The Return of the Solvent Debtor Doctrine?

After a ' 363 sale in the debtor's bankruptcy case enabled the debtor to repay in full the principal and interest outstanding under UPS's secured notes, as well as to pay in full all of the debtor's other secured and unsecured creditors, the debtor objected to the prepayment penalty portion of UPS's claim, which amounted to approximately $200,000, on the grounds that such a penalty was unreasonable under ' 506(b). Arguing that ' 506(b) permitted an oversecured creditor to recover only 'reasonable fees, costs, and charges,' the debtor sought to disallow the prepayment penalty as unreasonable. The bankruptcy court and district court agreed with the debtor, finding the prepayment penalty to be unreasonable in its entirety under ' 506(b) and, therefore, disallowing UPS's claim for the penalty. UPS appealed to the First Circuit.

At the First Circuit, a unanimous panel reversed the lower courts, finding that ' 506(b) governs the priority, but not the allowability, of claims asserted by oversecured creditors for fees and expenses. Rather than looking first to ' 506(b) for reasonableness, any analysis regarding the allowability of a claim ' whether oversecured, undersecured, or unsecured ' must start with 11 U.S.C.
' 502. If a prepayment penalty is enforceable under state law (and not otherwise disallowed under ' 502), then the party asserting the claim should have, at the least, an unsecured claim for the prepayment penalty. Only after determining whether the claim is allowable under ' 502 should courts consider whether the claim could also be subject to priority treatment as part of an oversecured creditor's secured claim under ' 506(b). Only reasonable fees and expenses of an oversecured creditor may be treated as secured under ' 506(b). Therefore, to the extent the claim is not reasonable, it is not entitled to treatment as a secured claim under ' 506(b). However, merely because a claim is not entitled to treatment as a secured claim under ' 506(b) does not deprive it of its allowability as a general unsecured claim. Accord Welzel v. Advocate Realty Inv., LLC (In re Welzel), 275 F.3d 1308 (11th Cir. 2001) (unreasonable portion of post-petition attorney fee claim is unsecured claim under ' 502).

In Gencarelli, the lower court found the prepayment penalty to be unreasonable under ' 506(b) without having first determined whether it was allowable under ' 502. The First Circuit therefore remanded the case back to the bankruptcy court for determination of whether the prepayment penalty was enforceable under state law. If so, given the debtor's solvency, UPS was entitled to payment in full of its claim for the prepayment penalty regardless of whether it was reasonable under ' 506(b). In other words, because UPS would be entitled to receive full payment on its claim regardless of whether it was secured or unsecured (due to the debtor's solvency), the reasonableness of the prepayment penalty under ' 506(b) was irrelevant. By avoiding this reasonableness inquiry, the First Circuit also dodged having to determine the appropriate standard for reasonableness under
' 506(b) (i.e., whether a bankruptcy law standard supersedes any state law standard), which may have proved interesting given that the lower courts determined UPS's prepayment penalty was unreasonable in its entirety regardless of its enforceability under state law.

Does Solvency Matter? Should It?

The First Circuit's analysis in Gencarelli of the interplay between ' 502 and ' 506(b) involved a straightforward exercise of statutory analysis. The First Circuit found that claims for unreasonable prepayment penalties enforceable under state law may be allowable under ' 502 and are not expressly disallowed by operation of ' 506(b). Under the Supreme Court's decision in Travelers, claims that are enforceable under state law should be allowed in bankruptcy unless they are 'expressly disallowed' under a specific provision of the Bankruptcy Code. Travelers, 127 S. Ct., at 1206. Because the First Circuit suggested no other statutory basis in the Bankruptcy Code to warrant disallowance of an enforceable claim for unreasonable prepayment penalties, under the rule adduced in Travelers, it would seem that any oversecured creditor would be entitled to an unsecured claim for unreasonable fees and expenses so long as such claims arise under a contractual right and are enforceable under state law.

