Fourth Circuit holds that creditor may "preserve" unpaid principal by allocating payment to interest in bankruptcy proceeding

In IN RE: NATIONAL ENERGY & GAS TRANSMISSION, the Fourth Circuit considered whether a creditor may allocate a payment made by a non-debtor guarantor first to interest then to principal, thus preserving the unpaid principal for collection in bankruptcy. At base, Liberty sought to collect $17 million from ET Power notwithstanding the fact that it has already received the full value —$140 million — of the debt which it was owed by ET Power on the petition date. Liberty argued that the additional $17 million was really unpaid principal inasmuch as it applied the payment of $140 million first to interest then to principal. The Fourth Circuit disallowed the claim:

We believe that § 502(b)(2) prevents Liberty from collecting the additional $17 million it seeks despite Liberty’s classification of that amount as principal. On the date the debtors filed their bankruptcy petition, the Agreement was effectively rejected and Liberty sustained damages, although the value of the damages was then unknown and disputed. Subsequently, through arbitration, Liberty’s damages were determined to be $140 million. Thus, Liberty’s damages and ET Power’s debt to Liberty on the petition date was $140 million, and by the terms of § 502(b)(2), Liberty could not collect in bankruptcy any additional amounts added due to the accrual of interest.