Section 365 of the Bankruptcy Code allows debtors to “assume” unexpired leases, recommitting themselves and their counterparties to the existing lease terms, subject to approval by the Bankruptcy Court.  If there are existing defaults under the lease, section 365(b) appears to require that the debtor provide the counterparty with adequate assurance of prompt cure of defaults, compensation for losses resulting from the defaults, and adequate assurance of future performance under the lease, ensuring that the landlord enjoys the full benefit of its bargain going forward.

Oral argument was held last month between appellant-landlord and appellee-debtor in the Ninth Circuit Court of Appeals regarding the hotly contested assumption of an office building lease and nightclub sublease in a Central District of California bankruptcy case.  The outcome may alter conventional thinking and the balance of power in connection with the process of lease assumption and cure of defaults in the bankruptcy context.  At issue is whether a debtor must satisfy the cure and adequate assurance requirements of section 365(b) at all when assuming an unexpired lease if none of the alleged defaults are “sufficiently material to result in the termination of the lease under state law.”

Affirmation of the District and Bankruptcy Court rulings may significantly impair landlord leverage to negotiate the terms of lease assumptions in the Ninth Circuit.

Hawkeye, the debtor, subleases the first four floors and part of the basement of the Pacific Stock Exchange Building in Los Angeles to a related entity, W.E.R.M. Investments, LLC which operates a successful nightclub and entertainment venue on the leased premises.  Shortly after commencing its bankruptcy case, Hawkeye moved to assume the lease and the landlord objected.  Extensive discovery, briefing, and a five-day bench trial followed.  It did not go well for the landlord.

Bankruptcy Judge Tighe found that none of the alleged on-going defaults were material enough to warrant forfeiture of the lease and explained that “I just cannot read 365 to say any teeny, tiny infraction means a Debtor-In-Possession loses the very valuable asset. That would be not in keeping with state law…”  Hawkeye’s assumption of the lease was approved without the need to provide the landlord with adequate assurance of future performance as required under section 365(b)(1)(A), (B) and (C) of the Bankruptcy Code, including prompt cure of defaults and compensation for pecuniary loss resulting from such defaults.

On appeal, District Court Judge Fernando L. Aenlle-Rocha agreed with the Bankruptcy Court and in an unpublished decision found that technical breach of the terms of a lease must be material under state law to be considered a default under section 365(b).  In addition, the District Court found no clear error in the Bankruptcy Court’s findings that the five separate alleged lease defaults were not in fact existing defaults at all (neither material nor “teeny tiny”).

Accordingly, if the Ninth Circuit agrees, Hawkeye will assume the lease under section 365(a).  Existing breaches, if any, that would not lead to termination of the lease would not need to be cured and the landlord will not be entitled to adequate assurance.  Assuming there was some identifiable breach, not only would this result appear to be out of step with the restorative policy of section 365(b), but the landlord will be left out in the cold with respect to outstanding non-material defaults.  So much for maintaining the ‘benefit of the bargain’ for non-debtor contract counterparties. Please check back for further developments.

Intercreditor disputes in bankruptcy are common.  Typically, however, they center around predictable disagreements between senior or junior classes of creditors such as valuation battles or lien perfection challenges.  A recent decision in the Delaware chapter 11 case of TPC Group has highlighted a new trend of “intra-creditor class warfare,” involving, in the understated words of Judge Craig Goldblatt, “transactions that seem to take advantage of technical constructions of loan documents in ways that some view as breaking with commercial norms.”

In TPC Group, Judge Goldblatt upheld a so-called “uptier” transaction, in which a majority of the holders of a particular series of secured notes agreed to purchase a new series of debt from the borrower, with the initial notes becoming subordinated to the new notes.  Pre-bankruptcy in 2019, TPC Group issued $930 million of secured 10.5% notes pursuant to a trust indenture.  The collateral agent for the 10.5% notes entered into an intercreditor agreement with the agent bank for the bank syndicate providing TPC Group with a revolving credit facility, providing the banks with a senior lien on inventory and receivables, and the 10.5% noteholders with a senior lien on substantially all other assets.

In 2021 and earlier this year, under a separate indenture, TPC Group issued approximately $205 million of new secured 10.875% notes to holders who constituted over a two-thirds majority of the 10.5% noteholders, secured by the same collateral as the 10.5% notes.  That majority of 10.5% noteholders voted to amend the 2019 indenture and the intercreditor agreement so that the liens securing the new 10.875% notes would be senior to the liens securing the 10.5% notes.

