Solvent Debtor Required to Pay Default Interest 9% Above Prime

In an atypical chapter 11 case where the mortgage lender and unsecured creditors were all paid in full and the debtor retained substantial equity after confirmation, the lender was entitled to collect default interest at seven percentage points above the contract rate, according to Bankruptcy Judge Mary Kay Vyskocil of Manhattan.

The Facts

The debtor owned a real estate project worth about $20.5 million. The property was subject to a mortgage for some $6.3 million carrying interest at 2 percentage points over prime.

Before bankruptcy, the debtor had a contract to sell the project for $20.5 million. The buyer made a $7.5 million deposit but failed to close. Instead, the buyer filed a lis pendens against the property. The lis pendens was an event of default under the mortgage, but the lender did not give notice of default or acceleration. However, the lis pendens did precipitate the filing of the chapter 11 petition.

The chapter 11 filing was also a notice of default, but, again, the lender did not give notice of default.

The court ruled that the buyer had breached the contract, thus allowing the debtor to retain the $7.5 million deposit. The debtor filed and confirmed a plan paying the lender and unsecured creditors in full.

Throughout the chapter 11 case, the debtor continued paying the mortgage. There never was a payment default before or after bankruptcy.

On confirmation, the lender received payment of principal plus interest at the contract rate. By stipulation, the parties agreed to litigate the allowance of default interest, amounting to some $1.1 million.

Equity Didn’t Help the Debtor

Under Section 506(b), an oversecured creditor is entitled to interest. In her February 14 opinion, Judge Vyskocil said that the Second and Fifth Circuits have held that default interest can be adjusted “based on equitable considerations.”

Before addressing equitable considerations, the debtor contended that the default rate never kicked in because the lender never gave notice of default. Concluding that default interest was automatic, Judge Vyskocil interpreted the note and mortgage as not requiring notice to invoke default interest. Furthermore, she said that giving notice of default after bankruptcy “arguably” would have violated the automatic stay.

Judge Vyskocil cited caselaw for the proposition that “‘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 unsecured creditors or impair the debtor’s fresh start or the contractual interest rate constitutes a penalty.’” She found no “equitable reasons to deviate from the contracted-for default rate,” because creditors were paid in full and the debtor walked away from bankruptcy with a substantial equity.

The debtor nonetheless contended that default interest was an unenforceable penalty.

Judge Vyskocil cited New York cases holding that a five-percentage-point differential “falls well within the range of reasonableness.” Where creditors are paid in full, she cited other cases where secured lenders were paid as much as 24 percentage points more than the nondefault rate.

Judge Vyskocil held that the default rate was not a penalty, even though the lender “was not harmed monetarily by the default.” In short, she said that the seven-percentage-point differential was “not so egregious or inequitable that the Court must rewrite the Debtor and Lender’s contract and apply a lower default rate of interest.”