The U.S. Bankruptcy Appellate Panel for the Eighth Circuit recently reversed a bankruptcy court's disallowance of post-petition interest at the default contract rate, holding that "the bankruptcy court erred in applying a liquidated damages analysis and ruling the default interest rate was an unenforceable penalty", and also erred in weighing "equitable considerations" to avoid enforcing the contractual default interest rate.
A copy of the opinion is available at: Link to Opinion
A pharmacy company and four related entities (collectively, the "Debtors") filed petitions for relief under Chapter 11 of the Bankruptcy Code. The "assets consisted primarily of inventory, equipment and real estate used in operating pharmacies in the southwest of Missouri." There were three secured creditors with liens on the assets.
The Debtors and their creditors agreed to sell the assets "at an auction sale free and clear of liens pursuant to 11 U.S.C. § 363." One of the secured creditors, in third position in order of priority, agreed to provide "debtor in possession financing and to serve as the so-called stalking horse bidder for the sale with an $8 million opening bid."
The bankruptcy court approved the debtor in possession financing and the bid procedures for the sale, and then entered an order approving the sale to the third-position secured creditor for almost $14,000,000. The proceeds were then distributed to the secured creditors in first and second position, leaving surplus proceeds of approximately $556,000.
The first-position creditor received "its full principal balance, estimated interest at the non-default rate set forth in its loan contracts, certain fees and expenses, less its share of the broker's fee for the sale." It then filed a "motion under 11 U.S.C. § 506(b) seeking allowance of ... postpetition attorney's fees plus $442.843.51 in interest calculated at an 18% default rate."
The Debtors and third-position secured creditor objected and, at the hearing, agreed to allow payment of postpetition attorney's fees, but not the default interest.
The bankruptcy court denied the first-position creditor's motion to enforce the default interest for two alternative reasons. First, "the default interest rate constituted an unenforceable penalty under Missouri law." Second, "the bankruptcy court held that the default interest rate could not be enforced based on 'equitable considerations.'" The bankruptcy court never actually ruled on the issue of "whether the default interest rate had even been triggered under the terms of the contracts."
The Debtors and first-position creditor appealed, arguing that (a) the default interest rate was not "an unenforceable penalty under Missouri law" because it was agreed upon in the contract and was authorized under Missouri law; (b) the bankruptcy court improperly weighed "'equitable considerations' under the plain language of 11 U.S.C. § 506(b)"; and (c) "to the extent that the bankruptcy court based its holding on a lack of default or a lack of notice, that too is erroneous under the express language of the loan documents."
The BAP for the Eighth Circuit began its opinion by noting that there was no dispute that under § 506(b), the "oversecured" first-position creditor was entitled to interest, reasonable attorney's fees and costs "under the agreement or State statute under which such claim arose." It then explained that the Supreme Court of the United States held in 1989 that "§ 506(b) allows all oversecured creditors, including those holding nonconsensual liens, to recover postpetition interest on their claims."
However, the BAP explained that although it "is clear that all oversecured creditors are entitled to postpetition interest, the Supreme Court did not set the rate at which an oversecured creditor is entitled to recover postpetition interest." It went on to explain that "'most courts have concluded that 'postpetition interest should be computed at the rate provided in the agreement, or other applicable law, under which the claim arose—the so-called contract rate of interest'", and cited to a 2001 Eighth Circuit ruling in which "we affirmed the bankruptcy court's decision that an assignee of the original lender was entitled to collect postpetition interest under Nebraska law and under § 506(b) at the 18% rate specified in the contract."
The BAP for the Eighth Circuit then framed the issues before it as: "(i) whether it was erroneous to apply a liquidated damages vs. penalty analysis to a contractual rate of interest set forth in a promissory note; and (ii) whether the bankruptcy court property considered equitable factors in denying the lender's claim for default interest."
Turning to the first issue, the Court explained that under section 502 of the Bankruptcy Code, the bankruptcy court must allow a claim unless it is unenforceable under applicable law, and that the applicable law was that of Missouri. In addition, under Missouri law, "parties to certain types of loans, such as those at issue here," can "agree in writing to any rate of interest, fees and other terms and conditions."
The BAP reasoned that the bankruptcy court erred when it diverged into "an analysis of liquidated damages provisions and penalty clauses," to support its reasoning that the "default interest rate constituted an unenforceable penalty under Missouri law" because although "often conflated," the two concepts are not the same.
Because "neither party was able to point to a single case under Missouri law which applied a liquidated damages analysis to a contractual interest rate set forth in a promissory note[,]" and the interest rate the in the different notes were not usurious under Missouri law, the BAP for the Eighth Circuit saw no reason "that an otherwise lawful interest rate can or should be denied or reduced under such an analysis."
In addition, the Court reasoned, "applying the 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)." Accordingly, "the bankruptcy court erred in applying a liquidated damages analysis and ruling the default interest rate was an unenforceable penalty."
The BAP then addressed the second issue: "whether the bankruptcy court property considered equitable factors in denying the lender's claim for default interest." It reasoned that even though "[i]n reviewing equitable considerations, the bankruptcy court was following what is likely the majority position … [of] a presumption in favor of the contract rate subject to rebuttal based upon equitable considerations[,]" the plain language of the statute governs unless "the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafter.'"
Even though the BAP for the Eighth Circuit recognized that "the statute in this case does not define the rate of interest to be applied[,] … no section of the Bankruptcy Code gives the bankruptcy court authority, equitable or otherwise, to modify a contractual interest rate prior to plan confirmation. In this case, the bankruptcy court need not have considered equitable factors in deciding the matter at hand."
The Court concluded that the first-position oversecured creditor "has an unqualified right to postpetition interest under § 506(b), and that interest should be computed at the rate —default as well as on-default — provided in the parties' agreement, as long as those rates are allowed under state law."
The decision of the bankruptcy court was reversed and the case remanded for the bankruptcy court to decide "whether and when the loans became in default and subject to the default rate of interest."
Ralph T. Wutscher
Maurice Wutscher LLP
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