The Bankruptcy Court for the District of Delaware recently expressed its view regarding the reach of the “solvent debtor exception” in In re The Hertz Corp., et al.  The solvent debtor exception is an equitable doctrine which supports the proposition that creditors are entitled to the full suite of their contractual rights if the debtor in bankruptcy is solvent. Notably, the doctrine has been advanced to support the argument that solvent debtors are required to pay post-petition interest owed to unsecured creditors at the contract rate of interest, including in some instances, the default rate.

The issue came before the Court in the context of an adversary complaint brought by two indenture trustees seeking, among other things, payment of post-petition interest at the contractual rate set forth in the underlying indentures. Under the debtors’ confirmed plan of reorganization, unsecured creditors were categorized as unimpaired and to be paid in full, in cash on the effective date, including post-petition interest at the federal judgment rate or an amount necessary to render them unimpaired. As unimpaired creditors, the noteholders were deemed to accept the plan and did not have an opportunity to vote. Equity holders were categorized as impaired and voted to accept the plan. Upon the effective date, the noteholders were paid outstanding principal plus interest through the petition date, plus post-petition interest through the effective date at the federal judgment rate. The indenture trustees commenced the adversary proceeding to recover the spread between the federal judgment rate and the contract rate (plus, in the case of one indenture trustee, certain make-whole payments which is not discussed here).  The debtors brought a motion to dismiss all causes of action.

Sections 726(a)(5) and 1129(a)(7) of the Bankruptcy Code provide for the payment of post-petition interest in respect of unsecured claims that are held by creditors that are impaired, rather than unimpaired, when the debtor is solvent. In particular, section 1129(a)(7) provides that: “[w]ith respect to each impaired class of claims or interests— (A) each holder of a claim or interest of such class (i) has accepted the plan; or (ii) will 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….” 11 U.S.C. § 1129(a)(7). Section 726(a)(5) of the Bankruptcy Code requires that, when due, interest is to be paid at the “legal rate.”  11 U.S.C. § 726(a)(5). The Court observed that “the Code is silent on what treatment unimpaired creditors must receive in a solvent Chapter 11 debtor case.”  Wells Fargo Bank, N.A., as Indenture Trustee et al. v. The Hertz Corp. et al., Adv. No. 21-50995, Doc. 28 at 30 (Dec. 22, 2021).  The indenture trustees argued that, as unimpaired creditors, they are entitled to the contract rate under section 1124(1).  That section provides that a class of claims is impaired under a plan unless it “leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest…..” 11 U.S.C. § 1124(1).  According to the debtors, the noteholders’ claims were limited by the Bankruptcy Code, not the plan, and therefor properly paid at the federal judgment rate and treated as unimpaired.

The plaintiffs advanced a number of arguments in support of their position.  They suggested that Congress, by repealing the former section 1124(3) of the Bankruptcy Code, expressed its intent that unimpaired creditors are entitled to post-petition interest at the contractual rate. Section 1124(3) had provided that a creditor is unimpaired if it “receive[s] . . . cash equal to the allowed amount of such claim….” 11 U.S.C. § 1124(3) (1988). That section had been interpreted by courts to provide that unimpaired creditors were not entitled to post-petition interest when read in conjunction with sections 726(a)(5) and 1129(a)(7), a reading that made little sense. After a detailed review of the legislative history, the Court failed to find any support for the plaintiffs’ proposition that Congress intended that unimpaired unsecured creditors be entitled to post-petition interest at the contractual rate.  See Wells Fargo v. Hertz at 31-35.

The indenture trustees also argued that case law should guide the Court’s decision.  A number of Supreme Court cases that were cited by the plaintiffs addressed post-petition interest in the context of a secured creditor and were therefore inapplicable according to the Court. Other Circuit Court cases were found to rely on the aforementioned Supreme Courts cases or on section 1129(b)(2) – the fair and equitable test — which is only applicable to impaired creditors, or otherwise expressly acknowledged that any right was subject to section 502(b). See Id. at 37-38. The Court also criticized the recent decision of the Bankruptcy Court, on remand, in Ultra Petroleum.  See In re Ultra Petroleum Corp., 624 B.R. 178 (Bankr. S.D. Tex. 2020).  In that case, the Court explained, the solvent debtor exception was relied on to allow unimpaired creditors post-petition interest at the contractual default rates, arguing that those creditors were entitled to have their equitable rights fully enforced under section 1124(1). See Id. at 39 (citing Ultra Petroleum at 203-04). However, “[a] bankruptcy court cannot use equitable principles to modify express language of the Code” according to the Court. Id. It follows that the fact that a creditor is treated as unimpaired by a plan cannot override the restrictions imposed by Section 502(b)(2). See Id. The Court further addressed the holding in In re Energy Future Holdings Corp., 540 B.R. 109 (Bankr. D. Del. 2015), which it found to be “problematic.” Id. at 40. In that case the court found that it “has the discretion to exercise its equitable power to require, among other things, the payment of post-petition interest, which may be at the contract rate or such other rate as the Court deems appropriate.” Energy Future at 124. The Court explained that Energy Future (i) relied on the fair and equitable test which is not applicable to unimpaired creditors, (ii) provides no guidance as to how unimpaired creditors must be treated and would therefore lead to “endless litigation” and (iii) leaves the determination of what rate of interest, if any, an unimpaired creditor is entitled to the discretion of the court and further “runs counter to recent Supreme Court jurisprudence (and Congressional amendments) that have sought to curb the bankruptcy court’s exercise of equitable discretion.” Id. at 40-41.

After a thoughtful analysis, the Court granted the debtors’ motion to dismiss with regard to the payment of post-petition interest, holding that the noteholders, although unimpaired, should receive the same treatment as would a class of impaired unsecured creditors facing a solvent debtor – post-petition interest at the federal judgment rate. The Court explained that it was “convinced that the solvent debtor exception survived passage of the Bankruptcy Code only to a limited extent. The Bankruptcy Code expressly codified the solvent debtor exception in section 506(b) as to oversecured creditors and in section[s] 1129(a)(7) and 726(a)(5) as to unsecured creditors. While the latter sections currently only apply to impaired creditors, when the Bankruptcy Code was originally enacted they applied to all unsecured creditors, impaired and unimpaired.” Id. at 42. The Court refused to accept that unimpaired creditors are entitled to their contract rate of interest (or perhaps more according to Energy Future) while impaired creditors are limited to the federal judgment rate. Instead, the Court stated that there exists ample evidence that Congress intended that unimpaired creditors of a solvent chapter 11 debtor should receive post-petition interest only in accordance with sections 1129(a)(7) and 726(a)(5).