Third Circuit Finds Make-Whole Is Unmatured Interest That Must Be Paid by Solvent Debtor

The US Court of Appeals for the Third Circuit on September 10, 2024 issued its anticipated opinion in In re The Hertz Corp., with a majority holding that make-whole premiums constitute unmatured interest disallowed by the US Bankruptcy Code, but also finding that solvent debtors must pay creditors their full claims as dictated by contract, including make-whole and post-petition interest, before distributions can be made to equity.

The decision brings the Third Circuit in line with decisions involving solvent debtors from the Fifth Circuit in Ultra Petroleum, which similarly ruled with respect to make-whole and unmatured interest, and the Ninth Circuit in Pacific Gas and Electric, which provided for payment of post-petition interest at the contract rate to unsecured creditors.

Case History

In May 2020, The Hertz Corp. filed for bankruptcy protection in the US Bankruptcy Court for the District of Delaware at the height of the COVID-19 pandemic. During its bankruptcy, as the economy recovered, so did Hertz. Hertz emerged from bankruptcy solvent and pursuant to a bankruptcy plan that purported to leave all creditors unimpaired and provide a return of more than $1 billion to equity holders.

The plan preserved a dispute, which was litigated post-confirmation, between Hertz and a group of unsecured noteholders over what it meant for the noteholders’ claims to be unimpaired. The noteholders contended that Hertz would have to pay them post-petition interest (i.e., interest accruing from the petition date of the bankruptcy through actual payment of their claims) at the contract rate specified in the notes, plus an additional make-whole amount required by the terms of the notes when they are retired prior to maturity. Hertz disputed payment of the make-whole and any post-petition interest in excess of the (much lower) federal judgment rate. Combined, the contract rate interest and make-whole would add more than $270 million to the noteholders’ recovery.

Delaware Bankruptcy Court Judge Mary F. Walrath found in favor of Hertz on the interest rate, finding that as unimpaired creditors of a solvent debtor, the noteholders were entitled to post-petition interest at the “legal rate,” per sections 1129(a)(7)(A)(ii) and 726(a)(5) of the bankruptcy code, which the bankruptcy court interpreted to be the federal judgment rate. The court also concluded that the “economic substance” of the make-whole was interest, and therefore it was disallowed pursuant to section 502(b)(2) of the bankruptcy code. Those decisions were appealed directly to the Third Circuit.

The Opinion

The Third Circuit agreed with the Bankruptcy Court, ruling that the make-whole is the “economic equivalent” of unmatured interest and is therefore disallowed by section 502(b)(2). Arguably, the Hertz decision is broader than the Fifth Circuit’s similar decision in Ultra because the Third Circuit found that any prepayment fee, regardless of its calculation method or its relation to future interest streams, can constitute the economic equivalent of unmatured interest because it is a fee for the noteholders’ profit agreed to as a condition to the issuance of the notes.

On the solvent debtor issues, the Third Circuit reversed the Bankruptcy Court, finding that Hertz, as a solvent debtor, must pay all post-petition interest due under the notes, including the make-whole. Unlike the Fifth and Ninth Circuits, the Third Circuit grounded its decision in the absolute priority rule, which provides that to be “fair and equitable,” a bankruptcy plan must pay creditors in full before any value can be returned to equity holders. The Third Circuit found that the US Supreme Court’s decision in Czyzewski v. Jevic Holding Corp. confirmed the absolute priority rule as a fundamental bankruptcy right of all creditors, not just those that are impaired. Accordingly, in order to be rendered unimpaired, the noteholders must receive the full amount of post-petition interest calculated pursuant to the terms of the notes, including make-whole, before value could be returned to equity.

Regarding the rate of post-petition interest, Hertz’s argued, consistent with the Bankruptcy Court’s opinion, that the federal judgment rate was applicable given that the bankruptcy code’s priority scheme is silent on the issue other than section 726(a)(5), which provides for payment of post-petition interest “at the legal rate” in solvent Chapter 7 cases. The Third Circuit disagreed and reversed the Bankruptcy Court on this issue. Relying on the long history of cases employing the solvent debtor exception, the Third Circuit found that the common law rule that solvent debtors must pay post-petition interest to creditors at the rate specified in their contract survived the bankruptcy code and is codified in its absolute priority rule.

Judge Porter dissented. He would have held that payment of the make-whole and contract rate interest was not necessary to render the noteholders unimpaired.

Implications

The Hertz decision further solidifies the survival of the solvent debtor exception, which entitles creditors to full payment of their valid contractual claims, including post-petition interest at the contract rate, before distributions can be made to equity. A likely challenge going forward will be how to reconcile the Hertz decision with the Third Circuit’s prior holding in In re PPI Enterprises Inc that landlords whose claims for unpaid rent are capped pursuant to section 502(b)(6) of the code can still be deemed unimpaired. Dicta in the Hertz decision suggests that the Hertz majority believes the two decisions can be reconciled, although the method is not explained.

With respect to the enforceability of make-whole provisions in bankruptcy, Hertz calls into question whether a make-whole or prepayment fee of any kind, no matter how calculated, can be considered anything other than the economic equivalent of unmatured interest disallowed pursuant to section 502(b)(2) of the bankruptcy code.