On January 17, 2019, the Fifth Circuit Court of Appeals issued an opinion holding that a creditor whose rights have been affected by operation of the Bankruptcy Code may nevertheless be “unimpaired” under a chapter 11 plan of reorganization. Importantly, this decision arising from a direct appeal in Ultra Petroleum Corp.’s (“Ultra”) chapter 11 bankruptcy cases addressed several key issues for debtors and key economic constituents, including signaling a departure from recent decisions of the Second and Third Circuits regarding the enforceability of “make-whole” premiums in chapter 11.

Background

Ultra involved a unique set of circumstances: a significant rise in commodity prices caused Ultra to become solvent during the pendency of its chapter 11 cases, and Ultra was able to confirm a plan of reorganization that proposed to pay creditors in full. Under Ultra’s plan of reorganization, a class of unsecured noteholders under a master note purchase agreement (the “Noteholders,” and such agreement, the “NPA”) were classified as unimpaired, and therefore deemed to accept the plan. Nevertheless, a dispute arose between Ultra and the Noteholders regarding whether the Noteholders were unimpaired in the context of the NPA. The Noteholders claimed that, in order for them to be unimpaired, Ultra was required to pay the make-whole premium under the NPA and postpetition interest at the default interest rate set forth in the NPA on the entirety of the Noteholders’ underlying claim, which they argued included the make-whole premium. Under the NPA, the make-whole premium matured as a consequence of automatic acceleration of the notes, which, under the NPA, was triggered upon Ultra filing bankruptcy. In response, Ultra argued that the make-whole premium should be disallowed on the basis that it represented the payment of “unmatured interest” under section 502(b)(2) of the Bankruptcy Code. Additionally, Ultra contended that the Noteholders were only entitled to postpetition interest on their claim at the federal judgment rate, rather than the higher default rate provided for in the NPA.

The bankruptcy court ruled in favor of the Noteholders on the grounds that Ultra’s plan of reorganization left the Noteholders unimpaired, and accordingly, they should be entitled to all contractual rights they have under applicable state law without “baking-in” any of the Bankruptcy Code’s limitations on claims. The bankruptcy court determined that the make-whole premium was permissible under New York law, and held that both the default interest and make-whole premium asserted by the Noteholders were payable under the terms of the NPA.

Reversing the bankruptcy court, the Fifth Circuit disagreed with the bankruptcy court’s determination of the requirements to be unimpaired under Ultra’s plan, and observed that the make-whole premium and postpetition interest may be limited by operation of the Bankruptcy Code. The Fifth Circuit remanded to the bankruptcy court the question of whether the Bankruptcy Code limited the amounts payable on account of the make-whole premium and postpetition interest as a consequence of Ultra’s facts and circumstances. In doing so, the Fifth Circuit provided guidance on how bankruptcy courts should consider make-whole premiums in chapter 11.

Impairment

The bankruptcy court’s reasoning focused on the Noteholders’ lack of impairment under Ultra’s plan, and it held that the Noteholders were entitled to receive all rights they would otherwise be entitled to under state law. In so doing, the bankruptcy court declined to follow the Third Circuit’s approach in In re PPI Enterprises (U.S.) Inc., 324 F.3d 197, 206-07 (3d Cir. 2003), where it assessed the section 502(b)(6) cap on a landlord’s claim before determining whether such claim is impaired. The Third Circuit reasoned that the landlord’s loss of payment did not arise as a result of the plan, but as a result of the Bankruptcy Code. In Ultra’s case, the bankruptcy court concluded that the issue of impairment was not a question of allowance, but of discharge: it is the plan that discharges liability, and because the Noteholders were entitled to the make-whole premium under state law and were unimpaired under Ultra’s plan, such liability was not discharged by the plan and Ultra remained responsible to pay it.

The Fifth Circuit reversed, concluding that the provisions of the Bankruptcy Code must be applied to determine the extent of a claim that is treated under a plan. The Fifth Circuit cited the text of section 1124(1), which requires that “the plan” alter the Noteholders’ legal, equitable, or contractual rights. Because the bankruptcy court did not consider the effect of the Bankruptcy Code on the Noteholders’ claims, the Fifth Circuit remanded the question of whether the Noteholders were entitled to the make-whole premium and contractual default interest under the Bankruptcy Code.

