Delaware Bankruptcy Court Rules That Unsecured Creditors Of A Solvent Debtor Are Entitled To Post-Petition Interest At The Federal Judgment Rate, Not…

On December 22, 2021, Judge Mary Walrath of the Bankruptcy Courtfor the District of Delaware held in In re The Hertz Corp.that redemption premiums may potentially qualify as unmaturedinterest, and that, to the extent that such redemption premiums areunmatured interest on unsecured debt, then creditors would only beentitled to receive the federal judgment rate, not the contractualrate of interest.1 The decision departs from a recentdecision from the Texas bankruptcy court in the UltraPetroleum case, which held that unimpaired unsecured creditorsof a solvent debtor would be entitled to receive the contractualrate of interest.

In the wake of the COVID-19 pandemic, the Hertz Corporation andits affiliates (the "Debtors") filed voluntary petitionsunder chapter 11 of the Bankruptcy Code. During the course of itsbankruptcy case, Hertz's liquidity position improved and thus,under Hertz's plan of reorganization, all creditors were beingpaid in full. However, the plan provided that unsecured creditorswould receive post-petition interest accruing at the federaljudgment rate or at any rate necessary to render creditorsunimpaired.2 The federal judgment rate was lower thanthe default interest provided in the indentures. The plan alsoprovided that prepetition equity holders would receivedistributions of cash and equity.3

In July 2021, Wells Fargo Bank, N.A., as indenture trustee forthe Debtors' unsecured senior noteholders, filed an adversarycomplaint against the Debtors seeking to recover (1) a make-wholepremium due under the senior notes (totaling approximately $147million) and (2) post-petition interest on their claims at thecontract default rate in excess of the federal judgment rate(approximately $125 million).4 The Debtors moved todismiss the complaint.

In a comprehensive opinion, the Court granted in part and deniedin part the Debtors' motion to dismiss. Of significance, theCourt held that only some of the senior noteholders were entitledto receive a redemption premium under the indentures, that theredemption premiums may potentially qualify as the economicequivalent of unmatured interest (and thus could be subject todisallowance), and that unsecured creditors of a solvent debtor areonly entitled to receive post-petition interest at the federaljudgment rate.

Indentures and credit agreements may require a borrower to pay aprepayment or redemption premium to "protect the lenders'right to a yield that was expected at the time that they made theirloans."5 A redemption premium thus refers to therepayment of a debt at or before its maturity date at a certainpercentage above its face value, which in certain circumstances maycompensate the lender or noteholder for lost interest as a resultof the early redemption of the debt.6

The Court first addressed whether the senior noteholders wereentitled to redemption premiums. The Debtors moved to dismiss thecomplaint on the grounds that the redemption premiums were notpayable under the express language of the indentures because theacceleration provisions (which were triggered automatically uponthe Debtors' filing) in the indentures did not provide for thepayment of redemption premiums. However, the Court rejected theDebtors' arguments that the indentures did not provide for thepayment of a redemption premium upon automatic acceleration byvirtue of the bankruptcy filing. Relying on the Third Circuit'sdecision in Energy Future Holdings, the Court held thatthe applicable contractual provision for determining thenoteholders' entitlement to redemption premiums was thespecific redemption provision, not the automatic accelerationprovision.7

Therefore, turning to the express language of the redemptionprovisions, the Court determined that some-but not all-of thenoteholders were entitled to receive a redemption premium.Specifically, the Court held that holders of certain senior notes(the "2022/2024 Notes") were not entitled to a redemptionpremium because the applicable redemption provisions only providedfor redemption "prior to maturity thereof at the applicableredemption price set forth below."8 Given that theredemption provision referred to an undefined term for maturity ofthe debt, the Court held that no redemption premium was due on the2022/2024 Notes because the notes matured as a result of thebankruptcy filing.9 In other words, because thebankruptcy filing and not the stated maturity date triggeredmaturity under the terms of the indenture, no such right to anyredemption premium existed post-petition.

