Contributed by Blaire Cahn
May a creditor collect postpetition interest from a non-debtor party even if section 502(b)(2) of the Bankruptcy Code prohibits the creditor from asserting such a claim for “unmatured interest” against the bankruptcy estate? If the creditor is in the Ninth Circuit, it may do so under a recent, albeit non-precedential, decision stemming from the Washington Group International chapter 11 cases.
The Ninth Circuit’s decision contains a limited discussion of the underlying facts, although those are set out in more detail in the decision of the Nevada District Court, whose order the Ninth Circuit affirmed. Prior to the commencement of the Washington Group debtors’ chapter 11 cases, one of the debtor’s subcontractors sued the debtor for damages arising from the debtor’s allegedly wrongful termination of the subcontract. The subcontractor ultimately prevailed and was awarded more than $15 million in damages against the debtor.
After the subcontractor collected a portion of the judgment from a supersedeas surety, the debtor’s Plan Committee requested that the bankruptcy court direct the subcontractor to seek collection first from a third party who was derivatively responsible for the debtor’s obligations. Not only did the bankruptcy court grant the Plan Committee’s motion, but it also rejected the subcontractor’s argument that it was permitted to recover postpetition interest from the third party; instead, the bankruptcy court limited the amount that the subcontractor could collect from the non-debtor third party to principal only. The district court overturned the decision of the bankruptcy court.
The Ninth Circuit found that, although section 502(b)(2) protects the bankruptcy estate from claims for unmatured interest, this protection does not extend to third parties. Quoting Bruning v. United States, the court noted that “[t]he basic reasons for the rule denying post-petition interest as a claim against the bankruptcy estate are the avoidance of unfairness as between competing creditors and the avoidance of administrative inconvenience” and concluded that the reasons cited in Bruning did not apply in this case. Collecting postpetition interest from a non-debtor third party would not harm the debtor’s creditors and would not cause any administrative inconvenience for the debtor’s estate. Moreover, the court found that the “mere possibility” that the third party could not or would not satisfy the full amount owed to the subcontractor is not sufficient to bar the subcontractor from asserting a claim for postpetition interest against the third party. The court pointed out that section 502(b)(2) is a “rule of distribution” that does not change the “interest bearing quality of the claim.”
Judge Watford, in a concurring opinion, addressed the possibility that the subcontractor’s claim might not be fully satisfied by the third party. In that situation, how does one calculate the subcontractor’s deficiency claim against the debtor? Ignoring the general principle that a creditor may assert the full value of its claim (in this case, the full principal amount) against a debtor so long as it does not receive greater than a 100% recovery, Judge Watford stated that, in such a circumstance, the subcontractor could not allocate any funds received from the third party to postpetition interest, but instead would have to subtract any funds received from the third party from the principal amount of its claim against the debtor. Judge Watford reasoned that not doing so effectively could circumvent the prohibition on unmatured interest set forth in section 502(b)(2). Notably, as support for his reasoning, Judge Watford cites In re National Energy & Gas Transmission, Inc., 492 F.3d 297, 302-303 (4th Cir. 2007), which addressed the situation in which the creditor recovered nominally the full amount of its claim from a third party, but still asserted a deficiency claim against the debtor because it applied a portion of the recovery from the third party to postpetition interest. In that situation, the Fourth Circuit concluded that the creditor was asserting a claim for disallowed postpetition interest against the debtor.
This case is an example of the strong protections offered by the Bankruptcy Code to debtors. Moreover, it illustrates that because such protections do not necessarily alter the liability of a non-debtor third party, the limited recourse that creditors may have as against a debtor does not necessarily apply to a non-debtor entity.