In National Energy & Gas Transmission, Inc. v. Liberty Electric Power, LLC (In re National Energy & Gas Transmission, Inc.),1 the Fourth Circuit held that, where an unsecured creditor receives payment from a non-debtor guarantor in partial satisfaction of a claim against the debtor, for purposes of the creditor's claim against the debtor, the creditor may not choose to allocate such payment to post-petition interest. The Court reasoned that to do so would effectively allow the creditor to receive unmatured interest on its claim, which would be contrary to Section 502(b)(2) of the Bankruptcy Code as well as the policy considerations of administrative convenience and fairness to other creditors underlying such section.

Background

National Energy & Gas Transmission Energy Trading Power, L.P. ("ET Power"), National Energy & Gas Transmission, Inc. ("NEGT"), and certain other affiliated companies (collectively, the "Debtors") filed for bankruptcy protection on July 8, 2003 (the "Petition Date").2 Prior to that time, ET Power had operated as an energy marketing and trading company, buying and selling electric power, natural gas, coal and other physical energy commodities, and engaging in energy-based financial and hedging transactions, such as future contracts, swaps, options and derivatives.3

Prior to the Petition Date, ET Power and energy-generating company Liberty Electric Power, LLC ("Liberty") had entered into an electricity tolling agreement (the "Agreement") under which ET Power effectively would provide Liberty with the natural gas necessary to generate electricity and then purchase the electricity that was generated.4 NEGT and its non-debtor subsidiary, Gas Transmission Northwest Corporation (GTN), both guaranteed "all amounts payable by [ET Power] under the Agreement," capped at $140 million.5 After the Petition Date, NEGT decided to sell GTN and, as part of the transaction, $140 million was reserved in escrow to provide for any liability to Liberty under the guarantee.

The bankruptcy court authorized the Debtors to reject the Agreement.7 Liberty filed a claim against the estates, seeking $5.4 million in unpaid invoices and $3.7 million in collection costs and fees (neither of which were at issue in the appeal).8 Liberty also claimed $140 million as a termination payment, which claim went to arbitration per the terms of the Agreement. The arbitration panel awarded Liberty the full $140 million along with interest from the date of rejection of the Agreement.9 To stop the accrual of interest, which had thus far amounted to approximately $17 million, Liberty was immediately paid the $140 million from the GTN sale escrow in full and final satisfaction of the GTN guarantee.10

Upon receipt of payment from GTN, Liberty allocated the $140 million first to interest, then to principal, seeking to collect the additional $17 million of the arbitration award from ET Power as part of its $140 million claim against the debtor.11 Liberty argued that the additional amount sought to be collected from ET Power did not represent a disallowable claim for post-petition interest, but rather a portion of unpaid principal because the interest portion of the award had been satisfied by the $140 million payment from GTN.12

The bankruptcy court allowed Liberty's claim for $140 million against ET Power, but held that the "maximum amount of distribution payable to Liberty" would be limited to the $17 million balance.13 The district court affirmed.14 The Fourth Circuit agreed that ET Power's debt to Liberty was not reduced by the payment that Liberty received from GTN,15 but disagreed as to the amount Liberty could collect from ET Power.16 Specifically, the Court held that, under Section 502(b)(2) of the Bankruptcy Code, Liberty could not collect the $17 million "balance", as it constituted an impermissible claim for unmatured interest.17

Fourth Circuit Agrees Debtor Remained Liable for Full Amount of Prepetition Claim

Liberty alleged, and the bankruptcy and district courts agreed, that Liberty had a claim for the full $140 million principal amount against ET Power — even though Liberty had received a payment from GTN in the same amount — because ET Power and the guarantors were jointly and severally liable under the Agreement.18 ET Power argued on appeal, however, that Liberty's claim against ET Power should be limited to the $17 million remaining due after Liberty's receipt of the $140 million from GTN and that Liberty should be barred from collecting the $17 million because such amount represented disallowable post-petition interest.19

The Fourth Circuit disagreed with both Liberty and ET Power, relying on both bankruptcy and state law.20 The Court first determined that, under bankruptcy law, ET Power's debt to Liberty was not reduced by the GTN payment because "the Supreme Court held [in Ivanhoe Building & Loan Ass'n of Newark v. Orr21] that a creditor need not deduct from his claim in bankruptcy an amount received from a non-debtor third party in partial satisfaction of an obligation."22 The Court then determined that, under New York law, ET Power's debt to Liberty could only be reduced by the GTN payment if GTN was a co-obligor under the Agreement as opposed to a surety.23 Despite language in the underlying agreement purporting to make GTN a co-obligor with ET Power, the Court concluded that GTN was ET Power's surety in fact.24 Accordingly, the Court held that ET Power remained liable to Liberty for the full amount of Liberty's claims against ET Power, unaffected by the payment received by GTN.25

