On remand from the Fifth Circuit, in its October 26, 2020, decision in In re Ultra Petroleum Corp.,1 the US Bankruptcy Court for the Southern District of Texas ruled that (1) make-whole premiums are allowed by the Bankruptcy Code under appropriate circumstances and (2) a solvent debtor must pay post-petition interest at the contractual default rate under the Bankruptcy Code.
The Ultra debtors’ failure to account for these amounts in their treatment of certain noteholders’ claims under the debtors’ confirmed Chapter 11 plan thus impaired these noteholders, which should have entitled them to vote on the plan. The bankruptcy court did not suggest how that issue should now be resolved (e.g., whether the debtors should now be required to pay these amounts, notwithstanding that their plan did not provide for such payment), leaving that issue to another day as the debtors appeal this latest decision.2
1. Prior Decisions
As described in our previous Legal Update on the Fifth Circuit’s November 2019 decision, the Ultra case involves unusual facts: the debtors were insolvent when they filed bankruptcy but became solvent during the course of the case after commodity prices rose significantly. The debtors’ confirmed plan provided that the debtors would pay certain noteholders the outstanding principal amount of their notes, plus post-petition interest at the federal judgment rate, but not a “make-whole” premium that was contractually triggered when the debtors filed for bankruptcy nor additional interest at the contractual default rate. The debtors claimed that this treatment left the noteholders unimpaired and thus not entitled to vote on the plan.
Reversing the bankruptcy court’s initial decision to the contrary, the Fifth Circuit’s November 2019 decision in Ultra3 held that a class of claims or interests is impaired, for purposes of Section 1124(1) of the Bankruptcy Code, only if the plan—as opposed to the Bankruptcy Code itself—alters the legal, equitable or contractual rights of the holders of such claims or interests. In the context of Ultra, this meant that if the noteholders’ claims for either a make-whole premium or post-petition interest at the contractual default rate were disallowed by the Bankruptcy Code, the plan’s failure to account for those amounts did not render the noteholders’ claims impaired. If, on the other hand, the Bankruptcy Code allowed either a make-whole premium or post-petition interest at the contractual default rate, and only the terms of the plan altered these obligations, then the noteholders’ claims were impaired entitling them to vote on the plan. The Fifth Circuit remanded to the bankruptcy court to decide (1) whether the make-whole premiums in question were allowed under the Bankruptcy Code or disallowed as claims for unmatured interest under Section 502(b)(2) of the Bankruptcy Code; and (2) whether the debtors were required to pay post-petition interest at the contractual default rate under the Bankruptcy Code, based on either the solvent debtor exception or other applicable rules or provisions.
2. Make-Whole Premiums
As to the first question, in its October 26, 2020, decision, the bankruptcy court held that make-whole premiums are not improper claims for unmatured interest under Section 502(b)(2) of the Bankruptcy Code but are instead allowable claims, in the appropriate circumstances, for liquidated damages that compensate noteholders for losses suffered due to prepayment of their notes. In so holding, the bankruptcy court characterized interest as “consideration for the use or forbearance of another’s money accruing over time” and unmatured interest as “interest that has not accrued or been earned as of a reference date.”4 By those definitions, the make-whole premium constituted neither interest nor unmatured interest because, “instead of compensating” noteholders “for the use or forbearance of their money,” the make-whole premium compensated noteholders for a debtor’s “decision not to use their money.”5 The bankruptcy court further noted that, unlike interest, a make-whole premium does not accrue over time, but rather fixes “the damages sustained” by the noteholders “at the time of prepayment.”6
The bankruptcy court also rejected the debtors’ argument that a make-whole premium constituted the “economic equivalent” of unmatured interest. In that regard, the bankruptcy court stressed the importance of looking at what a make-whole premium was intended to compensate for, stating that “the economic equivalent of interest must be the economic equivalent of consideration for the use or forbearance of another’s money accruing over time.”7 “Rather than compensating for delay or risk,” a make-whole premium “compensates for actual pecuniary loss.”8 It is a “principled economic estimation of the damages suffered by” a noteholder.9