By contrast, the Court held that holders of other senior notes(the "2026/2028 Notes") were entitled to a redemptionpremium under the express language of their indenture, whichdiffered from that of the 2022/2024 Notes. The redemptionprovisions for the 2026/2028 Notes provided that "[a]t anytime prior to [a specified date], the [senior notes] may also beredeemed (by the Company or any other person) in whole or in part,at the Company's option, at . . . the Redemption Price . . .." The Court read this provision to "simply [provide] theDebtors with the ability to redeem under the circumstances"specified in that provision, and notably did not contain therequirement that redemption must occur before maturity. Because thebonds were redeemed prior to the dates specified in the redemptionprovision, the Court found that, unlike the 2022/2024 noteholders,the 2026/2028 noteholders stated a plausible claim for relief as tothe 2026/2028 noteholders' entitlement to a redemptionpremium.10

The Court next addressed the Debtors' contention that theredemption premium should be disallowed as unmatured interest undersection 502(b)(2) of the Bankruptcy Code. Section 502(b)(2) of theBankruptcy Code provides that a claim is disallowed "to theextent that . . . such claim is for unmatured interest."Notably, "unmatured interest" is not defined in theBankruptcy Code, but rather has been interpreted by courts toinclude post-petition interest and contractual charges that are the"contractual equivalent" of futureinterest.11

The Court noted that while the Third Circuit in EnergyFuture Holdings did characterize a redemption premium as the"contractual substitute for interest lost on Notes redeemedbefore their expected due date,"12 it was notaddressing the issue in the context of section 502(b)(2)disallowance.13 Further, the Court discussed thedecision in Ultra Petroleum, where the Fifth Circuit notedthat a make-whole premium could be considered unmatured interestand remanded to the bankruptcy court to determine theissue.14 On remand, the Bankruptcy Court for theSouthern District of Texas concluded that the make-whole premiumwas not the economic equivalent of unmatured interest and notdisallowed under Section 502(b)(2).15 This decision iscurrently on appeal.

When deciding whether a contractual charge is unmaturedinterest, "courts look to the economic substance of thetransaction to determine what counts asinterest."16 In Hertz, the Court concludedthat to determine whether the redemption premium is the economicequivalent of unmatured interest is not a legal question, but afactual one.17 Put another way, simply characterizingthe makewhole claim as liquidated damages, breach of contractdamages, or another separate contract right could avoid the effectof section 502(b)(2) in the hands of an astute drafter. Inpractice, a contract could provide that upon default or redemption,"all unmatured interest" would be immediately due andpayable, therefore avoiding Bankruptcy Code section 502(b)(2)disallowance in contravention of the Bankruptcy Code.

In considering the redemption premium provision here, the Courtfound it significant that the premium is calculated on the presentvalue of unmatured interest due as of the redemption date, but leftthe door open for the noteholders to introduce evidence to thecontrary. The Court thus denied the Debtors' motion to dismissthe noteholders' claim that it must pay a redemption premium onthe 2026/2028 Notes.18

Finally, the Court addressed which interest rate would apply tothe redemption premium. Section 1124 of the Bankruptcy Codeprovides that a claim is unimpaired if, among other things, theplan "leaves unaltered the legal, equitable, and contractualrights" of the holder of that claim.19 However,section 502(b)(2) provides for the disallowance of any unmaturedinterest.20 Whether a claim is impaired has significantimplications: creditors that are impaired generally are entitled tocertain rights in the context of plan confirmation, including (i)the right to vote to accept or reject the plan and (ii) the rightto receive consideration equal to what the creditor would havereceived in a hypothetical chapter 7 liquidation.21

