An oversecured creditor is generally entitled to post-petition interest, to the extent provided for under a loan agreement, as a part of its secured claim in a bankruptcy case.[1] However, courts are split as to (1) whether or not the same applies to interest incurred at a contracted default rate when curing a monetary default through the debtor’s plan of reorganization, and (2) whether equitable considerations allow courts to disallow interest at the agreed-upon, contractual default rate, despite the provisions of §§ 506(b) and 1123(d).[2]
Entz-White, Ron Pair and the Bankruptcy Reform Act
The Ninth Circuit kicked off this 30+-year debate with its decision in Entz-White, holding that the Bankruptcy Code’s cure provisions entitled a debtor “to nullify all consequences of default, including avoidance of default penalties such as higher interest” upon cure of its default through its plan of reorganization.[3] As its basis, the Ninth Circuit leaned heavily on § 1124’s cure provisions,[4] as the Code lacked a clear definition of “cure” as used in § 1123.[5] While this pro-debtor view was in the minority, several courts have followed the Ninth Circuit’s approach.[6]
Meanwhile, the Supreme Court’s 1989 Ron Pair decision, its pre-Code Vanston decision and their progeny supported a majority presumption in favor of the contract rate, subject to rebuttal based on equitable considerations.[7]Ron Pair further made clear that the right to interest under § 506(b) is not subject to the reasonableness language that qualifies a creditor’s right to fees, costs and charges.[8]
In 1994, Congress amended the Bankruptcy Code to provide clarification with the addition of § 1123(d), which reads that, “[n]otwithstanding subsection (a) of this section ... if it is proposed in a plan to cure a default, the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.”[9] In doing so, the drafters confirmed that cure provisions in a plan should align with the terms of the underlying contract or agreement, to the extent allowed by state law.[10] More than 20 years after the 1994 amendments, the Ninth Circuit overruled Entz-White in light of the enactment of § 1123(d); however, its progeny remain good law in several jurisdictions.[11]
Post-Travelers and § 1123(d)
Courts have further read §§ 506(b) and 1123 against the Supreme Court’s decision in Travelers to support a black-letter-law approach to the allowance of post-petition interest.[12] In Travelers, the Supreme Court stated that “[c]reditors’ entitlements in bankruptcy arise in the first instance from the underlying substantive law creating the debtor’s obligation, subject to any qualifying or contrary provisions of the Bankruptcy Code.”[13] These courts have thus considered the equitable review set forth in prior cases to only be appropriate in exceptional circumstances.[14]
Most recently, the Eighth Circuit reviewed this issue in In re Family Pharmacy, finding that the consideration of equitable factors by the bankruptcy court, while adhering to the majority rule, was improper, and that “[s]imply put, no section of the Bankruptcy Code gives the bankruptcy court authority, equitable or otherwise, to modify a contractual interest rate prior to plan confirmation.”[15] The Eighth Circuit reversed the bankruptcy court’s holding and endorsed the view that under Ron Pair, “the pre-confirmation interest rate to be applied under § 506(b) to an oversecured creditor whose claim is evidenced by a promissory note or similar loan agreement is the contract (both nondefault and default) rate set forth in the note or loan agreement, to the extent enforceable under applicable law.”[16] The Eighth Circuit further found that, “absent state law to the contrary, a liquidated damages vs. penalty analysis is not applicable and should not be applied to a default interest rate set forth in a promissory note or similar loan agreement,” and that “equitable considerations should be used sparingly and only in exceptional circumstances.”[17]
Other Considerations
In addition to the Eighth Circuit, other courts have also found that default interest provisions are not subject to a liquidated damages vs. penalty analysis under state law, as applying a liquidated damages analysis to a contractual interest rate “brings into play ‘reasonableness’ factors that simply are not applicable to interest rates under 11 U.S.C. § 506(b).”[18]
Further, an award of default interest under § 506(b) is far from guaranteed and is subject to alteration under a debtor’s plan. As seen in the Fifth Circuit’s Linn Energy opinion, oversecured creditors that want to preserve and assert claims for post-petition default interest must carefully review a debtor’s plan and object, when necessary, to ensure that plan or confirmation order provisions do not preclude the recovery of default interest.[19]
The solvent-debtor exception has also arisen in cases involving both §§ 506(b) and 502, and it is worth attention in jurisdictions supporting an equitable review in connection with an award of default interest.[20]
Takeaways
While awards of and/or consideration of default interest under §§ 506(b), 1123 and 1124 are more likely as courts move away from the Entz-White line of cases, many circuits still provide lower courts with precedential, equitable authority to disallow default interest under certain circumstances. As such, factors such as creditor misconduct, potential harm to unsecured creditors, whether the contractual interest rate constitutes a penalty under state law or the contract’s terms, whether the application of default interest would impair the debtor’s fresh start, and whether the debtor is solvent may all be considered, depending on the court. Creditors should further take great care in reviewing the debtor’s plan or sale pleadings to ensure that all rights to contractual interest are being preserved, including default interest.
