Another Bankruptcy Court Rules The "Solvent Debtor Exception" Survived Enactment Of The Bankruptcy Code

Published date15 November 2021
Subject MatterLitigation, Mediation & Arbitration, Insolvency/Bankruptcy/Re-structuring, Insolvency/Bankruptcy, Trials & Appeals & Compensation
Law FirmJones Day
AuthorMr Paul Green and Mark Douglas

Whether the pre-Bankruptcy Code "solvent debtor exception" requiring the payment of postpetition interest to dissenting unsecured creditors under a chapter 11 plan survived the enactment of the Bankruptcy Code in 1978 has been the subject of a handful of recent court rulings. This is, perhaps, most notably true of the chapter 11 case of Ultra Petroleum Corp. in connection with a protracted battle over the debtor's obligation to pay make-whole premiums to unsecured noteholders.

The U.S. Bankruptcy Court for the District of Massachusetts weighed in on this issue in In re Mullins, 2021 WL 2948685 (Bankr. D. Mass. July 13, 2021). After delivering a treatise on the history and application of the exception, the court held that certain provisions of the Bankruptcy Code'namely, the "absolute priority rule" and the "best interests test"'"incorporate and implement the 'solvent debtor exception' established over the course of hundreds of years of insolvency jurisprudence." The court also held that the appropriate rate of postpetition "pendency" interest is the federal judgment rate.

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 vote to accept or 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: (i) "leaves unaltered the legal, equitable, and contractual rights" to which each creditor in the class is entitled; or (ii) cures any defaults (with limited exceptions), reinstates the maturity and other terms of the obligation, and compensates each creditor in the class for resulting losses.

Section 1124 originally included a third option, then section 1124(3), 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, in light of this third option, 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 (3d Cir. 2003).

The Bankruptcy Code's Priority Scheme

The Bankruptcy Code sets forth certain priority rules governing distributions to creditors in both chapter 7 and chapter 11 cases. Secured claims enjoy the highest priority under the Bankruptcy Code. See generally 11 U.S.C. ' 506. The Bankruptcy Code then recognizes certain priority unsecured claims, including claims for administrative expenses, wages, and certain taxes. See id. ' 507(a). General unsecured claims come next in the priority scheme, followed by any subordinated claims and the interests of equity holders.

In a chapter 7 case, the order of priority for the distribution of unencumbered assets is determined by section 726 of the Bankruptcy Code. The order of distribution ranges from payments on claims in the order of priority specified in section 507(a), which have the highest priority, to payment of any residual assets after satisfaction of all claims to the debtor, which has the lowest priority. Distributions are to be made pro rata to parties of equal priority within each of the six categories specified in section 726. If claimants in a higher category of distribution do not receive full payment of their claims, no distributions can be made to parties in lower categories.

In a chapter 11 case, the chapter 11 plan determines the treatment of secured and unsecured claims (as well as equity interests), subject to the requirements of the Bankruptcy Code. If a creditor does not agree to impairment of its claim under the plan'such as by agreeing to receive less than payment in full'and votes to reject the plan, the plan can be confirmed only under certain specified conditions. Among these conditions are the following: (i) the creditor must receive at least as much under the plan as it would receive in a chapter 7 liquidation (11 U.S.C. ' 1129(a)(7)) (commonly referred to as the "best interests" test); and (ii) the plan must be "fair and equitable" (Id. ' 1129(b)(1)).

Section 1129(b)(2)(B) of the Bankruptcy Code provides that a plan is "fair and equitable" with respect to a dissenting impaired class of unsecured claims if the creditors in the class receive or retain property of a value equal to the allowed amount of their claims or, failing that, if no creditor or equity holder of lesser priority receives any distribution under the plan. This is known as the "absolute priority rule."

Disallowance of Claims for Unmatured Interest and the Solvent Debtor Exception

Section 502(b)(2) of the Bankruptcy Code provides that a claim for interest that is "unmatured" as of the petition date shall be disallowed. See generally Collier on Bankruptcy ' 502.03 (16th ed. 2021) ("fixing the cutoff point for the accrual of interest as of the date of the filing of the petition is a rule of convenience providing for equity in distribution"). Charges that have been deemed to fall into this category include not only ordinary interest on a debt but also items that have been deemed the equivalent of interest, such as original issue discount and make-whole premiums (although the latter is the subject of vigorous dispute). Id. This means that, unless there is an exception stated elsewhere in the Bankruptcy Code (see below), any claim for postpetition interest will be disallowed.

The bar on recovery by creditors of interest accruing after a bankruptcy filing predates the enactment of the Bankruptcy Code and is derived from English law. Nicholas v. U.S., 384 U.S. 678, 682 (1966) (explaining that "[i]t is a well-settled principle of American bankruptcy law that in cases of ordinary bankruptcy, the accumulation of interest on claims against a bankruptcy estate is suspended as of the date the petition...

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