In Gencarelli, however, the First Circuit sought to avoid such an expansive ruling by limiting its decision to 'solvent debtor' cases, where all of a debtor's secured and unsecured creditors are paid in full. See Gencarelli, 2007 U.S. App. LEXIS 20751, at *14 ('Let us be perfectly clear. This is a solvent debtor case and, as such, the equities strongly favor holding the debtor to his contractual obligations as long as these obligations are legally enforceable under applicable non-bankruptcy law.'). In doing so, the First Circuit noted that, '[w]hen the debtor is solvent, 'the bankruptcy rule is that where there is a contractual provision valid under state law ' the bankruptcy court will enforce the contractual provision.” Id. (citing prior First Circuit law) (emphasis in original). In other words, contractual rights apparently are more enforceable when the debtor is solvent. After Gencarelli, therefore, courts in the First Circuit arguably have authority to decide on equitable bases, including the debtor's solvency, whether unreasonable fees and expenses of an oversecured creditor are recoverable under ' 502.

Notwithstanding the First Circuit's effort to limit its ruling to solvent cases, it remains dubious that an unsecured claim allowable under ' 502 and not otherwise disallowed by a provision of the Bankruptcy Code can be unenforceable based on general equitable considerations such as the solvency of the debtor. Such a result would seem inconsistent with Travelers. As such, serious questions remain regarding what role the 'solvent debtor' doctrine should play as a basis for disallowing otherwise enforceable claims after Travelers.

Applying Gencarelli to Claims By Unsecured Creditors

In addition to raising interesting questions regarding the viability of the 'solvent debtor' doctrine after Travelers (at least with respect to the allowance or disallowance of claims under ' 502), the Gencarelli case also contributes to the debate regarding the allowability under ' 502 of claims for post-petition attorney fees asserted by unsecured creditors. A question left unanswered by the Supreme Court in Travelers is whether ' 506(b), by statutorily limiting oversecured creditors to 'reasonable' post-petition fees and charges, necessarily precludes by implication any claims by unsecured creditors for such post-petition fees and charges, let alone unreasonable fees and charges.

The First Circuit's reasoned decision in Gencarelli strongly supports the argument that unsecured creditors should be entitled to allowed claims for postpetition attorney fees (despite the First Circuit's gallant effort to stay out of this debate).
See Gencarelli, at * 14 n.3 ('[T]his opinion should not be construed as speaking to the different question of whether an unsecured creditor can enforce a contractual right to post-petition fees against the estate of an insolvent debtor under section 502.') (citing Travelers). If, as Gencarelli suggests, the allowability of all claims should first be addressed under ' 502, and ' 506(b) only operates to determine whether some portion of such allowed claim may be entitled to priority as part of an oversecured creditor's secured claim, it follows that unsecured creditors (like oversecured creditors) should be entitled to allowed unsecured claims to the full extent permissible under applicable nonbankruptcy law.

Conclusion

The statutory analysis supporting allowance under ' 502 of unsecured claims against even insolvent debtors for fees and expenses that are enforceable under state law, albeit unreasonable under 506(b), is fairly straightforward. Regardless, despite Travelers, bankruptcy courts may continue to fall back on equitable principles such as the 'solvent debtor' line of cases cited in Gencarelli to ensure that such unsecured claims for fees and expenses (which can potentially swallow all recoveries in a case) remain the exception and not the rule.

Dion W. Hayes ([email protected]), a member of this newsletter's Board of Editors, is a partner, and Aaron G. McCollough mailto:[email protected]) is an associate, in the Restructuring and Insolvency Group at the Richmond, VA, office of McGuireWoods LLP. The views expressed in this article are those of the authors and do not necessarily represent the views of McGuireWoods LLP or its clients.

In the recent decision of UPS Capital Business Credit v. Gencarelli (In re Gencarelli), 501 F.3d 1 (1st Cir. 2007), the First Circuit tackled the thorny bankruptcy issue of how to treat a claim asserted by an oversecured creditor for a prepayment penalty deemed unreasonable under 11 U.S.C. ' 506(b) but enforceable under state law. While the First Circuit purported to limit its holding to cases involving solvent debtors, its analysis of the interplay between ' 506(b) and
' 502 could (and should) be broadly applied to permit oversecured creditors to assert unsecured claims for unreasonable prepayment penalties, even in insolvent cases, to the extent allowable under state law. Thus, the First Circuit not only added its weight to the list of authorities allowing as unsecured claims unreasonable prepayment penalties asserted by oversecured creditors, but, by implication, the court may have added further fuel to the debate regarding the allowability of claims by unsecured creditors for contractual, post-petition attorney fees, which has been lingering in the wake of the Supreme Court's decision in Travelers Casualty & Surety Company of America v. Pacific Gas & Electric Co. , 127 S. Ct. 1199 (2007). (Note, the term 'prepayment penalty' is no longer frequently used in bankruptcy parlance, particularly for secured creditors trying to enforce such 'penalties' after acceleration, but the term is used here [as it was in Gencarelli ] for convenience. Other commentators, courts, and contract drafters have, at times, referred to prepayment penalties as 'prepayment premiums,' 'yield maintenance premiums,' and various other iterations, but all of these terms refer generally to a contractual provision designed protect profits from long-term yields in the event the borrower repays a loan prior to expiration of the ordinary term.)