TPC Group filed a petition for relief under chapter 11 of the Bankruptcy Code at the beginning of June.  In connection with the filing, the holders of the 10.875% notes offered to provide debtor in possession (DIP) financing with $85 million of new money, but demanded a roll-up of $238 million in principal and accrued interest due under the 10.875% notes.  When TPC Group agreed and sought court approval for the DIP financing, two holders of the 10.5% notes which did not hold the 10.875% notes challenged the new loan, contending that the amendment of the 2019 indenture was invalid.

This necessitated an immediate review by Judge Goldblatt of the uptier transaction.  If the amendments of the 2019 indenture were proper and the 10.875% notes were validly senior to the 10.5% notes, then the roll-up of the prepetition debt into a new postpetition DIP loan facility with priority over nearly all other claims would have little practical impact.  But if the changes to 2019 indenture had been done in violation of the indenture terms, then, as Judge Goldblatt noted, the roll-up would elevate junior (and probably unsecured) debt and make the DIP loan “very expensive money indeed.”

The parties agreed that the questions raised were solely legal issues.  The objection and related motions were briefed and argued on an expedited basis, so that Judge Goldblatt could make a final ruling on the DIP loan.

The key substantive questions were whether the amendments and subordination violated the 2019 indenture’s ratable treatment clause, which requires payment to all noteholders “without preference or priority of any kind,” or effectuated a change to “the application of proceeds of Collateral [in a manner] that would adversely affect the Holders.”  Any such amendment would have required the unanimous consent of all 10.5% noteholders.

Judge Goldblatt decided that the amendments did not affect the ratable treatment of the 10.5% notes and ruled in favor of TPC Group and the 10.875% noteholders.

The 2019 indenture was silent on the question of subordination of the 10.5% notes.  Although acknowledging that it was a close call and that other courts had reached different conclusions regarding subordination and ratable treatment clauses, Judge Goldblatt noted that the 2019 indenture permitted the release of collateral upon approval of a two-thirds majority.  He concluded that if a release of the collateral, which he described as a more “drastic” action, could be done with less than 100% approval, then subordination similarly should not require unanimous consent.

Judge Goldblatt reasoned that the indenture trustee was still obligated to disburse proceeds of collateral ratably, and concluded that the ratable treatment clause was not violated simply because there would likely be fewer proceeds of collateral to disburse.  The ratable treatment clause, he stated, “should not be read as an anti-subordination provision in disguise.”  He therefore ruled that the amendments did not require unanimous approval, and that the changes to the 10.5% indenture and the intercreditor agreement had been validly effectuated.

While evincing some sympathy for the arguments put forward by the objecting 10.5% noteholders, and noting that the uptier transaction “may have violated . . . the ‘all for one, one for all’ spirit of a syndicated loan,” Judge Goldblatt determined that under the clear terms of the 2019 indenture the amendments were valid.  “There is nothing in the law that requires holders of syndicated debt to behave as Musketeers.”

Judge Goldblatt’s decision is an important addition to the developing jurisprudence on uptier transactions and similar intra-creditor disputes.  With interest rates rising and a wave of defaults looming, similar battles are going to be fought out in bankruptcy courts in the coming months.

A recent decision by Delaware Bankruptcy Judge John Dorsey will limit the ability of bankruptcy trustees to expand the lookback period for avoiding pre-bankruptcy transfers beyond the four years provided under most state law fraudulent conveyance statutes.  In dismissing a trustee’s action to recover transfers made more than four years prior to the commencement of the bankruptcy case, Judge Dorsey rejected the trustee’s effort pursuant to section 544(b) of the Bankruptcy Code to apply the Internal Revenue Service’s ten year lookback period to the disputed transactions.

J&M Sales, a Delaware corporation, filed for bankruptcy in August 2018 under chapter 7 of the Bankruptcy Code and a trustee was appointed to oversee its liquidation.  The Bankruptcy Code provides trustees with the ability to avoid and recover pre-bankruptcy transfers that diminish estate assets to the detriment of creditors, including conveyances made by an insolvent entity for which less than “reasonably equivalent value” was received in return.  Section 548 of the Bankruptcy Code gives a trustee the direct right to avoid such transfers made within a two year lookback period, and section 544(b) gives the trustee the right to piggy-back on the rights of a creditor under applicable state law, which typically provide a four year lookback, so long as such creditor “hold[s] an unsecured claim that is allowable under section 502 [of the Bankruptcy Code].”  Section 502(b) in turn provides that when a proof of claim is filed, the claim “is deemed allowed, unless a party in interest . . . objects.”

