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Oversecured Creditor's Right to Contractual Default-Rate Interest Allowed Under State Law

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. Although section 506(b) of the Bankruptcy Code provides that fees, costs or charges allowed as part of a secured claim must be "reasonable," the provision does not expressly impose any restrictions on the amount or nature of interest allowable as part of a secured claim. A Bankruptcy Appellate Panel for the Eighth Circuit recently considered whether a secured creditor is entitled to contractual default-rate interest under section 506(b).

In In re Family Pharmacy, Inc., 614 B.R. 58 (B.A.P. 8th Cir. 2020), the panel reversed a bankruptcy court's order disallowing a secured creditor's claim for interest at the default rate under the parties' contract, using a penalty-type analysis generally applied to liquidated damages provisions. According to the panel, such an analysis cannot be applied to default interest provisions. The panel also held that the bankruptcy court erred when it held that the default interest rate was unenforceable based on "equitable considerations."

Secured Creditor's Right to Interest, Fees, Costs, or Charges

Whether a claim is secured or unsecured is determined in accordance with section 506(a) of the Bankruptcy Code, which provides that a creditor holds a secured claim to the extent of the value of the collateral securing its claim and an unsecured claim for any deficiency. If a creditor is "oversecured" because the creditor's collateral has a greater value than the face amount of the claim, section 506(b) provides that the creditor is 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 or State statute under which such claim arose." As noted by a leading commentator, "the entitlement provided by section 506(b) marks a significant exception to the general rule that claims are not entitled to accrue interest after the commencement of the [bankruptcy] case." Collier on Bankruptcy ("Collier") ¶ 506.04 (16th ed. 2020).

In United States v. Ron Pair Enterprises, Inc., 489 U.S. 235 (1989), the U.S. Supreme Court determined that section 506(b) applies to both consensual and nonconsensual liens and security interests. Prior to Ron Pair, some courts ruled that interest was not allowable under section 506(b) with respect to nonconsensual liens, reasoning that: (i) the reference to an "agreement" in the provision modified the entitlement to interest, suggesting that interest could be allowed only if there was an agreement providing for it; and (ii) because nonconsensual liens, such as tax liens, do not involve agreements, such liens must be excluded from the scope of section 506(b). See generally Collier at ¶ 506.04[a] (citing cases). According to the Court in Ron Pair, the reference to an "agreement" in section 506(b) modifies only the reference to "reasonable fees, costs, or charges," but not to "interest." An oversecured creditor has an "unqualified" right to such interest, the Court concluded, as long as it is entitled to such interest under a contract or applicable law.

Notably, the Court did not specify the rate of interest to which an oversecured creditor is entitled under section 506(b). Most lower courts have since concluded that the interest rate should be the rate provided in the contract, or other applicable law, under which the claim arose—i.e., the "contract rate" of interest. Collier at 506.04[b][i] (citing cases).

Although courts may disagree over the payment of contractual default-rate interest as part of an allowed secured claim, whether a claim based on another common contractual provision designed to compensate the non-defaulting party—a liquidated damages clause—is less controversial.

Enforceability of Liquidated Damages Claims in Bankruptcy

Section 502(b)(1) of the Bankruptcy Code provides that, if a party objects to a claim, the bankruptcy court shall allow it except to the extent that "such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law for a reason other than because such claim is contingent or unmatured." Thus, state law generally determines whether a claim is enforceable in bankruptcy. See Travelers Cas. & Sur. Co. of Am. v. Pac. Gas & Elec. Co., 549 U.S. 443, 452 (2007).

Under the laws of most states, a "liquidated damages" provision in a contract specifying the amount of damages payable upon default without proof of actual damages is enforceable unless it represents a penalty. See, e.g., Breen v. Green, 2019 WL 5855978, at *10 (D.R.I. Sept. 13, 2019) ("Rhode Island law distinguishes contractual penalties from liquidated damages and treats the former as unenforceable as a matter of public policy."); In re John Q. Hammons Fall 2006, LLC, 612 B.R. 779, 797 (Bankr. D. Kan. Jan. 3, 2020) (noting that, "in Missouri, liquidated damages provisions are 'valid and enforceable'; on the other hand, 'penalty clauses are not'"); In re Madison 92nd St. Assocs. LLC, 472 B.R. 189, 196 (Bankr. S.D.N.Y. 2012) ("A liquidated damages clause is valid under New York law if: (1) actual damages are difficult to determine, and (2) the sum is not 'plainly disproportionate' to the possible loss.").

In Family Pharmacy, the bankruptcy appellate panel considered whether a creditor was entitled to contractual default-rate interest as part of its secured claims under section 506(b).

Family Pharmacy

In April 2018, Family Pharmacy, Inc. and four affiliates (collectively, the "debtors") filed for chapter 11 protection in the Western District of Missouri. At the time of the filing, the debtors' secured creditors were, in order of priority, the Bank of Missouri ("BOM"), which was owed $11 million under a series of promissory notes; Cardinal Health ("Cardinal"), which was owed $1 million; and JM Smith Corporation and an affiliate (collectively, "Smith"), which were owed $18 million. The notes held by BOM bore various non-default interest rates ranging from 3.65% to 7.5% and provided that the rate of interest would increase to 18% upon default. The notes further provided that a default would be triggered when the "Borrower fails to make any payment when due."

