Restructuring

Contributed by Marvin Mills
On April 9, 2012, the United States Bankruptcy Court for the Southern District of New York ruled that, in a case where the loan had matured and was in payment default well before commencement of the bankruptcy, an over-secured creditor’s claim would continue to accrue interest at the default rate set forth in the governing loan documents, despite the debtor’s contention that the default rate was an inequitable penalty.  The bankruptcy court concluded, however, that the secured creditor could not also receive a “late payment premium” because such premium and the default rate of interest were mutually exclusive.
In 785 Partners LLC, a secured creditor asserted a claim for payment of principal, regular interest, administrative fees, default interest, and a late payment premium, collectively due under certain governing loan documents.  The loan documents provided, among other things, that a failure to make payments due on the maturity date would constitute an event of default, which would trigger (1) a default rate of interest equal to a base rate plus 5%, and (2) a late payment fee of 5% of the amount due under the loan documents.  Prior to the commencement of the debtor’s bankruptcy case, the loans matured, and the debtor failed to make the required payments.  Consequently, an event of default occurred under the governing loan documents and default interest began to accrue prior to the debtor’s bankruptcy filing.
The dispute over the secured creditor’s claim centered on the default interest rate and the late payment premium.  The debtor argued that both the late payment premium and the default interest rate were “unenforceable penalties, inequitable and unreasonable.”  The debtor further argued that the late payment premium, was intended to “cover administrative and related expenses incurred in handling delinquent payments,” and was not recoverable under the terms of the loan documents.
Default Interest Rate Permitted
Prepetition interest
The bankruptcy court first addressed the permissibility of the prepetition default interest, and observed that such interest is permitted to the extent allowed under applicable non-bankruptcy law.  The bankruptcy court explained that an agreement to pay interest at a higher rate in the event of default is not a penalty, and a court cannot rewrite such an agreement based upon its “own notions of fairness and equity.”  According to the bankruptcy court, the parties to the loan documents were sophisticated parties represented by counsel and there was no evidence of overreaching.  The bankruptcy court further explained that, although section 506(b) of the Bankruptcy Code grants courts discretion to apply equitable considerations and to modify the amount of interest included in an over-secured creditor’s claim, that discretion applies only to postpetition interest.
The bankruptcy court also dismissed the debtor’s argument that, because the secured creditor had purchased the loans from the original lenders at a “steep” discount and was aware that the loans were in default at the time of purchase, the default interest rate should not apply.  The secured creditor, explained the bankruptcy court, “stands in the shoes of its assignor” and, therefore, could assert the same claims that the original lenders could assert under the loan documents.
Postpetition interest
In its analysis of the postpetition default interest rate, the bankruptcy court observed that, generally, interest ceases to accrue upon the commencement of a bankruptcy proceeding.  This rule is embodied in section 502(b)(2) of the Bankruptcy Code, which disallows claims for unmatured interest.  An exception to this rule exists for over-secured creditors, which exception is embodied in section 506(b) of the Bankruptcy Code.  Section 506(b) provides that, “[t]o the extent that an allowed secured claim is secured by property the value of which . . . is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim . . . .”
Section 506(b) does not state what rate applies to such postpetition interest.  The bankruptcy court opined that the applicable postpetition interest rate is not set by contract per se, and that “fixing the appropriate rate rests with the ‘limited discretion’ of the bankruptcy court.”  The bankruptcy court recognized, however, that there is a “rebuttable presumption that the over-secured creditor is entitled to default interest at the contract rate subject to adjustment based on equitable considerations.”  (Notably, the parties stipulated that the default interest rate was contractually set and began to accrue prior to the commencement of the debtor’s bankruptcy case.)
The bankruptcy court explained that a debtor bears the burden of rebutting the presumption that the contract rate is the appropriate postpetition interest rate.  The bankruptcy court identified three equitable bases for modifying the contract rate:  (1) misconduct by the secured creditor, (2) application of the contractual interest rate would harm the unsecured creditors or impair the debtor’s fresh start, or (3) the contractual interest rate constitutes a penalty.
The bankruptcy court considered these factors and concluded that the debtor failed to sustain its burden.  First, the bankruptcy court found no evidence of misconduct by the secured creditor.  Second, the bankruptcy court determined that application of the default rate would not harm unsecured creditors, or impair the debtor’s ability to reorganize.  The bankruptcy court based its conclusion on its determination that the debtor was solvent (because the debtor proposed to pay unsecured creditors in full and allow equity holders to retain their interests).  Evaluating the equities in a case where the loan was in default before the bankruptcy filing, the bankruptcy court reasoned that, “[r]educing the contract interest payable by a solvent debtor would unfairly grant a windfall to its equity.”
Finally, the bankruptcy court concluded that the debtor did not demonstrate that the default rate constituted a penalty.  The bankruptcy court ruled that, pursuant to applicable non-bankruptcy law, “a variable interest rate that increases following a default is not a penalty.”  The bankruptcy court dismissed the debtor’s assertion that the default rate was akin to liquidated damages and should be deemed an unenforceable penalty.  The determination as to whether an amount equates to liquidated damages or a penalty, explained the bankruptcy court, must be determined as of the date of the agreement, and not based upon hindsight.  The bankruptcy court indicated that the debtor failed to adduce any evidence supporting its argument that the default rate of 5% was intended to be a penalty, and observed, moreover, that such rate “falls within the range of reasonableness.”
Late Payment Premium Denied
Although the bankruptcy court concluded that interest at the default rate was allowable, it denied the secured creditor from obtaining the late payment premium.  Based upon the express language of the governing loan documents, the bankruptcy court explained that the late payment premium covered “(1) late payments due under the [l]oan [d]ocuments, (2) payable at the time of the late payment, and (3) it [was] intended to cover the additional costs of handling the late payment.”  The bankruptcy court further explained that the secured creditor would receive payment pursuant to a reorganization plan, not the loan documents.  Consequently, the debtor would never make a late payment pursuant to the loan documents, and the secured creditor would not incur any additional costs to handle such payment, i.e., the late payment premium would never come due.  The bankruptcy court separately noted that a “secured creditor is limited under [section] 506(b) to recovering ‘reasonable’ fees provided for in the agreement.”  According to the bankruptcy court, the secured lender could receive the default interest rate or a late charge, but not both, because “awarding both amounts to double recovery.”
The bankruptcy court’s opinion in 785 Partners LLC highlights a critical distinction in postpetition interest rate disputes.  Where there is a prepetition default triggering default-rate interest under the loan document, the court can, as a matter of equity, decline to enforce the contract and reduce the interest rate.  Judge Bernstein declined to do so after reviewing the applicable equitable factors in 785 Partners LLC.  The decision, however, does not speak to the circumstance where there was no pre-bankruptcy default and the only basis for the application of default-rate interest is a bankruptcy default (ipso facto) clause in the loan agreement.  The United States Court of Appeals for the Second Circuit has the latter issue before it in two appeals arising from the General Growth Properties bankruptcy.