The J&M Sales trustee sought to avoid a number of pre-bankruptcy transfers which took place earlier than August 2014, but was limited by the four year lookback period available to unsecured creditors under Delaware law.  The trustee contended, however, that he could utilize the IRS as the predicate creditor under section 544(b) and assert the IRS’s right to avoid transfers as far back as ten years.

The defendant transferees argued in opposition that the trustee could not use the IRS as a predicate creditor under section 544(b) because the IRS had not filed a proof of claim in the J&M Sales case.  The trustee countered that it was not necessary for the IRS to have filed a proof of claim, as section 544(b) references a claim that is “allowable” under section 502, rather than actually “allowed.”  He argued that the fact that the debtor had owed payroll taxes to the IRS at the start of the case was sufficient for the trustee to be able to step into the IRS’s shoes as predicate creditor and utilize the ten year lookback.  (The taxes were subsequently paid.)

Judge Dorsey disagreed.  Although he acknowledged a 2014 Pennsylvania decision that supported the trustee’s argument, Judge Dorsey determined that the weight of caselaw authority was contrary, and held that “in order to be considered an allowable claim for purposes of Section 544(b) there must be a proof of claim filed as required by Section 502.”  In a footnote, he observed that nearly every business debtor owes payroll taxes at the time of bankruptcy filing because such taxes are accrued but not actually due to be paid.  He stated that while he was reaching his decision based on the statutory language of sections 502 and 544(b), he was “troubled” by the implications of the trustee’s argument.  “Under the Trustee’s theory . . .  every business bankruptcy case would automatically have a ten-year lookback period for fraudulent transfers under Section 544(b). That cannot be what Congress had in mind when enacting Section 544(b).”

Judge Dorsey’s decision in J&M Sales will be frustrating for bankruptcy trustees and other parties which may be authorized to act on behalf of a debtor’s bankruptcy estate, such as official creditor committees in chapter 11 cases.  In many bankruptcy proceedings, the avoidance of pre-bankruptcy transfers, especially transfers made to a debtor’s insiders, offers the only chance of providing any distribution to unsecured creditors.  Given the prominence of the Delaware bankruptcy court, Judge Dorsey’s ruling will likely limit efforts to use the IRS’s expansive lookback rights to lengthen the period for avoiding pre-bankruptcy transfers.

In March, the U.S. Court of Appeals for the Second Circuit joined a growing majority of courts with Springfield Hospital, Inc. v. Administrator for the U.S. SBA, holding that no matter how forgiving its terms, a CARES Act’s Paycheck Protection Program (“PPP”) loan is not protected under section 525(a) of the Bankruptcy Code, which prohibits governmental units from denying, revoking, suspending, or refusing to renew a license, permit, charter, franchise, or other similar grant to a debtor solely because of its status as a debtor under the Bankruptcy Code. Specifically, the Second Circuit held that the PPP is not an “other similar grant” protected under section 525(a).

At the onset of the COVID-19 pandemic, a majority of Springfield Hospital’s non-essential procedures and office visits were cancelled, postponed, or rescheduled pursuant to stay-at-home orders which had an immediate and severe impact on cash flow. As a result, Springfield filed for chapter 11 in June 2019 in the District of Vermont. To satisfy near-term operating obligations, Springfield applied for multiple state and federal emergency grants, including the PPP loans that were denied because the hospital was a debtor in chapter 11 at the time of application.

Claiming that the SBA’s administration of the PPP discriminated against Springfield and violated section 525(a) of the Bankruptcy Code, Springfield commenced a lawsuit before the bankruptcy court seeking, among other things, an order enjoining SBA’s denial of the hospital’s PPP loan application on the basis that the applicant is a debtor in bankruptcy. The bankruptcy court ruled in favor of Springfield, granting a temporary restraining order and then an order enjoining the SBA from denying Springfield’s PPP loan application. Specifically, the bankruptcy court held that the line of Second Circuit cases excluding extensions of credit from protection under section 525(a) had been overruled by Congress or subsequent Second Circuit decisions; and regardless, the PPP is an “other similar grant” under section 525(a) as a matter of law. The bankruptcy court certified its decision for direct appeal to the Second Circuit because of a split in authority stemming from a contrary Western District of New York decision.