[1] “To the extent that an allowed secured claim is secured by property the value of which ... is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.” 11 U.S.C. § 506(b).
[2] See also 11 U.S.C. § 1123(a)(5)(G) (“Notwithstanding any otherwise applicable nonbankruptcy law, a plan shall ... provide adequate means for the plan’s implementation, such as ... curing or waiving of any default.”).
[3] Great W. Bank & Trust v. Entz-White Lumber & Supply Inc. (In re Entz-White Lumber & Supply Inc.), 850 F.2d 1338, 1342 (9th Cir. 1988).
[4] A class of claims is “impaired under a plan” unless the plan, “notwithstanding any contractual provision or applicable law that entitles the holder of such claim or interest to demand or receive accelerated payment of such claim or interest after the occurrence of a default,” (i) “cures any such default that occurred before or after the commencement of the case,” (ii) reinstates the maturity of the claim, and (iii) “compensates the holder of such claim or interest for any damages incurred as a result of any reasonable reliance by such holder on such contractual provision or such applicable law.” 11 U.S.C. § 1124(2).
[5] Entz-White, 850 F.2d 1338 at 1340-1343.
[6] See Florida Partners Corp. v. Southeast Co. (In re Southeast Co.), 868 F.2d 335, 338-39 (9th Cir. 1989); Platinum Capital Inc. v. Sylmar Plaza L.P. (In re Sylmar Plaza L.P.), 314 F.3d 1070, 1075 (9th Cir. 2002) (holding that plan filed for purposes of avoiding approximately $1 million in default interest was not filed in bad faith under § 1129); In re PCH Assocs., 122 B.R. 181, 200 (Bankr. S.D.N.Y. 1990); In re Johnson, 184 B.R. 570 (Bankr. D. Minn. 1995); In re Countrywood Investment Group Ltd., 117 B.R. 338 (Bankr. M.D. Tenn. 1990); In re Chateaugay Corp., 150 B.R. 529 (Bankr. S.D.N.Y. 1993) (cure precludes post-petition interest unless the debt matured without acceleration); In re Southeast Co., 868 F.2d 335, 339 (9th Cir. 1989) (“To allow pre-petition interest at the post-default rate would completely eliminate the benefits of cure in this case, as it would fail to nullify a significant consequence of the default.”); In re Garcia, 276 B.R. 627, 639 (Bankr. D. Ariz. 2002) (“For these reasons, this Court must conclude that Entz-White is still good law at least with respect to cures under Chapter 11 and 13 plans, so in this circuit at least, plans may cure all defaults.”); In re Bownetree LLC, No. 1-08-45854-DEM, 2009 WL 2226107, at *4 (Bankr. E.D.N.Y. July 24, 2009) (“It follows that a cure nullifies the consequences of a default, including a higher post-default interest rate.”); Rathblott v. Peoplestrategy Inc., No. CA 15-4293, 2016 WL 861348, at *3 (E.D. Pa. Mar. 7, 2016), aff’d, 685 F. App’x 107 (3d Cir. 2017) (“By curing, a party ‘is entitled to avoid all consequences of the default — including higher post-default interest rates.’”); In re Gillette Assocs. Ltd., 101 B.R. 866, 875 (Bankr. N.D. Ohio 1989) (“It is, thus, clear that Code Sec. 1124(2) provides the debtor-in-distress with the statutory tools necessary to effect a total healing of the scars of contractual default by placing the parties into the same position as they were [in] immediately before the default occurred.”). See also In re Taddeo, 685 F.2d 24, 29 (2d Cir. 1982) (“In short, ‘curing a default’ in Chapter 11 means the same thing as it does in Chapters 7 or 13: the event of default is remedied, and the consequences are nullified.”); In re Forest Hills Assocs., 40 B.R. 410, 415-417 (Bankr. S.D.N.Y. 1984).
