Scott C. Shelley & Solomon J. Noh, Show Me the Money: Another Look at Postpetition Interest in Solvent Debtor Chapter 11 Cases

• Publication year: 2011

SHOW ME THE MONEY: ANOTHER LOOK AT POSTPETITION INTEREST IN SOLVENT DEBTOR CHAPTER 11 CASES

Scott C. Shelley

Solomon J. Noh^*

INTRODUCTION

A controversy is brewing, both in the courts and among legal commentators, regarding the proper rate of interest payable to holders of general unsecured claims in so-called "solvent debtor" cases-chapter 11 cases in which the debtor emerges as a solvent entity.¹Interest rates for moneys advanced in commercial lending transactions, whether under a bond indenture or a bank credit facility, have been considerably higher in recent years than the federal judgment rate, which courts traditionally have applied to calculate postpetition interest owed on account of unsecured claims.²Depending on the depth of a debtor's claim pool, the amount of money at stake in this controversy can be substantial. For example, in a 24-month bankruptcy case in which the debtor has outstanding $1 billion of unsecured bonds bearing an 8.5 percent interest rate, and where the governing federal judgment rate is two percent, use of the contract rate, as opposed to the federal judgment rate, results in an incremental cost to the debtor of approximately $130 million. It is not surprising, therefore, that holders of contract-based claims would vigorously demand payment of postpetition interest at the higher contract rate.³

As discussed in greater detail below, notwithstanding the substantial amount of contrary case law, the terms of the Bankruptcy Code⁴do not mandate the application of the federal judgment rate in solvent debtor situations, and, in fact, appear to afford bankruptcy courts a substantial amount of discretion in determining how much interest is owed on account of general unsecured claims.

I. BACKGROUND

A. The "Solvent Debtor" Exception

In chapter 11 bankruptcy proceedings, holders of general unsecured claims typically are not entitled to payment of interest that accrues in respect of such claims on and after the date of the debtor's bankruptcy filing. The practice of disallowing postpetition interest is rooted in Sec. 502(b) of the Bankruptcy Code, which provides in relevant part:

(a) A claim or interest, proof of which is filed under section 501 of this title, is deemed allowed, unless a party in interest . . . objects.

(b) Except as provided in subsections (e)(2), (f), (g), (h) and (i) of this section, if such objection to a claim is made, the court, after notice and a hearing, shall determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that . . . (2) such claim is for unmatured interest.⁵

Under what commonly is referred to as the "solvent debtor" exception, however, a debtor that proves to be solvent⁶in the course of a chapter 11 case generally is required to pay postpetition interest, even on its prepetition general unsecured obligations.⁷The premise behind this exception is the deep-rooted principle that it would be "inequitable" to permit shareholders to retain any value before creditors are made whole.⁸That rule, which originally was judge- made, eventually was incorporated by statute into chapter 7 of the Bankruptcy Code (the liquidation chapter), but not expressly into chapter 11 (the reorganization chapter).⁹Section 726(a)(5), which embodies the solvent debtor exception, provides a fifth priority of distribution in a chapter 7 case to "interest at the legal rate from the date of the filing of the petition" on all creditors' claims.¹⁰Section 726(a)(6), in turn, provides a sixth priority of distribution to equity holders.¹¹Although the solvent debtor exception is not expressly incorporated into chapter 11 of the Bankruptcy Code, bankruptcy courts consistently have applied that rule in chapter 11 cases, albeit through varying legal theories, as described below.

Notwithstanding the relative consensus that has developed regarding the validity of the solvent debtor exception, there has been a substantial amount of disagreement in recent years as to what rate should be applied to calculate the amount of interest owed to unsecured creditors. Courts traditionally have applied the federal judgment rate, not only with respect to trade claims and other claims that have no agreed-upon rate of interest,¹²but also with respect to contract-based claims, such as those arising under a credit agreement or a bond indenture.¹³Recently, however, an increasing number of courts-including in high-profile chapter 11 bankruptcy mega-cases such as Loral Space & Communications and Mirant Corp.¹⁴-have applied the contract rate of interest to determine the amount of interest owed in solvent debtor situations.

