This is a favorable decision for commercial secured lenders. Although the ruling is not controlling on other bankruptcy courts as it is a trial court level ruling, courts may certainly consider it when presented with similar issues.

In In re 1111 Myrtle Avenue Group, LLC (Bankr. S.D.N.Y. 2019), a New York bankruptcy court held that a default interest rate provision of 7 percent was enforceable and not a penalty against a debtor, which retained significant equity postbankruptcy.

Background

On December 30, 2014, the lender lent the debtor $6,283,544.55, and the loan was secured by a commercial property in Brooklyn, New York. The governing loan contracts established a nondefault interest rate of 2 percent over the highest prime rate of interest and a default interest rate of 7 percent above the nondefault rate. Less than one year after receiving the loan, the debtor filed a Chapter 11 voluntary petition.

Prior to the bankruptcy filing, the debtor had entered into an agreement to sell the property for $20.5 million. In connection with the sale, the proposed buyer paid debtor a $7.5 million deposit. The sale, however, did not close. On the morning of the closing, the proposed buyer commenced a state court action against the debtor and also filed a lis pendens on the property.

Both the filing of a lis pendens on the property and the debtor’s bankruptcy filing constituted events of default under loan. The lender did not issue notices of default in connection with either of the events of default.

Following litigation in the bankruptcy, the debtor was able to retain the proposed buyer’s $7.5 million deposit. The court then confirmed the debtor’s Chapter 11 plan. Under the plan, the loan was paid in full, together with interest calculated at the nondefault rate. Unsecured creditors received a cash dividend equal to 100 percent of their allowed claims, totaling approximately $60,000. Equity holders retained their interest in the reorganized debtor (including the property valued at over $20 million) and received excess cash pro rata. The plan specifically ordered that the debtor escrow funds in anticipation of litigation over the lender’s likely claim to recover default rate interest. A week after plan confirmation, the lender filed a motion for payment of default interest (and legal fees).

Court’s Decision on Lender’s Motion for Payment of Default Interest

Application of Section 506(b)

As a threshold issue, the court recognized that under Section 506(b) of the Bankruptcy Code, an oversecured creditor is entitled to recover interest, but as the court discusses in its ruling, many courts have held that default interest can be subject to adjustment based on equitable considerations.

Analysis of Whether Default Rate Interest Was Triggered/Effect of No Notice of Default

The lender submitted that the lis pendens and bankruptcy filing each independently triggered default rate interest under Section 506(b). In determining whether lender was entitled to default rate interest, the court first analyzed the effect of the lender’s failure to provide notice of these events of default. The debtor argued that because the lender failed to issue a notice of default, the loan was never placed in default and the debtor was never given the opportunity to cure any alleged default. The court reviewed the language of the loan contracts and concluded that they allowed for payment of default rate interest in the absence of any notice of default. The court also noted that in the parties’ cash collateral stipulation, the lender reserved rights in regards to the allowance and payment pursuant to Bankruptcy Code Section 506(b) of default rate interest on its claim.

Analysis of Equitable Considerations

The court then addressed the equitable considerations and found no equitable reasons to deviate from the contracted-for default rate interest. The court stated:

The power to modify the contract rate based on notions of equity should be exercised sparingly and limited to situations where the secured creditor is guilty of misconduct, the application of the contractual interest rate would harm the unsecured creditors or impair the debtor’s fresh start or the contractual interest rate constitutes a penalty.

Analysis of 7 Percent Default Rate of Interest

As to the issue of whether the default rate interest in this case was an unenforceable penalty, the court (relying on New York case law) found that it was not. The court cited cases holding that a 5 percent differential between nondefault and default rates falls well within the range of reasonableness. The court noted that “[w]here, as here, creditors were repaid in full, courts have upheld substantially larger ranges between the default and non-default rates.”

Commentary and Takeaways

Commentary

This is a favorable decision for commercial secured lenders. Although the ruling is not controlling on other bankruptcy courts as it is a trial court level ruling, courts may certainly consider it when presented with similar issues. But it should not be overlooked that this case involved certain unique facts that may have factored into the court’s decision:

  1. the debtor’s equity in the property exceeded the amount of the loan by a ratio of more than a 3:1 (i.e., the lender was very over-secured); and
  2. the debtor was able to retain the $7.5 million purchase deposit as damages (i.e., the debtor not only had significant equity in the property but also reaped $7.5 million through an adversary proceeding filed in the bankruptcy case).

Takeaways for Lenders

A takeaway from this case for commercial lenders is to review your loan contract’s notice provisions and understand if, and when, a notice of default must be sent. In the end, the Myrtle court found that a notice was not needed, but much of the court’s analysis was focused on the effect of lender’s failure to provide notice of the events of default. This may have been avoided if lender had sent out notice of default in response to the lis pendens.