Should an Over-secured Creditor Be Entitled to Post-petition Interest at the Default Rate
Bankruptcy courts are generally required to deny claims for unmatured interest under §502(b)(2) of the Bankruptcy Code. Thus, "interest stops accruing at the date of the filing of the [bankruptcy] petition, because any claim for unmatured interest is disallowed..." H.R. Rep. No. 595, 95th Cong., 1st Sess. 352-54 (1977).
A claim for interest by an oversecured creditor, however, triggers an exception to this general rule.1 This exception is codified in 11 U.S.C. §506(b) and provides that if "an allowed secured claim is secured by property the value of which, after any recovery under SUPsection (c) of this section, is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim..."2
Section 506(b) and the accompanying legislative history is, however, silent on the rate of interest to be applied to an oversecured creditor’s principal claim. This has left courts to answer the question whether oversecured creditors’ should be entitled to receive the benefit of their bargain when debtors default, and specifically whether courts should allow oversecured creditors’ claims for default interest pursuant to their contracts.
The U.S. Supreme Court has not addressed this issue. As a result, there is no consensus among courts as to the appropriate rate of interest under §506(b). The case that many courts look to in resolving the interest rate debate is Vanston Bondholders Protective Committee v. Green, 329 U.S. 156 (1946). In Vanston, the Supreme Court relied in part on the application of equitable principles to reject a creditor’s bankruptcy claim for compound interest that the creditor had sought pursuant to the terms of the contract with the debtor. Id. at 166.
The Supreme Court’s reliance on "equitable principles" in 1946 has been interpreted by many courts as a continuing directive to use equitable principles to determine the appropriate interest rate to apply to a §506(b) post-petition interest claim.3 This has created a divergence of opinions because the facts and circumstances of each case become critical to any claim for default interest under the equitable principles analysis.
The reliance on Vanston, however, has been complicated by the Supreme Court’s holding in United States v. Ron Pair Enterprises Inc., 489 U.S. 235 (1989). In Ron Pair, the Supreme Court held that the entitlement to interest under §506(b) stands alone, and is not dependent upon the clause in §506(b): "provided for under the agreement under which such claim arose." Id. at 241-42.
Some bankruptcy courts have interpreted this holding as requiring that contractual provisions be ignored when applying §506(b) to post-petition interest claims. See, e.g., In re Consolidated Properties Ltd. Partnerships, 152 B.R. 452, 457 (Bankr. D. Md. 1993); In re DWS Invs., 121 B.R. 845, 849 (Bankr. C.D. Calif. 1990); In re Laymon, 117 B.R. 856, 858 (Bankr. W.D. Tex. 1990), rev’d Matter of Laymon, 958 F.2d 72 (5th Cir. 1992).
Such an interpretation, however, does not appear to be correct. Ron Pair only decided the issue of entitlement to post-petition interest. The court did not decide what should be the appropriate rate of interest under §506(b). Ron Pair, 489 U.S. at 243-246.
Current Case Law
Current §506(b) analysis and the issue of entitlement to post-petition default interest is obviously unsettled. Unfortunately only the Fifth, Seventh, Ninth and Eleventh Circuit Courts of Appeal have actually decided the issue.
In Laymon, 958 F.2d at 72, the Fifth Circuit reversed the bankruptcy court’s determination that Ron Pair required a holding that the issue of post-petition interest be "completely divorced from either the existence or the content of the underlying agreement." Id. at 74, (quoting Laymon, 117 B.R. at 858-59). The court found that Congress did not intend for §506(b) to effect a major change in pre-Code law4 because neither the legislative history nor the language of the statute referred to a specific rate of interest. Id. at 75. As a result, the court concluded that oversecured creditors are entitled to their contract rate of interest under §506(b), and may be entitled to their default rate of interest SUPject to the equities of the case. Id.
In In re Terry, 27 F.3d 241 (7th Cir. 1994), the court relied on Ron Pair to find that the award of post-default interest at the higher contract rate was reasonable because it compensated the secured creditor for "the additional but unforeseeable costs and risks associated with a defaulting borrower." Id. at 244. The Seventh Circuit concluded that "[w]hat emerges from post-Ron Pair decisions is a presumption in favor of the contract rate SUPject to rebuttal based upon equitable considerations." Id. at 243.
