When 100% Is Not Enough Post-petition Accruals on Oversecured Claims

When 100% Is Not Enough Post-petition Accruals on Oversecured Claims

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The petition date in a chapter 11 case is a bright line defining, and generally curtailing, the rights of creditors. Claims of unsecured creditors are frozen at the moment of filing and are likely to be satisfied with payments of cents on the dollar. For oversecured creditors, though, the Code provides protection not only for amounts accrued at the time of filing, but also post-petition interest, default interest and reasonable charges for such items as late fees, attorneys' fees and prepayment premiums.

The critical section of the Code is §506(b):

To the extent that an allowed secured claim is secured by property the value of which, after any recovery under subsection (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, and any reasonable fees, costs or charges provided for under the agreement under which such claim arose.

Section 506(b) was first made famous in United States v. Ron Pair Enterprises Inc., 489 U.S. 235 (1996), when the Supreme Court decided that the statute's unusual punctuation and plain meaning entitle taxing authorities and other nonconsensual lienholders to post-petition interest despite the absence of an agreement. As explained by the court, all oversecured creditors, both consensual and non-consensual, are entitled to post-petition interest, but other reasonable fees, costs and other charges will only be added to a secured claim to the extent they are both reasonable and are provided for in an agreement between the debtor and the creditor. While the court's ruling left no room for doubt as to the independence of the interest provision, it was silent as to the rate at which post-petition interest should accrue.

Since Ron Pair, the controversial issues that have arisen under §506(b) relate to the allowance of default interest, attorneys' fees, late fees and prepayment premiums. In the course of addressing these issues, the courts have also grappled with the interplay between allowance of claims under §502 and the determination of secured status under §506(b).

Default Interest

The majority view on default interest is that interest accrues at the rate provided in the contract, a result consistent with pre-Code law. 4 Collier on Bankruptcy ¶506.04[2][b] (15th ed. rev. 2005). As long as the default rate provided in the contract does not violate state usury laws or other applicable laws governing interest rates, an oversecured creditor's secured claim should include contractual default interest. To the extent that pre-Code case law recognized an equitable limitation on the allowance of interest, it was superseded by the enactment of §506(b). Equitable Life Assurance Society v. Sublett (In re Sublett), 895 F.2d 1381, 1386 (11th Cir. 1990).

A minority view seeks to graft an equitable restriction on the allowance of default interest. These courts look to the contract rate as a presumption rather than an absolute rule, a presumption that can be overcome by establishing equitable considerations allowing a deviation. See, e.g., Florida Asset Fin. Corp. v. Dixon (In re Dixon), 228 B.R. 166 (W.D. Va. 1998) (following presumption approach but finding no equitable justification on the facts for limiting 36 percent default rate on a guaranty of a $150,000 business loan). This approach places an evidentiary burden on the creditor to go forward with evidence to justify the use and fairness of the default rate.

Another approach used by certain courts to avoid using high default rates is to recharacterize the default interest as a "charge" rather than interest, thereby transferring the scrutiny of the claim to the final clause of §506(b). A recent example is In re AE Hotel Venture, 321 B.R. 209 (Bankr. N.D. Ill. 2005), appeal docketed on other grounds (Feb. 28, 2005), where the court declared that the additional 5 percent default interest was not true interest at all but instead a form of late charge, and therefore a "charge" for purposes of §506(b), which it rejected as unreasonable. Id. at 215-16. Notably, the court did not refer to state law in support of the recharacterization of default interest as something other than interest, a result at odds with the doctrine that in the absence of an important federal interest stated in the statute or the legislative history, rights are to be determined by state law.

Loan documents often require some triggering event for default interest, such as the existence of an "event of default" (which may require notice or expiration of grace periods) or acceleration of the loan. After commencement of the case, the automatic stay prevents a creditor from sending default notices or accelerating a loan, with the result that the creditor will then be unable to establish the pre-requisites for default interest. If default interest has not been properly triggered under the terms of the loan agreement at the time the petition is filed, post-petition interest will generally accrue at the non-default rate. In re Manville Forest Prods. Corp., 43 B.R. 293, 298 n.5 (Bankr. S.D.N.Y. 1984), aff'd. in part, rev'd. in part on other grounds, 60 B.R. 403 (S.D.N.Y. 1996).

The filing of a bankruptcy petition effects the automatic acceleration of debts, thereby allowing creditors to file claims for debts not yet due and payable according to their terms. In re Skyler Ridge, 80 B.R. 500, 507 (Bankr. C.D. Cal. 1987) ("The automatic acceleration of a debt upon the filing of a bankruptcy case is well established."); see, also, H.R. Rep. No. 595, at 353 (1977) (§502(b)(1) "operates as the acceleration of the principal amount of all claims against the debtor"); Manville, 43 B.R. at 298; In re Payless Cashways Inc., 287 B.R. 482, 488 (Bankr. W.D. Mo. 2002). However, this automatic acceleration does not entitle a lender to default interest or other post-acceleration rights if the loan documents require actual acceleration. In re Texaco Inc., 73 B.R. 960, 965-66 (Bankr. S.D.N.Y. 1987); Payless Cashways, 287 B.R. at 488.

Late Charges and Attorneys' Fees

Late charges and attorneys' fees are reviewed for reasonableness under the final clause of §506(b). Late fees have often been found to be unreasonable, and therefore rejected, when the creditor also claims default interest. See, e.g., In re 1095 Commonwealth Ave. Corp., 204 B.R. 284, 304-05 (Bankr. D. Mass. 1997); In re Vest Assocs., 217 B.R. 696, 701 (Bankr. S.D.N.Y. 1998).

