Determining a question of first impression within its circuit, the U.S. Court of Appeals for the First Circuit recently held that an oversecured creditor is entitled to collect a bargained-for pre-payment penalty from a solvent debtor, regardless of the penalty’s “reasonableness” under section 506(b) of the Bankruptcy Code.

In so holding, the First Circuit reversed the decisions of the U.S. Bankruptcy and District Courts for the District of Rhode Island. Gencarelli v. UPS Capital Business Credit, 50 F.3d 1 (1st Cir., Aug. 30, 2007).

In February 2002, Bess Eaton Donut Flour Co. (“Bess Eaton”), and its sole shareholder, Louis A. Gencarelli, Sr. (“Gencarelli,” together with Bess Eaton, the “Debtors”) entered into two commercial loan agreements with UPS Capital Business Credit (“UPS”). One loan, involving approximately $5 million was for a 30-year term; the other, involving approximately $2 million, was for a 20-year term. Each loan agreement allowed the borrowers to repay at any time.

Pre-payment, however, was subject to a pre-payment penalty provision, which provided that repayment within the first five years of the loan term would be assessed a fee equal to a percentage of the amount prepaid.

Successful Auction

Both Debtors filed their respective voluntary chapter 11 petitions in or around March 2004, and the bankruptcy court consolidated the cases. Subsequently, Bess Eaton sold all of its operating assets at auction, and the sale resulted in a far higher price than had been anticipated. Both Debtors’ bankruptcy estates received sale proceeds sufficient to pay all creditors in full, with accrued interest. Additionally, the Gencarelli bankruptcy estate retained a multimillion dollar surplus from the sale.

UPS timely filed a proof of claim in which it asserted a right to the unpaid principal balances of the two loans plus accrued interest. Moreover, because full repayment was to be made in the third year of the loans, UPS also asserted a right to pre-payment penalties assessed in accordance with the terms of the loans (which equaled about 3 percent of the outstanding principal balances, or approximately $200,000).

While the Debtors conceded liability for the unpaid balances and accrued interest, they opposed UPS’s entitlement to pre-payment penalties, and Gencarelli ultimately filed an objection to allowance of the pre-payment penalties portion of the claim. Gencarelli asserted that an oversecured creditor is entitled to recover such costs as pre-payment penalties only to the extent that they are “reasonable,” pursuant to section 506(b) of Title 11 of the United States Code (the “Bankruptcy Code”).

Gencarelli further argued that the pre-payment penalties demanded by UPS were unreasonable because they bore no rational relationship to the added expense that pre-payment might inflict on the lender.

UPS, without citing to particular authority, countered that the pre-payment penalties were valid under controlling Rhode Island state law, and therefore were enforceable in bankruptcy. Alternatively, UPS argued that the penalties were reasonable.

‘Reasonableness’ Standard

The bankruptcy court held that section 506(b) of the Bankruptcy Code governed the dispute, thus displacing state law and creating a uniform federal standard of reasonableness that served as a substantive limitation on the fees, costs and other charges that a secured creditor could recoup. The court further determined that the pre-payment penalties asserted by UPS only were enforceable to the extent that they were reasonable.

fter taking evidence on the reasonableness of the payments, the court concluded that the penalties were unreasonable and disallowed UPS’s claims for the penalties in their entirety.

UPS appealed to the U.S. District Court for the District of Rhode Island, arguing that a finding of “unreasonableness” under section 506(b) simply meant that the claim for penalties could not be allowed as a secured (i.e., higher priority) claim, and instead must be treated as an unsecured claim.

The district court agreed that section 506(b) governed the issue, and affirmed the bankruptcy court’s order. However, the district court did not address the possibility that unreasonable pre-payment penalties might qualify as unsecured claims.

First Circuit Decision

UPS subsequently appealed to the First Circuit, arguing that Section 506(b)’s reasonableness test is not relevant to the question as to whether an oversecured creditor is entitled to collect a contractually based pre-payment penalty from a solvent debtor. UPS maintained that Rhode Island state law governs the loan agreements at issue, and that the pre-payment penalties included in the proof of claim are enforceable under applicable state law.

Gencarelli opposed, and argued that the lower courts’ reasonableness analyses were correct.

Recognizing that the issue was one of first impression in the First Circuit, the court of appeals analyzed section 502 of the Bankruptcy Code, which governs the allowance of claims. The court noted that section 502(b) instructs a bankruptcy court to allow pre-petition claims made against the Debtor subject to several exceptions. In particular, the court recognized that the exception provided for in section 502(b)(1) calls for the disallowance of claims that are unenforceable under “applicable” law.

Notably, the court of appeals observed that the bankruptcy court disallowed UPS’s claims for pre-payment penalties not because they were unenforceable under Rhode Island state law, but because that court found that different law – section 506(b) of the Bankruptcy Code – governed allowance of that portion of UPS’s claim. Stated differently, the bankruptcy court disallowed the pre-payment penalties portion of UPS’s claim because it found that UPS, as an oversecured creditor, had failed to show that the pre-payment penalties were reasonable.

While acknowledging that section 506(b)’s priority scheme is of “tremendous importance” in bankruptcy cases, the court of appeals held that section 506(b)’s priority scheme is irrelevant in “solvent debtor” cases, where the debtor can afford to pay all claims – both secured and unsecured – in full. The court further articulated the “universal agreement” that, while section 506 furnishes a series of useful rules for determining whether and to what extent a claim is secured (and therefore entitled to priority), that section does not answer the materially different question of whether the claim itself should be allowed or disallowed.

Supporting Precedent

In support, the First Circuit cited cases by the U.S. Court of Appeals for the Eleventh and Second Circuits, among others. See Welzel v. Advocate Realty Inv., LLC (In re Welzel), 275 F.3d 1308, 1318 (11th Cir. 2001) (en banc) (holding that once a claim is found to be allowable under Section 502, it then must be assessed for reasonableness under Section 506 to determine its priority), and United Merchs. & Mfrs., Inc. v. Equitable Life Assurance Society (In re Merchs. & Mfrs., Inc.), 674 F.2d 134, 138 (2d Cir. 1982) (emphasizing, in dictum, that section 506 speaks only to whether costs can be treated as a secured claim).

The First Circuit further opined that under the statutory scheme envisioned by Gencarelli and adopted by the lower courts, unsecured creditors would be permitted to reap the full benefit of their contractually bargained-for rights through section 502, while oversecured creditors would be “uniquely singled out” for unfavorable treatment by operation of section 506(b). In addition, the First Circuit observed that it is improbable that Congress would have intended to allow debtors to avoid otherwise valid contractual obligations under state law (including pre-payment penalties) by filing bankruptcy petitions and invoking section 506(b)’s “reasonableness” requirement.

Agreeing with UPS’s reasoning, the First Circuit emphasized that in a solvent debtor case, the equities strongly favor holding the debtor to his contractual obligations, so long as those obligations are legally enforceable under “applicable nonbankruptcy” law. Hence, the court concluded that both precedent and policy militated in favor of allowing UPS’s claim for pre-payment penalties regardless of reasonableness.