The Second Circuit, focusing on the plain language of section 525(a), reversed the bankruptcy court. After analyzing the definition of “grant,” the Second Circuit acknowledged that the PPP is a grant, but concluded that the words “other” and “similar” in section 525(a) restrict the scope of protected grants to only those that are comparable to the other listed terms in the statute—licenses, permits, charters, and franchises. The Second Circuit further clarified that its prior precedent, which excluded a New York student loan guaranty program from section 525(a) protections, was indeed overruled, but only for student loans, pursuant to an amendment to section 525(a). In other words, Congress must expressly include certain types of loans within section 525(a)’s purview. The Second Circuit also disagreed with the bankruptcy court’s reliance on subsequent Second Circuit precedent, which held that eligibility for a public housing lease was protected under section 525(a), because loans and leases are “starkly different.” Finally, the court concluded that a PPP loan is a loan program despite its forgiveness mechanism because, among other things, PPP loans are evidenced by promissory notes, accrue interest, and can be deferred like traditional loans.

The Second Circuit stated that section 525(a) is unambiguous and cannot be read broadly to protect every type of government grant.  Even though the PPP ended on May 31, 2021, debtors should expect similar challenges in receiving the benefit of future government grants and loan programs without specific Congressional action.

For now, the Subchapter V debt limit is back down to $2.7 million.  Overshadowed by the contentious confirmation hearings for historic Supreme Court nominee Ketanji Brown Jackson, the Senate Judiciary Committee failed to act on proposed legislation that would have made permanent the increased $7.5 million debt limit and allowed more small businesses to file for bankruptcy protection under Subchapter V of Chapter 11.  Because of this congressional inaction, the legislation that temporarily increased the debt limit to $7.5 million expired on March 27, 2022.

While bankruptcy professionals await news about whether Congress will act, the delay will have real-world consequences for small businesses with non-insider debt between $2.7 million and $7.5 million, which no longer have the right to seek protection under Subchapter V – the easier, cheaper, and faster version of Chapter 11 with the goal of helping them successfully reorganize.

If approved, the Bankruptcy Threshold Adjustment and Technical Corrections Act (S.3823, 117th Cong. § 2(a) (2022)) would have eliminated the sunset provision from the CARES Act (Pub. L. No. 116-136, § 1113(a), 134 Stat. 281, 310–11 (2020)) and permanently increased the Subchapter V debt limit to $7.5 million.  Even without S.3823, the debt limit will automatically increase to $3,024,725 on April 1, 2022 per the routine adjustments recently announced by the Judicial Conference of the United States.  Adjustment of Certain Dollar Amounts in the Bankruptcy Code, 87 Fed. Reg. 24, 6625 (February 4, 2022).

The Senate Judiciary Committee does not currently have a hearing scheduled to consider S.3823, but Congress may still increase the debt limit by enacting a modified version of the bill.  We will continue to monitor and provide updates on Kelley Drye’s Bankruptcy Law Insights Blog.

Even if a modified version of the bill passes, some argue that more changes are needed to prevent large companies and private equity funds from taking advantage of Subchapter V to circumvent the safeguards Chapter 11 provides to creditors.  Our experience with Subchapter V suggests that, even more than in Chapter 11 cases, creditors need to be actively involved as soon as possible for a number of reasons, including the lack of oversight by a creditors’ committee, limited role of the Subchapter V trustee, expedited plan timeline, and ability of equity holders to maintain interests in reorganized debtors even if unsecured creditors are not paid in full.

Please see our prior post on this subject, $7.5 Million Increased Debt Limit For Small Business Debtors May Become Permanent, for background on Subchapter V and the Small Business Reorganization Act.

A paper to be published soon in the University of Southern California Law Review, “The Rise of Bankruptcy Directors,” is sharply critical of the increased use of supposedly “independent directors” by distressed companies, often in anticipation of filing for bankruptcy, and the related adverse impact on creditor recoveries.  Although the appointment of what the authors, Jared A. Ellias, Ehud Kamar and Kobi Kastiel, label “bankruptcy directors” has become common practice, this article appears to be the first in-depth analysis of the impact of such appointments on chapter 11 outcomes.  The authors note that “the percentage of firms in Chapter 11 proceedings claiming to have an independent director increased from 3.7% in 2004 to 48.3% in 2019.”  This trend has not been favorable for creditors, however.  While acknowledging that other factors could account for the negative association, the authors claim that “the recovery rate for unsecured creditors . . .  is on average about 20% lower in the presence of bankruptcy directors.”

Of particular concern to the authors is that such directors often seek to assume control of potential claims against corporate insiders: “bankruptcy directors often bypass the system of checks-and-balances that Congress created” by undertaking their own investigations of such claims and proposing settlements, tasks which historically in chapter 11 cases have been performed by an official creditors’ committee.  The authors cite examples where litigation settlements proposed by bankruptcy directors substantially undermine the efforts of creditor committees to pursue claims against controlling shareholders.

