Introductory Note
On May 2, 2023, we issued a note entitled聽听(the 鈥淧rimer鈥�) that discussed what make-wholes are and how certain courts have interpreted them. In broad strokes, the Primer discussed recent developments related to whether make-wholes will be disallowed in bankruptcy as 鈥渦nmatured interest鈥� under聽; how disallowed make-wholes should be treated in those rare cases where a debtor is solvent; and whether debtors can avoid paying make-wholes if the debt is reinstated through a plan of reorganization pursuant to聽. We invite our readers to review the Primer for more background on make wholes.
As it relevant here, the Primer also highlighted a pending noteholder appeal before the U.S. Court of Appeals for Third Circuit (the 鈥淭hird Circuit鈥�) arising out of the chapter 11 cases of Hertz Corporation (鈥淗ertz鈥�). This note explores the noteholder appeal in detail. It starts by recapping the background of the litigation; it discusses the arguments presented appeal, including oral arguments that occurred on October 25, 2023; and it concludes with a few of our thoughts and takeaways.
Background on Noteholder/Hertz Litigation
At the height of the Covid pandemic, Hertz filed for chapter 11 in the U.S. Bankruptcy Court for the District of Delaware (the 鈥淏ankruptcy Court鈥�) in May 2020. Hertz had several series of notes outstanding with a principal amount of approximately $2.8 bn (the 鈥淣otes,鈥� and the holders of the Notes, the 鈥淣oteholders鈥�). The interest rates on the Notes ranged from 5.5% to 7.125%, and Wells Fargo Bank N.A. (鈥淲F鈥�) and U.S. Bank, N.A. (鈥淯SB,鈥� and with WF, the 鈥淭rustees鈥�) served as indenture trustees on different series of the Notes. Some of the Notes also benefited from an 鈥淎pplicable Premium鈥� (referred to as a 鈥渕ake whole鈥� throughout this note) if the Notes were redeemed prior to their stated maturities.
Hertz鈥檚 luck changed considerably over the ensuing year鈥攙accines became common, and travel started to resume. Hertz then underwent a successful auction and sales process in May 2021 that allowed Hertz to propose a plan of reorganization that would pay all creditors in full and return value to equity. The Bankruptcy Court confirmed Hertz鈥檚 chapter 11 plan in June 2021, and the plan went effective shortly thereafter.
As is critical to this dispute,聽the plan classified the Noteholders as unimpaired, which meant two critical things: Noteholders were聽not聽entitled to vote on the plan of reorganization, and they were聽not聽entitled to the substantive protections of the Bankruptcy Code related to 鈥渃ramdown鈥� when impaired creditors vote against a plan of reorganization.聽As for their treatment under the plan, the plan provided that Noteholders would receive (i) payment in full on the effective date of the plan, which included pre-bankruptcy interest at the contract rate in the Notes聽plus听(ii) post-petition interest聽at the federal judgment rate听(i.e., the average 1-year constant maturity Treasury yield, which was 0.15% at the time). Critically, the plan reserved the Noteholders鈥� right to seek declaratory relief after plan confirmation to obtain payment of any post-petition interest or make-whole premium, as applicable, they would be entitled to receive in order to be 鈥渦nimpaired鈥� under the Bankruptcy Code. This reservation of rights ensured that any litigation over the Noteholders鈥� post-petition entitlements would not jeopardize Hertz鈥檚 plan of reorganization process.
Shortly after the plan was confirmed, the Trustees commenced litigation seeking a $147 mn make-whole payment聽plus聽$125 mn in contractual interest (roughly $270 mn in total). In two separate decisions issued on聽, and聽, the Bankruptcy Court considered two primary issues and reached the following two conclusions:
- First, the Bankruptcy Court considered whether the make whole on the Notes, which was triggered by the repayment of the Notes under Hertz鈥檚 plan, was the economic equivalent of 鈥渦nmatured interest鈥� that must be disallowed under聽. The Bankruptcy Court answered the question in the affirmative, holding that the make-whole was the equivalent of 鈥渦nmatured interest鈥� because the make-whole formula was based on accrued and unpaid interest and the present value of those interest payments. The Bankruptcy Court flatly rejected the argument that the premium was designed to compensate lenders for their reinvestment costs.
