On August 29, 2022, in the PG&E bankruptcy matter, the Court of Appeals for the Ninth Circuit became the first circuit-level court to address the question of what is the correct rate of interest to be applied to unimpaired unsecured claims against a fully solvent debtor. In its decision, the Ninth Circuit reversed the bankruptcy court’s and district court’s rulings and held that such creditors are entitled to receive postpetition interest at the contractual rate or the state law default rate, which are almost always significantly higher than the federal judgment rate.
Outside of the Ninth Circuit, bankruptcy courts are divided on the issue. In recent decisions in the District of Delaware and the Southern District of New York, bankruptcy courts have applied the federal judgment rate in such situations, whereas in the Southern District of Texas, bankruptcy courts have ruled that the contractual rate of interest must be used.
Over the next several years, it is a virtual certainty that other circuit-level courts will be asked to opine on the issue. In the meantime, solvent debtors or potentially solvent may choose to file bankruptcy cases outside the Ninth Circuit, if possible, to avoid paying unimpaired unsecured creditors the higher rate of interest. Additionally, both solvent debtors and unimpaired unsecured creditors to solvent debtors should be prepared to litigate the issue to the circuit level in cases maintained outside the Ninth Circuit.
PG&E was solvent before and during its bankruptcy proceedings. Under the debtors’ proposed chapter 11 plan, members of an ad hoc committee of holders of trade claims were to be paid the full principal amount of their unsecured claims plus interest at the federal judgment rate, rendering such holders’ claims “unimpaired” under the plan. The federal judgment rate, however, was materially lower than what the committee members would have otherwise been entitled to under either state law or the interest rates set forth in their respective contracts. Specifically, the committee members alleged a $200 million discrepancy in their recoveries due to the lower rate of interest being applied. Further, as unimpaired creditors, the committee members were not entitled to vote on the plan. The committee and other unsecured creditors objected to the plan on the basis that unsecured creditors to solvent debtors must be paid interest on their claims at the contractual or state law rate in order to be deemed unimpaired. The bankruptcy court ruled against the committee, however, finding that the lower federal judgment rate applied to their claims. The committee appealed the matter to the District Court for the Northern District of California, and the district court affirmed the bankruptcy court’s decision.
The Ninth Circuit’s Decision
The Ninth Circuit began its analysis by reaffirming the common law solvent-debtor exception, which is that “a solvent debtor must generally pay postpetition interest accruing during bankruptcy at the contractual or state law rates before collecting surplus value from the bankruptcy estate.” This exception was recognized under the former Bankruptcy Act (the predecessor statute to the Bankruptcy Reform Act of 1978). Because the Bankruptcy Code, as amended, lacked “any clear indication” that Congress intended to abrogate the solvent-debtor exception, the appellate court held that unimpaired unsecured creditors retained an equitable right to postpetition interest pursuant to their contracts or state law, and that “failure to compensate creditors according to this equitable right as part of a bankruptcy plan results in impairment.”
In reaching this conclusion, the Ninth Circuit relied on, among other reasons, the Bankruptcy Code’s structure. The court noted that the Bankruptcy Code provided impaired creditors with certain protections (e.g., the right to vote on a plan and the right of a dissenting impaired class to a plan that is “fair and equitable”). Further, the court noted that by defining impairment broadly, Congress ensured these protections would be available “to creditors whose rights were altered in any way by a plan.” The court reasoned that, without the solvent-debtor exception, PG&E would reap an improper windfall while steamrolling creditors’ statutory and equitable rights.
In sum, the court’s decision in PG&E now leaves solvent debtors who file in the Ninth Circuit with two options: (1) use the contractual or state law rate in calculating interest on unsecured unimpaired claims, or (2) designate such claims as impaired.
In its PG&E decision, the Ninth Circuit created the first circuit-level law on an issue that has bedeviled bankruptcy courts around the country. Going forward, parties in interest should expect significant litigation on the issue, and perhaps a circuit split that eventually finds its way to the United States Supreme Court.