In UPS Capital Business Credit v. Gencarelli (In re Gencarelli),1 the First Circuit Court of Appeals addressed the issue of whether a secured creditor is entitled to collect a prepayment penalty from a solvent debtor. The Court found that the secured creditor could collect the penalty, whether or not it is reasonable, so long as the penalty is enforceable under state law. The Court reasoned that any other holding would leave open the possibility that an unsecured creditor could recover more from a solvent estate than a secured creditor.


Bess Eaton Donut Flour Co. (“Bess Eaton”) and its sole shareholder, Louis Gencarelli (“Gencarelli”), entered into two commercial loan agreements with UPS Capital Business Credit (“UPS”). Both agreements were secured by real property and other business assets of Bess Eaton. The loan agreements (a) provided for a floating rate pegged to the prime rate, (b) contained prepayment penalties, and (c) were governed by Rhode Island law. The amount of the prepayment penalty was dependent on the year the loan was repaid, with a higher premium being owed if the loan was paid sooner rather than later.

Bess Eaton filed for chapter 11 protection and Gencarelli’s personal bankruptcy filing followed within a few days thereafter. Bess Eaton then sold all of its operating assets in a section 363(b) sale. Section 363(b) of the Bankruptcy Code permits a debtor to sell substantially all of its assets in chapter 11 outside of a plan of reorganization if certain circumstances exist (e.g., if the assets are rapidly declining in value). The section 363 auction of the assets was extremely successful, and it generated proceeds sufficient to pay all creditors in full with a contemplated surplus for distribution to Gencarelli.

UPS filed a proof of claim in the Bess Eaton case based on its secured loan. The claim requested payment of the principal and interest due under the loan, as well as a prepayment penalty because the loan was being paid prior to its maturity date.

Gencarelli objected to the portion of the UPS claim that sought recovery of a prepayment penalty. Gencarelli’s legal position was that, pursuant to section 506(b) of the Bankruptcy Code, an oversecured creditor is entitled to recover only “reasonable” costs and fees. Section 506(b) of the Bankruptcy Code provides that, to the extent a creditor has an interest in collateral sufficient to cover its claim, the holder of the claim shall be allowed interest and reasonable costs, fees or charges relating to the claim. Gencarelli argued that the amounts due on account of the prepayment penalty were not reasonable because they bore no rational relationship to the loss suffered by the lender as a result of the loan being prepaid.

UPS contended that the prepayment penalty was valid under state law and therefore should be paid. In the alternative, UPS argued that the prepayment penalty was reasonable.

Bankruptcy Court and District Court Rulings

The Bankruptcy Court for the District of Rhode Island found that state law did not govern the issue of whether UPS could recover the prepayment penalty. Instead, the Bankruptcy Court concluded that section 506(b) of the Bankruptcy Code created a uniform federal standard for recovery under a secured claim, which required that fees, costs and other charges recovered be “reasonable.” Because the Bankruptcy Court concluded that the prepayment penalty was unreasonable, it denied UPS the right to recover the prepayment penalty as part of its secured claim, despite the fact that the Bess Eaton estate was solvent.

UPS appealed the ruling to the District Court for the District of Rhode Island. The District Court affirmed the decision, finding that UPS could not recover on the penalty because it did not qualify as a reasonable cost or fee under section 506(b) of the Bankruptcy Code.


UPS appealed the decision to the First Circuit Court of Appeals. On appeal, UPS argued that, in a solvent debtor case, section 506(b)’s reasonableness standard does not apply to the question of whether a secured creditor is entitled to a prepayment penalty contained in the contract. UPS claimed that it was owed the prepayment penalty pursuant to section 502 of the Bankruptcy Code. Section 502 of the Bankruptcy Code is the operative section to determine whether a claim will be allowed or disallowed in general. It provides that a claim will be allowed, unless an objection is lodged and the claim falls within one of the nine exceptions to allowance set forth in section 502(b). One of the exceptions to allowance is when a claim is unenforceable against the debtor under applicable law (i.e., state law). Under that section, a claim does not need to be reasonable in order for such amounts to be recoverable; it just needs to be enforceable under state law. In response to the UPS argument under section 502 of the Bankruptcy Code, Gencarelli claimed that section 502 was not properly raised in the arguments below and thus could not be included as an issue on appeal.

Decision of the First Circuit

The First Circuit concluded that UPS had sufficiently described the section 502 issue such that the argument could be raised on appeal. Despite the fact that the issue had not been explicitly discussed below, the Court reasoned, “it is the making of an argument, not the mechanical citation to a particular authority, that preserves the argument for further appellate review.”2 The Court further noted that, in any event, the Court retains the discretionary authority to hear an issue not raised in the lower court.

The Court then found that, in order to determine UPS’s right to collect the penalty, section 506(b) should be read together with section 502. The First Circuit explained that, in deciding whether a secured creditor’s prepayment penalty should be paid by the estate, the first step is to determine whether it is allowable under section 502. Once the claim is deemed allowable, section 506(b) should then determine its priority as a secured or unsecured claim. The Court explained that, “[s]ection 502, not section 506(b), affords the ultimate test for allowability, and any claim satisfying that test is, at the very worst, collectible as an unsecured claim.” The Court emphasized that opinions of other Circuits have supported this view, some with direct discussion on the issue, such as Welzel v. Advocate Realty Inv. LLC (In re Welzel),3 Joseph F. Sanson Inv. Co. v. 268 Ltd. (In re 268 Ltd.),4 and others by implication, including United Merchs. & Mfrs. Inc. v. Equitable Life Assurance Soc’y (In re United Merchs. & Mfrs. Inc.).5 In considering section 502 together with section 506(b), the Court rejected Gencarelli’s argument that section 506(b) was designed to determine whether a prepayment penalty could be collected from the estate. The Court pointed out that it would defy logic to permit an unsecured creditor to collect a prepayment penalty in a solvent case while prohibiting a secured creditor from collecting these amounts. The Court reasoned:

[U]nder the statutory scheme envisioned by the debtor (and adopted by the lower courts), unsecured creditors would be permitted to reap the full benefit of their contractual bargains through the medium of section 502, while oversecured creditors would be uniquely singled out for unfavorable treatment by the operation of section 506(b).6

The Court added that, in a solvent case, as long as the terms of a creditor’s contract are enforceable under state law, the equities strongly favor holding the debtor to the terms of its agreement. The Court held that the Bankruptcy Code thus does not relieve a solvent debtor of its obligation to pay a prepayment penalty.

As a result, the Court reversed the decision of the District Court that held that the penalty could not be collected because it did not meet the reasonable test of section 506(b). While finding that the penalty would be allowed if it were permissible under state law, the Court remanded on the issue of whether the penalty was enforceable under Rhode Island law.


In the end, the Court dodged the issue of how section 506(b)’s reasonableness requirement applies to a prepayment penalty in a commercial loan. The Court admitted that there is no clear-cut answer and speculated that any decision would have “significant ramifications for the commercial lending industry.”7 In a solvent case, it seems more than fair that a creditor whose prepayment penalty is enforceable under state law should receive the payment of that penalty before shareholders receive a distribution. Yet, under certain factual circumstances, another court could find distasteful a result that allows a creditor to collect a severe penalty while leaving shareholders empty-handed. For now, at least, Gencarelli makes clear that a prepayment penalty enforceable under state law and otherwise allowable under section 502 of the Bankruptcy Code will be paid to a creditor when the assets of the estate are mo