A debtors' ability to formulate a plan of reorganization under Chapter 11 of the Bankruptcy Code is one of its most powerful tools. In a plan, the debtor must classify its creditors by the treatment to be afforded to them. Those creditors who are “impaired” by the proposed treatment may vote to accept or reject the plan. Creditors whose rights are unimpaired, however, are “deemed” to accept. The question of when a creditor's claim is “impaired” under a plan can be difficult, but often has a profound impact on a debtor's ability to reorganize. In an important recent decision, the U.S. Court of Appeals for the Fifth Circuit held that a creditor's reduced recovery resulting directly from a Bankruptcy Code provision does not constitute impairment for voting purposes, see Ultra Petroleum v. Ad Hoc Committee of Unsecured Creditors of Ultra Resources (In re Ultra Petroleum), 2019 U.S. App. LEXIS 1617 (5th Cir. Jan. 17, 2019).  Specifically, the Fifth Circuit held that a creditor is unimpaired under a plan of reorganization so long as it receives everything it is entitled to under the Bankruptcy Code, even if the plan incorporates and effectuates the Bankruptcy Code's claim disallowance provisions.

In Ultra Petroleum, the debtor and its subsidiaries were an oil and gas exploration and production company. Prior to a sharp decline in the price of crude oil, the debtors issued $1.46 billion in unsecured notes and borrowed $999 million under a revolving credit facility. The note agreement included a make-whole provision to compensate the noteholders for lost interest if the principal was retired early. Moreover, both the note agreement and the revolving credit facility included provisions imposing default interest of approximately 2 percent above the contractual rate upon the filing of bankruptcy. As a result of the decline in oil prices, the debtors filed petitions for Chapter 11 bankruptcy. During the pendency of their bankruptcy cases, however, crude oil prices increased, which returned the debtors to solvency. The debtors then filed a reorganization plan proposing to pay all creditors in full. Under this plan, the debtors intended to pay holders of claims related to the unsecured notes and revolving credit facility (the class 4 creditors) an amount equal to outstanding principal; pre-petition interest rate at a 0.1 percent rate; and post-petition interest at the federal judgment rate.

Because the debtors viewed their proposed treatment of the class 4 creditors as payment in full, they were deemed “unimpaired” and not entitled to vote to accept or reject the debtors' proposed plan. The class 4 creditors objected contending that they were impaired creditors because the plan did not pay the class 4 creditors for the contractual make-whole amount under the note agreement or pay post-petition interest at the contractual default rates.

The debtors argued that it was not the plan of reorganization that prevented payment of the make-whole amount to the class 4 creditors. Specifically, Section 502(b)(2) of the Bankruptcy Code requires disallowance of a claim for unmatured interest (which the debtors contend the make-whole amount was) or, alternatively, that the make-whole provision was a liquidated damages provision that is unenforceable under governing New York law. As to why post-petition interest at the contractual default rate was not permitted, the debtors argued that post-petition interest rates were limited by Section 726(a)(5) to the “legal rate,” or federal judgment rate of 28 U.S.C. Section 1961, not the contractual default rate.

The Bankruptcy Court held that the class 4 creditors were impaired under the plan of reorganization because the plan did not pay them all amounts due under state law. The bankruptcy court rejected the argument that the Bankruptcy Code itself disallowed portions of the creditors' claims and found that, because New York law permitted the recovery of the make-whole amount and the code did not limit post-petition interest to the federal judgment rate, that the debtors were required to pay the class 4 creditors for both the make-whole amount and post-petition contractual default interest in order for the class 4 creditors to be unimpaired under the plan. Due to the important questions of law at issue, the debtors appealed the bankruptcy court's decision directly to the Fifth Circuit.

The Fifth Circuit held that, where a plan of reorganization does not alter a creditor's legal, equitable or contractual rights, a creditor remains unimpaired by the plan, even if it incorporates the Bankruptcy Code's claim disallowance provisions. The Fifth Circuit's holding is largely based on the plain text of section 1124(1) of the Bankruptcy Code, which provides: “a class of claims or interests is impaired under a plan unless, with respect to each claim or interest of such class, the plan—leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest … .” The Fifth Circuit determined that, for a creditor to be impaired, the plan itself must be what impairs the creditor's legal, equitable or contractual rights, not other provisions of the Bankruptcy Code that may work a disallowance of the creditor's claim. The Fifth Circuit also found support in the Third Circuit's decision in In re PPI Enterprises (U.S.), 324 F.3d 197, 204 (3d Cir. 2003), which held that “the plan itself had to be the source of limitation on a creditor's legal, equitable, or contractual rights,” as well as other bankruptcy court decisions that found similarly.

The class 4 creditors asserted three main arguments, which the Fifth Circuit addressed in turn.  First, the creditors argued that Section 1124(1) referred to “claims,” not “allowed claims,” and therefore impairment was to be considered before application of the code's disallowance provisions. The Fifth Circuit found that, because Section 1124 is not about the allowance of claims, but rather about various claimants' rights, impairment is determined after considering all aspects that define the rights or entitlements of the claimants, including the code's disallowance provisions. Second, the class 4 creditors argued that the legislative history of Section 1124(3)'s repeal indicated that claims disallowance should not be considered in the impairment analysis. The Fifth Circuit determined that while the repeal of Section 1124(3) was to prevent an unfair result of denying a party its right to post-petition interest, the repeal was not intended to grant impaired status more freely.

Lastly, the class 4 creditors argued that the plan caused the impairment of their claims because the plan effectuated the code's disallowance provisions. The Fifth Circuit acknowledged that plans of reorganization, as the mechanism for a debtor's discharge, limit claims, but found that it is the Bankruptcy Code's substantive and procedural confirmation requirements that limits what can and must be contained in a plan. Thus, the Fifth Circuit concluded that when a plan limits claims based on the code's disallowance provisions, it is the Bankruptcy Code, and not the plan, that has caused impairment—thus, such creditors are not “impaired” under Section 1124.

Having found the distinction of plan impairment versus code impairment to be the relevant question, the Fifth Circuit remanded the case back to the bankruptcy court for further consideration—specifically, whether the make-whole and default post-petition interest rates are allowed under the code. Needless to say, this has been and remains a complex, but important issue in bankruptcy cases as impairment can impact the payment of large sums and dictate, in some circumstances, whether a debtor can emerge from bankruptcy. Substantially more development of this issue is likely in the coming months.

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice on national bankruptcy matters and workouts, including the representation of major energy and health care companies in bankruptcy proceedings and general litigation throughout the United States.

Marcy J. McLaughlin is an associate in the corporate restructuring and bankruptcy practice group of the firm, resident in the Wilmington office.