Rudolph J. Di Massa, Jr.

Lawrence J. Kotler

Catherine B. Heitzenrater

In today's low interest rate environment, the difference between a contractual interest rate and the federal judgment rate can be quite significant. It is not surprising, therefore, that this issue has become hotly litigated in cases involving solvent Chapter 11 debtors. Recently, the U.S. District Court for the Northern District of Illinois, in Colfin Bulls Funding A v. Paloian (In re Dvorkin Holdings), 547 B.R. 880 (N.D. Ill. 2016), determined that the ­interest rate ­provided for in the creditor's contract should be the presumptive ­applicable interest rate in cases involving solvent Chapter 11 debtors. While the opinion addresses several related issues, this article focuses on the court's analysis related to whether a creditor, in a solvent bankruptcy case, should receive interest at the contract rate or the federal judgment rate.

In Dvorkin, the court addressed a creditor's appeal of a confirmation order. Pursuant to that order, the bankruptcy court confirmed the debtor's plan which ­provided for payment in full of all unsecured claims, together with interest at the federal judgment rate. In reversing the bankruptcy court's confirmation order in part, the Dvorkin court held that where a debtor's estate is solvent, unsecured creditors should be presumptively entitled to the interest rate provided in the creditors' respective contracts, subject to a debtor's ability to rebut this presumption on equitable grounds.

Facts

Colfin Bulls Funding A, a creditor in the bankruptcy case of Dvorkin Holdings, filed a general unsecured claim in the debtor's bankruptcy case, based upon pre-petition loans made by Colfin to Dvorkin. In its bankruptcy case, Dvorkin subsequently filed a plan of reorganization pursuant to which it agreed to pay all claimants, including general unsecured claimants, in full. In addition to providing for the ­100 percent payment of all ­unsecured debt, the plan allowed that post-petition interest would be paid to eligible claimants at the "legal rate," as set forth in Bankruptcy Code Section 726(a)(5), which Dvorkin asserted was the federal ­judgment rate of 0.17 percent. Colfin objected to the debtor's plan and related disclosure ­statement on the basis that the federal ­judgment rate, as set forth in 28 U.S.C. Section 1961(a), was not the proper interest rate that should be paid on account of its claim. Instead, Colfin asserted that the default rate provided in Colfin's contract with Dvorkin governed.

The Bankruptcy Court's Ruling and the Parties' Arguments on Appeal

The bankruptcy court overruled Colfin's objection to approval of the debtor's ­disclosure statement, and rejected a ­competing plan advanced by other creditors. The competing plan contained ­provisions proposing to pay post-petition interest to eligible claimants at the default rate set forth in their respective contracts with Dvorkin. In overruling Colfin's objection to approval of the disclosure statement and rejecting the competing plan, the bankruptcy court ruled that section 726(a)(5) of the Bankruptcy Code required that post-petition interest be paid at the "legal rate," and that the term "legal rate" meant the federal judgment rate. The bankruptcy court also ­overruled Colfin's objection to confirmation of the debtor's plan for the same reasons, and Colfin appealed.

In its appeal papers, Colfin raised ­several issues including, inter alia, that the ­bankruptcy court erred in confirming the debtor's plan where the estate was solvent but the plan failed to provide for the ­payment of interest to creditors at their respective contractual interest rates. Colfin argued that both the "best interest of creditors" test, set forth in Bankruptcy Code section 1129(a)(7), and Section 1129(b)'s "fair and equitable test" required that a bankruptcy court award unsecured creditors post-petition interest at the rates set forth in their respective contracts. The debtor disagreed, arguing that the order ­confirming the debtor's plan should be affirmed on its merits based on the bankruptcy court's reasoning.

