Texas Bankruptcy Court Allows Make-Whole Premium As Liquidated Damages And Requires Solvent Chapter 11 Debtor To Pay Postpetition Interest -…

On October 26, 2020, the U.S. Bankruptcy Court for the SouthernDistrict of Texas issued a long-awaited ruling on whether naturalgas exploration and production company Ultra Petroleum Corp.("UPC") must pay a make-whole premium to noteholdersunder its confirmed chapter 11 plan and whether the noteholders areentitled to postpetition interest on their claims pursuant to the"solvent-debtor exception." On remand from the U.S. Courtof Appeals for the Fifth Circuit, the bankruptcy court answered"yes" on both counts, adding yet another chapter to adebate that has long occupied bankruptcy and appellate courts inthis and other chapter 11 cases. See In re Ultra PetroleumCorp., 2020 WL 6276712 (Bankr. S.D. Tex. Oct. 26, 2020).

In particular, the bankruptcy court held that: (i) thecontractual make-whole premium was not disallowed under section502(b)(2) of the Bankruptcy Code as "unmatured interest"or its "economic equivalent" but, rather, representedliquidated damages enforceable under New York law; and (ii) thenoteholders were entitled to interest on their claims at thecontractual default rate, rather than the federal judgment rate, inaccordance with the "solvent-debtor exception," which"has been widely recognized, both before and after adoption ofthe Bankruptcy Code" and is "rooted in the principle thatthe solvent debtor must pay its creditors in full before the debtormay recover a surplus."

UPC issued approximately $1.5 billion in unsecured notes from2008 to 2010. The note agreement, which was governed by New Yorklaw, provided that UPC had the right to prepay the notes at 100% ofprincipal plus a make-whole amount. The make-whole amount wascalculated by subtracting the accelerated principal from thediscounted value of the future principal and interest payments.Events of default under the agreement included a bankruptcy filingby UPC. In that event, failure to pay the outstanding principal,any accrued interest, and the make-whole amount immediatelytriggered the obligation to pay interest at a higher default ratespecified in the note agreement.

UPC filed for chapter 11 protection in April 2016. Improvingbusiness conditions during the course of the case allowed UPC toseek confirmation of a chapter 11 plan that provided for thepayment in cash of all unsecured claims in full. The plandesignated the noteholders' claims as "unimpaired"but did not provide for the payment of the make-whole amount andwould pay postpetition interest on the notes at the federal-fundsrate rather than the default rate. UPC contested thenoteholders' right to receive the make-whole amount. Theparties agreed that postpetition interest should be paid on thenoteholders' claims, but they disagreed on the appropriaterate. The plan distributed new common stock in the reorganizedentity to UPC's existing shareholders.

In its plan confirmation ruling, the bankruptcy court decidedthat under New York law, the make-whole amount was an enforceableliquidated damages provision, rather than an unenforceable penalty.The court rejected UPC's arguments that the make-whole amountwas "conspicuously disproportionate to foreseeable losses atthe time the parties entered" into the note agreement becauseit would result in a double recovery.

The court also held that UPC's chapter 11 plan impaired thenoteholders' claims because the plan failed to provide for thepayment of the make-whole amount and postpetition default-rateinterest. The court rejected UPC's position that, because themake-whole amount represented "unmatured interest" andwas not allowable under section 502(b)(2), the plan left thenoteholders' rights under the Bankruptcy Code unaltered, andthe noteholders' claims were therefore unimpaired under section1124(1).

The bankruptcy court certified a direct appeal of its order tothe 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 thatthe make-whole premium constituted "unmatured interest"disallowed by section 502(b)(2) and that, because the BankruptcyCode, rather than UPC's chapter 11 plan itself, disallowed thenoteholders' claim for a make-whole premium and postpetitioninterest at the contractual default rate, the noteholders'claims were not "impaired" for purposes of confirming theplan.

However, the Fifth Circuit acknowledged in Ultra I thatthe noteholders' claim for a make-whole premium might still beallowed because UPC was solvent. According to the court, "thecreditors can recover the Make-Whole Amount if (but only if) thesolvent-debtor exception survives Congress's enactment of 502(b)(2)."

Prior to the enactment of the Bankruptcy Code, the Fifth Circuitexplained, there existed a "solvent-debtor exception" tothe disallowance of interest accruing after the filing of abankruptcy petition derived from English law. The exceptionprovided that interest would continue to accrue on a debt after abankruptcy filing if the creditor's contract expressly providedfor it and that interest would be payable if the bankruptcy estatecontained sufficient assets to pay it after satisfying other debts.According to the Fifth Circuit, in such cases the post-bankruptcyinterest was treated as part of the underlying debt obligation, asdistinguished from interest "on" a creditor's claimthat might be allowed by the provisions of a bankruptcystatute.

