A New York bankruptcy court recently rejected a debtor’s challenge to a consensual state court judgment (“Judgment”) in favor of mortgagee, General Electric Capital Corporation (“GECC”), that had accelerated a debt and obtained a prepetition foreclosure judgment against debtor, 410 East 92nd Street (the “Hotel”), in the amount of approximately $74 million. In re: Madison 92nd St. Associates LLC, 472 B.R. 189 (Bankr. S.D.N.Y. 2012). After commencing the Chapter 11 bankruptcy, the debtor filed an objection to GECC’s proof of secured claim in the amount of the Judgment, arguing that (1) the portion of the Judgment that includes a prepayment premium should be disallowed, and (2) the court should fix the post-petition pendency interest rate under the Bankruptcy Code in the amount of the federal judgment rate, which is less than 0.2%, rather than the 9.0% rate under New York’s Civil Practice Law & Rules (“CPLR”). The bankruptcy court overruled the objections, holding that (1) debtor, having consented pre-petition to entry of judgment against it that included the prepayment premium, was barred from re-litigating the prepayment premium issue, which in fact was valid under New York state law, and (2) debtor failed to rebut the presumption that GECC, as oversecured creditor, was entitled to post-petition interest at the New York statutory rate of 9%.

Background

In May 2008, the debtor, owner of the Hotel, borrowed $62 million from GECC and secured that obligation by granting GECC a mortgage on the Hotel. The loan was due and payable on May 31, 2013, absent acceleration, prepayment or extension. Pursuant to the loan agreement, the debtor was required to pay interest only for the first two years, beginning on June 1, 2010, and thereafter was to make monthly principal amortization payments.

The loan agreement provided that the debtor did not have the right to prepay the loan before the 36th loan month and that any prepayment prior to that time would be subject to a “prepayment premium.” According to the debtor, this prepayment premium, was “designed to take into account both lost interest, and the loss [sic] opportunity cost from the lender having tied up its money in this loan instead of investing it elsewhere.” The premium amount was to be equal to the greater of 1% of the outstanding balance of the loan or the Make Whole Breakage Amount, which involved a complicated formula based in part on the U.S. Dollar Composite Swap Rate and the Weighted Average Life of the Loan. The loan agreement further provided that “[i]f the Loan is accelerated during the Lockout Period for any reason other than casualty or condemnation,” the debtor would be required to pay a prepayment premium equal to 5% of the outstanding balance of the loan.

The debtor defaulted and GECC accelerated the loan during the Lockout Period. Because the debtor failed to pay any installment of interest or principal within five days of the due date, it was obligated to pay a default interest rate of 6.94% plus an additional 5% as a pre-payment penalty. GECC subsequently commenced a foreclosure action in a New York trial court, and the debtor later agreed to the entry of a consensual Judgment, which included the 5% prepayment premium.

Following GECC’s notice a foreclosure sale of the Hotel, the debtor filed a chapter 11 bankruptcy petition, staying GECC’s foreclosure sale. GECC filed a proof of claim in the bankruptcy in the amount of the Judgment, and the debtor filed an objection thereto asserting that the prepayment premium should be disallowed and the post-petition interest rate should be fixed at the federal judgment rate. Pending the outcome of litigation over the objection, the debtor sold the Hotel pursuant to a confirmed plan. Since the debtor’s claim was oversecured — secured by property which was worth more than the amount of the loan — GECC’s lien attached to the proceeds of the sale.

The Prepayment Premium

In its objection, the debtor claimed that the bankruptcy court had the jurisdiction to overturn the state court’s approval of the prepayment premium. The bankruptcy court rejected this argument, finding that since a New York trial court with jurisdiction had previously approved the prepayment premium, debtor’s objection was barred the doctrine of res judicata. That doctrine “bars successive litigation upon the same transaction or series of transactions if (1) there is a judgment on the merits rendered by a court of competent jurisdiction, and (2) the party against who res judicata is invoked was a party to the earlier action.” Here, the bankruptcy court noted that a New York trial court with jurisdiction had rendered the Judgment, including the 5% prepayment premium as part of a damage award, and the debtor was a party to the action and had expressly consented to the entry of judgment.

The court further rejected the debtor’s argument that res judicata did not foreclose a challenge to the pre-payment penalty under the Bankruptcy Code. According to the court, absent a set of narrow and circumscribed set of exceptions, a bankruptcy court may not look behind a state court judgment to decide claims or issues resolved in a prior state court action. Exceptions to this rule include judgments procured by fraud or collision and where the state court lacked jurisdiction —none of which applied to this case, according to the court. The court also acknowledged that there are instances where a bankruptcy court may “look behind” a valid state court judgment to determine a bankruptcy issue that was never considered or decided in the state court action, or when a judgment creditor’s allowable claim is capped under the Bankruptcy Code. In both these scenarios, however, res judicata and collateral estoppel still apply and “components of the judgment cannot be re-litigated.” Additionally, the debtor’s challenge of the prepayment premium was not a “bankruptcy issue,” but rather an argument under nonbankruptcy law.

