Equitable Factors Result in Disallowance of Default Interest on a Fully Secured Claim

Equitable Factors Result in Disallowance of Default Interest on a Fully Secured Claim

Chief Bankruptcy Judge Cynthia A. Norton of Kansas City, Mo., drew a roadmap telling subordinate creditors how to block a fully secured lender from collecting default interest. Conversely, her July 3 opinion is a tutorial advising secured lenders on tactics to improve the chance of being paid default interest.

The Facts

The sale of the debtor’s pharmacy business in chapter 11 was looking like a bust. There were three secured creditors. At filing, the principal amounts of the debts, in order of priority, were $11 million, $1 million, and $16 million.

At a Section 363 sale, the stalking horse bidder was scheduled to make an initial offer of $8 million, not enough to pay off the first lien.

The first-lien debt was current on filing. The contract interest rates on the tranches owing to the first-lien lender ranged between 3.65% and 7.5%.

The third-lien lender provided post-petition secured financing. There were no payments to the senior lender after filing because the interim and final cash collateral orders did not call for any. The senior lender neither objected to the lack of post-petition debt service or declared the loan to be in default, nor made a claim for interest at the default rate, which was 18%.

The auction was an unexpected success. The final bid came in at almost $14 million, or enough to pay the first lien in full at the nondefault contract rate. The sale proceeds would also pay the second lien in full.

After paying the second-lien lender and the senior lender’s counsel fees, there was a surplus of about $550,000 that would be available for the third-lien lender. Just before the action, however, the first-lien lender made a claim for more than $440,000 in post-petition interest at the default rate.

The debtor and the junior lender objected to the allowance of the senior lender’s claim for interest at the default rate. Although Judge Norton said the caselaw was “murky,” she denied the claim for default interest under both Missouri and federal law.

State Law

While Section 506(b) entitles a fully secured creditor to the payment of interest, Judge Norton said that the rate must be enforceable under state law. In addition, she said that “most courts” presume the allowability of default interest if the rate is enforceable under state law.

According to Judge Norton, there are no Eighth Circuit cases to say whether the lender’s claim for default interest could be denied as a penalty or for equitable reasons under Missouri or bankruptcy law. However, Missouri will not enforce liquidated damages that amount to a “penalty.” To avoid being tagged as a penalty, liquidated damages under state law must not be unreasonably disproportionate to the amount of harm anticipated when the contract was made.

The senior lender had not, Judge Norton said, produced evidence to show that increasing the interest rate after default by some 14% was “either intended or a reasonable prediction of any harm” caused by default. The senior lender, she said, “in fact adduced no evidence of any harm.”

So, Judge Norton concluded that default interest on the facts of the case was an unenforceable penalty under Missouri law.

Federal Law

According to Judge Norton, all circuits confronting the question “either hold outright or at least suggest that courts may consider equitable factors” in the allowance of postpetition interest. More specifically, she said that the Second, Third, Fifth, Seventh and Ninth Circuits hold that equitable factors may be considered.

The Eighth Circuit, Judge Norton said, “has not definitively answered the question,” but she said the lender made “no persuasive argument why the Eighth Circuit would likely buck this consensus.” She therefore concluded that “a party’s contract default rate of interest is presumed enforceable, [but] the presumption may be rebutted and default interest disallowed when allowance would be inequitable.”

Applying the facts to the law, Judge Norton observed that a spread of 10.5% to 14.35% is “not within a range other courts have found reasonable.” For four months of postpetition interest at the default rate, the senior lender was claiming more than $750,000, where total interest at the nondefault rate would be less than $315,000.

Failing to inform the parties and the court earlier about a claim of more than $400,000 in default interest “greatly compounds the injustice,” Judge Norton said. The delay “weighs heavily against the Bank,” she said.

Judge Norton observed that DIP financing provided by the third-lien lender enabled the debtor to hold a successful auction when it initially appeared as though the senior lender would not even recover its principal in full.

Judge Norton therefore held that “the equities of this case under applicable federal bankruptcy law mandate disallowance of default interest.”

Question: Would Judge Norton have taken more than $400,000 away from the senior lender and given it to the junior lender if the junior lender had not provided DIP financing?