A month ago, I introduced a new set of writers to Distressed Debt Investing: Martin Bienenstock, Phil Abelson, and Vincent Indelicato from Dewey & LeBouef which penned their first (amazing) piece on Bankruptcy Rule 2019. This month, they wrote a fantastic piece on the federal judgement rate and its application in Chapter 11 bankruptcies, which came to the forefront in the Washington Mutual bankruptcy. Enjoy!
The Postpetition Interest Debate: What Distressed Debt Investors Need to Know
Bankruptcy Courts have long taken divergent approaches to the appropriate calculation of postpetition interest on general unsecured claims in solvent debtor cases. While some courts have applied the federal judgment rate of interest pursuant to 28 U.S.C. § 1961(a), other courts have favored the interest rate agreed upon prepetition between the debtor and its creditors to the extent enforceable under state contract law. The prepetiton contract rate of interest often substantially exceeds the federal judgment rate. Therefore, the decision to apply one rate of postpetition interest over the other can dramatically alter recoveries to holders of general unsecured claims.
The controversy surrounding the postpetition interest debate lies in fundamental disagreement over the statutory interpretation of section 726(a)(5) of the Bankruptcy Code, which provides that an unsecured claimholder of a solvent debtor is entitled to “payment of interest at the legal rate from the date of the filing of the petition.” 11 U.S.C. § 726(a)(5) (emphasis supplied).
Although the requirements of chapter 7 typically do not apply to chapter 11 proceedings, section 726 of the Bankruptcy Code applies indirectly through the “best interest of creditors” test in section 1129(a)(7), which requires that distributions proposed under a chapter 11 plan must at least equal the amount such holder would have received under a chapter 7 liquidation. Applying section 726(a)(5), a solvent debtor liquidating under chapter 7 would have to pay holders of general unsecured claims postpetition “interest at the legal rate” before it can make any distributions to equity interest holders.
While courts have historically split over whether the term “interest at the legal rate” means a rate fixed by federal statute (i.e., the federal judgment rate) or a rate determined by a prepetition contract (i.e., the contract rate), several recent decisions have favored the federal judgment rate as an appropriate metric for postpetition interest. See, e.g., Opinion, In re Washington Mutual, Inc. et al., Case No. 08-12229 (MFW) (Bankr. D. Del. Sep. 13, 2011); Onink v. Cardelucci (In re Cardelucci), 285 F.3d 1231 (9th Cir. 2002); In re Garriock, 373 B.R. 814 (E.D. Va. 2007); In re Adelphia Communications Corp., 368 B.R. 140 (Bankr. S.D.N.Y. 2007); In re Dow Corning Corp., 237 B.R. 380 (Bankr. E.D. Mich. 1999).
These courts have argued the application of a single, uniform interest rate, as opposed to varying rates based upon the individual contracts of each unsecured claimholder, ensures that no single creditor will receive a disproportionate share of any remaining assets to the detriment of other creditors. In addition to promoting the equitable treatment of creditors, these courts have ruled that the federal judgment rate also achieves judicial efficiency by eliminating the burdensome scenario under which a chapter 11 debtor would have to calculate postpetition interest at a different rate, based upon a different contract, for each individual creditor. Of course, the notion of equality among creditors who bargained for different deals may not be fair. And, the calculation of interest at different rates is hardly a daunting task.
Notwithstanding the courts that support the federal judgment rate in their calculation of postpetition interest, however, the jurisprudence still leaves the door open for the application of interest at the contract rate. This should come as good news to distressed debt investors holding unsecured claims against a solvent debtor’s estate that carry prepetition interest at a contract rate considerably higher than the governing federal judgment rate.
Even in the most recent bankruptcy court decision applying the federal judgment rate, Judge Walrath conceded that while “the federal judgment rate [is] the minimum that must be paid to unsecured creditors in a solvent debtor case . . . the [c]ourt [has] discretion to alter it.” See Opinion, Washington Mutual at 77 (citing Judge Walrath’s previous decision In re Coram Healthcare Corp., 315 B.R. 321, 346 (Bankr. D. Del. 2004) (ruling “the specific facts of each case will determine what rate of interest is ‘fair and equitable.’”)). But, Judge Walrath then clarified that “[t]o the extent that [she] suggested in Coram that the federal judgment rate was not required by section 726(a)(5), [she] was wrong.” See Opinion, Washington Mutual at 78 n. 35.
While the Washington Mutual decision may ultimately mean that holders of general unsecured claims have no entitlement to postpetition interest at the contract rate in the Third Circuit, Judge Walrath did recognize the appropriateness of contract rate interest in two limited circumstances: (i) when creditors are over-secured pursuant to section 506(b) of the Bankruptcy Code and (ii) when contractual subordination provisions require junior creditors to pay senior creditors all interest at the contract rate. See Opinion, Washington Mutual at 80-81. Of course, the latter observations were dicta.
Absent these two limited circumstances, distressed debt investors in the Third Circuit and elsewhere can utilize the equities of the case to argue for the application of contract rate interest. Even then, holders of unsecured claims have no certainty that they will prevail. Distressed debt investors must discount this risk as they try to analyze recoveries on general unsecured claims in chapter 11 cases of solvent debtors.
Martin Bienenstock
Phil Abelson
Vincent Indelicato
Good article. It may be worth clarifying though that the decision in Wamu only constitutes Judge Walrath's view, and is not necessarily the view of other judges in Delaware or other courts in the Third Circuit (nor is it binding on them), let alone the view of judges in the SDNY or other districts. This very much remains an open issue.
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