On January 17, 2019, the United States Court of Appeals for the Fifth Circuit in the Ultra Petroleum matter became the first court of appeals to hold the make-whole amount is unmatured interest and therefore disallowed by the Bankruptcy Code (the Code). This decision is inapposite to existing precedent of the Second Circuit and other state and federal courts, including bankruptcy courts, that have decided this issue. It also conflicts with other Fifth Circuit decisions holding that, for purposes of state law usury statutes, make-wholes are not interest. The Fifth Circuit has vacated a well-reasoned bankruptcy court decision (a summary of which can be found here), ignored prior precedent, and called into question the future of make-wholes in bankruptcy.
By way of background, in response to the Debtor’s objection to having the make-whole amount and post-petition interest be part of Noteholder claims, in September 2017, the United States Bankruptcy Court for the Southern District of Texas entered an order on the disputed claims holding that:
(1) the make-whole amount was an enforceable liquidated damages provision under New York law;
(2) because the Notes were classified as unimpaired under the plan of reorganization, pursuant to Section 1124(1) of the Code, the Debtors could not alter the Noteholders’ rights to the make-whole amount and post-petition interest as provided for in the Note Purchase Agreement, notwithstanding Section 502(b)(2) of the Code; and
(3) because the make-whole amount compensated the Noteholders for early payment of the Notes, and post-petition interest at the contract default rate compensated Noteholders for the late payment of amounts due following acceleration of the Notes, including the principal and make-whole, there was no double-counting.
The Bankruptcy Court did not address whether the make-whole amount was unmatured interest since the Noteholders were unimpaired under the plan. The Noteholders were awarded the full make-whole amount, post-petition interest at the contract default rate, and all other related fees and expenses.
The Debtors filed a direct appeal to the Fifth Circuit Court of Appeals. On January 17, 2019, the Fifth Circuit issued its decision reversing the Bankruptcy Court decision in part, vacating it in part and remanding for further proceedings in the Bankruptcy Court. The Fifth Circuit held that:
(1) since Section 1124(1) of the Code refers to impairment by the plan, a claim is not impaired under Section 1124 if a statute (e.g. Section 502(b)(2)), not the plan, is doing the impairing;
(2) impairment is evaluated after the claim disallowance provisions of Section 502(b) are applied (i.e., if the full amount of the claim, net of disallowed interest, is paid, there is no impairment);
(3) the make-whole amount was unmatured interested and disallowed under Section 502(b)(2) of the Code since (i) it was the economic equivalent of interest, (ii) it was unmatured as of the petition date, and (iii) other court decisions to the contrary were not persuasive; and
(4) Noteholders did not have a legal right (as opposed to a contractual right) to the post-petition interest, distinguishing between post-petition interest as part of a claim and post-petition interest on a claim. The Note Purchase Agreement did not provide for the contract default rate to apply to bankruptcy judgments (so there was no contractual right to post-petition interest on a claim, as well as no legal right).
The Fifth Circuit questioned (i) whether the solvent debtor rule survived enactment of the Code in 1978, noting that if the rule survived it would operate as an exception to the disallowance provision of Section 502(b)(2), and (ii) what is the appropriate rate of post-petition interest (i.e., the federal default rate, the contract default rate or another measure) if the solvent debtor rule survived, and remanded these questions to the Bankruptcy Court for further consideration.
According to the Fifth Circuit’s decision, Noteholders claims can be classified as unimpaired under the plan, even if they do not receive the make-whole amount and post-petition interest, if the claim allowance provisions of Section 502(b) do not permit make-whole amount and post-petition interest as part of an unsecured claim.
It is important to note that the Fifth Circuit’s decision in Ultra does not threaten the payment of the make-whole in connection with an optional prepayment of notes and its enforceability should be upheld based on a state law liquidated damages analysis. While only time will tell if the Fifth Circuit’s decision in Ultra will stand, pending any potential appeals, it is law within the Fifth Circuit and attention should be paid as to whether other circuits and bankruptcy courts follow suit.
If Ultra stands, investors and counsel should consider (i) using other liquidated damages formulas in default and acceleration mandatory redemption scenarios, such as fixed payment amounts based on a percentage of the principal amount outstanding, which would decrease over the life of the investment; (ii) accelerating the notes and payment of the make-whole amount due upon a “significant” default and forbearance request, while preserving the option for required holders to rescind such acceleration; (iii) negotiating a crystallization of the make-whole amount in connection with any significant amendment or out of court restructuring agreements; and (iv) adding language to the note agreement or the notes that the contract default rate applies to outstanding judgments for unpaid amounts due in respect of the notes.