The debtors undertook to sell their assets in bankruptcy. Although the initial stalking horse bid for the debtors' assets was only $8 million, after a marketing and auction process, the bankruptcy court approved a sale of substantially all of the debtors' assets to Smith for approximately $14 million. The sale proceeds were then disbursed to BOM and Cardinal, leaving excess proceeds of approximately $560,000. BOM received $11.3 million, which, pursuant to its proof of claim, included the outstanding principal amount of the promissory notes, interest at the respective non-default rates set forth in the notes, and certain related fees and expenses. BOM later filed a motion seeking allowance under section 506(b) of an additional approximately $18,000 in postpetition attorneys' fees, plus $443,000 in interest calculated at the 18% default rate specified in the notes. The debtors and Smith objected to the allowance of interest at the default rate as part of BOM's secured claim.

The bankruptcy court acknowledged that an 18% rate of interest was legal under Missouri law. Even so, it denied BOM's claim for default-rate interest for two reasons. First, reasoning that Missouri courts refuse to enforce liquidated damages clauses that are improper penalties, the bankruptcy court held that the default interest rate was unenforceable under "applicable law." In the alternative, the bankruptcy court held that the default interest rate could not be enforced on "equitable considerations." In so ruling, the court cited post-Ron Pair decisions representing the majority position that have applied "a presumption in favor of the contract rate subject to rebuttal based upon equitable considerations" (citing In re Terry Ltd. P'ship, 27 F.3d 241, 243 (7th Cir. 1994)). Those considerations included: (i) the spread between the 18% default rate and the non-default interest rates in the notes (ranging from 3.65% to 7.5%), which the court did not find to be a "reasonable prediction for any harm caused by a presumed default"; and (ii) BOM's failure to assert a claim for default interest until after the debtors' assets had fetched a higher price at auction than originally anticipated.

Prior to making its alternative rulings, the bankruptcy court addressed whether the default interest rate was triggered under the promissory notes. The debtors did not fail to make required payments under the notes until the day after they filed for bankruptcy. They argued that they were excused from doing so in the absence of a court order and, because the notes were not in default, interest therefore did not begin to accrue at the default rate. The bankruptcy court noted that decisions addressing this issue are "murky" and declined to rule on the issue in light of its ruling disallowing BOM's claim for default-rate interest.

BOM appealed the bankruptcy court's ruling to a bankruptcy appellate panel.

The Bankruptcy Appellate Panel's Ruling

A three-judge bankruptcy appellate panel ("BAP") reversed the bankruptcy court's decision. Writing for the court, Chief Judge Thomas L. Saladino explained that "the concepts of default interest and liquidated damages are often conflated." A liquidated damages provision provides for a fixed amount of damages in the event of a breach, whereas a default interest provision results in the escalation of the interest rate payable upon default.

Citing decisions from bankruptcy courts outside of the Eighth Circuit, Judge Saladino found that the bankruptcy court's decision to subject the default interest provision to a liquidated damages analysis was inappropriate (citing In re 3MBB, LLC, 609 B.R. 841, 848 (Bankr. E.D. Cal. 2019) (addressing California law); In re 785 Partners LLC, 470 B.R. 126, 131 (Bankr. S.D.N.Y. 2012) (addressing New York law)). He also noted that, although the Eighth Circuit appeared to apply a liquidated damages analysis to a default interest rate under Minnesota law in In re Bowles Sub Parcel A, LLC, 792 F.3d 897 (8th Cir. 2015), a careful reading of the decision and the district court ruling below reveal that the Eighth Circuit did not decide the issue, but merely "addressed the issues as presented by the parties."

Judge Saladino noted that neither BOM nor the debtors cited a single case under Missouri law that "applied a liquidated damages analysis to a contractual interest rate set forth in a promissory note." Moreover, he wrote, such an analysis "brings into play 'reasonableness' factors that simply are not applicable to interest rates under 11 U.S.C. § 506(b)."

The BAP also determined that the bankruptcy court erred by disallowing BOM's claim for default-rate interest due to "equitable considerations." The court noted that such considerations "should be used sparingly and only in exceptional circumstances" that are not present when the plain meaning of a statute "provides the answer in a more straightforward and less time-consuming manner." "Simply put," the BAP found, "no section of the Bankruptcy Code gives the bankruptcy court authority, equitable or otherwise, to modify a contractual interest rate prior to plan confirmation." As an oversecured creditor, the court explained, BOM had an "unqualified right" to postpetition interest under section 506(b), "and that interest should be computed at the rate—default as well as non-default—provided in the parties' agreement, as long as those rates are allowed under state law."

The BAP accordingly reversed the bankruptcy court's ruling and remanded the case to the bankruptcy court to determine whether the default interest rate was triggered under the notes.

Outlook

The BAP's decision in Family Pharmacy is consistent with Ron Pair's ruling that the term "reasonable" in section 506(b) modifies the terms "reasonable fees, costs, or charges" but not "interest." If the rate of interest—default or otherwise—under a secured instrument is valid and enforceable under state law and the value of the collateral securing the loan exceeds the face amount of the debt, the secured creditor is entitled to interest at the contract rate as part of its allowed secured claim. According to the BAP in Family Pharmacy, neither the analysis traditionally applied to liquidated damages clauses nor equitable considerations should have any bearing on an oversecured creditor's entitlement to interest under section 506(b). That said, the issue of whether the default rate was triggered in this case remains to be determined by the bankruptcy court on remand.

A version of this article is being published in Lexis Practice Advisor. It has been reprinted here with permission

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