Alternatively, the court found that even if res judicata did not bar the debtor’s challenge to the prepayment premium, the merits of the case warranted the same outcome. Under the New York common law “rule of perfect tender in time,” prepayment premiums, viewed as the price of the option exercisable by the borrower to prepay the loan and cut off the lender’s income stream, are generally enforceable. In particular, where a “clear and unambiguous clause requires the payment of a prepayment premium even after default and acceleration, the clause will be analyzed as a liquidated damages clause.” The court found that the loan agreement contained such a “clear and unambiguous” cause as it provided that “[i]f the Loan is accelerated during the Lockout Period for any reason other than casualty or condemnation,” the debtor would be required to pay a prepayment premium equal to 5% of the outstanding balance of the loan.

Additionally, the court held that the prepayment penalty was a valid liquidated damages provision and not an unenforceable penalty. Under New York state law, which governed this issue, a liquidated damages clause is valid if, at the time the parties entered into their agreement, “(1) actual damages are difficult to determine, and (2) the sum is not ‘plainly disproportionate’ to the possible loss.” To challenge a liquidated damages clause successfully, the debtor had the burden of showing that it was a penalty and that one of these two conditions has not been met.

The court found that the debtor failed to meet this burden. The prepayment premium was designed to compensate GECC for the lost stream of interest payments and its damages would depend on future changes in interest rates, not easily determinable at the inception of the loan. Thus, a premium based on the possibility that a quick default might be followed by a costly delay in payment was reasonable at the time. The debtor was further unable to show that, at the time of contracting and not at the actual time of the breach, “the 5% prepayment premium was ‘conspicuously disproportionate’ to GECC’s foreseeable damages in the event of default and acceleration during the Lockout Period.” The debtor failed to show that the 5% prepayment premium is disproportionately greater than the Make Whole Number since the debtor had not computed it. Ultimately, the court concluded, “there is no persuasive justification for disturbing the bargain struck by the parties.”

The Appropriate Interest Rate

On the basis that GECC was oversecured, the court determined that GECC’s right to post-petition interest was governed by a provision in the Bankruptcy Code, 11 U.S.C. § 506(b). Section 506(b) provides that such creditors are entitled to “interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.” Most bankruptcy courts have concluded that the appropriate, presumptive rate in this case should be the one provided in the parties’ agreement, the “contract rate,” or the applicable law under which the claim arose.

Contesting the application of the 9% interest rate by the New York state court, the debtor argued that the bankruptcy court should instead apply the federal judgment rate that was less than 0.2%. The court recognized its limited discretion — subject to equitable considerations — to deviate from the interest rate imposed under the contract by state law. Equitable considerations have been limited by courts to four scenarios: “where there has been misconduct by the creditor, where application of the statutory interest rate would cause direct harm to the unsecured creditors, where the statutory interest rate is a penalty, or where its application would prevent the Debtor’s fresh start.” The court declined to find that the debtor had met its burden of showing that any of these considerations applied, and therefore that the presumptive “contract rate” should be rebutted. GECC was not guilty of misconduct and the debtor did not argue that the statutory interest rate was a penalty. Since the debtor was liquidating, it did not require a fresh start. As to the issue of prejudice to unsecured creditors, the court noted that the debtor itself recognized that it would have enough money after receiving additional, expected funds to pay the 9% interest amount as well as all claims, including possibly unsecured claims. Thus the debtors could not show that the 9% rate would prejudice the unsecured creditors.

The debtor’s final argument that the court should apply the near-zero federal judgment rate was similarly rejected by the bankruptcy court. The Bankruptcy Code, 11 U.S.C. § 725(a)(5) requires a solvent estate to pay a post-petition “legal rate of interest” to its unsecured creditors. This rule is based on a few considerations, including (1) Congress’ intention to provide a single statutory rate, (2) a concern for uniformity, (3) treatment of bankruptcy claims as the equivalent of a federal judgment, and (4) equitable treatment of creditors as efficient and practical. These considerations, according to the court, did not apply in this case since GECC’s right to interest did not depend on the debtor’s solvency or Section 725(a)(5), but rather on GECC’s oversecured status. Section 506(b), which governs interest rates for oversecured creditors, does not mandate the use of the federal judgment rate, or any specific rate for that matter. Instead, “longstanding bankruptcy jurisprudence” requires the court to look at the parties’ agreement or other applicable non-bankruptcy law — New York state law, in this case. On these bases, the court overruled debtor’s objection to GECC’s claim.

Conclusion

The holding in In re Madison 92nd St. Associates LLC demonstrates the challenges that debtors in bankruptcy proceedings may face in challenging pre-petition judgments by a state court. In particular, a bankruptcy court usually will accord res judicata effect to such a judgment, even one that approves a prepayment premium, and will look to state law to determine the validity of a prepayment premium. Additionally, where a creditor is oversecured, a bankruptcy court usually will look to the “contract rate” or the relevant state law to determine the post-petition interest rate, and not to the almost-zero federal interest rate.