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If a primary obligor of a debt enters bankruptcy, does the non-debtor guarantor remain on the hook for post-petition interest? Can the creditor apply monies received from the non-debtor guarantor first to post-petition interest and then to principal? With respect to the first question, maybe not, but definitely not as for the second, at least according to a divided court in National Energy & Gas Transmission Inc. (f/k/a PG&E National Energy Group Inc.) et al. v. Liberty Electric Power LLC (In re National Energy & Gas Transmission Inc.). In National Energy, the 4th U.S. Circuit Court of Appeals reversed two lower court decisions that would have allowed an unsecured creditor to allocate a payment made by a non-debtor guarantor first to post�petition interest and then to principal, thereby preserving its ability to collect an additional $17 million from the bankruptcy estate. The 4th Circuit held that pursuant to Section 502(b)(2) of the Bankruptcy Code, the unsecured creditor was barred from receiving the additional $17 million from the estate because all of the monies received from the non-debtor-guarantor had to be applied against principal as opposed to post-petition interest. National Energy & Gas Transmission Energy Trading Power L.P. (ET Power) operated as an energy marketing and trading company. As part of its business, it entered into an electricity tolling agreement with Liberty Electricity Power LLC. ET Power’s obligations under the agreement were guaranteed by National Energy & Gas Transmission Inc. (NEGT), ET Power’s parent, and by Gas Transmission Northwest Corporation (GTN), a subsidiary of NEGT. Pursuant to the guarantees, NEGT and GTN each assured prompt payment of all amounts payable by ET Power to Liberty, including a termination payment and any damage award arising from ET Power’s breach of the agreement. The liability of each guarantor was capped at $140 million. On July 8, 2003, ET Power, NEGT and other related entities (but not including the guarantor GTN) filed for Chapter 11 relief and, at that time, also moved to reject the agreement. With the consent of Liberty, the agreement was rejected. As a result, Liberty sought $140 million as a termination payment, in addition to amounts that were owed to Liberty as of July 8, 2003, pursuant to the agreement. Liberty’s claim for the termination payment proceeded to arbitration. The arbitration panel awarded Liberty the full $140 million, plus interest accruing from the date of rejection. Following arbitration, GTN paid Liberty $140 million in full and final satisfaction of its guarantee. Upon receipt of this payment, Liberty allocated the $140 million first to the payment of interest (which had by then reached approximately $17 million) and then to principal. Liberty contended that it remained entitled to payment in the amount of $17 million from the estate, which it maintained was unpaid principal rather than post-petition interest. The debtors objected to Liberty’s claims on the basis that the $17 million was post-petition interest barred under Section 502(b)(2) of the Bankruptcy Code. The bankruptcy court, which was affirmed on appeal by the district court, agreed with Liberty and allowed Liberty’s claims. In reversing the decision of the lower courts, the 4th Circuit first addressed the policy behind Section 502(b)(2), which disallows claims for unmatured interest. The court stated, “The purpose of this section is two-fold: (1) the avoidance of unfairness among competing creditors, and (2) the avoidance of administrative inconvenience.” Noting its equitable nature, the court expressed its belief that Section 502(b)(2) prevents Liberty from collecting an additional $17 million despite Liberty’s classification of this amount as unpaid principal. The court observed that as of the petition date of July 8, 2003, the agreement was effectively rejected. Liberty’s damages were subsequently determined to be $140 million. Thus, ET Power’s debt to Liberty on the petition date was $140 million and, pursuant to Section 502(b)(2), Liberty could not collect any additional amounts, even though the arbitration panel’s award of interest may have been appropriate under the agreement and as a matter of non-bankruptcy law. The court further stated that the bar to collecting post-petition interest is not overcome by Liberty’s classification of its claim as unpaid principal because, “sift[ing] the circumstances surrounding” the claim, the reality is that the $140 million debt was increased only by the accrual of interest as a result of the arbitration award; therefore, Liberty’s claim for an additional $17 million constitutes disallowed post-petition interest no matter how Liberty classifies it and notwithstanding the fact that the payment of principal was made by a non-debtor guarantor. The court did acknowledge that post-petition interest may be allowed in some instances � such as those in which the estate is solvent or the interest is sought by an oversecured creditor � if the allowance will not result in administrative inconvenience or unfairness to creditors. However, in this case, the court found that allowing Liberty to collect post-petition interest will impact the estate and the amount that would otherwise be available for distribution to creditors. Therefore, the purpose of Section 502(b)(2) is best served by barring Liberty from collecting an additional $17 million from the estate. In so ruling, the court recognized that bankruptcy proceedings cannot affect the liability of a non-debtor; therefore, Liberty was free to classify GTN’s payment as interest and to pursue collection from GTN (to the extent permitted by the terms of its guarantee) of the full amount that Liberty believes it is owed. Comment This decision affirms the effect of Section 502(b)(2), which bars the accrual of post-petition interest on pre-petition claims, including claims resulting from the rejection or termination of a contract. It seems to go even further, however, to hold that the accrual of post-petition interest is prohibited even when the underlying contract as well as non-bankruptcy law otherwise entitles the claimant to such a recovery. Accordingly, unless another section of the Bankruptcy Code permits the accrual of post-petition interest on a particular type of claim, such as Section 506(b) � which permits oversecured creditors to collect post-petition interest notwithstanding Section 502(b)(2) � the amount of a prepetition claim is fixed as of the petition date and does not accrue interest thereafter. Moreover, in this case, even though the arbitration resulted in a $17 million interest award against a non-debtor, the creditor was not permitted to allocate the settlement monies received to interest until all principal was paid in full. Therefore, strategically, a creditor must consider whether to forego settlement with a non-debtor guarantor unless the guarantor pays all principal and interest or risk a recovery shortfall against the debtor because of the application of Section 502(b)(2).

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