Third Circuit court orders solvent debtors to pay contract rate interest, make-whole fees to unsecured creditors

Introduction

On September 10, 2024, the US Court of Appeals for the Third Circuit decided in In re Hertz that although make-whole fees are unmatured interest typically disallowed by section 502(b) of the Bankruptcy Code, a solvent debtor must pay its unsecured creditors interest calculated at the contract rate, not the federal judgment rate, including the make-whole fees.

The Hertz decision is one of first impression for the Third Circuit and aligns with similar rulings in In re Ultra Petroleum Corp. from the Fifth Circuit and In re PG&E Corp. from the Ninth Circuit, which were decided in 2022. Both circuits dealt with surplus cases involving solvent debtors who sought to avoid paying unimpaired and unsecured creditors post-petition interest at their contract rate, instead opting for the federal judgment rate. Both courts found (i) make-whole fees to constitute unmatured interest disallowed under section 502(b) in insolvent debtor cases but allowed in solvent debtor cases and (ii) the appropriate interest rate in the solvent debtor cases to be the negotiated contract rate (including default rate). In arriving at this conclusion, both courts relied on the pre-Bankruptcy Code so-called “solvent debtor exception” – an exception derived from the pre-Bankruptcy Code practice of requiring solvent debtors to pay contract interest rate and the application of the absolute priority rule (ie, debt gets paid in full before equity unless creditors agree otherwise). While the Fifth Circuit found that the lower federal judgment rate was a floor and ordered the contract rate to be applied in the solvent debtor case, the Ninth Circuit went further and held that applying the lower, federal judgment rate violated the Bankruptcy Code’s impairment protections.

Background

On May 22, 2020 (the Petition Date), The Hertz Corporation and its affiliated debtors (collectively, the Debtors) filed chapter 11 petitions in the Bankruptcy Court for the District of Delaware, largely as a result of the crippling effects of the COVID-19 pandemic on travel and rental car demand. At that time, the Debtors warned their stockholders that (a) they were unlikely to receive any recovery in the bankruptcy cases and (b) consequently common stock would likely be deemed worthless. The Debtors did not originally contemplate that all general unsecured creditors would ultimately be paid in full, and the Debtors certainly did not contemplate equity holders getting any recovery. During their bankruptcy cases, however, the doom and gloom predictions turned out to be false as the Debtors became solvent due to rapid recovery of the rental car market. As a result, the Debtors proposed a plan of reorganization that paid all of their creditors in full, rendering all unsecured claims “unimpaired.” Even stockholders received stock and other consideration, aggregating approximately $1.1 billion. The bankruptcy cases were a resounding success for the Debtors and their stakeholders.

Holders of unsecured bonds maturing biennially from 2022 to 2028 (the Bondholders) asserted claims for principal of approximately $2.7 billion plus interest of an additional $128 million calculated at the rate set forth in the applicable indentures. Pursuant to the plan of reorganization, however, the Debtors proposed to pay the Bondholders their full principal amount plus post-petition interest of only $3 million, calculated at the federal judgment rate. The difference between the contract rate and the federal judgment rate approximated $125 million.

Additionally, the applicable indentures required the Debtors to pay the Bondholders (i) a fixed redemption fee for the bonds maturing 2024 if the Debtors redeemed those bonds after October 15, 2019, but prior to maturity (the Redemption Window) and (ii) make-whole fees for bonds maturing 2026 and 2028. The Bondholders asserted that they were entitled to a fixed redemption fee because they were redeemed pursuant to the plan within the Redemption Window. The Debtors argued that the Petition Date triggered the maturity date under the indenture documents and the redemption followed a year after, and therefore no redemption fee was owed.

The Bondholders also argued that the Debtors owed them make-whole fees, designed as compensation for lost profits due to early bond redemption and reinvestment costs. The make-whole fees were valued at $142 million. The Debtors objected to payment of the make whole fees, arguing that they were unmatured interest expressly disallowed under section 502(b)(2).

The Bankruptcy Court rejects the fixed redemption fee claims, awards interest at the federal judgment rate, and defers ruling on the allowability of the make-whole payments

The Bankruptcy Court confirmed the Debtors’ plan of reorganization on June 10, 2021, and the plan went effective on June 30, 2021. Despite the overall success of a full-pay plan for their stakeholders, the Debtors were forced to litigate post-effective-date with the Bondholders with respect to the open issues of (a) the appropriate interest rate and (b) the allowability of the make-whole and fixed redemption fees. In July 2021, the Bondholders commenced an adversary proceeding, seeking payment of post-petition interest at the contract rate and the fees described above.

The Bankruptcy Court granted the Debtors’ motion to dismiss the Bondholders’ claims for 2024 fixed redemption fees on purely contractual grounds, reasoning that by their terms the 2024 bonds matured on the Petition Date when the Debtors filed the bankruptcy cases. Therefore, the Debtors redeemed the 2024 bonds after maturity and outside the Redemption Window. The Bondholders argued that the only maturity date relevant for the redemption fee was the “Stated Maturity” date of October 15, 2024. The Bankruptcy Court disagreed, noting that the indenture documents contemplated several maturity dates, including those by acceleration.

As to the make-whole fees, after hearing cross-motions for summary judgment, the Bankruptcy Court sided with the Debtors and disallowed the make-whole fee as unmatured interest because they were the economic equivalent of interest. The Bankruptcy Court rejected the Bondholders’ position that such payments do not fit the dictionary definition of unmatured interest and, therefore, should be paid by the Debtors to render the Bondholders unimpaired.

