Hertz Ruling Keeps 'Make-Whole' Fee Focus on Solvent Debtors (1)

Bondholders’ recent appeals court victory against Hertz Corp. came because the car rental giant was solvent, but debate surrounding “make-whole” interest-like payments for certain creditors of insolvent companies is likely still on the table.

A three-judge panel of the US Court of Appeals for the Third Circuit ruled last week that Hertz must pay unsecured bondholders post-petition interest at the higher rate agreed to in their contracts, plus special make-whole fees, which are generally a lump sum or fee payment incurred if a borrower pays the debt off early.

The 2-1 majority, consistent with rulings from the Ninth and Fifth circuits, reasoned that in the uncommon scenario of a bankrupt corporation becoming solvent—able to pay its debts—during its Chapter 11, it can’t skip paying full interest to unsecured bondholders. In 2021, Hertz was the rare bankrupt company that was able to not only pay its creditors in full, but also provide substantial recoveries for equity holders as well.

“It’s also the job of the creditors community to push back, and it’s the job of the courts to say, ‘take a step back,’” Roy T. Englert Jr., a partner at Kramer Levin Naftalis & Frankel LLP, said. “If you can pay your debts, you ought to pay your debts. Bankruptcy is not about letting solvent debtors shift money from creditors to shareholders.”

The decision, which results in more than $260 million for bondholders, reversed in part the US Bankruptcy Court for the District of Delaware’s 2021 ruling dismissing the make-whole claims and advances an expanding body of appellate law ensuring that solvent debtors must prioritize interest-like payments to unsecured creditors before paying equity holders. And while it confirms that unsecured creditors usually can’t collect such payments from insolvent debtors, it doesn’t preclude oversecured creditors—those with collateral worth more than its loan—from collecting such premiums in Chapter 11 cases with insolvent debtors.

Hertz has indicated that it plans to seek a rehearing. The company, in a statement, called the bankruptcy court’s 2021 decision “well-reasoned” and reiterated that it met all of its legal obligations to its unsecured noteholders.

“We believe that existing Third Circuit precedent strongly supported the Bankruptcy Court’s holding,” Hertz said.

The amount owed under make-whole provisions in debt contracts is sometimes calculated to give creditors the present value of interest payments they would have received if the borrower had continued paying down the debt over time.

The Third Circuit majority found that because the Hertz bondholders’ make-whole premiums fall into the category of unmatured interest, which is prohibited under the code, they generally wouldn’t be allowed.

But because Hertz became solvent, it had to pay unimpaired creditors interest at the rate in their debt contract that accrued post-bankruptcy, the Third Circuit ruled.

“The first part of the decision is a victory for Hertz, but the second part, which is much more important, takes away that victory and gives it to the noteholders,” said Schuyler G. Carroll, a bankruptcy partner at Manatt Phelps & Phillips LLP.

The other circuits’ rulings concentrated on the common law, solvent-debtor exception from before the bankruptcy code was enacted and whether that superseded the code’s prohibition on the collection of post-petition, unmatured interest as part of a creditor’s claim.

Third Circuit Judge Thomas L. Ambro’s opinion shifted the terms of the debate, emphasizing Chapter 11’s absolute priority rule that requires senior creditors to be paid in full before other, unsecured creditors.

“He invokes the absolute priority rule and its centrality and bankruptcy in a way that neither the Fifth nor the Ninth Circuit did,” Englert said.

Since 2022, solvent-debtor rulings involving Hertz, Pacific Gas and Electric Corp. in the Ninth Circuit, and Ultra Petroleum Corp. in the Fifth Circuit have resulted in more than $850 million in interest and interest-like payments potentially going back to unsecured creditors.

While it’s unusual for a debtor to become solvent during its bankruptcy, Englert said when they do, the interest issues can be significant. “It’s about half a billion dollars or a billion dollars a pop, so even though it comes up very rarely, it’s economically significant in every case in which it comes up.”

Hertz emerged from bankruptcy in June 2021 and, as part of its plan, paid off about $2.7 billion of principal debt to its unsecured bondholders. The company’s prior stockholders recovered more than $1 billion.

“Distributing a massive gift to the Stockholders, would impermissibly ‘deviate from the basic priority rules,’” the Third Circuit said.

For the 13 months Hertz spent in bankruptcy, its plan had it pay its noteholders at a lower, federal judgment interest rate of roughly 0.17% instead of a higher contract rate between 5.5% and 7.125%.

Combined, the interest and make-whole payments left out by Hertz’s plan added up in mid-2021 to about $260 million—now roughly $300 million with interest.

While the Hertz opinion is a significant win for bondholders, the appeals court made clear that unsecured creditors won’t likely be as lucky in the much more common scenario of an insolvent Chapter 11 debtor.

That means the opinion’s application to resurrect make-whole premiums may be limited, said David M. Hillman, co-head of Proskauer Rose LLP’s restructuring group, even though some questions about the payments remain unanswered.

There’s a significant contrast between the section of the bankruptcy code that requires payment of interest to an oversecured creditor with the section that prohibits the payment of interest that hasn’t matured when bankruptcy is filed, Hillman said. An oversecured creditor has statutory rights to recover post-bankruptcy interest, he said.

That means that even when a debtor is insolvent, and creditors aren’t paid in full, there’s still a statutory path for an oversecured creditor to collect a make-whole payment, Hillman said.

With oversecured creditors having different protections than unsecured creditors, Hillman predicted that make-whole claims will continue to be litigation targets.

“The Hertz decision and Ultra Petroleum before it from the Fifth Circuit, they do not sound the death knell for make-whole premiums across the lender market,” Hillman said.

In addition, many of the make-whole provisions in secured term loans are calculated as a fixed fee or a fixed percentage of the principal being repaid. That’s opposed to a formula where the key input, as in Hertz and Ultra, was unmatured interest.

“That’s an important and substantive distinction, and, as a result, at best, it’s unclear whether a court would view a make-whole based on a fixed fee,” Hillman said.

The case is In re Hertz Corp., 3d Cir., No. 23-1169, opinion 9/10/24.

To contact the reporter on this story: James Nani in New York at [email protected]

To contact the editors responsible for this story: Maria Chutchian at [email protected]; Rob Tricchinelli at [email protected]

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