In the March 2008 issue, we discussed a decision from the In re Urban Communicators PCS, Ltd. Partnership1 case. In that decision, the United States Bankruptcy Court for the Southern District of New York held that under section 506(b) of the Bankruptcy Code, the Bankruptcy Court could limit the rate of postpetition interest to be paid to an over-secured creditor to an amount less than the contract interest rate. The Bankruptcy Court found that, in light of the debtors’ efforts to engage in extensive litigation to preserve value for the estate, as well as the impact that a large interest payment would have on the debtors and other creditors, the Bankruptcy Court had discretionary and equitable authority to reduce the contract interest rate to a level the Bankruptcy Court deemed fair.2

Subsequent to the publication of that article, the United States District Court for the Southern District of New York heard the appeal from that decision. The District Court affirmed the Bankruptcy Court’s holding regarding the creditor’s secured status and entitlement to post-petition interest, but overturned the Bankruptcy Court’s determination regarding the reduction of post-petition interest.3

Gabriel Capital, L.P. (“Gabriel”), an oversecured creditor of the debtors, was contractually entitled to post-petition interest at a default rate of 19%, compounded quarterly. After three years of litigation, the debtors successfully prevented the Federal Communications Commission (“FCC”) from auctioning its spectrum licenses which also served as collateral for Gabriel’s claim. During that time, however, the interest on Gabriel’s claim continued to compound until it amounted to what was effectively a simple interest rate of 38% annually. Although the 38% would have normally exceeded the New York statutory usury limitations, these statutes provide an exemption for loans in excess of $2.5 million. As the majority of Gabriel’s claim arose from an $8 million note, the Bankruptcy Court found that the interest on that note was not subject to reduction pursuant to the usury statutes. However, the Bankruptcy Court found that the interest on the second note owed to Gabriel, in the amount of $1 million, would be reduced as not to exceed the 25% usury threshold.

However, in consideration of the debtors’ efforts to protect their interests in the licenses, and contemplating that the payment of the contractual rate of interest would bring the original $11 million prepetition debt to a total of $27 million post-petition, the Bankruptcy Court reduced the interest on both notes to 25% simple interest in order to prevent Gabriel’s claim from absorbing the entirety of the debtors’ estate. As a result of the reduction, unsecured creditors would be paid in full and some estate funds would be available to be distributed to the debtors’ equity holders. Gabriel then appealed the Bankruptcy Court Order to the District Court to the extent that it reduced the post-petition interest beyond the point that all unsecured creditors were fully compensated.

On appeal, the District Court found that although bankruptcy courts do indeed possess the equitable power to reduce post-petition interest payments, this power must be applied in the following limited contexts: (i) to prevent direct harm to unsecured creditors; (ii) to respond to misconduct by the secured creditor; (iii) to ensure the debtor’s ability to receive a “fresh start”; or (iv) to prevent the use of interest as a penalty. Finding a lack of evidence to support any of the above criteria, the District Court ruled that the Bankruptcy Court should not have reduced the post-petition interest beyond the point of preventing prejudice to other creditors.

While not shutting the door completely to the allowance of “equitable considerations” in the reduction of interest rates, the District Court nevertheless stated:

[W]here that power [to modify rights created by state law or private agreement is] not explicit . . . the Court should be loathe to exercise it in the absence of compelling evidence that recognition of a right created by state statute or private agreement would do violence to the principles which constitute bankruptcy law.4

What emerges from the District Court’s decision on appeal is that there continues to be a presumption in favor of upholding contract interest rates, which are then subject to the equitable considerations of prejudice to the debtor or other creditors. Ultimately, Urban Communicators now stands for the principle that it is appropriate for courts to reduce awards of post-petition interest to the point that they no longer prejudice unsecured creditors, but not further.5 As of the writing of this article there is no further appeal pending.