While in theory “bankruptcy directors” should be a positive contribution to the outcome of a chapter 11 case by combining “corporate law’s deference to independent directors with bankruptcy law’s faith in neutral trustees[,]” the authors note that the independence of such directors may reasonably be questioned, given the tendency of certain individuals to be repeatedly appointed in multiple cases where the same law firms act as counsel to the debtor.  Sifting through publicly available data, the authors found 15 individuals, referred to as “super-repeaters,” who were frequently appointed to directorships of distressed companies, a total of 252 appointments in all.  In 44% of these appointments, the company either filed for bankruptcy while its super-repeater bankruptcy director sat on the board, or had done so a short time prior.

The article concludes with certain specific policy proposals, including that judges afford the traditional deference to bankruptcy directors as “independent” only when they have the support of a significant majority of the creditors with claims at risk.  The authors also note proposed legislation that would expand the power of official creditor committees in two important ways –  giving them first, the exclusive ability to pursue and settle litigation against corporate insiders, and second, the right to seek a hearing before the bankruptcy court to examine potential conflicts of interest of any director.

Chapter 11 filings are currently in a lull, but are expected to increase in the second half of this year due to waning pandemic relief and growing economic uncertainty stemming from international events, rising energy prices and interest rates.  This article will be the starting point of closer scrutiny on the role of bankruptcy directors in large cases.

The law that temporarily increased the maximum amount of debt a company may have to qualify as a small business under Subchapter V – the cheaper, easier, and faster version of Chapter 11 – from $2.7 million to $7.5 million, is about to expire.  A bill introduced in the Senate this week by a bipartisan group of senators led by Senator Chuck Grassley (R-Iowa), however, would make the $7.5 million debt limit permanent.

Bankruptcy professionals have been anxiously waiting to see whether Congress will again come together to continue allowing more small businesses to elect Subchapter V treatment.  A similar bipartisan effort at the end of last year to extend other bankruptcy protections instituted under the Consolidated Appropriations Act failed and, as a result, those protections expired on December 27, 2021.  If the bill proposed this week does not pass by March 27, 2022, the debt limit would revert back to $2,725,625, then it would increase to $3,024,725 on April 1, 2022 per the adjustments recently announced by the Judicial Conference of the United States.

Even if the bill passes, some members of the bankruptcy bar argue that more changes are needed to prevent large companies and private equity funds from taking advantage of Subchapter V to circumvent the safeguards Chapter 11 provides to creditors.  Our experience with Subchapter V  suggests that, even more than in Chapter 11 cases, creditors need to be actively involved as soon as possible for a number of reasons, including the lack of oversight by a creditors’ committee, limited role of the Subchapter V trustee, expedited plan timeline, and ability of equity holders to maintain their interests in certain circumstances even if unsecured creditors are not paid in full.

If approved, the Bankruptcy Threshold Adjustment and Technical Corrections Act (S. 3823, 117th Cong. § 2(a) (2022)) would delete the sunset provision from the CARES Act (Pub. L. No. 116-136, § 1113(a), 134 Stat. 281, 310–11 (2020)) and permanently increase the Subchapter V debt limit to $7.5 million.

As background, the Small Business Reorganization Act (“SBRA”) enacted by Congress in 2019 included a new Subchapter V that allowed small “Main Street” businesses to restructure under a modified form of Chapter 11.  Subchapter V was intended to address the hurdles to reorganization facing small businesses by relaxing the complex requirements of Chapter 11, reducing costs, and expediting the timing of the bankruptcy process.  To qualify as a small business under Subchapter V, a company must show that, among other things, its “aggregate noncontingent liquidated secured and unsecured debts” do not exceed the limit set by the statute when the bankruptcy petition is filed.  11 U.S.C. § 1182(1)(A).  When the SBRA went into effect on February 19, 2020, the limit was $2,725,625.  In the early days of the COVID-19 pandemic, Congress passed the CARES Act, which temporarily raised the debt limit to $7.5 million through March 27, 2021.  In March 2021, the COVID–19 Bankruptcy Relief Extension Act extended the expiration of the $7.5 million debt limit to March 27, 2022.

The allowance of postpetition interest in solvent debtor chapter 11 cases has become an important issue in recent years for corporate issuers, bondholders and other creditors.  This post will examine a recent decision in the Hertz case by Judge Mary Walrath of the U.S. Bankruptcy Court for the District of Delaware on the rate of interest payable to unsecured creditors who are entitled under the Bankruptcy Code to full payment of their claims under a plan of reorganization.  (Judge Walrath also addressed other topics in her decision pertaining to the allowance of make-whole premiums, which were examined in an earlier post.)

