Fifth Circuit Finds Ultra Make Whole Barred as ‘Unmatured Interest’ but Debtors Must Pay Make Whole and Contract-Rate Postpetition Interest Under ‘Solvent-Debtor Exception’

Relevant Documents:
Opinion
Judgment

In a long-awaited decision that deepens a split among courts on the issue, a divided three-judge panel of the U.S. Court of Appeals for the Fifth Circuit issued an opinion this afternoon affirming Judge Marvin Isgur’s October 2020 Ultra Petroleum ruling holding that debtors must pay unsecured creditors make whole premiums and contract-rate postpetition interest (including default interest) to render them unimpaired in solvent cases.

However, the majority opinion, written by Judge Jennifer Elrod and joined by Judge E. Grady Jolly, rejects Judge Isgur’s conclusion that make whole claims do not necessarily qualify as “unmatured interest” disallowed under section 502(b)(2) of the Bankruptcy Code. Instead, the majority finds that the make whole premium must be paid in this case notwithstanding that it qualifies as unmatured interest under section 502(b)(2) because “the solvent-debtor exception” requires Ultra “to pay what it promised now that it is financially capable” (emphasis added).

“To sum up,” the majority concludes, “Ultra is right about one thing: Creditors’ Make-Whole Amount is disallowed ‘unmatured interest’ under the Bankruptcy Code,” but “the traditional solvent-debtor exception compels payment of the Make-Whole Amount because it is a valid contractual debt under applicable state law.” “For similar reasons,” the majority continues, “Ultra cannot avoid payment of contractual default-rate interest in favor of the much-lower Federal Judgment Rate: Creditors are entitled to what they bargained for with this solvent debtor, and the Code does not preclude the contractual interest rate.”

The majority’s decision is in accordance with the Ninth Circuit’s Aug. 29 PG&E ruling that the solvent-debtor exception survived the enactment of the Bankruptcy Code in 1978 and requires payment of contract-rate postpetition interest to unimpaired unsecured creditors in solvent cases unless compelling equitable circumstances require otherwise - although the majority opinion does not mention the PG&E decision. The make whole issue was not before the Ninth Circuit in that case.

However, the majority’s ruling conflicts with Judge Mary Walrath’s December 2021 Hertz decision and other Delaware precedent denying unimpaired creditors postpetition interest at contract rates, instead imposing the federal judgment rate, even in solvent cases. The ruling further conflicts with Delaware cases holding that make whole premiums with appropriate contractual language qualify as “liquidated damages” rather than unmatured interest barred by section 502(b)(2).

In a dissenting opinion, Judge Andrew Oldham criticizes the majority for applying the solvent-debtor exception to preserve the make whole claim despite the “clear statutory text” of section 502(b)(2). “If it’s ‘unmistakably clear’ that a Code provision is incompatible with a prior bankruptcy practice, then the Code overrides that prior practice,” Judge Oldham writes. “The Code provides that all claims for unmatured interest are disallowed,” the dissent continues, and “[t]he solvent-debtor exception provides that not all claims for unmatured interest are disallowed. That’s a stark contradiction.”

Make Whole Premium Analysis

Unmatured Interest

The Fifth Circuit foreshadowed today’s decision regarding the make whole premium in its first Ultra ruling in January 2019. In that unanimous opinion, the court of appeals said that the make whole premium at issue appears to be “the economic equivalent of ‘interest,’’’ since its purpose is to “compensate the lender for lost interest.” However, the panel said, “[i]f the pre-Code solvent-debtor exception survives in the background of the Code,” then it might operate as a carve-out from section 502(b)(2)’s general bar on unmatured interest. The panel in the first Ultra decision left the issue to Judge Isgur on remand.

In today’s opinion, the majority decides the issue definitively. “Contractual make-whole amounts, like the one at issue here, are expressly designed to liquidate fixed-rate lenders’ damages flowing from debtor default while market interest rates are lower than their contractual rates,” the majority says, and “[l]enders’ damages equal the present value of all their future interest payments.” “In other words, a make-whole amount is nothing more than a lender’s unmatured interest, rendered in today’s dollars,” the majority concludes (emphasis added).

The majority vehemently rejects the argument that a make whole premium can include unmatured interest in “liquidated damages” and thus avoid section 502(b)(2), including by using an equation for a “Fake-Whole Amount” as an illustration: “Fake-Whole Amount = (∑ [all unmatured interest payments] + $1.00) × 1.” “Of course, this Fake-Whole Amount is nothing more than unmatured interest plus one dollar (for good measure),” the majority says. “[T]he Make-Whole formula, like the Fake-Whole formula, does nothing to its unmatured interest component to render the result different in kind.”