The Fifth Circuit further explained that the Bankruptcy Codecontains several exceptions to the general principal that upon abankruptcy filing, unmatured interest is disallowed under section502(b)(2). For example, section 506(b) provides that an oversecuredcreditor is entitled to interest during the bankruptcy case at thecontract rate. Further, in a chapter 7 case, the distributionscheme set forth in section 726 designates as fifth in priority ofpayment interest on allowed unsecured claims "at the legalrate" (which has been interpreted to mean the federalstatutory rate for interest on judgments set by 28 U.S.C.?1961). Thus, if the estate in a chapter 7 case is sufficientto pay claims of higher priority, creditors are entitled topostpetition interest before the debtor can recover anysurplus.

In a chapter 11 case, the chapter 7 priority scheme can applyunder section 1129(a)(7). Referred to as the "bestinterests" test, section 1129(a)(7) mandates that, unless eachcreditor in an impaired class accepts a chapter 11 plan, thecreditor must receive at least as much under the plan as it wouldin a chapter 7 liquidation of the debtor.

The Fifth Circuit emphasized, however, that each of theseprovisions is a statutory grant of postpetition interest "on aclaim," rather than an allowance of postpetition interestaccruing as part of the claim itself. According to the court,disallowance of the latter type of interest is absolute pursuant tosection 502(b)(2), unless the pre-Bankruptcy Code solvent-debtorexception allowing postpetition interest as part of a claimsurvived the enactment of section 502(b)(2).

The Fifth Circuit doubted that it survived. Even so, the courtnoted, the bankruptcy court's resolution of the Bankruptcy Codeversus chapter 11 plan impairment question prevented it fromconsidering whether "Congress chose not to codify thesolvent-debtor rule as an absolute exception to 502(b)(2)" or whether lawmakers' silence on that score in1978 should be presumed as an indication that certainlong-established bankruptcy principles should remain undisturbed.The Fifth Circuit accordingly remanded the case below to make thatdetermination. It also remanded the case to the bankruptcy courtfor additional findings regarding the appropriate rate ofpostpetition interest.

After agreeing to rehear the case, the Fifth Circuit partiallyvacated its decision in Ultra I. See In re UltraPetroleum Corp., 943 F.3d 758 (5th Cir. 2019) ("UltraII"). In Ultra II, the court reaffirmed itsprevious ruling regarding impairment but again remanded the casebelow to determine whether the make-whole premium was disallowedunder section 502(b)(2) as unmatured interest, whether thenoteholders were entitled to postpetition interest under the"solvent-debtor exception," and, if so, at what rate.

At the outset of its opinion on remand, the bankruptcy courtframed the issues before it as: (i) "does the Bankruptcy Codedisallow a contractual claim for [a make-whole premium] when aninterest-bearing obligation is prepaid?"; and (ii) "doesthe Bankruptcy Code permit a solvent debtor to forego contractualobligations to an unimpaired class of unsecured creditors, butstill pay a distribution to its shareholders?" The courtsanswered "no" on both counts.

The Make-Whole Premium Was Liquidated Damages Ratherthan Unmatured Interest. Addressing the first issue, thebankruptcy court explained that, because the Bankruptcy Codedefines neither "interest" nor "unmaturedinterest" (as used in section 502(b)(2) or elsewhere), thoseterms must be defined according to their ordinary meanings underapplicable nonbankruptcy law. According to the court, the ordinarymeaning of "interest" is "consideration for theuse or forbearance of another's money accruing overtime," and "unmatured interest" means"consideration for the use or forbearance of another'smoney, which has not accrued or been earned as of a referencedate." In bankruptcy, the reference date is the date ofentry of the order for relief (which is the petition date involuntary cases).

The court rejected the noteholders' argument that themake-whole premium matured due to acceleration. In this case, thecourt explained, "whether interest is matured at the moment offiling is determined without reference to acceleration clausestriggered by a bankruptcy petition."

However, the bankruptcy court concluded that the make-wholepremium was not interest because it did not compensate thenoteholders for UPC's use or forbearance of thenoteholders' money but, instead, "compensate[d] the[noteholders] for the cost of reinvesting in a less favorablemarket." It further explained that, in an unfavorable market,UPC's decision not to use the noteholders' money wouldcause them to suffer damages, which the make-whole premiumliquidated. The court also wrote that "[t]he Make-Whole Amountis not unmatured interest simply because it could equal zero whenreinvestment rates are high." Moreover, the make-whole premiumdid not accrue over time but, rather, "is a one-time chargewhich fixes the [noteholders'] damages when it istriggered."