Fourth Circuit Does Not Allow Creditor to Collect From Debtor on Account of Creditor's Claim

The Court next addressed what it labeled "the more fundamental question presented by this appeal": Whether Liberty could collect the additional $17 million it sought from ET Power's bankruptcy estate.26 In answering such question, the Court looked to Section 502(b)(2) of the Bankruptcy Code.

Section 502(b)(2) of the Bankruptcy Code provides that a claim shall not be allowed "to the extent that ... [it] is for unmatured interest[.]"27 The Court framed such Section as equitable in nature and identified its purpose as (1) the avoidance of unfairness among competing creditors, and (2) the avoidance of administrative inconvenience.28 Accordingly, the Court stated that it would "sift the circumstances surrounding any claim to see that injustice or unfairness is not done in administration of the bankrupt estate."29

As of the Petition Date, Liberty's damages resulting from the Debtors' rejection of the Agreement — and ET Power's corresponding debt — were determined through post-petition arbitration to be $140 million.30 Pursuant to Section 502(b)(2) of the Bankruptcy Code, Liberty could only collect in bankruptcy such principal amount without any unmatured interest, regardless of whether (i) the arbitration panel awarded interest under the Agreement pursuant to non-bankruptcy law or (ii) the debt was guaranteed by a non-debtor third party.31

Despite Liberty's choosing to allocate the GTN payment, first to interest, then to principal, and accordingly classifying its remaining $17 million claim against ET Power as principal, the Court thought such an act was contrary to the language and purpose of Section 502(b)(2) and warranted a sifting of circumstances (i.e., looking through form to substance) and a reversal of the lower courts' rulings.32 Because ET Power's debt was capped at $140 million by the filing of the bankruptcy petition, and because the debt was increased only by the accrual of post-petition interest pursuant to the arbitration award, the Court concluded that Liberty's claim for an additional $17 million constituted a claim for disallowable post-petition interest and that the purpose of Section 502(b)(2) of the Bankruptcy Code would best be served by barring Liberty from collecting the $17 million from the estate.33

Dissent Identifies Majority Opinion's Flaws

The dissenting opinion noted that (i) contract law entitled Liberty to be paid in full, including interest, by its jointly and severally liable debtors, (ii) bankruptcy law dictated that Liberty could not recover unmatured interest against debtor ET Power and (iii) bankruptcy law had no impact on the accrual of unmatured interest against non-debtor guarantor, GTN.34

The dissent posited that the majority opinion confused these three independent principles and effectively limited GTN's liability for interest accruing after ET Power filed its bankruptcy petition.35 As a result, according to the dissent, the majority opinion contradicted Section 524(e) of the Bankruptcy Code, which provides that the "discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of, any other entity for such debt."36

The dissent also disagreed with the majority's posturing of its decision as a necessary response to the equitable purposes of Section 502(b)(2) of the Bankruptcy Code.37 Specifically, the dissenting opinion could not find unfairness in the fact that Liberty bargained, outside of bankruptcy, for a guarantee of payment.38 Neither could the dissent see that the lower courts' rulings would require burdensome recomputation of interest, as they specified the allowed amount of Liberty's claim as determined in the arbitration proceeding.39 The dissent would have affirmed the decision of the district court.40

Comment

The Court does not discuss whether GTN is entitled to a claim against ET Power for reimbursement or by right of subrogation on account of GTN's $140 million payment to Liberty. If GTN is not allowed a claim against ET Power on account of GTN's payment, the Court's ruling creates a large windfall for ET Power's creditors, as ET Power then is discharged from liability on a $140 million obligation without having made any payments to anyone at all.

If GTN is indeed allowed a $140 million claim for reimbursement or by right of subrogation, under Section 509(c) of the Bankruptcy Code, such claim would be subordinated to Liberty's right to recover the remaining $17 million due to it.41 In that case, Liberty would be in the same position it would have been in had it been allowed a $140 million claim against ET Power, with the right to recover for itself only the first $17 million distributed on account of the claim — the result the bankruptcy and district courts seem to have embraced.