By: Donald L Swanson
It’s rare thing. But it happens: a profoundly-insolvent debtor files bankruptcy, only to become solvent thereafter and able to pay all debts in full.
How can this happen? Here are three examples I’ve seen:
- A spendthrift’s great expectations materialize, upon the death of a wealthy relative, just in time to benefit creditors (i.e., during 180 days after filing).
- A sole proprietor in Chapter 11 wins a multi-million dollar lottery and becomes solvent.
- In the late 1980s, at the end of the Farm Crisis, when cattle prices were extremely low, an insolvent rancher filed Chapter 12—just as cattle prices start to rebound. At a plan confirmation hearing, secured creditor proves that cattle prices had increased since plan filing, so the plan must be amended to current prices; but prices increase, again, before a hearing can occur on the amended plan, so debtor must amend again. These steps repeat until debtor is solvent and able to pay all debts in full.
Yep. It can happen.
The two questions for unsecured claims, in each of such circumstances, is this:
- What is the “legal rate” for post-petition interest on unsecured claims for the solvent debtor: contract rate or federal judgement rate; and
- Is a creditor “impaired” when a Chapter 11 plan proposes to pay interest at the rate required by the Bankruptcy Code, if that rate is less than the contract rate?
The U.S. Fifth Circuit Court of Appeals addresses these two issues in In re Ultra Petroleum Corp., Case No. 17-20793 (decided November 26, 2019). And it provides some fascinating analysis in doing so.
[Note: Ultra Petroleum is an unusual case in two respects: (i) factually, it involves an insolvent debtor that becomes solvent by a post-petition rise in value of its assets, and (ii) procedurally, it is before the Fifth Circuit on direct appeal from a Bankruptcy Court.]
Both of the two questions above are involved. Here’s what happened.
Ultra Petroleum Corp. does oil and gas exploration and production. Ultra was a profitable company, back in 2014, as oil prices topped $100 per barrel. But soon thereafter, oil prices dropped under $30 per barrel. So, Ultra filed Chapter 11. During the bankruptcy, oil prices rose back to $80 per barrel, and Ultra became solvent again.
Ultra proposed a Chapter 11 plan to pay creditors in full, including post-petition interest at the federal judgment rate: i.e., as the “legal rate” under § 726(a)(5).
A “legal rate” corollary, under the plan, is that the following claims of an unsecured creditor will not be paid:
- $186 million for post-petition interest at the contract default rate; and
- $201 million for make-whole amounts.
Ultra’s plan declares that, since interest will be paid at the “legal rate,” the unsecured creditor is “unimpaired” and, therefore, not entitled to vote on or object to the plan.
The unsecured creditor objects anyway, insisting impairment, since the plan does not propose to pay contract obligations in full.
Bankruptcy Court Rulings
The Bankruptcy Court rules that Ultra, as a solvent debtor, is obligated to pay all contract obligations in full, “regardless of any disallowance provisions in the Bankruptcy Code.”
The Bankruptcy Court also declares that a debtor’s obligation to pay the “legal rate” of interest under § 726(a)(5) of the Bankruptcy Code does not apply to a solvent debtor under Chapter 11. But the Bankruptcy Court does not identify what the “legal rate” might be.
Arguments at Fifth Circuit
Creditor argues to the Fifth Circuit that it is entitled to post-petition interest under the contract, including default rates and make-whole amounts, because of Debtor’s solvency. Unless and until Debtor’s plan pays such obligations, creditor argues, it is impaired.
Debtor argues, under § 502(b)(2) of the Bankruptcy Code, that the unsecured claim must be disallowed to the extent it seeks unmatured interest:
- make-whole amounts qualify as unmatured interest;
- creditor is entitled, at most, to post-petition interest at the “legal rate”—i.e., federal judgment rate, not contract rate;
- the Bankruptcy Code—not a plan—sets the limits of a creditor’s claim; and
- a creditor who receives post-petition interest at the “legal rate” is unimpaired, regardless of what contracts might provide.
Fifth Circuit Rulings
The Fifth Circuit’s opinion resolves only the impairment issue.
The Fifth Circuit follows what it describes as “the monolithic mountain of authority” in holding that the Bankruptcy Code—not the reorganization plan—defines the limits of claims. Specifically, it (i) rules that the Bankruptcy Court erred by ordering Debtor to pay post-petition default interest and make-whole amounts, and (ii) reverses the Bankruptcy Court’s refusal to follow Bankruptcy Code disallowance provisions.
The Fifth Circuit also remands the issue of what the “legal rate” under § 726(a)(5) might be.
Fifth Circuit Rationale
According to the Fifth Circuit, the Bankruptcy Court erred in concluding that, (i) it could ignore disallowance provisions of the Bankruptcy Code, (ii) “unimpairment” requires that a creditor receive everything it is entitled to receive under state law, and (iii) Debtor is required to pay all post-petition interest at contract default rates and all make-whole amounts.
A creditor is entitled to accept or reject a Chapter 11 plan, unless the plan doesn’t actually affect the creditor’s rights—in which case the creditor’s rights are not impaired. If the creditor is not impaired under the plan, the creditor is conclusively presumed to have accepted it.
So, the question is whether the creditor is “impaired” by the plan.
The answer is this: a creditor is impaired only if “the plan” alters a claimant’s legal, equitable, or contractual rights. When it is the Bankruptcy Code, instead of the plan, that alters a creditor’s rights, there is no impairment.
