A senior mortgagee battled the debtor and a junior mortgagee over its entitlement to post-petition interest: If and when did it become oversecured and thus entitled to interest? Was it entitled to interest at the default rate? Should the interest be compounded?
The senior lender (Prudential) agreed to make a construction loan of up to $192.2 million to finance a mixed-use development, including hotel, condo units, parking garage, restaurant, spa, and bar. After the project opened, it obtained fewer condo commitments than required and did not have sufficient funds to complete the restaurant, spa, and bar. When Prudential declined to provide further financing, the City of Boston made a $10.5 million loan secured by a junior lien on most of Prudential’s collateral and a first lien on $4 million cash provided by an affiliate of the debtor. Prudential required the City to subordinate its right to payment.
After the debtor defaulted and restructuring negotiations failed, the debtor and several affiliates filed for bankruptcy. Prudential filed a proof of claim asserting a secured claim of not less than ~$180.1 million, plus fees, costs and pre- and post-petition interest. However, Prudential drew down on a letter of credit, reducing its claim by ~$15 million, and received additional payments throughout the bankruptcy.
Eventually the debtor obtained court approval to sell the hotel and garage to unrelated parties for $89.5 million. After resolving various contingencies, the sale closed several months later, resulting in net proceeds of ~$88.3 million for payment to Prudential.
Immediately after the sale the debtors proposed a plan of reorganization that would pay Prudential in full with interest from the effective date of the plan at 4.25% per annum. It did not include any post-petition, pre-effective date interest.
Prudential objected, arguing that it was entitled to post-petition interest (as well as reasonable fees, costs or charges) to the extent that it was oversecured at the contractual default rate of 14.5% per annum (5% higher than the base rate) accruing from the petition date.
The debtors responded that Prudential became oversecured only upon the closing of the hotel sale and that the default rate was unenforceable and inequitable. Among other things they noted that Prudential argued, and the bankruptcy court agreed, that it was undersecured when it moved for relief from the automatic stay earlier in the case.
The bankruptcy court gave Prudential the default rate of 14.5% per annum commencing on the hotel sale date’, and did not allow compounding. On appeal to the bankruptcy appellate panel, the BAP gave Prudential the default rate of interest starting from the petition date and allowed compounding.
As background, the 1st Circuit noted that generally post-petition interest is not allowed, but there is an exception for oversecured creditors. Under Section 506(a) of the Bankruptcy Code a secured creditor has a secured claim “to the extent of the value of such creditor’s interest in the estate’s interest in such property.” Under Section 506(b), if the value of the property is greater than the claim, then “there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.”
The first question was at what point in time should the valuation determination be made. Some courts take a “single-valuation” approach, where the determination is always made at a fixed point in time – usually the petition date or the confirmation date. Others take a “flexible” approach, where the bankruptcy court has discretion to determine the appropriate date. Since the collateral value or the allowed claim may change over time, there may be some point in time between the petition date and the confirmation date when the creditor becomes oversecured.
Based on a legislative analysis, considerations supporting flexibility in other contexts that seemed equally applicable to the valuation time, and its views on what would yield the fairest result, the 1stCircuit determined that the bankruptcy court was permitted, but not required, to use a flexible approach. Turning to whether the determination based on the sale price entitled Prudential to post-petition interest from the sale date or the petition date, it concluded that the bankruptcy court did not commit clear error in determining that the post-petition interest should start on the sale date.
It also agreed that the values reflected in the debtor’s bankruptcy schedules and the bankruptcy court’s determination in the context of the motion for relief from the automatic stay were not determinative. In particular: “We now hold, as have other courts, that a valuation made for one purpose at one point in a bankruptcy proceeding has no binding effect on valuations performed for other purposes at other points in the proceeding.”
In computing interest, the court concluded that a bankruptcy court was not required to accept the contract provisions, although generally there is a presumption that the contracted interest rate (including default rate) should apply if it is enforceable under state law and there are no equitable considerations leading to a different result.
Under state law the question was whether default interest was an allowable liquidated damages provision for an unenforceable penalty. Although Prudential did not do any analysis of whether the rate was reasonably related to anticipated damages, the burden was on the debtor to show that the amount was “unreasonable and grossly disproportionate to the real damages from a breach or unconscionably excessive.” The debtor did not carry that burden.
With respect to federal equitable principles, the bankruptcy court considered various factors, including that other creditors would not be harmed since it was contemplated they would be paid in full, and courts have approved larger spreads between the base and default interest rates than 5%.
On compounding, while acknowledging that there was a basis in the loan documents to find that interest should be compounded monthly, it found that Prudential “cannot claim entitlement to compounding where it – whether by inadvertence or an attempt to sandbag the Debtors and mislead the bankruptcy court we cannot say – did not seek compound interest until after the bankruptcy court granted it post-petition interest at the default rate running from the hotel sale date.”
Consequently, the 1st Circuit affirmed the bankruptcy court’s determination that Prudential should receive post-petition interest at the default rate without compounding from the date of the hotel sale.
Some may be surprised to learn that a lender needs to do more than simply show that it is over-secured in order to receive its contract interest for the period between the petition date and confirmation of a plan. Most courts hold that a bankruptcy court has at least limited discretion to use another rate, and it is important to be clear on what is being asked for.