Because the make-whole premium was not interest, the courtwrote, "it is also not unmatured interest" or its"economic equivalent," which the court defined as"in economic reality, . the economic substance of unmaturedinterest," such as unamortized original issue discount onbonds. Instead, the bankruptcy court ruled that the make-wholepremium was an enforceable liquidated damages clause under New Yorklaw, 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 wasobligated to pay postpetition interest to the noteholders. It wrotethat, according to the legislative history, "Congress gave noindication that it intended to erode the solvent debtorexception" when it enacted the Bankruptcy Code. Moreover,"[e]quitable considerations" continue to support it,including the policy against allowing a windfall at the expense ofcreditors to any debtor that can afford to pay all of itsdebts.

According to the court, this conclusion is also supported bypost-Bankruptcy Code court rulings involving solvent debtors aswell as the removal from the Bankruptcy Code in 1994 of section1124(3), which did not require the payment of postpetition intereston claims to render a class of creditors unimpaired under a chapter11 plan, and therefore deemed to accept it, even though more juniorclasses would receive value under the plan. In short, the courtwrote, there is a "'monolithic mountain of authority,'developed over nearly three hundred years in both English andAmerican courts, holding that a solvent debtor must make itscreditors whole" (quoting Ultra II, 943 F.3d at760).

The court explained that, standing alone, neither section 105(a)of the Bankruptcy Code (giving the bankruptcy court broad equitablepower), section 1129(a)(7) ("best interests" test), norsection 1129(b)(1) (requiring a cram-down chapter 11 plan to be"fair and equitable" with respect to dissenting impairedclasses of creditors) is a statutory source for the solvent-debtorexception. Instead, the court wrote, "piecing these BankruptcyCode provisions together," the solvent-debtor exception flowsthrough section 1124(1), which provides that, to render a class ofclaims unimpaired, a plan must leave unaltered the claimants'"legal, equitable, and contractual rights." According tothe court, "[b]ecause an unimpaired creditor has equitablerights to be treated no less favorably than an impaired creditorand to be paid in full before the debtor realizes a recovery, aplan denying post-petition interest in a solvent debtor case altersthe equitable rights of an unimpaired creditor under 1124(1)."

Finally, the bankruptcy court held that the default contractrate was the appropriate rate of interest, rather than the federaljudgment rate. The court explained that the noteholders' rightto postpetition interest was based on "two key equitablerights"-the right to receive no less favorable treatment thanimpaired creditors and the right to have their contractual rightsfully enforced. According to the court, if the noteholder classwere paid interest at the federal judgment rate, it would be worseoff than if it were impaired under UPC's plan because"even though the [noteholders] would receive identicalinterest as a hypothetical impaired class, as an unimpaired classthe Claimants were deprived of the right to vote for or against theplan." In addition, the court noted, limiting the noteholderclass to interest at the federal judgment rate would contravene thepurpose of the solvent-debtor exception, which dictates that when adebtor is solvent, "a bankruptcy court's role is merely toenforce the contractual rights of the parties."

The circuit courts of appeals have come to conflictingconclusions over the allowance of make-whole premiums inbankruptcy. The Third Circuit allowed a make-whole premium inDelaware Trust Co. v. Energy Future Intermediate Holding Co.LLC (In re Energy Future Holdings Corp.), 842 F.3d 247 (3dCir. 2016). The Second Circuit disallowed one in BOKF NA v.Momentive Performance Materials Inc. (In re MPM SiliconesLLC), 874 F.3d 787 (2d Cir. 2017), cert. denied,, 138S. Ct. 2653 (2018), but because the make-whole never became payableunder the relevant terms of the notes. In Ultra Petroleum,the bankruptcy court noted that MPM is distinguishablebecause the Second Circuit "was not presented with thequestion of whether a make-whole is unmatured interest."Therefore, it wrote, to the extent the Second Circuit appeared tosay that make-whole premiums are disallowed, it isdicta.

The bankruptcy court's ruling regarding the solvent-debtorexception is notable. However, whether it will be embraced bycourts adhering to a "plain language" approach to therelevant provisions of the Bankruptcy Code is an open question.Moreover, given the relative rarity of solvent-debtor chapter 11cases, the issue may not be subject to extensive scrutiny.

Finally, the court's determination that the unsecuredcreditors of a solvent debtor are entitled to interest at thecontract rate, rather than the federal funds rate, iscontroversial. 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); Inre Cuker Interactive LLC, 2020 WL 7086066 (Bankr. S.D. Cal.Dec. 3, 2020); In re Pacific Gas & Electric Co., 610B.R. 308 (Bankr. N.D. Cal. 2019).

The bankruptcy court certified a direct appeal of his ruling onremand to the Fifth Circuit on November 30, 2020. As such, theFifth Circuit will have yet another opportunity to consider whetherthe make-whole premium in Ultra Petroleum should beallowed.

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Texas Bankruptcy Court Allows Make-Whole Premium As Liquidated Damages And Requires Solvent Chapter 11 Debtor To Pay Postpetition Interest -...