Background:

The Hertz Corporation filed for protection under chapter 11 of the U.S. Bankruptcy Code in May 2020, its business decimated by the Covid-19 pandemic.  In little more than a year, however, it had recovered so successfully that it was able to propose a plan of reorganization that purported to pay unsecured creditors in full.

Hertz claimed that under its plan, the holders of its over $2.7 billion of unsecured bonds were “unimpaired.”  Hertz’s plan proposed to pay the bondholders the full principal amount of the bonds, and interest accrued during the course of the chapter 11 case at the federal judgment rate rather than the significantly higher rate set forth under the terms of the bonds and the indentures.

The bondholders disputed that their claims were unimpaired because, among other things, the plan did not provide for payment at the contract rate under the indentures.  They also argued that a pre-Bankruptcy Code equitable doctrine commonly known as the “solvent debtor exception” entitled them to full payment of interest.

The two sides agreed to let the plan proceed to confirmation and have Judge Walrath determine afterwards what the bondholders were entitled to receive.  Post-confirmation, Hertz moved to dismiss the bondholders’ claims for postpetition interest at the contract rate under the indentures.

Judge Walrath’s Analysis

In her decision on Hertz’s motion to dismiss the claims, Judge Walrath looked at the Bankruptcy Code to resolve whether the contract rate or the federal judgment rate would apply on any allowed postpetition interest.

Non-Impairment – Under the Bankruptcy Code, creditors’ claims are unimpaired if “the plan . . . leaves unaltered the legal, equitable and contractual rights” of the holder of such claim.  Unimpaired creditors do not have a right under the Bankruptcy Code to vote to accept or reject a proposed plan, but are instead deemed to accept.  The bondholders asserted that their treatment as unimpaired creditors under the plan entitled them to all of their rights under the indentures, including the payment of both the make-whole premiums and interest at the contract rate.

Judge Walrath disagreed.  In most chapter 11 cases, section 502(b) of the Bankruptcy Code expressly disallows claims for “unmatured interest,” i.e, interest which had not yet accrued as of the commencement of the case.  She cited a Third Circuit decision, PPI Enterprises, that held that a creditor’s claim was not impaired if the claim was limited or disallowed not by the plan itself, but rather by the Bankruptcy Code as a matter of law.  Since section 502(b) disallows claims for unmatured interest, the failure under the plan to provide for payment of future unpaid interest would not constitute impairment.

Solvent Debtor Exception – The bondholders cited a number of pre-Bankruptcy Code cases which held that where a debtor is solvent, creditors are entitled to contract rate interest on their claims and other contractual rights before any value should go to shareholders.

The bondholders pointed to a recent decision by Judge Marvin Isgur in the Southern District of Texas who, faced with similar issues in the case of Ultra Petroleum Corp., ruled that the solvent debtor exception remained good law and effectively overrode section 502(b)’s disallowance of unmatured interest with respect to solvent debtors and required the payment of interest at the contract rate.

Judge Walrath acknowledged the solvent debtor exception, but interpreted it more narrowly than Judge Isgur.  She pointed to section 726(a)(5) of the Bankruptcy Code, which provides for payment of interest “at the legal rate” in solvent debtor chapter 7 liquidation cases, and section 1129(a)(7) of the Bankruptcy Code, which mandates that impaired creditors be treated as well under a chapter 11 plan as they would under a hypothetical chapter 7 case.

Judge Walrath determined that the weight of caselaw authority viewed “the legal rate” under section 726(a)(5) as the federal judgment rate rather than contract rate interest.  Reasoning further that Congress could not have intended for unimpaired creditors to be treated worse than impaired creditors, she held that the solvent debtor exception required payment of accrued and unpaid interest on the bonds at the federal judgment rate.

Conclusion

Judge Walrath recognized the solvent debtor exception to the disallowance of unmatured interest under section 502(b), but only to the extent of requiring payment of accrued postpetition interest at the federal judgment rate.

Value fluctuations stemming from the pandemic disruption and the subsequent rapid recovery, and ongoing economic volatility and uncertainty means that more solvent debtor cases can be expected moving forward into 2022.  Given the influence of the Delaware Bankruptcy Court in large chapter 11 cases, Judge Walrath’s analysis in Hertz will inform the calculations of debtors and bondholders during plan negotiations in such cases.

The treatment of make-whole premiums in solvent debtor chapter 11 cases has become an important issue in recent years for corporate issuers and bondholders.  This post will examine a recent decision in the Hertz case by Judge Mary Walrath of the U.S. Bankruptcy Court for the District of Delaware on the allowance of such claims.  (Judge Walrath also addressed other topics in her decision pertaining to the treatment of unimpaired creditors and postpetition interest, which will be examined in a separate post.)

