Although the general rule is that creditors are not entitled to post-petition interest and fees, that is not necessarily the case for an over-secured lender. In 785 Partners, the lender held a secured loan with a principal balance of approximately $81 million, which was secured by a building with a market value of $91.7 million and an escrow fund of approximately $18 million, making the loan over secured. A payoff letter showed a balance due of $100,845,002.80, including approximately $6.7 million in regular interest, $8 million in default interest, and $3.8 million as a “late payment premium.” At over 10% of the amount due, the default interest and late fees spelled the difference for the debtor between potentially being required to use almost half of the escrow fund for the secured claim and being allowed to use the entire escrow fund for other purposes.
The debtor disputed the default interest, which was at a rate of 10% (5% base rate plus 5% default rate), and the late payment fees (5%, including 5% of the matured principal balance) for both pre-petition and post-petition periods, arguing that they were unenforceable penalties, inequitable and unreasonable. The court’s analysis addressed treatment of default interest for pre-petition and post-petition but pre-plan confirmation. (Post-confirmation is governed by the plan of reorganization, which usually involves new loan documents.)
Pre-petition, the court concluded that interest is generally allowable to the extent permitted under nonbankruptcy law. Under New York law, an agreement to pay interest at a default rate was not a penalty, but rather an allocation of risk that gave the borrower the benefit of a lower rate of interest than would be obtained if the lender had to build in the risk of default into a higher uniform rate for the full life of the loan.
The court disagreed with a Pennsylvania bankruptcy case (400 Walnut Assocs., L.P v. 4th Walnut Assocs., L.P. (In re 400 Walnut Assocs., L.P.), 461 B.R. 308 (Bankr. E.D. Pa. 2011)) cited by the debtor in which a claim relating to pre-petition default interest was not allowed based on the considerations used to evaluate post-petition interest. The 785 Partners court concluded that Section 506(b) of the Bankruptcy Code relates only to post-petition interest and does not apply to pre-petition interest, which must be determined under state law.
The court also rejected the debtor’s arguments about the equities, concluding that the amount paid by the lender to acquire the loan was not a consideration even if the lender may have acquired the loan at a reduced price.
Turning to post-petition interest, generally interest stops accruing at the beginning of the case. However, Section 506(b) provides that if the value of the collateral is greater than the secured claim, then the lender is allowed “any reasonable fees, costs, or charges provided for under the agreement or state statute under which such claim arose.”
Under the court’s analysis, the secured lender is not entitled to its contract rate, but rather the rate is set with the “limited discretion” of the bankruptcy court. For an over secured creditor, there is a rebuttable presumption that it is entitled to the contract default rate subject to adjustment based on equitable considerations, which should be limited to situations of misconduct, where the rate would harm unsecured creditors or impair the debtor’s fresh start, or where it constitutes a penalty.
In this case, the debtor was solvent, so that it was planning to pay unsecured creditors in full and permit the owners to retain their equity interests. Given that there was also no evidence of misconduct and the default rate did not constitute a penalty under New York law, the court allowed interest at the 10% contract default rate during the bankruptcy.
Interestingly, the court did not allow the late payment premium. As is typically the case, the 5% fee was justified by the lender as covering “administrative and related expenses incurred in handling delinquent payments.” Here the court said there would not be any late payments, so there would not be any additional expenses of handling delinquent payments. It also noted that Section 506(b) limits the claim to “reasonable” fees, and the general rule is that over-secured creditors can receive default interest or late charges but not both, since otherwise this would amount to a double recovery.
The bottom line: the lender was entitled to recover 10% default interest and 5% late fees for the pre-petition period, and 10% default interest for the post-petition period through confirmation.
Noteworthy points: Generally decisions by bankruptcy judges in the same district are not considered binding precedent, much less decisions by bankruptcy judges in other districts. (In fact, some bankruptcy courts have held that they are not bound by district court decisions, even though bankruptcy decisions can be appealed to district courts.) Although a bankruptcy court may be persuaded by the logic in another bankruptcy case, it is free to make its own decision. So, as illustrated by the Pennsylvania bankruptcy case referenced in the opinion, it is not unusual to be able to find conflicting bankruptcy decisions supporting all sides of an argument (although in this particular case the district court subsequently overruled the bankruptcy court so that the Pennsylvania case now aligns with 785 Partners).
Also, many issues under the Bankruptcy Code are determined by reference to state law. New York law tends to be relatively favorable to lenders. In assessing what might happen in a bankruptcy, the fact the applicable loan documents are governed by New York law is a factor that should be taken into account.