(A)(ii) and 726(a)(5) of the Bankruptcy Code – which was the Federal Judgment Rate.
What is a Make-Whole and When Is It Due?
Bond indentures and note purchase agreements typically contain a provision stating that the note issuer (the borrower) may elect to redeem all or a portion of the notes before they mature. Usually, an issuer will redeem its fixed-rate notes early when interest rates are falling. This is because, in a falling interest rate environment, the issuer can reissue new notes at a lower interest rate than its then-existing fixed-rate notes. This is good for the issuer, because doing so would reduce its interest expense.
However, what is good for the issuer is not good for the noteholders, who had expected to receive ongoing interest payments at the fixed rate specified in the debt documents. If the issuer redeems the bonds early, then noteholders would need to deploy the redemption proceeds in a market where interest rates had declined. To compensate the noteholders for the resulting loss of future interest payments, debt documents typically provide that the issuer must pay a make-whole amount to the noteholders if it redeems the notes early.
In contrast to an issuer’s election to redeem notes early, debt documents virtually always provide that the issuer’s bankruptcy automatically accelerates the issuer’s obligation to repay the notes. This automatic acceleration leaves noteholders with a claim in the issuer’s bankruptcy case in the amount of the unpaid principal and accrued pre-petition interest. Some (but not all) debt documents specify that a make-whole amount is also due if the issuer enters bankruptcy.
The Noteholders Lose the Battle, as the Fifth Circuit Holds That Make-Whole Claims Are the Economic Equivalent of Unmatured Interest
In Ultra, the noteholders argued that a make-whole is different than “unmatured interest,” because (a) “interest” generally is defined as “consideration for the use or forbearance of another’s money accruing over time” and (b) because the noteholders were being paid under the chapter 11 plan, there was no actual “further use or forbearance.” The noteholders argued that a make-whole instead functions more like ordinary damages, designed to compensate the noteholders for the transaction costs involved in securing a comparable loan.
Section 502(b)(2) of the Bankruptcy Code disallows claims for “unmatured interest.” That section states:
(b) Except as provided in subsections (e)(2), (f), (g), (h) and (i) of this section, if such objection to a claim is made, the court, after notice and a hearing, shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that — …
(2) such claim is for unmatured interest; …
The Fifth Circuit rejected the noteholders’ argument, noting that its precedents interpret Section 502(b)(2) to disallow claims for the “economic equivalent” of unmatured interest. See, e.g., In re Pengo Indus., Inc., 962 F.2d 543, 546 (5th Cir. 1992) (holding that original issue discount (OID) constituted unmatured interest as a matter of economic fact). Thus, it did not matter whether a make-whole fits within the dictionary definition of “interest.” According to the court, the economic substance of a make-whole is the same as interest, and thus had to be disallowed under Pengo.
But the Noteholders Win This War, as the Solvent-Debtor Exception Permits Them to Receive the Make-Whole in This Case
Because the Ultra debtors were solvent, the Fifth Circuit had to determine whether the “solvent-debtor exception” survived the enactment of Section 502(b)(2) in 1978. The court noted that for about three centuries of bankruptcy law, courts have held that an equitable exception to the usual rules applies in the unusual case of a solvent debtor. In the rare case in which debtor has sufficient money to repay its creditors in full, that debtor ought to repay its debts in their entirety before taking the surplus for itself.
The debtors argued that the Bankruptcy Code abrogated that doctrine as applied to make-whole claims, because Section 502(b)(2) simply disallows claims for unmatured interest regardless of whether the debtor is solvent. In contrast, Section 726(a)(5) of the Bankruptcy Code specifically allows claims for post-petition interest when the debtor is solvent. Therefore, the Debtors argued, Congress intended to disallow claims for unmatured interest in solvent-debtor cases, because otherwise Congress would have included permissive language in Section 502(b)(2) (like it did in Section 726(a)(5)).
The majority of the Fifth Circuit panel rejected that argument, holding that the abrogation of a prior bankruptcy practice generally requires an “unmistakably clear” statement on the part of Congress, and that any ambiguity will be construed in favor of prior practice. See Cohen v. de la Cruz, 523 U.S. 213, 221-22 (1998). The majority concluded that because Section 502(b)(2) does not expressly disallow unmatured interest in solvent-debtor cases, the past practice of allowing unmatured interest in those cases must continue. Accordingly, the debtors were obligated to pay the make-whole amount in this particular case because they were solvent.