In In re SUPlett, 895 F.2d 1381 (11th Cir. 1990). The bankruptcy court disallowed the creditor’s claim for the default interest relying on Vanston, 329 U.S. at 156, to find that such payment would be "unfair to the other creditors." Id. at 1385.
The Eleventh Circuit reversed, finding that the bankruptcy court’s reliance on Vanston was fatally flawed "because whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code." Id., (quoting Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 206 (1988)). The court went on to state that "to the extent that Vanston’s equitable analysis suggests a result contrary to the language of the present Bankruptcy Code, Vanston has been superseded." Id. at 1386.
The court concluded by citing four factors that it held must be present to award default interest: (1) the creditor is oversecured; (2) the claimed default interest is provided for in the loan documents; (3) the claimed interest is reasonable under state law; and (4) the debtor is solvent. Id.
The Ninth Circuit has denied post-petition default interest. In In re Entz-White Lumber and Supply Inc., 850 F.2d 1338 (9th Cir. 1988), the debtor argued that by paying the arrearage on the secured creditor’s obligation, it had cured the default pursuant to §1124, and thus was entitled to avoid all consequences of default, including payment of default interest. Id. at 1340. The creditor argued that Congress only intended to allow debtors to cure defaults arising from acceleration. Thus, since the debtor’s obligation to the creditor had matured pre-petition, the default rate was not a "consequence" of default that the debtor could avoid. Id.
The Ninth Circuit agreed with the debtor. The court found that if a debtor’s plan of reorganization provides that the debtor will pay the arrearage on a debt or pay a matured obligation in full, the debtor will be deemed to have cured the debt. Id. at 1341-1342. As a result, if a debtor cures a default as part of a plan of reorganization, the debtor "is entitled to avoid all consequences of default—including higher post-default interest rates." Id. at 1342.
It is curious to note that after the Entz-White court spent its entire analysis rejecting the right to default interest, the court stated in a footnote, "[w]e continue, of course, to recognize bankruptcy courts’ ‘broad equitable discretion’ in awarding post-petition interest." Id., n.9.
The federal Courts of Appeal in the First, Second, Third, Fourth, Sixth, Eighth and Tenth Circuits have not ruled on the issue of the proper rate of interest to apply under §506(b).5 Bankruptcy courts in these circuits, however, have both allowed and rejected claims for post-petition default interest. These decisions seem to fall into two categories: The courts either rely on the cure rationale of the Ninth Circuit to reject claims for default interest, or the courts rely on equitable principles in determining the entitlement to default interest. See In re Maywood Inc., 210 B.R. 91 (Bankr. N.D. Tex. 1997) (applying Laymon to determine that the equities of the case preclude default interest); In re Johnson, 184 B.R. 570 (Bankr. D. Minn. 1995) (citing Entz-White and Countrywood in holding that the plan payments to the oversecured creditor constituted a full cure, thereby nullifying the consequences of default); In re Kalian, 178 B.R. 308 (Bankr. D.R.I. 1995) (it is within the court’s discretion to determine applicable interest rate); In re Consolidated Properties Ltd. Partnership, 152 B.R. 452 (Bankr. D. Md. 1993) (default interest rates should be examined for reasonableness); In re Chateaugay Corp., 150 B.R. 529 (Bankr. S.D.N.Y. 1993) (cure precludes post-petition interest unless the debt matured without acceleration); In re Courtland Estates Corp., 144 B.R. 5 (Bankr. D. Mass. 1992) (reliance on Laymon to find that contract rate of interest was appropriate); Matter of Timberline Property Development Inc., 136 B.R. 382 (Bankr. D.N.J. 1992), (default interest is permitted where the rate is designed "to provide actual compensation to a creditor for admin-istrative or other costs incurred as
a result of default." Id. at 385); In re Countrywood Investment Group Ltd., 117 B.R. 338 (Bankr. M.D. Tenn. 1990), (adopted Entz-White analysis to preclude application of default interest); In re Consolidated Operating Partners L.P., 91 B.R. 113 (Bankr. D. Colo. 1988), (court relied on Vanston to find that the equities of the case dictated whether an oversecured creditor was entitled to default interest); Matter of Arlington Village Partners Ltd., 66 B.R. 308 (Bankr. S.D. Ohio 1986), (equities of case allowed creditor to receive the market rate of interest SUPject to a comparison to the pre-default and default rates of interest); In re W.S. Sheppley & Co., 62 B.R. 271 (Bankr. N.D. Iowa 1986)6 (flexible approach is the best method in accordance with the Vanston equity analysis).
