In In re Ultra Petroleum Corp., 913 F.3d 533 (5th Cir. 2019), the U.S. Court of Appeals for the Fifth Circuit ruled that a "make-whole," or "prepayment," premium owed on unsecured notes issued by a chapter 11 debtor constituted unmatured interest disallowed by section 502(b)(2) of the Bankruptcy Code. The ruling represents a landmark decision on the allowance of such premiums in chapter 11, over which there has been considerable litigation in recent years, including at the circuit court level.

Enforceability of Make-Whole Premiums in Bankruptcy

Restrictions on a borrower’s ability to prepay secured debt are a common feature of bond indentures and credit agreements. Lenders often incorporate "no-call" provisions to prevent borrowers from refinancing or retiring debt prior to maturity. Alternatively, a loan agreement may allow prepayment at the borrower’s option, but only upon payment of a "make-whole premium" (commonly referred to as a "prepayment penalty"). The purpose of these prepayment penalties is to compensate the lender for the loss of the remaining stream of interest payments it would otherwise have received had the borrower paid the debt through maturity.

Most recent court rulings addressing the allowance of claims for make-whole premiums have focused on highly technical legal and contractual issues. For instance, in Del. Tr. Co. v. Energy Future Intermediate Holding Co. LLC (In re Energy Future Holdings Corp.), 842 F.3d 247 (3d Cir. 2016), the U.S. Court of Appeals for the Third Circuit ruled that certain noteholders were entitled to payment of a premium upon the redemption of their notes during a chapter 11 case. According to the Third Circuit, the premium was warranted because the optional redemption provision in the note indenture (which required the payment) did not conflict with the indenture’s acceleration provision, which provided that the notes were accelerated upon a bankruptcy filing, thereby potentially no longer making payment of the debt a "prepayment" that would require the payment of a "prepayment premium" under the contract. By contrast, in Momentive Performance Materials Inc. v. BOKF, NA (In re MPM Silicones, L.L.C.), 874 F.3d 787 (2d Cir. 2017), the U.S. Court of Appeals for the Second Circuit held that certain noteholders were not entitled to a prepayment premium because the notes were accelerated upon the bankruptcy filing and, therefore, could no longer be prepaid.

As noted, make-whole or prepayment premiums are typically structured to compensate noteholders for lost future interest resulting from payment of their notes prior to maturity. As a consequence, claims for such premiums have long been challenged (with mixed results) under section 502(b)(2) of the Bankruptcy Code, which disallows claims for "unmatured interest." Compare In re Ridgewood Apartments of DeKalb Cnty., Ltd., 174 B.R. 712, 720 (Bankr. S.D. Ohio 1994) ("Absent actual prepayment by the Debtor, [the lender’s] claim for a prepayment penalty could be no more than a contingent liability. Further, because the contingent claim is for interest which is not yet due at the time the bankruptcy was filed (because prepayment had not occurred), it would not be allowed to an undersecured creditor [under section 502(b)(2)]"), with In re 360 Inns, Ltd., 76 B.R. 573, 576 (Bankr. N.D. Tex. 1987) ("[T]he prepayment penalty was not unmatured interest as contemplated in § 502(b)(2), inasmuch as the prepayment penalty was activated and matured once the plan of reorganization proposed to prepay [the lender’s] debt.").

However, more recent litigation over such premiums has generally sidestepped this issue, focusing instead on the technical provisions of the indentures at issue. The Fifth Circuit’s decision in Ultra Petroleum refocuses the analysis on the legal issue of whether a make-whole premium is unmatured interest that must be disallowed under section 502(b)(2).

Impairment Under a Chapter 11 Plan

Classes of claims or interests may be either "impaired" or "unimpaired" by a chapter 11 plan. The distinction is important because only impaired classes have the ability to reject a plan. Under section 1126(f) of the Bankruptcy Code, unimpaired classes of creditors and shareholders are conclusively presumed to have accepted a plan.

Section 1124 provides that a class of creditors is "impaired" under a plan unless, among other things, the plan: (1) "leaves unaltered the legal, equitable, and contractual rights" to which the claimant is entitled; or (2) cures any defaults (with limited exceptions), reinstates the maturity and other terms of the obligation, and compensates the claimant for resulting losses.

Section 1124 originally included a third option for rendering a claim unimpaired—by providing the claimant with cash equal to the allowed amount of its claim. In In re New Valley Corp., 168 B.R. 73 (Bankr. D.N.J. 1994), the court ruled that a solvent debtor’s chapter 11 plan that paid unsecured claims in full in cash, without postpetition interest, did not impair the claims.

