Fifth Circuit: Compensation Bounties Should Be Banned in Bankruptcy | McGuireWoods LLP

The United States Court of Appeals for the Fifth Circuit issued a decision on October 14, 2022 regarding the treatment of compensation premiums in bankruptcy. The court held that the demands for payment of a compensatory premium are the economic equivalent of the interest not yet due and were therefore dismissed under Article 502 (b) (2) of the Bankruptcy Code – unless the “solvent debtor exception” applies.

The “solvent debtor’s exception” is an equitable exception in bankruptcy to the general rule that prohibits unexpired interest from accumulating after the petition. One of the issues here was whether this exception survived the enactment of the Bankruptcy Code, which did not expressly codify it.

The Fifth Circuit’s decision stems from the Ultra Petroleum Corp. bankruptcy pending in the U.S. Bankruptcy Court for the Southern District of Texas and follows several years of litigation. This is the first circuit-level ruling on this issue and is a significant departure from previous bankruptcy court rulings that treated set-off bonuses as recoverable liquidated damages that should be treated differently than unearned interest.


Ultra Petroleum Corp. and its affiliates filed for bankruptcy protection in 2016, but became solvent during the case due to an increase in crude oil prices. As a result, debtors were able to propose a Chapter 11 plan that purported to pay their creditors in full, including some unsecured noteholders. While the Chapter 11 plan treated the noteholders as intact (i.e. it did not alter their contractual rights), it did not provide for the payment of the noteholders’ claim for a premium of compensation. The debtors’ reasoning was that since Section 502(b)(2) of the Bankruptcy Code prohibits claims for “unmatured interest”, the claim based on the set-off premium (which, in the debtors’ view, was the economic equivalent of unearned interest) should be rejected.

Noteholders objected to this treatment proposed by the plan and argued that they are impaired if the plan does not provide for payment of the make-up premium. The bankruptcy court agreed, but the Fifth Circuit (in its earlier decision on appeal) did not. The Fifth Circuit ruled that if the set-off bonus can be disallowed as unmatured interest under Section 502(b)(2), then it’s the Bankruptcy Code rather than the chapter plan. 11 which is detrimental to ticket holders. The case was then sent back to the bankruptcy court to decide whether the compensation bonus should be disallowed under the Bankruptcy Code. On remand, the bankruptcy court determined that the compensation premium was not the equivalent of unearned interest because it did not compensate noteholders for the use or withholding of their money but , instead, the set-off premium compensated noteholders only for a breach of a promise to use the money and, therefore, was better characterized as liquidated damages.

The Fifth Circuit decision

On appeal, the Fifth Circuit disagreed, holding that a set-off award actually compensates creditors for the use or forbearance of the money – specifically, the future use of their money. In the view of the Fifth Circuit, compensation awards are “nothing more than a lender’s unearned interest, rendered in today’s dollars”, whether or not the parties characterized them as damages. liquidated in the loan documents. Essentially, the court ruled that a compensation premium constituted both damages and the economic equivalent of unexpired interest. The Fifth Circuit left open the possibility that lenders could receive compensation awards as true liquidated damages in the future, but only if those damages are unrelated to unearned interest.

However, the Fifth Circuit held that while compensation bonuses should generally be disallowed as unearned interest under Section 502(b)(2), in the Ultra case, the offset premium was nonetheless payable under the “solvent debtor exception,” which overrides Section 502(b)(2). The Fifth Circuit disagreed with the debtors’ argument that the solvent debtor exception, which predates the Bankruptcy Code, was repealed in 1978 when Congress enacted the Bankruptcy Code without expressly incorporating the exception. The Fifth Circuit further held that where the solvent debtor exception applies, post-petition interest should be paid at the contract rate rather than the federal judgment rate. This decision is consistent with the Ninth Circuit’s August 2022 decision in In re PG&E Corp.46 F.4th 1047 (9th Cir. 2022).

Take away food

There are several key takeaways from the Fifth Circuit’s decision:

  • Except in the very rare case where the debtor is solvent, set-off bonuses can now be denied in bankruptcy in the Fifth Circuit, which includes the Bankruptcy Court for the Southern District of Texas – one of the nation’s most popular bankruptcy courts for Corporate filings under Chapter 11.
  • The Fifth Circuit was clear that labeling the set-off premium as liquidated damages in loan documents would not change the outcome when, in essence, the set-off premium is the economic equivalent of unearned interest.
  • The Fifth Circuit’s view was much less clear regarding the circumstances in which a compensation award may be permitted. In dicta, the court suggested that set-off bonuses could potentially be allowed as liquidated damages if they related to anticipated transaction costs, although the nature and extent of eligible costs remains to be determined. It may also be that a fixed prepayment charge is acceptable, or possibly a charge based on time markers and/or a percentage of the outstanding principal balance.
  • Due to this uncertainty, litigation over the eligibility of offset bonuses is likely to grow as lenders seek to circumvent the opinion in Ultra Oil.
  • Nothing in the court’s decision limits its applicability to unsecured claims, and therefore compensation premiums due to secured creditors are also likely to be disallowed.

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