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Default Interest Payable to Oversecured Creditor Subject to Reasonableness Limitation, reprinted in the April 2006 ABF Journal, Vol. 4, No. 3

It is generally well understood that an oversecured creditor is entitled to interest, and to the extent provided for under a loan agreement, related fees and charges as part of its secured claim in a bankruptcy case. Even so, certain kinds of fees and charges may be limited if the bankruptcy court decides that they are not reasonable. What qualifies as "reasonable" and, more generally, what kinds of charges are subject to this limitation, have been subjects of considerable debate in the courts, sometimes with inconsistent and confusing results. An Illinois bankruptcy court recently added to the extensive body of case law addressing these questions in In re AE Hotel Venture.

Treatment of Oversecured Claims under the Bankruptcy Code

The Bankruptcy Code classifies a debtor's obligations in terms of "claims" rather than "debts." This means that a creditor owed money based upon a transaction that took place prior to the debtor's bankruptcy filing is generally treated under the statute as the holder of either an unsecured pre-petition claim or a secured pre-petition claim. Moreover, if the face amount of a claim exceeds the value of any collateral securing it, the creditor will hold both a secured claim, to the extent of the value of the collateral, and an unsecured claim for the deficiency. Classification of claims is an essential part of the bankruptcy process. It determines, among other things, the priority of payment afforded to the claim, whether the claimant is entitled to adequate protection of its interest in the collateral, how the claim can be treated under a chapter 11 plan, and the leverage the claimant can exert in connection with the plan confirmation process.

Whether a claim is secured or unsecured is determined in accordance with section 506(a) of the Bankruptcy Code. If it turns out that a claim is "oversecured" because the creditor's collateral has a greater value than the face amount of the claim, section 506(b) gives the creditor certain rights that are not conferred upon other kinds of creditors. Specifically, an oversecured creditor is generally entitled to receive, as part of its secured claim, "interest on [its] claim, and any reasonable fees, costs, or charges provided for under the agreement under which such claim arose."

In determining what payments an oversecured creditor is entitled to under section 506(b), a court must make a number of inquiries. First, does a right to payment arise under the relevant agreements? Second, does anything under relevant non-bankruptcy law excuse the debtor from payment? Third, is the payment properly considered to be "interest" or is it properly considered to be a "fee, cost or charge," such that the "reasonableness" limitation applies? Fourth, if it is a fee, cost or charge, is the payment of such amount reasonable? An Illinois bankruptcy court was called upon to answer these questions in AE Hotel Venture.

AE Hotel Venture

AE Hotel Venture operated a suburban Chicago hotel that it acquired with a $7.6 million loan from a securitization trust. The loan was evidenced by a ten-year promissory note maturing in 2007. The hotel served as collateral for the loan. The note and mortgage contained a number of provisions regarding additional interest, fees and charges that could be assessed by the creditor upon the occurrence of an event of default.

After making more than six years of payments, AE defaulted on its obligations under the promissory note in 2003. The trust commenced foreclosure proceedings in May 2004. These proceedings were suspended three days later when AE filed a chapter 11 petition.

The trust asserted a secured claim against AE in the amount of more than $8.6 million, comprised of $6.8 million in principal and approximately $1.8 million in interest and charges under the note. AE objected to the amount of interest, related fees and charges claimed by the trust. AE conceded that certain attorneys fees' as well as pre- and post-petition interest at the non-default rate of 9.72% was properly payable as part of the trust's allowed secured claim under section 506(b). However, AE objected to interest and related fees claimed by the trust to the extent that the amounts in question represented default rate interest and a prepayment premium. The bankruptcy court examined each element of the trust's $1.8 million assessment in determining the appropriate amount of its secured claim under section 506(b).

One component of the amount claimed by the trust was a late charge of over $17,000. This charge was assessed by the trust in accordance with a provision in the note that called for a percentage of the unpaid balance to be charged if a note installment was not timely paid. According to the loan documents, the purpose of this charge was "to defray the expense incurred in handling and processing such delinquent payment and to compensate Mortgagee for the loss of the use of such delinquent payment." The late charge was not contested by AE, and was allowed by the court.

The next item considered by the court was over $120,000 in default interest. This amount represented the difference between the regular 9.72% interest rate and the 14.72% default rate provided for under the note. Even though default interest was provided for under the loan agreement and was permissible under state law, the court concluded that default interest was not properly allowable under section 506(b).

In doing so, it interpreted the language of the statute to distinguish between "interest" and "default interest," which the court ruled was not a form of interest at all, but instead, a kind of "charge" that should be subject to the "reasonableness" qualifier. In following other courts that have adopted this approach, the court explained that the purpose of "interest" is to compensate a creditor for the delay in receiving money owed, whereas the purpose of "default interest" is to reimburse a creditor for extra costs which are incurred due to a default. Thus, the court reasoned, default interest is not interest at all, but is instead similar to other charges that are incurred upon default and are designed to reimburse creditors for the costs of default.

Next, the court concluded that the default interest requested was not reasonable. If default interest were allowed, the court emphasized, the trust would be compensated twice for its extra costs: first, through the imposition of late charges (which the note itself said was being assessed due to the extra costs imposed on the creditor); and, second, through the imposition of default interest. Thus, the court disallowed default interest as part of the trust's secured claim.

$1.2 million of the total amount sought by the trust represented a prepayment premium. Because the amount was clearly a "charge," two questions remained: first, whether the amount was provided for under the agreement; and second, whether the amount was otherwise permissible under applicable state law (here, Illinois law). The court noted that a third question — whether the amount was otherwise "reasonable" under federal bankruptcy law — would have been relevant, but was not raised by AE and would not be considered.

The court rejected AE's contention that the premium was not even properly payable under the terms of the documents because the debt having been accelerated upon default, any prepayment was involuntary. According to the court, the note did not make payment of the premium turn on whether the payment was voluntary; instead, it provided that the premium would be payable unless there was an actual foreclosure by the trust. Because there had been no foreclosure, the court held that the premium was "provided for under the agreement" as mandated by section 506(b).

Finally, the court considered whether the premium was an unenforceable "penalty" or an allowable liquidated damages clause under Illinois law. AE having conceded that the amount of the prepayment premium was, in fact, approximately equal to the actual damages that would be incurred by the trust, rather than a penalty, the court rejected AE's argument that the premium was an unenforceable penalty and allowed the premium as part of the trust's secured claim.

Analysis

AE Hotel does not represent a significant departure from existing caselaw regarding the allowance of default interest as part of a secured claim under section 506(b) — several courts have previously employed the same rationale to reach a similar result. Most find that a default interest rate amounting to approximately two-percent over the base rate for a loan is reasonable. However, many courts will disallow late fees if the loan documentation also entitles the lender to interest at the default rate.

The decision demonstrates how bankruptcy courts will scrutinize various components and charges commonly included in loan documentation by secured creditors. For secured creditors, this mean that careful consideration should be employed in drafting loan documentation to create an evidentiary record adequate enough to demonstrate unequivocally what the business deal is between the parties, and to indicate the purpose for each cost, fee or charge assessed therein.

Interestingly, the issue commonly challenged in this context — whether a pre-payment premium is reasonable under section 506(b) — was not considered by the bankruptcy court because AE either failed or neglected to raise the issue. Prepayment premiums are not disallowed per se in a bankruptcy case. Instead, the inquiry under section 506(b) centers on whether the amount of the premium is reasonable.

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In re AE Hotel Venture, 321 B.R. 209 (Bankr. N.D. Ill. 2005).

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