Section 506(b) only governs the secured status as opposed to allowance of claims, which is governed by §502. The interplay between §506(b) and §502 is illustrated by Welzel v. Advocate Realty Investments LLC (In re Welzel), 275 F.3d 1308 (11th Cir. 2001). There, the promissory notes included a fixed 15 percent charge for attorneys' fees, which the court found to be enforceable under state law. Id. at 1313. Since §506(b) limits an oversecured creditor's claim to reasonable fees, the court bifurcated the attorneys' fee claim into a secured claim for the actual and reasonable fees incurred and an unsecured claim for the balance of the 15 percent charge.

Prepayment Premiums

The subject of the most heated debate under §506(b) is prepayment premiums. These charges frequently are included in fixed-rate loans and are designed to compensate a lender for a portion of the interest it will be unable to earn over the original term of the loan if the borrower pays it off prior to maturity. Prepayment premium formulas vary widely, but the most basic formulation requires payment of the difference between the market rate of interest at the time of prepayment and the contract rate for the duration of the loan, discounted to present value. In re Duralite Truck Body & Container Corp., 153 B.R. 708, 714 (Bankr. D. Md. 1993).

Case law on prepayment premiums is far from uniform, but certain principles are generally recognized by the courts. First, the prepayment premium must be one that is "provided for under the agreement under which such claim arose." Code §506(b). This involves an analysis of the four corners of the loan documents to determine whether all preconditions have been satisfied. Second, almost all decisions hold that the prepayment provision must be one that is enforceable under applicable state law. Ferrari v. Barclays Am./Business Credit Inc. (In re Morse Tool Inc.), 87 B.R. 745 (Bankr. D. Mass. 1988); In re Kroh Bros. Dev. Co., 88 B.R. 997 (Bankr. W.D. Mo. 1988); Skyler Ridge, 80 B.R. at 503-04; AE Hotel Venture, 321 B.R. at 217. But, see In re A.J. Lane & Co., 113 B.R. 821 (Bankr. D. Mass. 1990) (applying exclusively a federal law reasonableness test). Applicable state law may merely review the parties' agreement for the possible existence of special equitable circumstances justifying deviation from the express terms (Clean Harbors v. John Hancock Life Ins. Co., 17 Mass. L. Rep. 468 (Super. Ct. 2004)) or may examine the prepayment premium formula as a liquidated damage provision. This analysis may involve a determination of whether damages could be uncertain and difficult to prove and whether the contract is not so unconscionable, unreasonable or disproportionate that the estimation could not be what the parties intended. In re Hidden Lake Ltd. P'ship., 247 B.R. 722 (Bankr. S.D. Ohio 2000) (applying Ohio law in a case concerning the allowance of a prepayment premium as an unsecured claim under Code §502). State law also may provide that acceleration by a lender waives any entitlement to a prepayment charge, at least in the absence of a clear expression of the parties' intent that a prepayment charge will be required even after acceleration. In re LHD Corp., 726 F.2d 327 (7th Cir. 1984); Ferreira v. Yared, 32 Mass. App. Ct. 328, 331 (1992).

Bankruptcy decisions on prepayment premiums diverge when construing the reasonableness requirement in §506(b). Some courts equate reasonable charges with actual damages and limit the allowable prepayment premium to the lender's actual, provable damages arising from prepayment. Sachs Elec. Co. v. Bridge Info. Sys. Inc. (In re Bridge Info. Sys. Inc.), 288 B.R. 556, 564 (Bankr. E.D. Mo. 2002); Morse Tool, 87 B.R. at 750. If the lender fails to prove its damages, the prepayment charge is rejected. Other courts have evaluated the reasonableness of the prepayment charge at the time the loan was made. In re Schaumberg Hotel Owners Ltd. P'ship., 97 B.R. 943, 953 (Bankr. N.D. Ill. 1989). If the formula provides a fair estimate of the lender's projected damages, the clause will be deemed reasonable and will be enforced without the necessity of proof of actual damages.

Regardless of the approach adopted by the courts, a prepayment charge expressed as a fixed percentage of principal prepaid, regardless of the time of payment, will almost surely be rejected as unreasonable. See In re Schwegmann Giant Super Mkts., 287 B.R. 649, 655-56 (E.D. La. 2002). Similarly, a clause that requires a prepayment charge even though market rates have risen since the date of the loan also will be deemed unreasonable. A.J. Lane, 113 B.R. at 829. Conversely, a prepayment premium or make-whole charge that only imposes a charge to the extent of the harm caused by a decline in comparable market interest rates generally will be accepted.

Practice Pointers

Oversecured creditors enjoy a protected status under the Code, and their claims, including additional charges for default interest, prepayment premiums and late charges, must be fairly and equitably treated in any chapter 11 plan. A lender seeking allowance of a secured claim for prepayment premiums or other charges under §506(b) should anticipate the court's legal analysis and create an appropriate evidentiary record. The fairness and application of the pre-payment formula should be demonstrated both in terms of prospective and actual losses to the lender. If permitted, parol evidence as to the sophistication of the parties and circumstances surrounding the origination of the loan will bolster the record and enhance the prospects for allowance of the charge. Even though the better-reasoned cases hold that default interest should be allowed at the contract rate, a lender seeking default interest should also submit evidence of the normal and customary nature of the default charge and the harm that will be addressed by its allowance.


Footnotes

1 Board Certified in Business Bankruptcy Law by the American Board of Certification. Return to article

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Friday, July 1, 2005