[7] United States v. Ron Pair Enterprises Inc., 489 U.S. 235, 242, 109 S. Ct. 1026, 1031, 103 L. Ed. 2d 290 (1989) (“The plain meaning of legislation should be conclusive, except in the rare cases [in which] the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafters.”); Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156, 67 S. Ct. 237, 91 L. Ed. 162 (1946) (pre-Code case in which Supreme Court relied on equitable principles to disallow compound interest sought by creditor, used in later cases to support use of equitable principles to determine appropriate interest rates under § 506(b)). See also In re Fam. Pharmacy Inc., 614 B.R. 58, 65 (B.A.P. 8th Cir. 2020) (discussing Ron Pair). See also In re Courtland Estates Corp., 144 B.R. 5, 9 (Bankr. D. Mass. 1992); In re Hollstrom, 133 B.R. 535, 539 (Bankr. D. Colo. 1991); DWS Invs., 121 B.R. at 849 (Bankr. C.D. Cal. 1990); Matter of Terry Ltd. P’ship, 27 F.3d 241, 243 (7th Cir. 1994); Wells Fargo Bank N.A. v. Beltway One Development Group LLC (In re Beltway One Development Group LLC), 547 B.R. 819 (B.A.P. 9th Cir. 2016) (determining post-petition interest on oversecured claim under § 506(b) is “separate and distinct from the fair and equitable test for plan confirmation under § 1129(b)” and is claim issue, not confirmation issue; further, entitlement to default interest during pendency of case “is not automatic but may be allowed upon demonstrating that it meets certain requirements”); Gen. Elec. Capital Corp. v. Future Media Prods. Inc. (In re Future Media), 536 F.3d 969 (9th Cir.), amended 547 F.3d 956 (9th Cir. 2008) (in context of § 363 sale, court held that presumption of allowability for contract default interest rate exists when default rate is not unenforceable under applicable nonbankruptcy law, placing burden on debtor for rebuttal); Matter of Laymon, 958 F.2d 72, 75 (5th Cir. 1992) (whether default or pre-default rate should apply “must be decided by examining the equities involved in this bankruptcy proceeding”); In re Suplett, 895 F.2d 1381, 1386 (11th Cir. 1990) (default interest is allowable when creditor is oversecured, claimed default interest is provided for in loan documents, claimed interest is reasonable under state law, and debtor is solvent); In re Maywood Inc., 210 B.R. 91 (Bankr. N.D. Tex. 1997); In re Consolidated Properties Ltd. Partnership, 152 B.R. 452 (Bankr. D. Md. 1993) (default interest rates should be examined for reasonableness); In re Consolidated Operating Partners L.P., 91 B.R. 113 (Bankr. D. Colo. 1988); In re W.S. Sheppley & Co., 62 B.R. 271 (Bankr. N.D. Iowa 1986) (flexible approach is best method in accordance with Vanston equity analysis); Matter of Arlington Village Partners Ltd., 66 B.R. 308 (Bankr. S.D. Ohio 1986), (equities of case allowed creditor to receive market rate of interest subject to comparison to pre-default and default rates of interest). Compare with In re Dixon, 228 B.R. 166, 173 (W.D. Va. 1998) (“Clearly, no exercise of the bankruptcy court’s equitable powers may infringe on the plain meaning of the Bankruptcy Code.”); White v. Coors Distrib. Co. (In re White), 260 B.R. 870, 879 (B.A.P. 8th Cir. 2001) (assignee of original lender was entitled to collect post-petition interest under Nebraska law and under § 506(b) at contract interest rate).
[8] Ron Pair, 489 U.S. at 241, 109 S. Ct. at 1026.
[9] 11 U.S.C. § 1123(d).
[10] See In re Sagamore Partners Ltd., 620 F. App’x 864, 868-69 (11th Cir. 2015) (Section 1124’s definition of impairment “does not allow us to ignore the clear mandate of § 1123 that allows a creditor to demand default-rate interest as a condition for reinstating the loan”); see also In re Southland Corp., 160 F.3d 1054, 1059-1060 and n. 6 (5th Cir.1998) (“Congress, in bankruptcy amendments enacted in 1994, arguably rejected the Entz-White denial of contractual default interest rates.”); but see Sylmar, 314 F.3d 1070, 1075 (9th Cir. 2002) (holding that, with respect to 11 U.S.C. § 1129(a)(3), Entz-White remains good law). In re K & J Properties Inc., 338 B.R. 450, 461 (Bankr. D. Colo. 2005) (“Section 1123(a)(5)(G) and section 1124(2) provide no basis to nullify the post-petition default interest … to the extent it is otherwise allowable under [underlying] loan documents and applicable nonbankruptcy law.”)
[11] See In re New Invs. Inc, 840 F.3d 1137, 1139 (9th Cir. 2016) (“Entz-White’s rule of allowing a curing debtor to avoid a contractual post-default interest rate in a loan agreement is no longer valid in light of § 1123(d).”); fn. 6.