Because of the perceived unfairness of New Valley, Congress removed this option from section 1124 of the Bankruptcy Code in 1994. Since then, most courts considering the issue have held that, if an unsecured claim is paid in full in cash with postpetition interest at an appropriate rate, the claim is unimpaired under section 1124. See, e.g., In re PPI Enterprises (U.S.), Inc., 324 F.3d 197, 205–07 (3rd. Cir. 2003).

Ultra Petroleum

Ultra Petroleum Corp. ("UPC") issued approximately $1.5 billion in unsecured notes from 2008 to 2010. The note agreement, which was governed by New York law, provided that UPC had the right to prepay the notes at 100 percent of principal plus a make-whole amount. The make-whole amount was calculated by subtracting the accelerated principal from the discounted value of the future principal and interest payments. Events of default under the agreement included a bankruptcy filing by UPC. In that event, failure to pay the outstanding principal, any accrued interest, and the make-whole amount immediately triggered the obligation to pay interest at a default rate specified in the note agreement (the greater of 2% over the nondefault rate or 2% over prime).

UPC filed for chapter 11 protection in April 2016. Improving business conditions during the course of the case allowed UPC—a "solvent debtor" (discussed below)—to seek confirmation of a chapter 11 plan that provided for the payment in cash of all unsecured claims in full. The plan designated the noteholders’ claims as "unimpaired" but did not provide for the payment of the make-whole amount or postpetition interest at the default rate. UPC contested the noteholders’ right to receive the make-whole amount. The parties agreed that postpetition interest should be paid on the noteholders’ claims, but they disagreed on the appropriate rate.

The bankruptcy court first decided that under New York law, the make-whole amount was an enforceable liquidated damages provision, rather than an unenforceable penalty. The court rejected UPC’s arguments that the make-whole amount was "conspicuously disproportionate to foreseeable losses at the time the parties entered" into the note agreement because it would result in a double recovery.

The court also held that UPC’s chapter 11 plan impaired the noteholders’ claims because the plan failed to provide for the payment of the make-whole amount and postpetition default-rate interest. The court rejected UPC’s position that, because the make-whole amount represented "unmatured interest" and was not allowable under section 502(b)(2), the plan left the noteholders’ rights under the Bankruptcy Code unaltered, and the noteholders’ claims were therefore unimpaired under section 1124(1). The court noted in dicta that UPC might have attempted to render the noteholders unimpaired without paying the make-whole amount by reinstating the notes and curing any defaults, as permitted by section 1124(2), but elected not to do so.

The bankruptcy court certified a direct appeal of its order to the Fifth Circuit, which agreed to hear the appeal.

The Fifth Circuit’s Ruling

Initially, the Fifth Circuit ruled that a claim is not impaired under a chapter 11 plan if the plan fails to pay an amount that is disallowed by the Bankruptcy Code. In so ruling, the court followed the Third Circuit’s rationale in PPI Enterprises, where the court held that a landlord’s future rent claim capped under section 502(b)(6) of the Bankruptcy Code was not impaired under a chapter 11 plan because the Bankruptcy Code, not the plan, capped the claim.

Instead, the Third Circuit held, consistent with PPI Enterprises, section 1124 mandates that the relevant barometer for impairment is whether the plan itself, as distinguished from another provision of the Bankruptcy Code, limits the claimant’s legal, equitable, or contractual rights. Many other courts have adopted this approach. See, e.g., In re Tree of Life Church, 522 B.R. 849, 861–62 (Bankr. D.S.C. 2015); In re RAMZ Real Estate Co., 510 B.R. 712, 717 (Bankr. S.D.N.Y. 2014); In re K Lunde, LLC, 513 B.R. 587, 595–96 (Bankr. D. Colo. 2014); see generally Collier on Bankruptcy ¶ 1124.03[6] (16th ed. 2019).

Next, the Fifth Circuit held that section 502(b)(2) disallowed the noteholders’ claim for a make-whole premium because the premium constituted "unmatured interest." The court explained that, "looking to economic realities," section 502(b)(2) disallows any claim that is the "economic equivalent of unmatured interest." The make-whole premium fit that bill in this case, the court concluded, because the purpose of a make-whole provision "is to compensate the lender for lost interest" (citing Collier at ¶ 502.03[3][a]; MPM Silicones, 874 F.3d at 801–02 & n.13). According to the Fifth Circuit, section 502(b)(2) does not require a make-whole premium to be unmatured interest—instead, the provision demands only that "it walk, talk, and act like unmatured interest."