The Court's Analysis

The Dvorkin court rejected the debtor's arguments and held in favor of Colfin. In its decision, the district court determined that, due to the debtor's failure to provide for the payment of interest to eligible creditors at the interest rate provided in each of their ­respective contracts, Colfin's claim was "impaired" under the debtor's plan: ­because the plan also provided that the ­equity ­holders of the debtor would retain their pre-petition interests in the debtor, the plan could not be confirmed as it violated the Bankruptcy Code's absolute priority rule.

In reaching this decision, the court first examined whether the Bankruptcy Code requires that interest be paid at the federal judgment rate rather than the contract rate. As reasoned by the Dvorkin court, if it were clear that the Bankruptcy Code provided for interest to accrue at the federal judgment rate, the debtor's plan would have been in compliance with the Bankruptcy Code, and Colfin's claim would not be impaired. If, however, the Bankruptcy Code was interpreted to allow for interest to accrue at the contractual rate, then Colfin's claim would be impaired.

In reviewing Sections 502(b)(2) and 726(a)(5) of the Bankruptcy Code, the Dvorkin court concluded that the Bankruptcy Code does not dictate that post-petition interest be paid at the federal judgment rate. The court opined that the term "legal rate," as used in Section 726(a)(5), does not necessarily equate to the term "federal judgment rate" as urged by the debtor. According to the Dvorkin court, had Congress intended this outcome, Congress would have used the term "federal judgment rate" rather than the term "legal rate" in section 726(a)(5). The Dvorkin court held that, by failing to include such language, Congress intended to leave undisturbed the meaning of the term "legal rate" as it had been commonly used before enactment of the Bankruptcy Code, which meaning ­contemplated the applicable interest rate contained in the parties' ­respective contracts. Specifically, the Dvorkin court noted that "if Congress had intended for 'interest at the legal rate' to mean, in all cases, the federal judgment rate, it would have been simple enough for Congress to state its intention clearly—either in the original enactment of the code or its ­subsequent amendments." The court concluded that, by failing to do so, Congress did not ­necessarily intend that the term "legal rate" be interpreted to mean "federal judgment rate."

As further support for its decision, the Dvorkin court noted that the bankruptcy process provides a mechanism for ­enforcing the parties' pre-bankruptcy rights under specific terms and conditions and that, ­generally, contract rights should be enforced in the absence of compelling equitable considerations leading to a contrary result. By permitting a solvent debtor to pay interest to eligible creditors at the historically lower federal judgment rate rather than the rate dictated by contract, the Dvorkin court observed that this would ­create perverse incentives for solvent entities to file for bankruptcy as a way of depriving creditors of their rights to contractual interest. This, the Dvorkin court concluded, should not be permitted where a debtor has sufficient funds to pay all claims, including ­contractual interest. Accordingly, the Dvorkin court ruled that "if the unsecured creditor's contract provides for the payment of interest, there is a presumption that the creditor is entitled to the contractual amount. This presumption may be rebutted by equitable ­considerations." Given this ruling, the Dvorkin court remanded the case to the bankruptcy court to apply its analysis and determine whether any equitable considerations existed in this case to overcome the ­presumption that Colfin was entitled to interest at the rate provided in its contract.

Conclusion

While courts in other jurisdictions (including Delaware) have held that the term "legal rate" as used in section 726(a)(5) of the Bankruptcy Code means "federal judgment rate," the Dvorkin court conducted a thorough and compelling analysis and ultimately came to the opposite conclusion. To the extent followed by other courts, this decision could result in significantly increased returns to unsecured creditors in solvent bankruptcy cases, especially as the difference between the federal judgment rate and a contractual rate of interest could be as much as 10 to 15 percentage points. Accordingly, it is ­important for counsel to address this issue early in the plan process and to advocate for the client's rights to contractual ­post-petition interest

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. Lawrence J. Kotler, a partner with the firm, practices in the area of reorganization and finance. Catherine B. Heitzenrater is an associate with the firm and practices in the areas of bankruptcy, corporate reorganization, creditors' rights, commercial finance and secured transactions.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.