Third Circuit Orders Hertz to Pay Noteholders Post-petition Interest, including Make-Whole Premiums, at Contract Rates

Executive Summary

The US Court of Appeals for the Third Circuit recently held that Hertz’s noteholders are entitled to post-petition interest payments, including make-whole premiums, at the contract rate as part of the company’s Chapter 11 plan of reorganization. In doing so, the majority opinion focused on whether the Bankruptcy Code gave the debtors “leverage to deny their unsecured noteholders more than a quarter billion dollars of interest they promised to pay pre-bankruptcy,” while “giving lower priority equityholders four times that amount” under the debtors’ reorganization plan as originally confirmed. This decision generally reflects the positions taken by the Fifth Circuit and the Ninth Circuit courts of appeals, in the Ultra¹ opinion and the PG&E² opinion, respectively.

Background

Hertz filed for Chapter 11 bankruptcy in 2020 and, as part of its plan of reorganization (the “Plan”) that was confirmed in 2021, Hertz promised to “leave all of [its] creditors unimpaired – in other words, it would not alter any of their rights.” Accordingly, all of Hertz’s creditors were presumed to have accepted the Plan and not entitled to vote on it. On the effective date of the Plan, Hertz paid off its pre-petition debt, including certain unsecured bonds (“Notes”), in cash. However, the Plan did not provide for payment of the stated contract rate of interest on the Notes for the time Hertz was in bankruptcy; instead, Hertz paid interest for that period at the (lower) federal judgment rate. The Plan also didn’t provide for payment of certain contractually due “Applicable Premiums” that were meant to compensate the Noteholders for early redemption of the Notes. Hertz’s stockholders, who were junior in right-of-payment to the Noteholders, received roughly $1 billion in value under the Plan.

In July 2021, the Noteholders filed a complaint seeking payment of post-petition interest at the contract rate, as well as payment of the Applicable Premiums. The US Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) dismissed the Noteholders’ claims for contract rate interest, holding that the Noteholders were entitled only to interest at the “legal rate” (i.e., the federal judgment rate). After fact discovery on whether Hertz was contractually required to pay the Applicable Premiums, the Bankruptcy Court found that those claims, though contractually valid, were the equivalent of claims for unmatured interest and, accordingly, disallowed the claims. The Noteholders moved for reconsideration, arguing that the Fifth and Ninth Circuits had reached different conclusions on both issues. The Bankruptcy Court was not persuaded and, instead, certified its decision for direct appeal to the US Court of Appeals for the Third Circuit (the “Court of Appeals”). The Third Circuit agreed to take the appeal directly.

What the Court Decided

The dispute before the Court of Appeals centered around the allowability and amount of post-petition interest and the Applicable Premiums owed to the Noteholders. Hertz argued that the Applicable Premiums were akin to claims for make-whole premiums that constitute unmatured interest disallowed by section 502(b)(2) of the Bankruptcy Code; the Noteholders disagreed, and maintained the payments were not the economic equivalent of interest, and even if so, were required to be paid under the so-called “solvent debtor” exception. And as for payment of post-petition interest on the Notes, the dispute centered on the proper rate: as the Court of Appeals noted,  “[w]hile the parties agree that the [Bankruptcy] Code requires debtors to pay post-petition interest if they are solvent, they disagree whether this entitles creditors to post-petition interest at the federal judgment rate or the contract rate—a dispute with teeth, because the latter exceeds the former by more than 30 times in this case.”

In its decision, the Court of Appeals agreed that while the Applicable Premiums at issue would ordinarily be disallowed as claims for unmatured interest, Hertz as a solvent debtor was nonetheless obligated to pay the Applicable Premiums before making any distribution to junior equity holders, under the absolute priority rule as codified as Section 1129 (which provides, among other things, that for a plan to be “fair and equitable,” a Chapter 11 debtor must pay its creditors in full before equity holders can receive any distribution on account of their interests).

In connection with its ruling, the Court of Appeals noted that the required payment of the Applicable Premiums in the applicable Notes was both definitionally and in “substance” the economic equivalent of interest, as the premiums sought to ensure the Noteholders would receive the return they expected for their investment in the Notes redeemed before their redemption date; in particular, the premiums were “compensation” Hertz agreed to pay upon a contingency (i.e., redemption of the Notes and the early return of the Noteholders’ capital) in exchange for the use of the Noteholders’ money. Accordingly, the Court of Appeals held that the Bankruptcy Court correctly determined the Applicable Premiums would, in the ordinary case, be disallowed as unmatured interest under section 502(b)(2) of the Bankruptcy Code.

However, despite the language in section 502(b)(2), the Court of Appeals invoked the absolute priority rule, holding that the Noteholders were entitled to payment of the Applicable Premiums under Hertz’s plan, which provided for distributions to holders of equity interests on account of their pre-petition stock. Specifically, the Court of Appeals noted:

“[T]he absolute priority rule requires creditors’ obligations be paid in full before owners, with junior rights to the business, take anything at all. So it should be no surprise that several thoughtful decisions conclude that the Bankruptcy Code’s absolute priority rule, which incorporates common law and Bankruptcy Act jurisprudence, can require payment of contract rate interest in solvent debtor cases.”

After a thorough examination of common law bankruptcy principles, applicable case law, legislative intent, and the existing Bankruptcy Code, the Court of Appeals followed Fifth Circuit’s decision in Ultra, which held that “when a debtor can pay its creditors interest on its unpaid obligations in keeping with the valid terms of the contract, it must.”

As to whether the Bankruptcy Code requires solvent debtors to pay post-petition interest at the contractual rate, rather than the federal judgment rate, the Court of Appeals acknowledged that even though the absolute priority rule can require a solvent debtor to pay post-petition interest at the contract rate, that is not always the case. Rather, the absolute priority rule requires a court’s determination of the “equitable rate of post-petition interest,” and whether there are “compelling equitable considerations” against awarding the Noteholders interest at the contract rate.

Here, the Court of Appeals held that it would not remand the case to the Bankruptcy Court to determine the correct interest rate.  Instead, the Court of Appeals ruled that post-petition interest should be paid at the contract rate, invoking the equitable consideration that “[i]t would be profoundly unfair to scrimp on the Noteholders’ interest when the junior [s]tockholders already received a billion dollar distribution.”

Key Takeaways

The Third Circuit’s decision in Hertz is a favorable one for senior creditors, as the Court interpreted the Bankruptcy Code “holistic[ally]” to find that it “disfavors nonconsensual distributions to equity over creditors.” It also is largely consistent with (although arguably more expansive than) the decisions from the Fifth and Ninth Circuits in Ultra and PG&E, creating greater uniformity among jurisdictions, as well as greater certainty for funded debt creditors that their claims will be paid as contractually provided for, if a debtor seeks to reorganize and its equity holders seek to retain value under a plan.

¹ Ultra Petroleum Corp. v. Ad Hoc Comm. of Opco Unsecured Creditors (In re Ultra Petroleum Corp.), 51 F.4th 138 (5th Cir. 2022), cert. denied, 143 S.Ct. 2495 (2023).

² Ad Hoc Comm. of Holders of Trade Claims v. Pac. Gas & Electric Co. (In re PG&E Corp.), 46 F4th 1047 (9th Cir. 2022), cert. denied, 143 S.Ct. 2492 (2023).