Finally, the Bankruptcy Court awarded the Bondholders interest at the federal judgment rate, holding that the Bankruptcy Code expressly limited interest at the federal contract rate even in solvent debtor cases. In so holding, Judge Mary F. Walrath relied on sections 1129(a)(7)(A)(ii) and 726(a)(5) to find that the distributions to impaired creditors under a plan must be no less than the amount that such creditors would receive in a chapter 7 liquidation, under which interest is calculated at the federal judgment rate. On that ground, the Bankruptcy Court rejected the solvent debtor exception. The Bankruptcy Court also found the Ultra decision, upon which the Bondholders heavily relied, unpersuasive and distinguishable because the Ultra court based its reasoning on precedent involving secured creditors.

The Bondholders moved for reconsideration on the issue of post-petition interest based on subsequent opinions from the Fifth and Ninth Circuit Courts of Appeals in Ultra and PG&E. The Bankruptcy Court did not change its decision in light of this opinion and, instead, sua sponte certified the decision for a direct appeal to the Third Circuit.

The Third Circuit agrees with the Bankruptcy Court that the fixed redemption fee was not payable

The Third Circuit spent little time on the fixed redemption fee issue, agreeing with the Bankruptcy Court’s interpretation of the indentures. Importantly, the Third Circuit refused to consider anything but the four corners of the documents, emphasizing that “if the commercially sophisticated parties thought that such outcome was unfair, they should not have agreed to the terms that compel such outcome.”

The Third Circuit agrees that the make-whole fees were unmatured interest

With respect to the make-whole fees, the Third Circuit agreed with the Bankruptcy Court that under both economic equivalency and definitional approaches the make-whole fees were, in fact, unmatured interest. The Third Circuit came to this conclusion after studying each of the three components of the make-whole fee: (i) interest coupons owed through the redemption date, (ii) the redemption fee, and (iii) a present value discount. In the Third Circuit’s view, the first two components were unequivocally the unmatured interest as they were “‘compensation’ for [Debtors’] use of [Bondholders’] funds” and the present value discount was not transformative enough to make them something else.

The Third Circuit agreed with the Bankruptcy Court’s analysis of the economic equivalent approach, but also used the definitional approach to find that the make-whole fees were definitionally interest because they were a condition negotiated in exchange for the Debtors ability to borrow the Bondholders’ funds. Therefore, make-whole payments were deemed unmatured interest prohibited by section 502(b)(2).

The Third Circuit reverses the Bankruptcy Court on the applicable interest rate and the entitlement to make-whole fees

Although the Debtors prevailed with respect to categorizing the make-whole fees as unmatured interest, and, notwithstanding the applicability of section 502(b)(2), the Third Circuit awarded the Bondholders the make-whole fees (as interest) under the solvent debtor exception. The Third Circuit posited that the solvent debtor exception should be enforced because the Bankruptcy Code did not clearly reject that “tradition.” To the contrary, the Third Circuit grounded its decision on a broad reading of the Supreme Court’s seminal decision in Czyzewski v. Jevic Holding Corp. – applying the absolute priority rule to all creditors and all provisions of the Bankruptcy Code unless there is a clear statement to the contrary.

Because the Hertz-proposed plan provided for payment that would render the Bondholder claims unimpaired, the Third Circuit explored the statutory construct of “impairment.” Importantly, the Third Circuit ruled that “[a] creditor is impaired if its treatment violates the absolute priority rule” and, therefore, ultimately found it inequitable for stockholders to receive billions of dollars, while the Bondholders lost approximately a quarter million dollars of payments they were contractually owed. Because unsecured creditors are higher up in the priority waterfall, paying out stockholders before the Bondholders received their make-whole fees would in fact make the Bondholders impaired under the plan.

This statutory reading, in conjunction with equity holders receiving distributions, meant that the plan violated the absolute priority rule and should not have been confirmed, as the Bondholders were deemed unimpaired and were not given a right to vote. According to the Third Circuit, the Debtors’ failure to pay contract interest rendered the Bondholders impaired and entitled to vote on the Plan. Therefore, the Third Circuit required that the Bondholders must receive interest at the contract rate to (a) render them unimpaired under the plan and (b) enable the distribution to equity holders to remain undisturbed. The Third Circuit helpfully distinguished the now-repealed section 1124(3) that defined unimpairment (ie, a creditor is unimpaired if such creditor received cash equal to the allowed amount of its claim) and noted that after that section was used to deny postpetition interest to an unimpaired creditor in a solvent debtor case, Congress repealed it.

The Third Circuit noted, however, that there are scenarios where an unsecured creditor may be entitled to post-petition interest, but not at the contract rate, if giving one set of creditors interest at the contract rate means other creditors will not get the same interest treatment. At that point, the bankruptcy court would need to apply an “equitable rate of post-petition.” However, the Third Circuit did not remand this case to the Bankruptcy Court because (i) the Debtors never requested remand, and (ii) the equitable rate should be determined prior to confirmation and prior to funds being distributed, which could not be done in the instant case.

Key takeaways of Hertz

Solvent debtors cannot use the Bankruptcy Code to avoid paying their creditors what they bargained for, including the contract interest rate. This rationale is grounded in the absolute priority rule, which requires that creditors higher in the distribution waterfall receive their full payment prior to any distribution to more junior classes of claims and interests.

Lastly, the Third Circuit joined the Fifth and Ninth Circuits to follow the solvent debtor exception. The fact that these leading Circuit Courts opted to follow the solvent debtor exception foreshadows future similar opinions from other courts.

If you have any questions about this ruling or any restructuring-related matter, please reach out to the authors, Robert Klyman, Oksana Koltko Rosaluk, and Robert Moskalewicz, or your usual DLA Piper contact.