In order to fully understand the differences between the traditional approach to calculating postpetition interest and this revised approach, it is important first to understand the confirmation requirements contained in

Sec. 1129 of the Bankruptcy Code.

B. Relevant Bankruptcy Principles

Under the Bankruptcy Code, a chapter 11 debtor may formulate a plan of reorganization containing a proposed treatment of creditors' claims.¹⁵A bankruptcy court, in turn, may confirm the proposed chapter 11 plan if it concludes that each of the requirements set forth in Sec. 1129 have been satisfied. One such requirement is the satisfaction of the "best interests of creditors" test in Sec. 1129(a)(7), which provides that:

With respect to each impaired class of claims or interests . . . each holder of a claim or interest of such class [must either] (i) [have] accepted the plan; or (ii) . . . receive or retain under the plan on account of such claim or interest property of a value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under chapter 7 of this title on such date . . . .¹⁶

Under this test, a debtor cannot confirm a chapter 11 plan unless each holder of an impaired¹⁷claim either has accepted the plan or will receive under the plan at least what it would receive under a hypothetical chapter 7 liquidation. As discussed above, Sec. 726, which sets forth the distributional priority scheme applicable in chapter 7 liquidation cases, provides in subsection (a)(5) that a solvent debtor that liquidates under chapter 7 is required to pay postpetition interest to general unsecured creditors at "the legal rate" before making any distributions to junior stakeholders.¹⁸

In addition to the best interests of creditors test, another confirmation requirement in Sec. 1129(a) is that each class of claims or interests must either have voted to accept the proposed chapter 11 plan or have been rendered unimpaired under the plan.¹⁹In the event that one or more classes of claims or interests has voted to reject the plan-but the plan satisfies all of the remaining conditions of Sec. 1129(a)-a bankruptcy court nevertheless may confirm the plan in a "cramdown" under Sec. 1129(b), if it finds, among other things, that the plan is "fair and equitable" with respect to each class of claims or interests that is impaired under, and has not voted to accept, the plan.²⁰The fair and equitable requirement set forth in Sec. 1129(b) primarily is designed to incorporate into the Bankruptcy Code what commonly is referred to as the "absolute priority rule," which embodies the concept that "the stockholder's interest in the property is subordinate to the rights of creditors[;] [f]irst of secured, and then of unsecured, creditors . . . to the extent of their debts creditors are entitled to priority over stockholders against all the property of an insolvent corporation."²¹Thus, the absolute priority rule requires that creditors be paid in full, including postpetition interest, before equity holders may participate in any recovery.²²It is notable that this rule, as articulated in Case v. L.A. Lumber, relates to the priority in payment of all of a senior creditor's "debts" as opposed to merely the amount of the creditor's allowed claim.²³

II. DISCUSSION

A. The Traditional Approach to Calculating Postpetition Interest

Courts that have applied the federal judgment rate uniformly to calculate the amount of postpetition interest owed in solvent debtor cases often begin and end their analysis with the best interests of creditors test contained in

Sec. 1129(a)(7) of the Bankruptcy Code. In doing so, courts have reasoned that under the hypothetical liquidation scenario contemplated under Sec. 1129(a)(7), which incorporates by reference the distribution scheme set forth in

Sec. 726(a)(5),²⁴a solvent debtor would be required to pay postpetition interest to general unsecured creditors at "the legal rate" before making any distributions to junior stakeholders.²⁵

Because the Bankruptcy Code fails to provide a definition for the term "the legal rate," courts were left to determine what the applicable rate should be, and in the process, considered the practical implications of applying a uniform rate as opposed to rates that vary by claim. One of the principal concerns raised by courts was that applying varying interest rates would in many instances disproportionately benefit some creditors at the expense of others:

The problem [with utilizing varying rates] . . . is that different creditors will have different rates of interest, depending upon their contracts or the applicable statutory rate. One contract might provide for interest at 18%, another at 9%. . . .

Quite often . . . there are only enough assets to pay some interest to creditors, not enough to pay all creditors all the interest they claim at their contract or statutory rates. Using those rate [sic], some creditors would receive a disproportionately large percentage of the remaining assets compared to their underlying unsecured claims, to the prejudice not of the debtor, but of other, otherwise equally situated, unsecured creditors.²⁶

In addition, courts reasoned that application of a uniform...