Value fluctuations stemming from the pandemic disruption, the subsequent rapid recovery, and ongoing volatility and uncertainty means that more solvent debtor cases can be expected moving forward into 2022.  Given the influence of the Delaware Bankruptcy Court in large chapter 11 cases, Judge Walrath’s detailed analysis in Hertz of the indenture language and applicable Bankruptcy Code provisions will inform the calculations of debtors and bondholders during plan negotiations in such cases.

Background:

The Hertz Corporation filed for protection under chapter 11 of the U.S. Bankruptcy Code in May 2020, its business decimated by the Covid-19 pandemic.  In little more than a year, however, it had recovered so successfully that it was able to propose a plan of reorganization that purported to pay unsecured creditors in full.

Hertz claimed that under its plan, the holders of its over $2.7 billion of unsecured bonds, issued pursuant to four separate indentures with maturity dates in 2022, 2024, 2026 and 2028, were “unimpaired.”  The bondholders disputed that their claims were unimpaired because, among other things, the plan did not provide for payment of $272 million of make-whole premiums (a common type of payment required under bond indentures in the event that the issuer chooses to redeem; i.e., repay the bonds ahead of the scheduled payment date) which the bondholders asserted were due under the terms of the indentures.

The two sides agreed to let the plan proceed to confirmation and have Judge Walrath determine afterwards what the bondholders were entitled to receive as unimpaired creditors.  Post-confirmation, Hertz moved to dismiss the bondholders’ claims for the make-whole premiums.

Key Issues:

Hertz denied that it had an obligation to pay the make-whole premiums, arguing that (i) none were owed under the terms of the indentures, and (ii) the claims for a make-whole premium should be disallowed as “unmatured interest” under section 502(b) of the Bankruptcy Code.

In her decision on Hertz’s motion to dismiss the claims, Judge Walrath first considered the provisions of the indenture governing the “acceleration” of the bonds upon the bankruptcy filing, and addressing the “redemption” (i.e., voluntary early repayment) of the bonds.  She then examined whether the “maturity” of the bonds could occur ahead of the scheduled payment date.  Finally, Judge Walrath looked at the Bankruptcy Code to resolve whether the make-whole premium claims, even if payable under the terms of the indentures, should nevertheless be disallowed as “unmatured interest.

Judge Walrath’s Analysis

Acceleration – Hertz contended that no make-whole premiums were owed because the acceleration provision in the indentures spoke only of principal and accrued interest under the bonds becoming immediately due upon a bankruptcy filing, with no mention of any premium.

Judge Walrath rejected this argument.  She noted that under Energy Future Holdings (“EFH”), the leading case on make-whole premiums in the Third Circuit, the acceleration clause was not applicable.  She held instead that the redemption clause, which expressly provided for payment of the make-whole premium upon an early voluntary repayment, was the “operative” provision.

Redemption – Hertz next asserted that the redemption provision should not apply, because the early repayment of the bonds was not a voluntary decision by Hertz, but was instead required as a result of the bankruptcy filing.  The Second Circuit made such a ruling in the MPM Silicones case.

Although the Third Circuit in the EFH case ruled to the contrary, and held that a payment under a bankruptcy plan constituted a voluntary early repayment that triggered an obligation to pay a make-whole premium, Hertz asked Judge Walrath to distinguish that decision.  The EFH case had been commenced with the specific purpose of trying to avoid the payment of a make-whole premium, while Hertz had no such intent when it filed.

Judge Walrath, however, declined Hertz’s invitation to disregard EFH and apply MPM.  She agreed instead with the bondholders, who argued that regardless of whether Hertz had filed for bankruptcy with any specific intent to avoid payment of the make-whole premiums, the filing itself was a “strategic, voluntary decision[.]”  The subsequent repayment of the bonds under the bankruptcy plan was therefore a voluntary early repayment that constituted a redemption and triggered the obligation under the indentures to pay the make-whole premiums.

Maturity – Hertz had one further argument as to why the make-whole premiums were not payable under the terms of at least two of the indentures.

The indentures for the 2022 and 2024 bonds stated that the make-whole premiums would be payable if the bonds were redeemed after a specified date but “prior to maturity.”  The other two series of bonds, the 2026 and 2028 bonds, omitted the words “prior to maturity.”