The noteholders contended that because the plan designatedsenior noteholders as unimpaired for purposes of section 1124 ofthe Bankruptcy Code (which provides that a class of claims orinterests is impaired under a plan unless the plan leaves suchclass's legal, equitable, and contractual rights to such claimsor interests unaltered), the noteholders should be entitled toreceive interest at the contract rate. On the other hand, theDebtors argued that because it was section 502(b)(2) of theBankruptcy Code that disallowed unmatured interest, rather than theDebtors' plan, the senior noteholders' claim was unimpairedunder Third Circuit precedent.22 The Court ruled infavor of the Debtors, holding that unsecured creditors "arenot impaired within the meaning of section 1124(1)" becausethe senior noteholders' claim to unmatured interest or theredemption premium was modified by section 502(b)(2) of theBankruptcy Code, and not the Debtors' plan.23

Nevertheless, the noteholders argued that they were entitled totheir contract rate of interest because "the Debtors are awashin cash, paid all creditors in full, and provided a substantialreturn on investment to equity."24 The Courtacknowledged that prior to the enactment of the Bankruptcy Code,courts applied a "solvent debtor" exception. Thisexception provided that the contractual rights of unimpairedcreditors must be preserved in bankruptcy when a debtor is solvent.The Court found, however, that "the solvent debtor exceptionsurvived the passage of the Bankruptcy Code only to a limitedextent."25 Indeed, the Court noted that Congressexpressly codified the solvent debtor exception in two sections ofthe Bankruptcy Code: section 506(b) (which provides for payment ofpost-petition interest to oversecured creditors)26 andsection 726(a)(5) as to impaired unsecured creditors.

However, the Bankruptcy Code "is silent on what treatmentunimpaired creditors must receive in a solvent chapter 11 debtorcase."27 The Court found that nothing in theexpress text of the Bankruptcy Code or in its legislative historyrequired the payment of post-petition interest at the contract rateof interest. Thus, the Court held that even if the solvent debtorexception survived the enactment of the Bankruptcy Code, theBankruptcy Code did not specify what interest rate would berequired to establish that an unsecured creditor is unimpaired. TheCourt noted that Congress could have provided a solvent debtorexception for unimpaired unsecured claims by (i) exceptingunmatured interest from disallowance under section 502(b) when thedebtor is solvent or (ii) by amending section 1124 to provide thatunimpaired creditors must receive their contract rate of interest,in addition to payment in full of their allowed claim. But Congresscreated neither exception.

Due to the lack of guidance from the text of the BankruptcyCode, courts have remained split on the applicable "legalrate" of interest for unimpaired unsecured creditors in asolvent chapter 11 debtor case. Some courts have held thatunsecured creditors are entitled to receive post-petition interestat the "contract rate," meaning the interest ratespecified in the prepetition contract (or if there is no contract,the interest rate specified under state law).28 However,other courts have held that creditors of a solvent debtor are onlyentitled to receive interest at the federal judgment rate, which istypically lower than the contract rate.29

The Court concluded that the federal judgment rate was theappropriate applicable rate of interest in Hertz. Insupport of its conclusion, the Court noted that neither theBankruptcy Code nor its legislative history indicated any intentfor unimpaired unsecured creditors of a solvent debtor to receivebetter treatment than impaired unsecured creditors.30The Court thus found no basis to distinguish between unimpaired andimpaired unsecured creditors in a solvent debtor case.31Pursuant to sections 1129(a)(7) and 726(a)(5) of the BankruptcyCode,32 impaired unsecured creditors in a solvent debtorchapter 11 case are entitled to receive post-petition interest atthe federal judgment rate. Specifically, section 726(a)(5) requirespayment of interest at the "legal rate" before anydistributions to equity holders can be made, and section 1129(a)(7)provides that with respect to each impaired class of claims orinterests, creditors are entitled to receive what they would havereceived in a liquidating chapter 7 case.