[12] See fn. 13.
[13] Travelers Cas. & Sur. Co. of Am. v. Pac. Gas & Elec. Co., 549 U.S. 443, 127 S. Ct. 1199, 1204-05, 167 L. Ed. 2d 178 (2007).
[14] “Generally stated, ‘when an oversecured creditor’s claim arises from a contract, the contract provides the rate of post-petition interest,’ so long as a higher default rate does not ‘produce an inequitable or unconscionable result.’ This Court agrees with those courts concluding, however, that a modification of a contracted-for default rate based on equitable considerations ‘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.’” In re John Q. Hammons Fall 2006 LLC, 612 B.R. 779, 799 (Bankr. D. Kan.), as amended (Jan. 21, 2020), on reconsideration, 614 B.R. 371 (Bankr. D. Kan. 2020) (citing In re 1111 Myrtle Ave. Group LLC, 598 B.R. at 740) (internal quotation omitted). See also Law v. Siegel, 571 U.S. 415, 426, 134 S. Ct. 1188, 188 L. Ed. 2d 146 (2014) (“Marrama most certainly did not endorse, even in dictum, the view that equitable considerations permit a bankruptcy court to contravene express provisions of the Code.”);Norwest Bank Worthington v. Ahlers, 485 U.S. 197, 206, 108 S. Ct. 963, 99 L. Ed. 2d 169 (1988) (“[W]hatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of the Bankruptcy Code.”); In re K & J Props. Inc., 338 B.R. 450, 457 (Bankr. D. Colo. 2005) (noting that courts have considered “whether the bankruptcy estate is solvent, ... whether the default rate of interest in issue is unusually high considered by itself or in comparison to the pre-default rate, and whether there is a relationship between the default rate and the loss by the oversecured creditor that may be compensated, as opposed to a default rate that merely serves as a ‘penalty.’”); In re Gen. Growth Props. Inc., 451 B.R. 323, 328 (Bankr. S.D.N.Y. 2011) (“The payment of default interest in this matter is also consistent with the increasing reluctance of courts in this and other circuits, in construing the requirement of § 506(b) that an oversecured creditor receive ‘interest,’ to modify private contractual arrangements imposing default interest rates except where: (i) there has been creditor misconduct; (ii) application of the contractual interest rate would cause harm to the unsecured creditors; (iii) the contractual interest rate constitutes a penalty; or (iv) its application would impair the debtor’s fresh start.”); In re 3MB LLC, 609 B.R. 841, 849 (Bankr. E.D. Cal. 2019) (same, citing In re 785 Partners LLC, 470 B.R. 126, 134 (Bankr. S.D.N.Y. 2012)).
[15] In re Fam. Pharmacy Inc., 614 B.R. 58, 66 (B.A.P. 8th Cir. 2020).
[16] Id.
[17] Id. at 67.
[18] In re Fam. Pharmacy Inc., 614 B.R. at 64. See In re 3MB LLC, 609 B.R. 841, 848 (Bankr. E.D. Cal. 2019) (noting that default interest has long been allowed in California without resorting to a liquidated-damages analysis); In re 785 Partners LLC, 470 B.R. 126, 131 (Bankr. S.D.N.Y. 2012) (citing with approval New York state court case holding that agreement to pay interest at higher rate after default is agreement to pay interest and not a penalty).
[19] See Matter of Linn Energy L.L.C., 927 F.3d 350 (5th Cir. 2019) (pre-petition lenders were not entitled to default interest on their claims where unambiguous confirmed plan language disallowed the same).
[20] See In re Ultra Petroleum Corp., 624 B.R. 178, 204 (Bankr. S.D. Tex. 2020) (finding post-petition default interest allowable under solvent-debtor exception, which “is based on the critical public policy consideration that a debtor cannot walk away from bankruptcy with a windfall while creditors walk away with depleted pockets”); In re Suplett, 895 F.2d 1381, 1386 (11th Cir. 1990) (default interest is allowable when creditor is oversecured, claimed default interest is provided for in loan documents, claimed interest is reasonable under state law, and debtor is solvent); In re K & J Props. Inc., 338 B.R. 450, 457 (Bankr. D. Colo. 2005) (noting that courts have considered “whether the bankruptcy estate is solvent,... whether the default rate of interest in issue is unusually high considered by itself or in comparison to the pre-default rate, and whether there is a relationship between the default rate and the loss by the oversecured creditor that may be compensated, as opposed to a default rate that merely serves as a ‘penalty.’”).