Texas Bankruptcy Court Enforces Make-Whole Premiums and Postpetition Default Interest
The U.S. Bankruptcy Court for the Southern District of Texas awarded on Oct. 26, 2020, a make-whole premium and post-petition interest at the contractual default rate (as opposed to the materially lower federal judgment rate) to noteholders in the first Ultra Petroleum bankruptcy case.1 Although the court rendered its decision in the context of a solvent debtor that sought to deem the petitioning noteholders unimpaired, the court's conclusions regarding make-whole premiums have broader implications for loan and high-yield market participants.
In Ultra, a rise in commodity prices resulted in a solvent debtor and permitted Ultra to propose a plan that provided for a full recovery to creditors and a distribution to equity. Ultra's proposed plan sought, however, to deny a group of noteholders their make-whole premium and post-petition interest at the contractual default rate. Ultra contended that the noteholders had no right to those amounts under the U.S. Bankruptcy Code and therefore were unimpaired and could not vote on or object to the plan. The noteholders countered that the Bankruptcy Code itself did not prohibit payment of the make-whole or default interest and, therefore, they were in fact impaired.
After the Bankruptcy Court ruled in favor of the noteholders, the U.S. Court of Appeals for the Fifth Circuit took up Ultra's appeal and remanded the case back to the Bankruptcy Court. According to the Fifth Circuit, if the make-whole and interest were unenforceable because of a provision in the Bankruptcy Code (as opposed to a provision solely in the plan), the noteholders would be unimpaired and Ultra would prevail. Accordingly, although the issue of impairment was critical to the Fifth Circuit ruling, the dispute on remand to the Bankruptcy Court involved far broader principles surrounding claim allowance involving make-wholes.
On remand the issues were:
- Does the Bankruptcy Code disallow a contractual claim for "make-whole" liquidated damages when an interest-bearing obligation is prepaid?
- Does the Bankruptcy Code permit a solvent debtor to forgo contractual obligations to an unimpaired class of unsecured creditors but still pay a distribution to its shareholders?2
A Make-Whole Represents Liquidated Damages, Not Unmatured Interest
With respect to the first issue, Bankruptcy Code section 502(b)(2) expressly disallows, for policy reasons, claims for "unmatured interest." There is a split among courts as to whether make-whole premiums are the equivalent of unmatured interest and are therefore unenforceable as a matter of law.
In a decision that has impact for both secured and unsecured creditors, U.S. Bankruptcy Judge for the Southern District of Texas Marvin Isgur found that the make-whole premium at issue did not constitute "unmatured interest." Rather, under New York law, he ruled that the make-whole premium constituted a reasonable liquidated damages provision. Judge Isgur reasoned that interest represents the "cost associated with the use or forbearance of another's money … normally expressed as a percentage accruing over time,"3 while the make-whole approximates and fixes damages "for the cost of [a creditor] reinvesting in a less favorable market."4 Moreover, although the make-whole, as is typical, made reference to interest rates in a discounted cash-flow formula to calculate the premium, Judge Isgur reasoned that such a reference simply created a ceiling for early debt repayment and did not transform the damages provision into unmatured interest.5 Accordingly, the step-down in the premium over time made the damages provision reasonable and not an unenforceable penalty provision. As the make-whole did not represent unaccrued interest as of the petition date (or interest at all for that matter), Judge Isgur found that the make-whole was not per se disallowed under section 502(b). Finally, because the notes were not accelerated prior to Ultra's bankruptcy, but rather as a result of the filing, the Court calculated the make-whole without reference to the indenture's acceleration clause.6
Solvent Debtors Must Pay Interest at the Contractual Rate, Including at Default Rate
Turning to the second issue, Judge Isgur held that the solvent-debtor exception – an equitable, judicial remedy requiring debtors "with the means to pay [its] debts in full … to do so" 7 – survived the adoption of the Code in 1978. According to Judge Isgur, the solvent debtor exception requires a debtor whose assets exceed its liabilities to pay creditors "the post-petition interest to which they are legally or contractually entitled" in order to classify such claims as unimpaired under Bankruptcy Code section 1124.8 Stemming from this ruling was a decision that default interest at the contract rate, as opposed to the federal judgment rate, was the correct rate of interest that Ultra needed to pay the noteholders to leave them unimpaired. Judge Isgur reasoned that to hold otherwise would allow Ultra to alter the noteholders' legal rights, deprive the noteholders of a right to vote, result in unimpaired creditors being treated worse than impaired creditors, and undermine the strong policy rationale of the solvent debtor exception that supports a creditor receiving the benefit of its bargain when a debtor is solvent. 9
Lenders Should Take Comfort in Ultra
Although the Ultra decision presented as a solvent debtor case in the context of plan impairment, lenders should take comfort that the 1) make-whole premiums were not found to constitute unmatured interest but rather liquidated damages for harm caused by early debt prepayment and 2) solvent debtor exception is not only alive and well but protects a lender's contractual right to interest at the default rate.
Ultra has appealed Judge Isgur's decision, and we will provide updates on these critical subjects as they develop.
In the meantime, lenders should seek professional legal advice and take care to structure make-whole provisions and default interest calculations so as to 1) survive debt acceleration, including automatic acceleration on account of a bankruptcy filing, and 2) avoid a determination that those provisions represent unenforceable penalty provisions.
Please contact the authors or your assigned Holland & Knight representative for additional information or to answer any questions.
1 In re Ultra Petroleum Corp., No. 16-32202, slip op. (Bankr. S.D. Tex. Oct. 26, 2020), ECF No. 1874.
2 Id. at 1.
3 Id. at 12.
4 Id. at 14–16.
5 Id. at 24.
6 Id. at 15.
7 Id. at 27– 28.
8 Id. at 32-42.
9 Id. at 36.
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