In re 400 Walnut Associates, L.P., 2012 BL 140988 (E.D. Pa. June 7, 2012)

CASE SNAPSHOT

The creditor appealed the denial of its claim for pre-petition interest at the contractual default rate. The district court reversed and remanded the case, holding that the bankruptcy court had incorrectly applied an "equitable analysis" in making its decision.

FACTUAL BACKGROUND

The debtor’s real property was subject to a loan and mortgage. Prior to filing for bankruptcy, 400 Walnut Associates, L.P. had stopped making payments on the loan, and its lender sent the debtor a formal notice of default. The loan agreement provided for a default rate of interest of 16 percent (the non-default rate was 5 percent). The lender subsequently sold the loan to 4th Walnut Associates. Upon purchasing the loan, 4th Walnut issued a new notice of default to the debtor. Months later, the debtor filed a petition for relief under chapter 11 of the Bankruptcy Code. 4th Walnut filed a proof of claim for $15.3 million, which included pre-petition interest calculated at the default rate. The debtor objected. The bankruptcy court, applying an equitable analysis, held that the creditor was not entitled to interest at the default rate, which decision was appealed by 4th Walnut. The bankruptcy court, relying on case law founded on section 506(b) of the Code, found that default interest was inappropriate because it was unreasonable, as the loan was purchased at a discount; the default rate was more than three times the non-default rate; and the rate hindered the debtor’s ability to confirm a chapter 11 plan.

COURT ANALYSIS

The debtor argued that the district court lacked jurisdiction to review the lower court decision, arguing that the decision was not final and that the district court should not exercise its discretion to hear an interlocutory appeal. The district court agreed that the lower court’s decision lacked finality because it did not dispose of all of the claims, but nevertheless exercised its discretion to hear the appeal as interlocutory. The court concluded that the appeal of the bankruptcy court’s decision satisfied all of the elements necessary to exercise its discretion because: (i) it involved a "controlling question of law;" (ii) it offered "substantial ground for difference of opinion" as to its correctness; and (iii) if appealed immediately, it "materially advance[d] the ultimate termination of the litigation."

Turning to the merits of the case, the court concluded that the bankruptcy court applied the wrong legal standard in deciding the claim for pre-petition interest at the default rate. Rather than analyzing whether the default rate was appropriate and permissible under state law, the bankruptcy court stated that the claim for default interest was subject to an "equitable analysis" focusing on the risk of default, the reasonableness of the default rate, and the "effect of the higher rate on the debtor’s ability to reorganize."

The district court found that the lower court "incorrectly applied an equitable analysis to Creditor’s entire claim for default interest, failing to distinguish between interest that accrued before and after Debtor filed its bankruptcy petition." The district court adopted the majority approach that section 506(b) of the Bankruptcy Code is applicable only in the context of post-petition claims. "The Bankruptcy Court’s reliance on section 506(b) with respect to claims for pre-petition interest is misplaced. There is no ‘reasonableness’ test for interest that accrues prior to the filing of the bankruptcy petition." The district court, in reversing the bankruptcy court decision, held that a creditor "may recover pre-petition default interest so long as the parties contracted for it and it is permitted under state law."

PRACTICAL CONSIDERATIONS

The court made clear that a claim for default interest is evaluated in light of the contractual terms, and state law, and that a determination of reasonableness consistent with section 506(b) is inapplicable to claims for pre-petition interest.