Background and Analysis in Gencarelli

With the exception of the debtor's solvency, the facts in Gencarelli are not particularly unique. UPS Capital Business Credit ('UPS') was the debtor's prepetition lender under a $7 million loan secured by certain of the debtor's property. The credit agreement between the parties required the debtor to pay certain premiums to UPS upon repayment of the loan prior to maturity, with the amount payable tied to the timing of the prepayment. UPS filed timely proofs of claim asserting its secured claims and including its right to the prepayment penalty as part of its claims.

After a ' 363 sale in the debtor's bankruptcy case enabled the debtor to repay in full the principal and interest outstanding under UPS's secured notes, as well as to pay in full all of the debtor's other secured and unsecured creditors, the debtor objected to the prepayment penalty portion of UPS's claim, which amounted to approximately $200,000, on the grounds that such a penalty was unreasonable under ' 506(b). Arguing that ' 506(b) permitted an oversecured creditor to recover only 'reasonable fees, costs, and charges,' the debtor sought to disallow the prepayment penalty as unreasonable. The bankruptcy court and district court agreed with the debtor, finding the prepayment penalty to be unreasonable in its entirety under ' 506(b) and, therefore, disallowing UPS's claim for the penalty. UPS appealed to the First Circuit.

At the First Circuit, a unanimous panel reversed the lower courts, finding that ' 506(b) governs the priority, but not the allowability, of claims asserted by oversecured creditors for fees and expenses. Rather than looking first to ' 506(b) for reasonableness, any analysis regarding the allowability of a claim ' whether oversecured, undersecured, or unsecured ' must start with 11 U.S.C.
' 502. If a prepayment penalty is enforceable under state law (and not otherwise disallowed under ' 502), then the party asserting the claim should have, at the least, an unsecured claim for the prepayment penalty. Only after determining whether the claim is allowable under ' 502 should courts consider whether the claim could also be subject to priority treatment as part of an oversecured creditor's secured claim under ' 506(b). Only reasonable fees and expenses of an oversecured creditor may be treated as secured under ' 506(b). Therefore, to the extent the claim is not reasonable, it is not entitled to treatment as a secured claim under ' 506(b). However, merely because a claim is not entitled to treatment as a secured claim under ' 506(b) does not deprive it of its allowability as a general unsecured claim. Accord Welzel v. Advocate Realty Inv., LLC (In re Welzel), 275 F.3d 1308 (11th Cir. 2001) (unreasonable portion of post-petition attorney fee claim is unsecured claim under ' 502).

In Gencarelli, the lower court found the prepayment penalty to be unreasonable under ' 506(b) without having first determined whether it was allowable under ' 502. The First Circuit therefore remanded the case back to the bankruptcy court for determination of whether the prepayment penalty was enforceable under state law. If so, given the debtor's solvency, UPS was entitled to payment in full of its claim for the prepayment penalty regardless of whether it was reasonable under ' 506(b). In other words, because UPS would be entitled to receive full payment on its claim regardless of whether it was secured or unsecured (due to the debtor's solvency), the reasonableness of the prepayment penalty under ' 506(b) was irrelevant. By avoiding this reasonableness inquiry, the First Circuit also dodged having to determine the appropriate standard for reasonableness under
' 506(b) (i.e., whether a bankruptcy law standard supersedes any state law standard), which may have proved interesting given that the lower courts determined UPS's prepayment penalty was unreasonable in its entirety regardless of its enforceability under state law.

Does Solvency Matter? Should It?