Hertz contended that the reference to “maturity” included the acceleration due to the bankruptcy filing, and that the payment of the 2022 and 2024 bonds under the plan was therefore a redemption after “maturity.”  Judge Walrath agreed, and dismissed the claims for the make-whole premiums with respect to the 2022 and 2024 bonds.

Economic Equivalent of Interest – Judge Walrath next considered whether the remaining make-whole premium claims with respect to the 2026 bonds and the 2028 bonds should be disallowed under the Bankruptcy Code.  Section 502(b) of the Bankruptcy Code expressly disallows claims for “unmatured interest,” i.e, interest which had not yet accrued as of the commencement of the case.  Hertz argued that the make-whole premiums were the economic equivalent of future unpaid interest and could not be allowed under section 502(b).

The bondholders countered that the make-whole premiums are not future unpaid interest but are instead a liquidated damages provision “intended to compensate the [bondholders] for the uncertainty and potential losses incurred in reinvesting that money in a different market environment, which implicates numerous factors beyond simply the periodic payment of interest.”  The bondholders pointed to a recent decision by Judge Marvin Isgur in the Southern District of Texas who, faced with similar issues in the case of Ultra Petroleum Corp., ruled that a make-whole premium did not constitute future unpaid interest and would not be disallowed under section 502(b).

Judge Walrath acknowledged Ultra Petroleum and other similar cases cited by the bondholders.  At the same time she expressed concern that the premium is ultimately “calculated, in large part, on the present value of the unmatured interest due on the [bonds] . . . .”  She determined that the nature of the make-whole premiums presented a question of fact that would require an evidentiary hearing.

Since she was ruling on Hertz’s motion to dismiss the make-whole premium claims as a matter of law, she declined to disallow the claims under section 502(b).  The bondholders, however, will need to present evidence at a future hearing that the make-whole premiums are not the economic equivalent of future unpaid interest.

A recent decision reminds creditors of the harsh consequences of failing to comply with a court imposed deadline for filing claims in a bankruptcy case. The U.S. Court of Appeals for the Third Circuit recently held in Ellis v. Westinghouse that claims accruing after confirmation of a chapter 11 plan, but  before the plan goes effective, are subject to the administrative claim deadline established by the plan. Absent a few narrow exceptions, creditors that fail to file an administrative claim by the deadline risk having their claims discharged. This first impression decision directly impacts creditors with claims that accrued during the post-confirmation, pre-effective date period, including contract counterparties, landlords, employees, unpaid suppliers, and equipment lessors.

Westinghouse filed for chapter 11 bankruptcy relief in March 2017 and confirmed its plan on March 28, 2018. The plan required creditors to file claims for administrative claims, those relating to obligations arising post-petition, within 30 days after the plan’s effective date, or such claims would be forever discharged. Timothy Ellis was a vice president of Westinghouse, and on May 31, 2018, two months after the bankruptcy court confirmed the plan, but prior to the plan going effective, Ellis was terminated. Ellis believed he was wrongfully terminated because of his age.

Westinghouse’s plan went effective on August 1, 2018, five months after it was confirmed. Westinghouse sent creditors a notice of the effective date of the plan which included a reminder to file administrative claims by August 31, 2018, the deadline set by the plan. Both Ellis and Westinghouse agreed that Ellis’ employment claim accrued on his termination date, giving Ellis 91 days before the deadline to file his claim with the bankruptcy court.

Ellis, however, did not file a claim by the August 31, 2018 deadline. Instead, on October 2018, Ellis filed a lawsuit against Westinghouse for employment discrimination. In response, Westinghouse filed a motion for summary judgment, asserting that the plan discharged Ellis’ claim. The district court denied Westinghouse’s motion, concluding that the bankruptcy code cannot discharge or create a bar date for claims that arose post-confirmation but pre-effective date.

The Third Circuit disagreed and reversed the district court, holding that the bankruptcy code authorizes bankruptcy courts to set deadlines for post-confirmation, pre-effective date claims, and that claims that are filed late may be discharged.

Although creditors have a few exceptions, the result is harsh.  First, the bankruptcy code allows creditors to file untimely administrative claims after showing “cause” for the delay. Additionally, administrative claim deadlines must comply with due process, so a claim is only subject to discharge if a creditor received adequate notice of the bankruptcy and had a fair opportunity to press the claim.  Neither exceptions appears to apply to Mr. Ellis’ situation.

The Ellis v. Westinghouse decision is the first ruling by a U.S. Court of Appeals regarding the discharge of claims accruing post-confirmation, but prior to the a plan effective date. Other Courts are likely to follow the Third Circuit’s reasoning, so creditors should carefully follow a plan’s administrative claim deadline or otherwise have their claims discharged.