Even so, the Fifth Circuit acknowledged that the noteholders’ claim for a make-whole premium might still be allowed because UPC was solvent. According to the court, "[T]he creditors can recover the Make-Whole Amount if (but only if) the solvent-debtor exception survives Congress’s enactment of § 502(b)(2). We doubt it did. But we vacate and remand to allow the bankruptcy court to answer the question in the first instance. "

Prior to the enactment of the Bankruptcy Code, the Fifth Circuit explained, there existed a "solvent-debtor exception" to the disallowance of interest accruing after the filing of a bankruptcy petition derived from English law. The exception provided that interest would continue to accrue on a debt after a bankruptcy filing if the creditor’s contract expressly provided for it and that interest would be payable if the bankruptcy estate contained sufficient assets to pay it after satisfying other debts. According to the Fifth Circuit, in such cases the post-bankruptcy interest was part of the underlying debt obligation, as distinguished from interest "on" a creditor’s claim that might be allowed by the provisions of a bankruptcy statute.

The Fifth Circuit further explained that the Bankruptcy Code contains several exceptions to the general principal that upon a bankruptcy filing, unmatured interest is disallowed under section 502(b)(2). For example, section 506(b) provides that an oversecured creditor is entitled to interest during the bankruptcy case at the contract rate. Further, in a chapter 7 case, the distribution scheme set forth in section 726 designates as fifth in priority of payment interest on allowed unsecured claims "at the legal rate" (which has been interpreted to mean the federal statutory rate for interest on judgments set by 28 U.S.C. § 1961). Thus, if the estate in a chapter 7 case is sufficient to pay claims of higher priority, creditors are entitled to postpetition interest before the debtor can recover any surplus.

In a chapter 11 case, the chapter 7 priority scheme can apply under section 1129(a)(7). Referred to as the "best interests" test, section 1129(a)(7) mandates that, unless each creditor in an impaired class accepts a chapter 11 plan, the creditor must receive at least as much under the plan as it would in a chapter 7 liquidation of the debtor.

However, the Fifth Circuit emphasized, each of these provisions is a statutory grant of postpetition interest "on a claim," rather than an allowance of postpetition interest accruing as part of the claim itself. According to the court, disallowance of the latter type of interest is absolute pursuant to section 502(b)(2), unless the pre-Bankruptcy Code solvent-debtor exception allowing postpetition interest as part of a claim survived the enactment of section 502(b)(2).

The Fifth Circuit doubted that it survived. The court explained that part of the rationale for the solvent-debtor exception was a concern that, prior to the enactment of the Bankruptcy Code, solvent debtors could file for bankruptcy in bad faith to avoid paying interest to creditors, who would be powerless to stop the then ex parte bankruptcy proceedings. However, the Bankruptcy Code contains a more direct mechanism for dealing with bad-faith bankruptcy filings. Section 1112(b) provides that a bankruptcy court shall convert or dismiss a chapter 11 case "for cause," which has been construed to include filing for bankruptcy in bad faith. See In re SGL Carbon Corp., 200 F.3d 154 (3d Cir. 1999).

According to the Fifth Circuit, the bankruptcy court’s resolution of the Bankruptcy Code versus chapter 11 plan impairment question prevented it from considering whether "Congress chose not to codify the solvent-debtor rule as an absolute exception to § 502(b)(2)" or whether lawmakers’ silence on that score in 1978 should be presumed as an indication that certain long-established bankruptcy principles should remain undisturbed. The Fifth Circuit accordingly remanded the case below to make that determination.

Finally, the Fifth Circuit also remanded the case to the bankruptcy court for additional findings regarding the appropriate rate of postpetition interest. The Fifth Circuit determined that it could not answer that question without additional findings because: (i) the only provision of the Bankruptcy Code that speaks to the appropriate interest rate payable on a claim—section 726—did not apply in this case; and (ii) the pre-Bankruptcy Code practice of allowing postpetition interest in solvent cases provided no guidance on this issue because "the modern concept of post-petition interest on a claim[, as distinguished from as part of a claim,] had no analogy under pre-Code law."

Postscript

On January 31, 2019, an ad hoc committee of unsecured creditors and the noteholders jointly petitioned the Fifth Circuit for a rehearing en banc of its ruling. According to the appellees, the ruling "decides two questions of exceptional importance and will, if not rectified, upend existing financial transactions and chill the willingness of lenders to provide future capital." They also argued that the ruling is "in conflict with several prior Fifth Circuit decisions, the Second Circuit, and lower federal and New York state court decisions" and that rehearing "is necessary to secure uniformity of this Court’s decisions and to avoid substantial disruption in the financial markets and bankruptcies nationwide."