The First Circuit's analysis in Gencarelli of the interplay between ' 502 and ' 506(b) involved a straightforward exercise of statutory analysis. The First Circuit found that claims for unreasonable prepayment penalties enforceable under state law may be allowable under ' 502 and are not expressly disallowed by operation of ' 506(b). Under the Supreme Court's decision in Travelers, claims that are enforceable under state law should be allowed in bankruptcy unless they are 'expressly disallowed' under a specific provision of the Bankruptcy Code. Travelers, 127 S. Ct., at 1206. Because the First Circuit suggested no other statutory basis in the Bankruptcy Code to warrant disallowance of an enforceable claim for unreasonable prepayment penalties, under the rule adduced in Travelers, it would seem that any oversecured creditor would be entitled to an unsecured claim for unreasonable fees and expenses so long as such claims arise under a contractual right and are enforceable under state law.

In Gencarelli, however, the First Circuit sought to avoid such an expansive ruling by limiting its decision to 'solvent debtor' cases, where all of a debtor's secured and unsecured creditors are paid in full. See Gencarelli, 2007 U.S. App. LEXIS 20751, at *14 ('Let us be perfectly clear. This is a solvent debtor case and, as such, the equities strongly favor holding the debtor to his contractual obligations as long as these obligations are legally enforceable under applicable non-bankruptcy law.'). In doing so, the First Circuit noted that, '[w]hen the debtor is solvent, 'the bankruptcy rule is that where there is a contractual provision valid under state law ' the bankruptcy court will enforce the contractual provision.” Id. (citing prior First Circuit law) (emphasis in original). In other words, contractual rights apparently are more enforceable when the debtor is solvent. After Gencarelli, therefore, courts in the First Circuit arguably have authority to decide on equitable bases, including the debtor's solvency, whether unreasonable fees and expenses of an oversecured creditor are recoverable under ' 502.

Notwithstanding the First Circuit's effort to limit its ruling to solvent cases, it remains dubious that an unsecured claim allowable under ' 502 and not otherwise disallowed by a provision of the Bankruptcy Code can be unenforceable based on general equitable considerations such as the solvency of the debtor. Such a result would seem inconsistent with Travelers. As such, serious questions remain regarding what role the 'solvent debtor' doctrine should play as a basis for disallowing otherwise enforceable claims after Travelers.

Applying Gencarelli to Claims By Unsecured Creditors

In addition to raising interesting questions regarding the viability of the 'solvent debtor' doctrine after Travelers (at least with respect to the allowance or disallowance of claims under ' 502), the Gencarelli case also contributes to the debate regarding the allowability under ' 502 of claims for post-petition attorney fees asserted by unsecured creditors. A question left unanswered by the Supreme Court in Travelers is whether ' 506(b), by statutorily limiting oversecured creditors to 'reasonable' post-petition fees and charges, necessarily precludes by implication any claims by unsecured creditors for such post-petition fees and charges, let alone unreasonable fees and charges.

The First Circuit's reasoned decision in Gencarelli strongly supports the argument that unsecured creditors should be entitled to allowed claims for postpetition attorney fees (despite the First Circuit's gallant effort to stay out of this debate).
See Gencarelli, at * 14 n.3 ('[T]his opinion should not be construed as speaking to the different question of whether an unsecured creditor can enforce a contractual right to post-petition fees against the estate of an insolvent debtor under section 502.') (citing Travelers). If, as Gencarelli suggests, the allowability of all claims should first be addressed under ' 502, and ' 506(b) only operates to determine whether some portion of such allowed claim may be entitled to priority as part of an oversecured creditor's secured claim, it follows that unsecured creditors (like oversecured creditors) should be entitled to allowed unsecured claims to the full extent permissible under applicable nonbankruptcy law.

Conclusion

The statutory analysis supporting allowance under ' 502 of unsecured claims against even insolvent debtors for fees and expenses that are enforceable under state law, albeit unreasonable under 506(b), is fairly straightforward. Regardless, despite Travelers, bankruptcy courts may continue to fall back on equitable principles such as the 'solvent debtor' line of cases cited in Gencarelli to ensure that such unsecured claims for fees and expenses (which can potentially swallow all recoveries in a case) remain the exception and not the rule.

Dion W. Hayes ([email protected]), a member of this newsletter's Board of Editors, is a partner, and Aaron G. McCollough mailto:[email protected]) is an associate, in the Restructuring and Insolvency Group at the Richmond, VA, office of McGuireWoods LLP. The views expressed in this article are those of the authors and do not necessarily represent the views of McGuireWoods LLP or its clients.