“The relevant consideration is whether the makewhole amount merely compensates the borrower for the search and transaction costs of ‘seek[ing] to find someone else to use the capital,’ or goes further and compensates creditors for the loss of future interest ‘through the guise of a make-whole premium,’” the majority emphasizes. “Liquidated damages certainly can compensate for anticipated transaction costs that are not unmatured interest,” the majority acknowledges, but “the Make-Whole Amount, unlike the transaction-costs liquidated damages in the hypothetical, is both liquidated damages and the ‘economic equivalent of unmatured interest’ - indeed, that is its whole point.”

The majority further rejects the noteholders’ argument that the make whole is not “interest” because it “does not compensate Creditors for any actual ‘use or forbearance’” of funds. According to the majority, the make whole “compensates Creditors for the future use of their money, albeit use that will never actually occur because of Ultra’s default” - and “[t]his is simply another way of saying that the interest is unmatured.”

The majority also rejects the noteholders’ argument that even if the make whole qualifies as interest, the obligation matured when the debtors filed for chapter 11. “The bankruptcy court correctly rejected the argument, reasoning that the [master note purchase agreement]’s acceleration provision was an ipso facto clause that is not to be considered in assessing whether the payment it triggered had matured,” the majority explains. Furthermore, it adds, “a make-whole amount contractually triggered by a bankruptcy petition cannot antedate that same bankruptcy petition,” and thus could not have matured prior to the filing.

Even if the make whole was neither interest nor unmatured, the majority continues, it would still be disallowed under section 502(b)(2) because it is the economic equivalent of unmatured interest, like an original issue discount - “interest masquerading as ‘principal.’” “Whether the claim also happens to be denominated ‘liquidated damages’ is beside the point,” the majority reasons. “Like interest masquerading as ‘principal,’ interest labeled ‘liquidated damages’ is still interest.”

Solvent-Debtor Exception

Despite the application of section 502(b)(2), the majority nevertheless finds that the solvent Ultra debtors should have been obligated to pay the make whole premium sought by the noteholders to render them unimpaired. “In the ordinary case, the Bankruptcy Code would disallow a makewhole amount that functionally equates to unmatured interest,” the majority explains, but “this is not the ordinary case” because “Ultra became ultra solvent.” “And when a debtor is able to pay its valid contractual debts, traditional doctrine says it should - bankruptcy rules notwithstanding,” the majority concludes (emphasis added).

The majority’s reasoning follows the solvent-debtor analysis in the PG&E postpetition interest decision. “Because the Code’s general bar on claims for unmatured interest does not specifically address the solvent-debtor scenario, for which traditional bankruptcy practice has always provided an exception, we conclude that the pre-Code doctrine concerning solvent debtors’ obligations remains good law, and the exception operates in this case to suspend § 502(b)(2)’s disallowance of Creditors’ Make-Whole Amount,” the majority holds.

Like the majority in PG&E, the majority notes that section 502(b)(2) of the Bankruptcy Code is merely a continuation of section 63(a)(1) of the pre-Code statutes, which also barred unmatured interest claims. The solvent-debtor exception existed under that older statute, the majority reasons, so it is not expressly eliminated by section 502(b)(2).

In the dissent, Judge Oldham criticizes this point, arguing that “[i]t’s simply not true that the 1898 and 1938 Acts precluded unmatured interest, full stop.” “Though § 63(a)(1) of the Acts expressly prohibits some unmatured interest, it does not contain a blanket bar on all unmatured interest - unlike 11 U.S.C. § 502(b)(2),” Judge Oldham concludes.

Finally, the majority rejects the debtors’ fall-back argument that the make whole premium is an unenforceable penalty under New York law because it is duplicative of postpetition interest. “The Make-Whole Amount and the post-petition interest address two different harms,” the majority says. “The Make-Whole Amount serves as liquidated damages for Ultra’s breach; the post-petition interest compensates for Ultra’s lag in paying the accelerated principal (and the Make-Whole itself), which were already due and payable for the duration of the bankruptcy.”

Postpetition Interest Rate Analysis

Regarding postpetition interest, the majority departs slightly from the PG&E analysis. Instead of reasoning that section 726(a)(5) of the Bankruptcy Code (which provides for payment of postpetition interest “at the legal rate”) does not apply to unimpaired claims and thus does not obviate the solvent-debtor exception, the majority finds that section 726(a)(5) merely sets the “legal rate” (presumed to equal the federal judgment rate) “as a floor - not a ceiling” - - for what unimpaired creditors must receive.

“So, even if ‘the legal rate’ is the Federal Judgment Rate, the Code does not preclude unimpaired creditors from receiving default-rate postpetition interest in excess of the Federal Judgment Rate in solvent-debtor Chapter 11 cases,” the majority explains.