The U.S. Court of Appeals for the Fourth Circuit has held that a creditor may not allocate payment by a nondebtor to interest first, before applying the balance to principal—and then seek to collect the remainder of the principal from a jointly liable debtor.

That strategy violated the Bankruptcy Code’s prohibition against collecting post-petition interest, the court reasoned in National Energy & Gas Transmission, Inc. v. Liberty Electric Power, LLC, No. 06-1459 (4th Cir. July 10, 2007). The majority’s rationale drew a pointed dissent.

The debtor, National Energy & Gas Transmission Energy Trading Power, L.P. (ET Power), was an energy trading company that entered into a tolling agreement with Liberty Electric Power LLC. The agreement allowed ET Power to provide Liberty with natural gas and then purchase electricity that was generated from the natural gas.

Rejection Damages

The tolling agreement was guaranteed by ET’s parent company, National Energy & Gas Transmission, Inc. (NEGT) as well as another NEGT subsidiary, GTN. In 2003, ET Power and NEGT—but not GTN—filed for relief under chapter 11. The debtors obtained bankruptcy court approval to reject the tolling agreement with Liberty. Following an arbitration proceeding, Liberty was awarded $140 million as a termination payment, plus interest accruing from the date of the rejection up to the date of the award.

GTN was sold to the TransCanada Corporation, and as part of the sale, GTN agreed to pay Liberty $140 million, which the company had held in escrow, to stop the further accrual of interest. Liberty allocated the GTN payment first to cover the interest owed under the arbitration award, with the remainder going to principal.

Liberty also continued to assert claims against NEGT and ET Power for $140 million each, maintaining that because the debtors were jointly and severally liable, it could pursue claims against them until it received full payment of the total debt. The creditor claimed it was not seeking post-petition interest, but rather the unpaid principal, because the interest portion of the award had been paid by GTN. Liberty conceded that it could not actually collect more than the $17 million it was still owed on ET Power’s debt.

The bankruptcy court agreed with Liberty, and allowed the claim for $140 million against ET Power, but provided that the maximum amount of distribution that would be payable to Liberty would be limited to $17 million. The district court affirmed.

Fourth Circuit Reversal

However, the Fourth Circuit reversed. The court acknowledged that “as a matter of bankruptcy law, ET Power’s debt to Liberty is not reduced by the amount which Liberty received from GTN.”

This was consistent with New York law, the court said, noting that under federal bankruptcy rules, state law governs the substance of claims. Reading New York law, the court concluded that GTN was a “surety” for ET Power’s obligations to Liberty, and therefore the value of ET Power’s debt to Liberty was not reduced by the $140 million received from GTN.

However, the court added, the “fundamental question” on appeal was whether the Bankruptcy Code bars Liberty from collecting the $17 million sought in satisfaction of its debt. Section 502(b)(2) of the Bankruptcy Code prohibits claims for post-petition interest. The purposes of the provision are to ensure fairness among creditors, and avoid administrative inconvenience, the court noted.

ET Power’s debt to Liberty on the petition date was $140 million, and Liberty had collected that full amount, the court determined.

“Liberty could not collect in bankruptcy any additional amounts added due to the accrual of interest,” the court stated. “This result is not altered simply because Liberty holds a guarantee from a non-debtor third party. Accordingly, the arbitration panel’s award of interest on the $140 million in damages, while perhaps appropriate under the Agreement and as a matter of non-bankruptcy law, is not collectable from the debtors in bankruptcy by virtue of § 502(b)(2).”

The court supported its conclusion by citing the need to be fair to creditors. “A contrary result would permit Liberty, or any other creditor, to classify a payment on a debt from a non-debtor guarantor as non-principal, thus preserving the full value of the principal for collection in bankruptcy.”

Dissent

In a dissent, Circuit Judge Duncan noted that Section 502(b)(2) “has no impact on the accrual of unmatured interest against non-debtors, including non-debtor guarantors.”

Further, Section 524(e) of the Code provides that “the discharge of any debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt,” he stated.

“I fail to see the unfairness in the fact that Liberty bargained, outside of bankruptcy, for a guarantee of payment. That other creditors may not have secured such a guarantee, and therefore might ultimately recover proportionately less than Liberty, strikes me as no injustice,” he concluded.

Under the court’s holding, creditors may find it difficult to obtain interest against jointly liable debtors even if only one debtor is under bankruptcy protection. Both the holding and the dissent should be considered in instances involving a bankrupt and a nonbankrupt obligor, and a significant amount of post-petition interest has been incurred.