- Second, the Bankruptcy Court considered whether the Noteholders were nonetheless entitled to post-petition interest under the so-called 鈥渟olvent-debtor exception,鈥� which is an exception to the prohibition on the payment of post-petition/unmatured interest. In broad strokes, this doctrine rests on the theory that it would be inequitable to permit the return of any funds to the debtor or equity without paying creditors the full benefit of their contractual bargain (such asa make-whole) or some other form of post-petition interest. On this issue, the Bankruptcy Court held that the 鈥渟olvent-debtor exception鈥� does exist under the Bankruptcy Code, but the court said it was limited to the payment of interest at the federal judgment rate (and not the contract rate between Hertz and the Noteholders). The Noteholders were therefore only entitled to interest at the federal judgment rate, which was considerably lower than the contract rate. On this point, the Bankruptcy Court recognized that its reasoning conflicted with recent decisions issued the Fifth Circuit in聽Ultra Petroleum聽and the Ninth Circuit in聽PG&E. (Our聽聽discusses these decisions as well.)
In November 2022, the Bankruptcy Court certified an appeal of its decision directly to the Third Circuit (bypassing the Delaware District Court).
Arguments on Appeal
On appeal, the Trustees make a number of detailed and nuanced arguments articulating why the Noteholders are entitled to $270+ mn in post-petition interest/compensation. We distill the key arguments as follows:
- First, the Trustees argue that the Bankruptcy Code鈥檚 provision that allows a debtor to classify creditors as unimpaired (thereby denying creditors the right to vote on a plan of reorganization) has been violated in this case. Specifically,聽听(with emphasis added) provides that 鈥渁 class of claims or interests is impaired under a plan unless, with respect to each claim or interest of such class, the plan鈥� (1) leaves聽unaltered the legal, equitable, and contractual rights聽to which such claim or interest entitles the holder of such claim or interest.鈥� The Trustees argue that 搂 1124(1) requires that Hertz pay the Noteholders post-petition interest at the contract rate and/or a make-whole, as applicable, because it would otherwise alter their聽legal, equitable and contractual听谤颈驳丑迟蝉.
- Second, and relatedly, the Trustees argue that denying the Noteholders post-petition interest at the contract rate denies them of their聽equitable聽rights under 搂 1124(1) when a debtor鈥攍ike Hertz鈥攊s wildly solvent and otherwise has the wherewithal to honor its contractual commitments. The Trustees cite to recent decision in Fifth and Ninth Circuits, which have recognized the so-called 鈥渟olvent debtor exception.鈥� The Trustees argue that 搂 1124(1) incorporates the meaning of the solvent debtor exception by preserving the Noteholders鈥� equitable rights.
- Third, the Trustees argue that the Noteholders鈥� entitlement to post-petition interest at the contract rate is based in equity, and any limitation on that entitlement鈥攍ike an entitlement that is limited to the federal judgment rate, like the Bankruptcy Court did in this case鈥攎isreads the Bankruptcy Code. The Trustee argue that the provisions of the Bankruptcy Code that limit payments to the federal judgment rate only apply to聽impaired听(not聽unimpaired) creditors.
- Fourth, the Trustees argue that make-whole in this case is not unmatured interest or its economic equivalent because it compensates investors who are otherwise forced to reinvest at potentially less advantageous market conditions. The Trustees argue that a make-whole is just compensation for the premature termination of a payment obligation. Just because future interest is an input variable in the calculation of a make whole premium, the Trustees argue, does not transform the obligation into one for unmatured interest. Indeed, the Trustees argue that a protection against prepayment in the form of a make-whole is, by itself, a valuable right in any lending arrangement. It follows that disallowing a make-whole unfairly puts two lenders that have different bargained-for credit protections in the same position post-bankruptcy.
Hertz, on the other hand, argues that the Third Circuit should affirm the Bankruptcy Court in all respects. Hertz makes number of detailed arguments, which we distill as follows:
- First, Hertz argues that any impairment to the Noteholders is not being done聽by the plan of reorganization聽itself, which is what聽聽otherwise proscribes (i.e., 鈥�the plan鈥� (1) leaves unaltered鈥︹��). Rather, Hertz argues that the Noteholders鈥� claim for post-petition interest and/or a make whole has been altered聽by the Bankruptcy Code itself, which disallows unmatured interest under聽. In other words, unimpaired creditors like the Noteholders are entitled to the full amount of their lawful claim鈥攚hich they received under the Hertz plan鈥攂ut their lawful claim had already been altered by the provision of the Bankruptcy Code that disallows unmatured interest. Because the plan pays the Noteholders everything their claim entitles them to as a matter of law, there is no impairment under聽. Stated even more succinctly, it is the Bankruptcy Code and not the plan of reorganization that is doing the impairing, which applies equally regardless of whether a debtor is solvent or insolvent.
