Bankruptcy provides an opportunity for a fresh financial start. In that spirit, creditors’ contractual rights are often impaired. But what happens in those rare circumstances when a debtor is deemed solvent? According to a recent decision from the United States Fifth Circuit Court of Appeals in In re: Ultra Petroleum Corp., solvent debtors are fully bound by all financial obligations and nothing less. In those rare cases where a debtor is (or becomes) solvent, this decision creates a big win for creditors.
Ultra Petroleum Corp., an oil and gas exploration and production company, filed a Chapter 11 bankruptcy case in 2016. During the pendency of that case, the price of natural gas soared. By the time Ultra proposed its reorganization plan, it was solvent. Ultra proposed a reorganization plan that provided for payment in full of its unsecured claims but took the position that the Bankruptcy Code excused payment of both contractual make-whole premiums and post-petition interest at the contractual default interest rate. The affected creditors objected.
After years of litigation including two trips to the appellate court, the Fifth Circuit became the first circuit court to hold that the make-whole premiums or yield maintenance—a type of prepayment penalty to compensate lenders for loss of interest—should be disallowed under section 502(b)(2) of the Bankruptcy Code, which disallows claims for “unmatured” interest. Other bankruptcy courts in the Second, Third, Sixth, and Seventh Circuits had previously allowed such claims, either as a contractual obligation or otherwise as liquidated damages.
Here, the Court was unpersuaded by the creditor’s arguments that the make-whole premiums are akin to liquidated damages and held that instead “[a] make-whole amount is nothing more than a lender’s unmatured interest, rendered in today’s dollars.” The Court noted that make-whole premiums, by their very nature, “are expressly designed to liquidate fixed-rate lenders’ damages flowing from debtor default while market interest rates are lower than their contractual rates Lenders’ damages equal the present value of all their future interest payments.” As such, those payments must be disallowed if the acceleration is triggered by the bankruptcy filing.
For most debtors in bankruptcy, this holding is a win and a welcome ruling as it supports the elimination of often-significant financial obligations. But for creditors, the decision should be a factor in pricing loans and setting fees designed to achieve a certain yield on a loan.
For Ultra, however, there was no such win. After ruling that make-whole premiums are not enforceable under section 502(b)(2) of the Bankruptcy Code, the Fifth Circuit addressed whether there was an exception in this case as Ultra was in fact a “solvent” debtor. The court held that if a debtor is solvent, unsecured creditors are nonetheless entitled to payment of contractual remedies including make-whole premiums and post-petition interest at the full contractual or state judgment rate. In so ruling, the Fifth Circuit became aligned with the Ninth Circuit’s recent decision focusing on a solvent debtor exception in Ad Hoc Comm. of Holders of Trade Claims v. PG&E (In re PG&E Corp.), 46 F.4th 1047 (9th Cir. 2022).
So while the decision is a clear win for creditors in the rare circumstance of the solvent debtor (here to the tune of an additional $387M), it confirms concerns regarding the enforceability of the make-whole premiums and yield maintenance provisions in the context of bankruptcy—issues that creditors may need to include in their calculations when entering into loan agreements.