In a dissenting opinion, one judge on the panel noted that the language of Section 502(b)(2) precludes unmatured interest – full stop. In contrast, the analogous provisions of the 1898 Bankruptcy Act were more ambiguous than Section 502(b)(2)’s clear bar. In the dissenting judge’s view, Congress clearly intended to annul the solvent-debtor exception with respect to unmatured interest when it enacted Section 502(b)(2).
The Noteholders Were Entitled to Post-Petition Interest at the Contract Rate
Section 1129(a)(7)(A)(ii) of the Bankruptcy Code provides that a court may cram down a chapter 11 plan on impaired creditors if they “will receive or retain under the plan … property of a value … that is not less than the amount that [they] would so receive or retain if the debtor were liquidated under chapter 7.” (Emphasis added). In turn, Section 726(a) of the Bankruptcy Code provides a waterfall for the distribution of a debtor’s assets in chapter 7. Section 726(a)(5) of the Bankruptcy Code provides that before equityholders receive any property of the estate, creditors are entitled to receive payment of post-petition interest “at the legal rate.”
Citing In re Cardelucci, 285 F.3d 1231 (9th Cir. 2002), the debtors argued that Section 726(a)(5) refers to “the legal rate,” which denotes a singular, non-variable interest rate. With that in mind, the only reasonable single rate under federal law is the Federal Judgment Rate. The Fifth Circuit questioned that logic, noting that if Congress really had intended the term “the legal rate” to mean the Federal Judgment Rate, it could have simply cross-referenced the statutory provision that designates the Federal Judgment Rate – 28 U.S.C. § 1961.
Nevertheless, the Fifth Circuit did not decide the question of whether Section 726(a)(5) refers to the Federal Judgment Rate, because Section 1129(a)(7)(A)(ii) only sets a floor – not a ceiling – for what an impaired creditor is to receive in a cramdown scenario. Thus, creditors of a solvent debtor are entitled to post-petition interest of at least the Federal Judgment Rate. As a matter of equity, the noteholders in this case were entitled to post-petition interest at the contract rate when these particular debtors were “fully capable of paying up.”
In large chapter 11 cases, noteholders’ make-whole amount claims can be astronomical. In Ultra Petroleum, that claim amounted to approximately $201 million, so the questions that the Fifth Circuit addressed here are no pittance.
The Fifth Circuit’s holding contrasts with the Second and Third Circuits, which did not analyze the “unmatured interest” issue at all. Rather, the Second and Third Circuits focused on the specific language of the underlying debt documents and applied contract law. See, e.g., In US Bank Trust National Ass’n v. American Airlines, Inc. (In re AMR Corp.), 730 F.3d 88 (2d Cir. 2013) (disallowing make-whole claim where the indenture provided voluntarily redeemed its notes before the maturity date, because the issuer’s bankruptcy filing accelerated the maturity date); In re MPM Silicones, L.L.C., 874 F.3d 787 (2d Cir. 2017) (holding that no make-whole was due because the filing of a voluntary bankruptcy petition did not trigger the indentures’ optional redemption clauses); In re 1141 Realty Owner LLC, 598 B.R. 534 (Bankr. S.D.N.Y. 2019) (allowing make-whole claim when the indenture specified that it is payable even after an acceleration); In re Energy Future Holdings Corp., 842 F.3d 247, 251 (3d Cir. 2016) (holding that an issuer that decides to refinance its debt on better terms during its bankruptcy does so “voluntarily,” thus triggering the make-whole provision in the underlying debt documents).
Many debt documents now specify that a make-whole is due when the notes are accelerated because of an issuer’s bankruptcy. This may be enforceable in the Second and Third Circuits, but is not enforceable in the Fifth Circuit (absent the issuer’s solvency).
Noteholders should continue to try to add specific provisions in debt documents that require make-wholes when notes are accelerated because of the issuer’s bankruptcy. However, noteholders would be equally well-advised not to expect their claims for make-wholes to be allowed in the issuer’s bankruptcy, particularly if the issuer ends up filing in any bankruptcy court in the Fifth Circuit.
These materials were written by Michael J. Riela at Genworth North America Corporation in New York, NY (Michael.Riela@genworth.com). Editorial contributions were provided by John Kim of Brower Law Group in Laguna Hills, CA (john@BrowerLawGroup.com).