- Second, Hertz acknowledges that the solvent-debtor exception may have existed before the Bankruptcy Code was enacted in 1978, but Hertz argues that the Third Circuit should disregard it now because the exception was not incorporated into the Bankruptcy Code. To the extent the exception exists, Hertz argues that any claim for post-petition interest should be based on the text of the Bankruptcy Code, which provides for post-petition interest in solvent debtor cases at the 鈥渓egal rate鈥� of interest (or federal judgment rate).
- Third, Hertz argues that the Bankruptcy Court correctly held that the component parts of the make whole at issue clearly show that it was the functional equivalent of unmatured interest.
Oral Arguments
The Third Circuit held oral argument on October 25, 2023. The panel was comprised of Circuit Judges Krause, Porter, and Ambro, and each judge showcased a strong grasp of the issues presented. The initial focus of the argument was on the intricacies of the make whole in this case, and the judges demonstrated an awareness of the potential nuanced distinctions between permissible make wholes and unmatured interest that must otherwise be disallowed. The panel then peppered lawyers for each side with thoughtful questions, and one panel member even stated that this this case raises very tough questions. The panel gave no indication on how or when it will render its decision.
Thoughts and Takeaways
This appeal raises tricky and nuanced issues in the area of bankruptcy law that have divided trial and appellate judges all over the country. We have no doubt that Judges Krause, Porter, and Ambro will similarly wrestle with these issues over the months ahead. We do offer a few thoughts and impressions.
The first is on the issue of whether make wholes are unmatured interested. As we explored in our make-whole聽聽earlier this year, we note that most lower courts have historically concluded that make-wholes are akin to permissible liquidated damages or debts that are fully payable upon a bankruptcy filing and are not 鈥渦nmatured interest鈥� that must be disallowed under the Bankruptcy Code. We noted that this former majority rule appears to be trending in the other direction with cases like the Fifth Circuit鈥檚 decision in聽Ultra Petroleum聽and the Bankruptcy Court鈥檚 decision in this case.
Our gut feeling is that the trend will probably continue with courts finding that make wholes are unmatured interest. That being said, we were pleasantly surprised that the Third Circuit at oral argument demonstrated an acute appreciation for both the purpose of make wholes and that, depending on the facts and circumstances, make wholes may not invariably lead to disallowance as unmatured interest. Even so, the Third Circuit could affirm the Bankruptcy Court on this point and say that the question of whether the make whole was the economic equivalent of unmatured interest was a factual question, and that the Bankruptcy Court鈥檚 factual determinations should only be reversed for an abuse of discretion or for clear error. This would allow the Third Circuit to dodge the issue entirely, and it would not surprise us if the court did so here.
Beyond the make wholes, it is anyone鈥檚 guess how the Third Circuit will rule on the question of what post-petition interest rate applies to the Noteholders鈥� claim under the so-called solvent debtor exception. The issue has been considered by two federal appellate courts in the last couple of years鈥攖he first was by the Fifth Circuit in聽Ultra Petroleum, and the second was by the Ninth Circuit in聽PG&E. Each court found that the solvent debtor exception is alive and well, and that creditors of solvent debtors are entitled to the contract rate of interest in the post-petition period. Moreover, the U.S. Supreme Court recently denied聽certiorari聽review earlier this fall on both of those decisions. But the聽Ultra Petroleum听补苍诲听PG&E聽decisions were both decided by 2-1 votes over vigorous dissents, which demonstrates that there is no clear consensus among federal judges on this issue. Our sense is that the Third Circuit panel might be sympathetic to at least the economic position of the Noteholders in this case, but the panel gave no indication of which way it was leaning.
We will continue to follow this appeal and issue subsequent report(s) as appropriate, but as we noted in our Primer, the end result of this case could potentially be of diminished significance because solvent debtors are the rare exception in bankruptcy.
Mark Lightner, Esq.
Head of Special Situations Legal Research