The Court noted that adopting a uniform rule to apply to allunsecured creditors regardless of whether they are impairedprovides more certainty and fairness in bankruptcy cases. The Courtstated that providing that "all general unsecured creditorsare entitled to the same post-petition interest in a solventchapter 11 debtor case prevents a debtor from paying preferredcreditors more than others simply by classifying them asunimpaired."33 While the noteholders complainedthat designation of their claims as unimpaired deprived them of theright to vote on the plan, the Court found that thenoteholders' impairment would not have resulted in differenttreatment. Specifically, the Court stated that if the noteholders"had been treated as impaired and if they had voted againstthe Plan, they would have received the same treatment: payment infull in cash of their allowed claim plus post-petition interest inaccordance with sections 1129(a)(7) and726(a)(5)."34 In other words, the noteholders wouldhave still received interest at the federal judgment rate.

The Court thus rejected the noteholders' reliance on theTexas bankruptcy court's decision in Ultra Petroleum.In that case, the Texas bankruptcy court held that the BankruptcyCode did not abolish the solvent debtor exception and that thesolvent debtor exception would require payment of default interestprovided in the contracts. The Ultra Petroleum court'sdecision hinged on its determination that unimpaired creditors wereentitled to have their equitable rights fully enforced undersection 1124(1) in a "solvent debtor" case.35Judge Walrath did not find this reasoning persuasive because"[a] bankruptcy court cannot use equitable principles tomodify express language of the Code," such as section502(b)(2), which "expressly disallows claims of unsecuredcreditors for unmatured interest."36 TheDebtor's solvency, according to the Court, does not "waivethe application of section 502(b)(2)."37 Therefore,the Court concluded that the noteholders failed to state aplausible claim that the Debtors must pay post-petition interest onthe senior notes at the contract rate rather than at the federaljudgment rate and dismissed this count in the noteholders'complaint.

Judge Walrath's decision in Hertz confirms thatunder Third Circuit precedent, it is the applicable redemptionprovision-not the acceleration provision-that is determinative asto a creditor's entitlement to receive a redemption premium inbankruptcy. Where, as with the 2026/2028 noteholders inHertz, the entitlement to receive a premium is notdependent on a redemption occurring prior to a maturity date, thencreditors may be entitled under their contracts to receive theredemption premium in bankruptcy. By contrast, as with the2022/2024 noteholders, if the redemption premium is dependent onthe redemption occurring prior to the maturity date and theindenture provides for automatic acceleration upon a bankruptcyfiling, then a court could conclude, as the Court did here, thatthe creditors are not entitled to the redemption premium under theexpress language of the governing agreements.

Judge Walrath's decision also underscores the split amongcourts as to the proper treatment of unimpaired unsecured creditorsin a solvent chapter 11 case. Consistent with a recent decision inthe PG&E case in California,38 JudgeWalrath held that both impaired and unimpaired unsecured creditorsin a solvent chapter 11 debtor case are entitled to receive thefederal judgment rate, not the contractual rate of interest. TheHertz decision thus conflicts with the UltraPetroleum decision in Texas, which held that unimpairedunsecured creditors of a solvent debtor are required to receivetheir contractual default rate of interest.

Unimpaired unsecured creditors of a solvent debtor shouldtherefore be mindful that this is an evolving issue in bankruptcythat remains unsettled and can vary among courts and districts.Even where a debtor is solvent and has sufficient liquidity to paypost-petition interest, a court may conclude that an unsecuredcreditor of a solvent debtor may only be entitled to post-petitioninterest at the federal judgment rate, which likely issubstantially lower than the default rate of interest.

Footnotes

1 Wells Fargo Bank, N.A. v. The Hertz Corp. (In reThe Hertz Corp.), Adv. No. 20-11218 (MFW), 2021 WL 6068390, at*3 (Bankr. D. Del. Dec. 22, 2021).