This answer is consistent with decisions from another circuit court and from bankruptcy courts across the entire country. By contrast, the creditor cannot point to a single decision that suggests otherwise. Additionally, Collier’s treatise states the point in unequivocal terms: “Alteration of Rights by the Code Is Not Impairment under Section 1124(1).”
–Solvent Debtor Exception: Some History
Creditor asserts entitlement to all contract rights accruing post-petition under the “solvent-debtor” exception. Debtors disagree.
The Fifth Circuit provides a historical, pre-Code perspective on the solvent-debtor exception.
- In eighteenth-century England, only a creditor could start a bankruptcy—there was no such thing as a debtor’s voluntary petition. Then, a commission administered the bankrupt’s estate and had authority to “breake open the [bankrupt’s] House” to seize him and all of his goods.
- Several debtor-friendly rules softened things: e.g., English law, (i) allowed creditors to recover interest that accrued before the proceeding began—but not after, and (ii) after paying creditors in full, the bankrupt could recover any surplus left in the estate.
- Exceptions to these rules existed: e.g., (i) a secured creditor could recover interest from collateral that generates income to pay the interest, (ii) an over-secured creditor could recover post-petition interest up to the value of the collateral, and (iii) when the estate is solvent and the Bankrupt is entitled to a surplus, creditors have a right to receive interest before the bankrupt gets a surplus.
U.S. bankruptcy law is codified against this background.
- The Constitution authorizes Congress “[t]o establish . . . uniform Laws on the subject of Bankruptcies throughout the United States.”
- When Congress first exercised that constitutional power to adopt permanent federal bankruptcy legislation in 1898, it borrowed extensively from the English system, including the principle barring creditors from recovering post-petition interest—and the exceptions to that principle.
- In 1978, Congress enacted an entirely new Bankruptcy Code, which adopted many of the early bankruptcy principles borrowed from England: e.g., Congress codified, (i) the general rule barring post-petition interest (§ 502(b)(2) disallows a claim to the extent it seeks unmatured interest), and (ii) the over-secured creditors exception (§ 506(b) allows a creditor to recover interest contract rate interest, if the value of collateral is greater than the allowed secured claim).
At first blush, it appears Congress also codified the solvent-debtor exception in § 726(a)(5)&(6):
- “property of the estate shall be distributed— . . . (5) fifth, in payment of interest at the legal rate from the date of the filing of the petition . . . ; and (6) sixth, to the debtor”; and
- § 1129(a)(7) requires that a Chapter 11 plan provide creditors at least what they would get in a chapter 7 liquidation, including post-petition interest at the “legal rate.”
But there are some distinctions between England’s law and the Bankruptcy Code:
- Like England’s law, the post-petition interest rule applies to all creditors in Chapter 7 cases, but it only applies to impaired creditors in Chapter 11; and
- The Code changed the applicable interest rate to the “legal rate”—whether that means a rate set by statute or by contract remains to be determined.
Fifth Circuit: Tipping its hand but not deciding
The Fifth Circuit declares that post-petition interest at the contract default rate and make-whole amounts can be recovered only if the solvent-debtor exception survives Congress’s enactment of § 502(b)(2). On whether the exception survives, the Fifth Circuit declares:
- “We doubt it did. But we vacate and remand to allow the bankruptcy court to answer the question in the first instance.”
On whether the “legal rate” in § 726(a)(5) means a contract rate or a statutory judgment rate, the Fifth Circuit says:
- The pre-Code solvent-debtor exception says nothing about post-petition interest on unimpaired claims in Chapter 11 cases;
- It is not clear what should fill that vacuum, and the bankruptcy court said nothing about it; and
- We therefore vacate the award of post-petition interest and remand that question to the bankruptcy court as well.
On these issues, the Fifth Circuit declares that, since it is a court of review, not of first view, they will let the Bankruptcy Court make the choices in the first instance.
Make-Whole Amounts Qualify as Post-Petition Interest
Whether something qualifies as post-petition “unmatured interest,” under § 502(b)(2), is determined by looking to economic realities, not trivial formalities. And any claim that is the economic equivalent of unmatured interest is disallowed.
Make-whole amounts in this case qualify as unmatured interest. Here’s why:
- Make-whole amounts are the economic equivalent of “interest”: the purpose is to compensate the lender for lost interest, and its calculations capture the value of the interest creditor would have eventually received, absent prepayment;
- The interest for which make-whole amounts compensates was “unmatured” when debtors filed bankruptcy, and § 502(b)’s disallowance provisions apply “as of the date of the filing of the petition”—on which day debtors did not owe the make-whole amounts;
- The acceleration clause is unenforceable as an ipso facto clause that keys acceleration to debtor’s bankruptcy filing; and
- Decisions taking a contrary view are unpersuasive.
Concerns about Bad Faith
Much of the pre-Code law regarding solvent debtors is motivated by concerns that they would seek bankruptcy protection, in bad faith, simply to avoid paying their debts in full.
Here’s how the Fifth Circuit responds:
- Chapter 11 addresses this problem by creating a motion-to-dismiss procedure for bad-faith filings;
- In this case, creditor has not raised the bad faith issue: that is presumably because the debtor is solvent and a good-faith filer; and
- We trust the Bankruptcy Court, on remand, will consider what effect (if any) debtor’s good faith or bad faith has on the solvent-debtor exception (if any exists).
It will be interesting to see how the Bankruptcy Court handles this case on remand.
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