The Effect of the 1994 Amendments
In 1994, Congress added SUPsection (d) to §1123, which directs that any amount necessary to cure a default in a proposed plan is to be determined by the agreement between the debtor and the creditor and any applicable non-bankruptcy law. 11 U.S.C. §1123(d). Because the amendment is to be applied prospectively, 140 Cong. Rec. H. 10,770 (October 4, 1994), hereinafter Cong. Rec., SUPsection (d) is only applicable to contracts entered into after October 22, 1994. As a result, there is no known case law interpreting this SUPsection.7
At first blush, it would appear that Congress’s intention in drafting the SUPsection was quite clear, and that Congress intended for the agreement of the parties and state law to control the cure provisions. However, the legislative history evidences that it was Congress’s intent in enacting the section to prevent creditors from receiving interest on interest payments, and interest on late charges and other fees. Cong. Rec. H. 10,770.8
The actual language that was enacted, however, does not appear to accomplish Congress’s intent. This is because Congress actually passed an earlier version of the bill that appears to, in fact, expand creditors’ rights by requiring the debtor to comply with the underlying contract in order to effect a cure. Mark A. Shaiken and Irvin C. Ness, Wiley Law Special Report on the 1994 Bankruptcy Reform Act, p. 46 (Wiley Law Publications 1994).
With no case law and confusing legislative history, rules of statutory construction should dictate that the plain meaning of the statute controls the interpretation of the Bankruptcy Code provisions. U.S. v. Ron Pair Enters. Inc., 489 U.S. 235, 242 (1989). This means that courts should find that the agreement of the parties and state law controls the award of default interest in the context of cure.
Clearly such an interpretation impacts the current law, particularly in the Ninth Circuit. It remains to be seen, however, whether any circuit will utilize the section to alter existing law.9
The Future of the §506(b) Analysis
It seems likely that jurisdictions will continue to diverge in their opinion regarding oversecured creditors’ rights to post-petition default interest under §506(b). The jurisdictions will remain split because the legislative history of §506(b) does not provide courts with any direction for interpreting and applying the interest provision. As well, the issue is not presently before the U.S. Supreme Court.
Thus, it would appear that the only method for creating uniformity among the jurisdictions is for Congress to clarify oversecured creditors’ rights to post-petition interest under §506(b). Congress can either amend the section to conform with its original intent to expand secured creditors’ rights under the Bankruptcy Code; or Congress can remain true to bankruptcy’s equity principles and place restrictions on secured creditors’ rights to interest.
3It is curious that many courts have continued to rely on Vanston in their analysis of default rates despite the Code’s legislative history that shows Congress’s intent to create "significant changes from current law...[i]n the treatment of secured creditors and secured claims." H.R. Rep. No. 595, 95th Cong., 1st Sess. 180 (1977). Return to Text
4Under pre-Code law, the majority of courts utilized the contract rate of interest in allowing an oversecured creditor post-petition interest, provided such rate did not produce an inequitable or unconscionable result. Laymon, 958 F.2d at 74. Return to Text
5The Eighth Circuit, however, has intimated that default interest may be appropriate, SUPject to a reasonableness standard. See First Bank Investors’ Trust v. Tarko, 129 F.3d 471, 477 (8th Cir. 1997). Return to Text
6Sheppley is one of the first cases to analyze the right to default interest under §506(b). The analysis includes an excellent summary of default interest entitlements under pre-Code law. Return to Text
8Congress actually wanted to statutorily overrule the holding in Rake v. Wade, 508 U.S. 464 (1993). Cong. Rec. H. 10,770. In Rake, the court held that an oversecured creditor was entitled to be paid interest on mortgage arrearages in order for the debtor to cure defaults on its mortgage payments, even if the mortgage instrument did not provide for interest, and state law did not require such. Rake, 508 U.S. at 473. Return to Text
9On March 28, 1997, Judge Samuel J. Steiner, sitting in the Western District of Washington at Seattle, refused to apply the plain meaning of §1123(d) to require that default interest be paid in order to affect a cure under §1124. It was Judge Steiner’s opinion that In re Casa Blanca Project Lender L.P., 196 B.R. 140 (9th Cir. BAP 1996), was still good law, and that the holding permitted him to use equitable principles to deny default interest. (This issue arose in In re Sahlberg Equipment Inc., B.R. No. 96-02787, an unreported decision.) Return to Text