Restructuring

This is the second post in our series on Judge Sontchi’s postpetition interest decision in Energy Futures Holdings, issued on October 30, 2015.  As we discussed in our first post, the court ruled on four separate issues regarding when unsecured creditors are entitled to receive postpetition interest under a chapter 11 plan.  The court held, first, that postpetition interest is not a constituent part of an unsecured claim.  Unsecured creditors therefore can receive the full value of their allowed claims without receiving postpetition interest.  The court then considered whether something elsewhere in the Bankruptcy Code might entitle unsecured creditors to postpetition interest under a chapter 11 plan. 
In this post, we discuss the court’s consideration of whether the best interests test under section 1129(a)(7) of the Bankruptcy Code entitles unsecured creditors to postpetition interest and, if so, at what rate.
The “legal rate” of interest in bankruptcy, including for purposes of the best interests test, is the federal judgment rate.
The court held that the best interests test under section 1129(a)(7) of the Bankruptcy Code requires that unsecured creditors that are in impaired classes and that vote to reject a plan receive postpetition interest at the federal judgment rate where the debtor is solvent.  Specifically, section 1129(a)(7)(A) of the Bankruptcy Code provides that a creditor in an impaired class either has accepted a chapter 11 plan or is receiving at least as much under the plan as it would receive in a hypothetical chapter 7 liquidation.  Chapter 7 distributions are governed by section 726(a) of the Bankruptcy Code, which establishes a series of distribution priorities in a chapter 7 liquidation.  In relevant part, section 726(a) provides:

[P]roperty of the estate shall be distributed . . .

(2) second, in payment of any allowed unsecured  claim . . .

(5) fifth, in payment of interest at the legal rate from the date of the filing of the petition, on any claim paid under paragraph . . . (2) . . . ; and

(6) sixth, to the debtor.

Accordingly, in chapter 7—as well as under the best interests test in chapter 11—unsecured creditors are entitled to postpetition interest on their claims “at the legal rate from the date of the filing of the petition” before the debtor, or its shareholders, receive a distribution.
What has garnered more debate is the meaning of the phrase “the legal rate” in section 726(a)(5).  The phrase is not defined in the Bankruptcy Code and has been the subject of differing views among the courts.  The EFH court’s view—which is generally considered to be the prevailing view—is that “the legal rate” refers to the federal judgment rate established by 18 U.S.C. § 1961(a) rather than the applicable contract rate or state postjudgment rate.  In joining in the prevailing view, the EFH court quoted Judge Walrath’s reasoning from Washington Mutual:

First, section 726(a)(5) states that interest on unsecured claims shall be paid at “the legal rate” as opposed to “a” legal rate or the contract rate.  As the LTW Holders note, where Congress intended that the contract rate of interest apply, it so stated.

Second, the payment of post-judgment interest is procedural by nature and dictated by federal law rather than state law, further supporting use of the federal judgment rate.

Third, the use of the federal judgment rate promotes two important bankruptcy goals: “fairness among creditors and administrative efficiency.”

Accordingly, the court held that “the legal rate” under section 726(a)(5) is the federal udgment rate, and so unsecured creditors that reject a solvent debtor’s chapter 11 plan are entitled to receive postpetition interest on their claims at the federal judgment rate.
The next two sections of Judge Sontchi’s decision address the implications of the impairment and cramdown requirements of the Bankruptcy Code for unsecured creditors’ entitlements to postpetition interest.  We will analyze those in upcoming posts on the Weil Bankruptcy Blog.
Scott Bowling is an Associate at Weil Gotshal & Manges, LLP in New York.