The United States Bankruptcy Court for the Southern District of New York recently awarded an oversecured lender post-petition interest on the full amount of its secured claim at the default rate set forth in the lender’s contract (19%) plus compound (PIK) interest up to the aggregate rate of 25% (the maximum rate allowable under New York State usury laws). In re Urban Communicators PCS Limited Partnership, et al., 2007 Bankr. LEXIS 4062 (Bankr. S.D.N.Y. 12/11/07) (Gerber, B.J.). Relying on Section 506(b) of the Bankruptcy Code, the court held the oversecured lender to be entitled to post-petition interest on its claim. According to the court, the “great majority of courts” rely on the parties’ contract to determine what rate of interest should be awarded. Id. at *51. Nevertheless, it was not required to use the contract rate; rather, the issue was within the court’s discretion. Id. at *54–55. Though the 19% default rate was found acceptable, giving full effect to the compounding (PIK interest) provision here would have increased the effective interest rate to an unacceptable 38%, the court explained. The equities favored limiting the awarded rate to the 25% state law criminal usury cap.† Id. at *63–64.
The debtor’s only assets were radio wave spectrum licenses, which had been improperly cancelled by the FCC when the debtor filed for Chapter 11 protection. The debtor succeeded in forcing the FCC to reinstate the licenses, but only after a costly nine-year battle. A subsequent sale of the reinstated licenses made the debtor solvent.
Prior to the debtor’s Chapter 11 filing, the lender had loaned it $9 million in two separate notes (the “Notes”), each of which provided for quarterly PIK interest which itself accrued interest. The default interest rate under the Notes was 19%, but given the compounding factor of the PIK interest, the court calculated the effective default interest rate to equal 38%. Id. at *3. The contract terms were undisputed, and the debtor had stipulated to the default interest rate and the compounding when it had negotiated cash collateral orders with the lender during the bankruptcy case. Id. at *40–43. Therefore, subject to applicable law, the debtor was bound by the provisions in the contract. Id. at *43.
Analysis: Entitlement vs. Equity
The court found that the lender was entitled to post-petition interest as a matter of bankruptcy law, but that the rate of interest was within the court’s discretion. Further, under United States v. Ron Pair Enterprises, 489 U.S. 235 (1989), interest rates need not be determined by the parties’ agreement. Id. at *50-51. Most courts, however, rely on the contract rate. Id. at *51. The court here held that the rate was still within its discretion and that circumstances might dictate a rate different from the contract rate. Id. at *53, citing In re Milham, 141 F.3d
420 (2d Cir. 1998) (per curiam). Although the 19% default rate would be acceptable in most solvent commercial debtor situations, because compounding effectively increased the rate to 38%, the court was forced to exercise its equitable power and impose a reasonable limit on the lender’s recovery. Id. at *60-61. Balancing of the Equities Favors 25% Limitation
“Fairness” dictated that the lender’s recovery here be capped at 25% per annum (even though New York’s usury laws did not apply here). Id. at *64. First, the court found that permitting an interest recovery at the full 38% interest rate “would drive most or all of the Debtors into insolvency and impair the recoveries of junior creditors.” Id. at *56. Second, (i) the requested amount exceeded the highest interest rate ever approved in a reported bankruptcy case, and (ii) the “public policy” embodied by the 25% usury provision provided a benchmark for the court’s exercise of its equitable discretion. Id. at *57 and *59. Finally, the court noted the “unique circumstances” of the case. Had the shareholders not financed the FCC fight, the lender’s claim would have been worthless. It was thus unfair to strip the shareholders of any recovery so that the secured lender could recover an interest windfall. Id. at *62-63.