The bankruptcy court similarly rejected the debtors’ argument that a make-whole premium should be disallowed because it was an “economic substitute” for unmatured interest.10 The bankruptcy court concluded that Section 502(b)(2) of the Bankruptcy Code does not disallow claims for amounts that contracting parties agree will be paid as a substitute for interest so long as those amounts are not meant as compensation “for the use or forbearance of another’s money.”11
3. Interest at Contractual Default Rate
As to the second question—whether and in what circumstances the noteholders might be entitled to post-default interest at the contract rate—the bankruptcy court acknowledged that, under Section 502(b)(2) of the Bankruptcy Code, interest on an unsecured claim typically stops accruing when a bankruptcy case is filed. However, in certain circumstances, creditors may demand post-petition interest on their claims. One such circumstance, the court noted, at least prior to enactment of the Bankruptcy Code, was when a debtor was solvent; in that circumstance, creditors were entitled to all interest owed on their claims in accordance with the terms of their contractual arrangements. Citing to legislative history and the policy objectives underlying the Bankruptcy Code—including the longstanding equitable principle that a “fortunate” (i.e., solvent) debtor must repay its creditors12—the court concluded that the solvent-debtor exception still applies today even though it was not expressly codified by the Bankruptcy Code.
In applying the exception, the bankruptcy court noted that Section 1124 of the Bankruptcy Code provides that a creditor’s claim is impaired unless the plan leaves unaltered the creditor’s “legal, equitable, and contractual rights.”13 In this case, the court held that because the debtors were solvent, the noteholders had an equitable right to be treated at least as favorably as impaired creditors and to be paid post-petition interest before the debtor’s equity holders received any recovery. The court concluded that those same equitable rights entitled the noteholders to be paid post-petition interest at the contractual default rate rather than the federal judgment rate.
To summarize then, the Fifth Circuit previously held in Ultra that a claim is not impaired if the provisions of the Bankruptcy Code—and not just the plan itself—disallow certain aspects of a claim. That left outstanding the question of whether the debtors’ proposed treatment of the noteholders’ claims in Ultra was dictated by the debtors’ plan or by the Bankruptcy Code. If only the plan modified their rights, the noteholders’ claims were impaired, entitling them to vote. If, however, the Bankruptcy Code disallowed aspects of their claims, the noteholders’ claims were unimpaired, rendering them not entitled to vote.
In its October 26, 2020, decision, the bankruptcy court took the former view—because the noteholders were entitled under the Bankruptcy Code to both their make-whole premium and post-petition interest at the contractual default rate, the debtors’ plan impaired those claims. Should the bankruptcy court’s decision hold, the debtors will presumably be required to pay the noteholders both the make-whole premium and post-petition interest at the contractual default rate. It is not clear whether the debtors will have the wherewithal to do so under the terms of their since confirmed plan.
Assuming further appeals proceed, it will bear watching how initially the district court and then, presumably, the Fifth Circuit will ultimately rule, particularly on the allowability of the make-whole premium at issue. Such premiums, the contractual provisions that govern them, and the situations in which they become due have now been litigated in a number of high-profile bankruptcy cases, and further appellate rulings on their allowability will undoubtedly impact how they are approached in the future.
3 Ultra Petroleum Corp. v. Ad Hoc Comm. of Unsecured Creditors of Ultra Res. (In re Ultra Petroleum Corp.), 943 F.3d 758, 2019 WL 6318074 (5th Cir. 2019). The Fifth Circuit’s opinion withdrew and superseded its January 2019 opinion in Ultra Petroleum Corp. v. Ad Hoc Comm. of Unsecured Creditors of Ultra Res. (In re Ultra Petroleum Corp.), 913 F.3d 533 (5th Cir. 2019).