2 Id. at *2.

3 Id.

4 Id. at *3.

5 See In re Chemtura Corp., 439 B.R. 561, 596(Bankr. S.D.N.Y. 2010).

6 See In re MPM Silicones LLC, 874 F.3d 787, 802(2d Cir. 2017).

7 In re The Hertz Corp., 2021 WL 6068390, at *3(citing In re Energy Future Holdings Corp., 842 F.3d 247(3d Cir. 2016)).

8 Id. at *5.

9 Id. at **5-6.

10 Id. at *7.

11 Id. at n.11.

12 In re Energy Future Holdings Corp., 842 F.3dat 251; see also In re MPM Silicones, 874 F.3d, 787, 802(2d Cir. 2017) (noting that a make-whole premium "was intendedto ensure that the Senior-Lien Note holders received additionalcompensation to make up for the interest they would not receive ifthe Notes were redeemed prior to the maturitydate.").

13 In re Energy Future Holdings Corp., 842 F.3dat 251, 253 n.1.

14 In re Ultra Petroleum Corp., 943 F.3d 758,765 (5th Cir. 2019).

15 In re Ultra Petroleum Corp., 624 B.R. 178,188-95 (Bankr. S.D. Tex. 2020).

16 In re Doctors Hosp. of Hyde Park, Inc., 508B.R. 697, 705 (Bankr. N.D. Ill. 2014).

17 In re The Hertz Corp., 2021 WL 6068390, at*8.

18 Id.

19 11 U.S.C. 1124(1).

20 Id. 502(b)(2).

21 See 11 U.S.C. 1129(a)(7),1126.

22 In re PPI Enters. (US), Inc., 324 F.3d 197,204 (3d Cir. 2003) (holding that a creditor is unimpaired if it isthe effect of the Bankruptcy Code that modifies its rights, not thedebtor's plan).

23 In re The Hertz Corp., 2021 WL 6068390, at*11.

24 Id.

25 Id. at *16.

26 Id.

27 Id. at *11.

28 See, e.g., In re Dow Corning Corp.,456 F.3d 668 (6th Cir. 2006) (&ldquldquo;When a debtor issolvent, then, the presumption is that a bankruptcy court'srole is merely to enforce the contractual rights of the parties,and the role that equitable principles play in the allocation ofcompeting interest is significantly reduced.").

29 See, e.g., In re Cuker Interactive,622 B.R. 67, 71 (Bankr. S.D. Cal. 2020) ("[A]ssuming theCreditors are unsecured, they must receive postpetition interest atthe Federal Judgment Rate to be unimpaired by the Plan.");In re PG&E, 610 B.R. 308, 312-313 (Bankr. N.D. Cal.2019) (holding that unimpaired unsecured creditors are onlyentitled to receive post-petition interest at the federal judgmentrate).

30 In re The Hertz Corp., 2021 WL 6068390, at**11-13.

31 Id. at *14 (distinguishing DowCorning, 456 F.3d at 678-80 because its ruling was premised onsection 1129(b), which considers the rights of impaired creditors,not unimpaired creditors, in a solvent chapter 11 debtorcase).

32 See 11 U.S.C. 726(a)(5) (providingpayment of post-petition interest at "the legal rate" tocreditors, before any distribution to the debtor (or equity), inthe event there are funds left after paying all other claims in achapter 7 liquidation case); id. 1129(a)(7)(providing that with respect to each impaired class of claims orinterests, each holder of such claim has either accepted the planor will receive at least what it would have received in aliquidating chapter 7 case).

33 In re The Hertz Corp., 2021 WL 6068390, at*17.

34 Id. at *16.

35 See In re Ultra Petroleum Corp., 624 B.R.178, 196 (Bankr. S.D. Tex. 2020).

36 In re The Hertz Corp., 2021 WL 6068390, at*15.

37 Id.

38 In re PG&E Corp., 610 B.R. 308 (Bank.N.D. Cal. 2019).

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Delaware Bankruptcy Court Rules That Unsecured Creditors Of A Solvent Debtor Are Entitled To Post-Petition Interest At The Federal Judgment Rate, Not...