On April 9, 2012, Judge Stuart M. Bernstein of the U.S. Bankruptcy Court for the Southern District of New York held that an oversecured creditor in a single asset real estate case was entitled to receive prepetition and postpetition interest at the contractual default rate, but declined to allow late payment premiums provided under the loan documents. 785 Partners LLC, Case No. 11-13702 (Bankr. S.D.N.Y. Apr. 9, 2012). The case reaffirms SDNY bankruptcy courts' deference to the contractual default rate for calculating postpetition interest due to an oversecured creditor when the debtor is solvent and equitable considerations favor imposition of the default rate, a topic which we first discussed here in the context of General Growth Properties' chapter 11 cases. 785 Partners also provides greater clarity in the Southern District of New York regarding the allowance of prepetition interest and late payment charges.
In January 2007, PB Capital Corporation and Commerce Bank, N.A. extended loans to the debtor to finance the construction of a condominium in Manhattan. The loans were secured by first priority mortgages on the condominium, as well as pledges on certain contract deposits and a letter of credit. The debtor never obtained the requisite condominium approvals from the New York State Attorney General and, as a result, was unable to sell any of the condominium units.
The loans matured in August 2009, and the debtor commenced chapter 11 proceedings in August 2011. One month prior to the debtor's chapter 11 filing, the original lenders assigned the loans to First Manhattan Developments REIT ("FM"). The debtors subsequently sought to confirm a plan of reorganization that provided FM with an amended and restated note. FM objected to the plan, asserting that the allowed amount of its claim should include prepetition and postpetition interest at the default contract rate and certain late payment premiums provided under the loan documents. Although the debtor did not challenge the vast majority of FM's claim, it contended that the default contract rate (as applied to both prepetition and postpetition interest) and the late payment premiums were inequitable, unenforceable penalties.
The Court first addressed the appropriate allowed amount of prepetition interest, noting that prepetition interest is generally allowable to the extent and at the rate permitted under the applicable non-bankruptcy law. Applying New York law, the Court observed that it is well settled that an agreement to pay interest at a higher rate in the event of a default is not a penalty. The policy underlying this general proposition is that a higher default interest rate reflects the parties' bargained-for allocation of risk – which benefits the creditor and the debtor. Stated differently, if creditors were prohibited from imposing variable rates, debtors could end up paying higher costs of capital because creditors likely would impose higher rates for the full life of the loan in order to reallocate the risk.
Applying these general principles to the facts of the case, the Court held that the contractual default rate did not constitute a penalty and there was otherwise no basis to disturb the parties' bargain. In so holding, the Court relied upon the fact that the debtor and the original lenders were sophisticated parties who were represented by counsel, and there was no evidence of any overreaching. The Court also rejected the debtor's appeal to equitable considerations by attempting to focus the Court on what FM paid for the loans in July 2011, and the time and effort FM had expended in enforcing the loans. Specifically, the Court found that the extent of FM's enforcement efforts and any discounts FM may have factored into its purchase price were irrelevant. Vis-ŕ-vis the debtor, FM stood in the shoes the original lenders, its assignors, and could assert the same rights subject to the same limitations that the original lenders could have asserted.
Turning to the issue of the appropriate allowed amount of postpetition interest, the Court began by noting that, as a general rule, interest ceases to accrue at the beginning of a bankruptcy proceeding. An exception to this rule is embodied in section 506(b) of the Bankruptcy Code, which entitles an oversecured creditor to postpetition interest. Notably, section 506(b) of the Bankruptcy Code does not specify an interest rate. However, courts in the Second Circuit have interpreted section 506(b) as creating a rebuttable presumption in favor of the default contract rate, subject to modification only in instances where (i) the secured creditor is guilty of misconduct (ii) application of the default rate would harm unsecured creditors or impair the debtor's fresh start, or (iii) the default rate constitutes a penalty.
On the record before it, the Court concluded that the debtor had failed to rebut the presumption in favor of the contractual default rate. There was no evidence of misconduct by FM, and the debtor offered no proof that application of the default rate would harm unsecured creditors or impair the debtor's fresh start. Rather, the record established just the opposite – the plan proposed to pay unsecured creditors in full and to permit equity to retain their interests. Thus, the debtor was solvent. This fact weighed heavily in the Court's analysis, as reducing contractual default rate payable by a solvent debtor would unfairly grant a windfall to the debtor's equity.
Additionally, the Court rejected the debtor's argument that the contractual default rate was akin to liquidated damages that are so disproportionate to the damages suffered so as to be a penalty. In the first instance, the debtor failed to identify any authority supporting application of a liquidated damages analysis to a default interest clause in a loan negotiated by sophisticated parties. However, the Court found that, in any event, the debtor failed to provide any evidence regarding the parties' intentions when they entered into the loans, which is a key consideration in evaluating the propriety of liquidated damages. Moreover, the Court concluded that the 5% differential between the contract non-default rate and default rate fell within the range of reasonableness previously recognized by other New York courts, and accordingly, did not constitute a penalty.
Late Payment Premiums
Finally, the Court addressed the late payment premiums, holding that the premiums were not allowable. Per the prepetition loan documents, a late payment premium of 5% applied to any payment that was more than five days late. Importantly, the premium was payable at the time of a late payment under the prepetition loan documents. As a factual matter, the Court found that the debtor would never be making a late payment under the prepetition loan documents because upon confirmation of the debtor's plan, all of FM's rights under the loans will be extinguished in exchange for the amended and restated note. Thus, all subsequent payments by the debtor on account of FM's secured claim would be made under the plan and the new note, rather than under the prepetition loan documents and therefore the late payment premium under the prepetition loan documents would never be triggered.
Separately, however, the Court concluded that section 506(b) of the Bankruptcy Code, which also permits oversecured creditors to recover reasonable fees provided under the loan documents, prevented FM from receiving the late payment premiums. In reaching this conclusion, the Court found that case law is unequivocal on the point – oversecured creditors may receive payment of either default interest or late charges, but not both. The reason for this prohibition is simple – late charges and default interest are designed to compensate the lender for the same injury, so awarding both amounts to a double-recovery.
785 Partners reinforces the growing trend among courts to honor the parties' bargain when construing section 506(b) of the Bankruptcy Code, absent evidence that there has been creditor misconduct, the default rate constitutes a penalty, or application of the default rate would cause harm to unsecured creditors or otherwise impair the debtor's fresh start. Additionally, the case underscores New York law's general deference to contract rates of interest, and puts creditors on notice that they may be entitled to either late charges or contractual default interest – but not both.
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