It is common for lenders to require borrowers to agree to pay a higher interest rate, known as the default rate, following an event of default under a loan. Some loan agreements also require the borrower to pay a fee in the event of a late payment. If the borrower files for bankruptcy protection, the Bankruptcy Code affords special protection to secured creditors with respect to collecting interest.
In general, an oversecured creditor (a creditor whose collateral is valued at more than its claim) is entitled to collect interest until such time as the sum of the principal and interest equals the value of its collateral. However, the Bankruptcy Code does not specify the rate at which the oversecured creditor may collect interest. In a recent decision, the Bankruptcy Court for the Southern District of New York held that an oversecured creditor is generally entitled to collect both pre-petition and post-petition interest at the default rate, but not late payment fees. See In re 785 Partners LLC, 2012 WL 1154282 (Bankr. S.D.N.Y. Apr. 9, 2012).
In January 2007, 785 Partners LLC borrowed approximately $84 million from PB Capital Corporation and Commerce Bank, N.A. to finance the construction of a building located at 48th Street and Sixth Avenue in Manhattan. The loan, which was secured by the building and certain other collateral, matured on August 7, 2009.
On July 11, 2011, one of the original lenders sent 785 Partners LLC a pay-off letter, showing that as of August 3, 2011, 785 Partners LLC owed approximately $81.2 million in principal, $6.7 million in regular interest at 5%, $8 million in default interest at an additional 5%, and $3.8 million as a late payment premium. Shortly after the pay-off letter was sent to 785 Partners LLC, the original lenders sold the loan to First Manhattan Developments REIT . On August 3, 2011, 785 Partners LLC filed for relief under chapter 11 of the Bankruptcy Code with the Bankruptcy Court for the Southern District of New York.
First Manhattan filed a timely proof of claim in the amount of approximately $106 million. After taking into account First Manhattan’s security interests in the building and other collateral, the court assumed for purposes of the decision that First Manhattan was oversecured.
The debtor challenged First Manhattan’s claim with respect to (i) payment of pre-petition interest at the default rate, (ii) payment of post-petition interest at the default rate, and (iii) the late payment premium, arguing that the default rate interest and late payment premium were unenforceable penalties, inequitable and unreasonable.
The Bankruptcy Court’s Analysis
Pre-Petition Default Rate
The debtor argued that a bankruptcy court may reduce the default interest rate applicable to the pre-petition portion of a secured claim on equitable considerations. The court disagreed. The court first noted that pre-petition interest is generally allowed to the extent and at the rate permitted under state law. Under New York law, an agreement to pay a higher interest rate in the event of default is an agreement that “reflects the allocation of risk as part of the bargain struck between the parties,” and is not considered a penalty. A court cannot adjust the pre-petition portion of a claim (thereby rewriting the parties’ bargain) based on its own notions of fairness and equity. The court stressed that this was especially true in the context of real property transactions “where commercial certainty is a paramount concern” and the agreement was negotiated at arm’s length between sophisticated, counseled parties.
The debtor also argued that First Manhattan should be precluded from collecting interest at the default rate because it had already factored the debtor’s existing default into the price it paid for the loan. However, the court quickly dismissed that argument, noting that First Manhattan was the assignee of the original lenders and therefore stood in the shoes of the original lenders vis-à-vis the debtor. Accordingly, the court held there was no basis to disturb the parties’ bargained-for pre-petition interest rate.
Post-Petition Default Rate
Unlike pre-petition interest (which, as noted above, is determined under state law and may not be adjusted by a bankruptcy court), post-petition interest that an oversecured creditor may collect as part of its claim can be modified pursuant to Section 506(b) of the Bankruptcy Code at the “limited discretion” of a bankruptcy judge. The court noted that there is a rebuttable presumption that an oversecured creditor is entitled to collect interest at the contractual default rate. That presumption can be rebutted by showing that the interest rate should be modified on equitable grounds.
However, the court stated that, “the power to modify the contract rate based on notions of equity should be exercised sparingly.” Such judicial intervention is only appropriate in certain limited situations, such as where (a) the secured creditor is guilty of misconduct, (b) the application of the contractual interest rate would harm the unsecured creditors or impair the debtor’s fresh start, or (c) the contractual interest rate constitutes a penalty.
In the case of 785 Partners, the court determined that none of those factors were present. Moreover, the debtor was solvent and proposed to pay unsecured creditors in full. As the court explained, the reluctance to modify the contract interest rate is especially strong where the debtor is solvent and reducing the interest rate would only serve to increase the distribution to equity.
With respect to whether the default rate constituted a penalty, the issue turned on New York law and, as noted above, an increase in the interest rate after an event of default is not a penalty under New York law. Although the court agreed with the debtor that a higher default rate of interest has some penal effect in that it compels timely compliance with payment requirements under a loan, it concluded that the default rate was designed to compensate the secured party “for the increased risk of non-payment and the costs associated with the debtor’s default.” As such, the court allowed First Manhattan’s claim for post-petition default interest.
Late Payment Premium
Although the court determined that interest at the default rate was permissible, the court refused to permit First Manhattan to collect the late payment premium for two separate reasons.
First, the court noted that Section 506(b) limits the secured creditor to recovery of “reasonable” fees. Allowing a lender to recover default interest and late payment fees would result in double recovery because both payments are designed to compensate the lender for the same injury. Accordingly, case law on the matter “is uniform that oversecured creditors may receive payment of either default interest or late charges, but not both.”
Second, the court determined that the late payment premium was contemplated specifically to compensate the original lenders for incurring the additional costs of handling late payments made pursuant to the loan agreement. However, no payments would be made pursuant to the loan agreement. Instead, the debtor’s plan provided that First Manhattan would receive payments pursuant to an amended note and amended mortgage. Accordingly, First Manhattan would not incur any costs handling late payments under the loan agreement and the late payment premium would never become due.
Conclusion and Takeaways
From the In re 785 Partners decision, lenders should take some comfort that, at least with respect to pre-petition interest, they will be entitled to collect at the default rate if the agreement is governed by New York law. However, lenders should be wary of loans governed by other (non-New York) law. For example, the Bankruptcy Court in In re 785 Partners referred to a decision by the Bankruptcy Court for the Eastern District of Pennsylvania, In re 400 Walnut Assocs., L.P., 461 B.R. 308 (Bankr. E.D. Pa. 2011), in which the court relied on the Section 506(b) factors in disallowing a claim for pre-petition default interest under a contract governed by Pennsylvania law. With respect to post-petition interest, the 785 Partners decision suggests that courts will take equitable concerns into account but will rarely modify or disallow an oversecured lender’s claim for default interest at the contract rate. However, if a creditor is awarded post-petition interest at the default rate, that creditor will most likely not be permitted to collect any late payment fees.