Make-Whole Premium

Although the Fifth Circuit remanded the question of whether the Noteholders were entitled to the make-whole premium, it provided substantive comments on how the bankruptcy court should consider the make-whole premium.

Section 502(b)(2) of the Bankruptcy Code bars a creditor from recovering any “unmatured interest” as of the petition date. Other courts that have analyzed make-whole premiums, including recent decisions from the Second and Third Circuits, have determined that such payments are not “interest,” and/or are not “unmatured” as of the petition date.

The Fifth Circuit reviewed the NPA and concluded that the make-whole premium represented the economic equivalent of interest and, therefore, qualified as interest under section 502(b)(2) of the Bankruptcy Code. The Fifth Circuit determined that the make-whole premium had not matured as of the petition date because the ipso facto clause in the NPA—which was designed to accelerate and mature the make-whole premium upon a bankruptcy filing—should be disregarded when determining whether interest is unmatured under section 502(b)(2).

The Fifth Circuit’s conclusion that the make-whole premium constituted interest was heavily disputed by the Noteholders. Indeed, the majority of cases consider make-whole premiums to be in the nature of option payments or liquidated damages, intended to compensate lenders for the loss of yield that results if a borrower prepays a loan. The Fifth Circuit ultimately concluded that interest and liquidated damages are not necessarily mutually exclusive, and that for a make-whole premium to be treated as unmatured interest under section 502(b)(2), it need only “walk, talk, and act like unmatured interest.”

The Fifth Circuit’s second conclusion—that the make-whole premium was unmatured as of the petition date—is predicated on disregarding what was described as an “ipso facto” clause in the NPA—an agreement that was presumably not executory. There is no direct textual support in the Bankruptcy Code for rendering such a clause unenforceable in this context, and the Fifth Circuit’s decision to do so is in conflict with the Second Circuit’s ruling in In re AMR Corp., 730 F.3d 88 (2d Cir. 2013). In AMR the Second Circuit found that the Bankruptcy Code does not broadly or categorically deny enforcement of ipso facto clauses, rather, the Bankruptcy Code renders them unenforceable only in certain circumstances, none of which are applicable to ipso facto clauses contained in non-executory debt instruments. Instead, the Fifth Circuit relied on the legislative history of section 502(b)(2) to conclude that ipso facto clauses should be disregarded for the purpose of determining whether interest is matured as of the petition date.

Postpetition Interest

The Fifth Circuit acknowledged that the Noteholders were entitled to some amount of postpetition interest on their claims given the recovery to equity holders on account of their interests, and that the bankruptcy court should determine the interest rate. The Fifth Circuit suggested that because the Bankruptcy Code did not specifically provide for an applicable rate, either the federal judgment rate or an equitable rate established by the bankruptcy court could be appropriate.

Key Take-Aways

While much of the Fifth Circuit’s discussion of make-whole premiums is dicta, this ruling suggests that make-whole premiums that are not matured as of the petition a date are not likely to find support in the Fifth Circuit. While the Second and Third Circuits generally scrutinize the language of the applicable debt instrument to determine whether a make-whole premium is payable as of the petition date, the approach outlined by the Fifth Circuit unseats what have been viewed as enforceable make-whole premiums in the Second and Third Circuits. Core to the Fifth Circuit’s ruling is its legal conclusion that a make-whole premium is unmatured interest. Lenders seeking to manage the risk of this outcome may consider negotiating to obtain loan provisions that cause debt maturity, acceleration, and triggering of a make-whole premium to occur prior to a bankruptcy filing, and taking any requisite affirmative steps pursuant to the loan provisions prior to a bankruptcy filing in order to mitigate the risk that a court will conclude that a make-whole premium is unmatured as of the petition date.

This ruling may also impact financing economics and venue decisions in future matters. For example, the pricing of lender financing will likely be adjusted to account for the risk that a make-whole will be determined unenforceable. Additionally, secured lenders may consider making use of cash collateral or provision of debtor-in-possession financing contingent on the borrower commencing chapter 11 in a forum less adverse to make-whole premiums and with certain stipulations and other provisions included in the applicable orders. Conversely, debtors with the benefit of financing options may seek out the Fifth Circuit in order to compromise a lender’s make-whole premium.

This update presents a high-level summary of several key takeaways from the Fifth Circuit’s ruling in In re Ultra Petroleum Corp., 2019 WL 237365 (5th Cir. Jan. 17, 2019).