Advanced Distressed Debt: Collecting Default Interest From Solvent Debtors

Earlier this month, the Distressed Debt Investing blog posted an entry on the recent Washington Mutual decision issued by the United States Bankruptcy Court for the District of Delaware, which addressed the issue of whether unsecured claimants holding claims against a solvent estate are entitled to postpetition interest at the contract rate or the federal judgment rate.  In the Washington Mutual case, the court held that the federal judgment rate (which is often much lower than a contractual rate of interest) was the appropriate rate of interest.  Today’s blog entry considers the same issue, but in a case involving secured creditors (versus unsecured creditors).

This is a timely topic because with the higher incidence of default in many loan portfolios and growing emphasis at financial institutions on “revenue enhancement opportunities” in almost all business lines, lenders should be increasingly concerned as to whether they are being appropriately compensated for this additional risk in their portfolios from the defaulted assets.  One method to enhance yield is to put more emphasis on collecting interest at the higher, default rate upon the occurrence of an event of default, especially one triggered by an insolvency event.  Luckily, the United States Bankruptcy Court for the Southern District of New York handling the General Growth Properties cases recently provided some guidance on that very issue.  In re General Growth Properties, Inc., 451 B.R. 323 (Bankr. S.D.N.Y.  June 16, 2011); In re General Growth Properties, Inc., 2011 WL 2974305 (Bankr. S.D.N.Y. July 20, 2011).  Even though these decisions have been appealed, they nonetheless are instructive and have already been raised in cases pending in other districts.

As most lenders realize, the general rule under the Bankruptcy Code is that a creditor is not entitled to post-petition interest; however, Section 506(b) explicitly provides that an over-secured creditor is entitled to interest on its claim – but does not specify the applicable interest rate.  The General Growth court noted, and the debtor and lenders agreed, that there is a rebuttable presumption that an over-secured creditor is entitled to interest at the contract rate.  In addition to this statutory basis for permitting post-petition interest, there is a judicially created exception founded on the principle that creditors should receive interest as a compensation for delay due to the bankruptcy prior to any distributions to equity holders, although that result has been modified in some cases by equitable considerations (e.g., creditor misconduct and determinations that a high contractual default rate constitutes a penalty).

Both of the General Growth cases involve the applicable creditor’s objection to its treatment under the plan of reorganization because it did not receive post-petition interest at the default rate.  Due to the large amounts of money involved in the cases (amount disputed is about $100 million), they have generated some significant attention among lenders.

The loan in the first case was not in default prior to the filing of the case, and the debtor sought to “reinstate” the debt under the plan of reorganization without paying default interest.  While a significant portion of that court decision addressed issues incident to debt reinstatement matters, the opinion also contains a helpful analysis as to whether an ipso facto clause (automatically accelerating the loan at the filing of the case) can trigger the right to receive post-petition default interest.

The subject promissory note contained the fairly typical formulation that (i) a default occurs upon the borrower filing a bankruptcy petition, (ii) the occurrence of such an event automatically, without the sending of notice or any other action, caused the entire principal amount of the loan to become immediately due and payable and (iii) interest on this outstanding principal balance would accrue at the default rate.  The debtor argued, among other things, that the ipso facto clause was invalid, and thus, at the time of the filing of the case there was not a default that required the payment of interest at the default rate.

As a statutory matter, Section 365(e)(1) of the Bankruptcy Code provides that ipso facto clauses are invalid only if included in executory contracts or unexpired leases, and the promissory note was obviously not an unexpired lease and was not an executory contract because the only remaining obligation thereunder was the repayment of the outstanding loan by the debtor.  The court held that ipso facto clauses in agreements other than executory leases or unexpired leases are not automatically invalid and that, upon an examination of the facts and circumstances in the instant case, payment of default interest was appropriate because the debtor was highly solvent, the plan was confirmed on a basis that reinstated the debt and the debtor had already emerged from bankruptcy. Therefore, the lenders’ right to collect the additional interest had clearly not impaired the ability of the debtor to exercise its rights to file for bankruptcy protection and gain a fresh start through the reorganization process.

Some may argue that this decision should be restricted to debt that is reinstated pursuant to a plan and therefore does not have a broader application, such as to loans that matured during the pendency of a bankruptcy case.  However, the same bankruptcy court rejected that view when it adopted its reasoning in a second matter.  The loan in this second General Growth proceeding was already in default at the time the debtor filed for bankruptcy, although the creditors had not yet filed an acceleration notice (the underlying credit agreement contained the same mechanism as in the first matter described above).  In its discussion of upholding the ipso facto clause and automatic acceleration, the court explained that failing to uphold such provisions would deter creditors from withholding an acceleration notice during pre-petition workouts, which acceleration could trigger cross-defaults under other agreements and have the effect of pushing the borrower into seeking bankruptcy protection.  The court noted that the refusal to enforce the automatic acceleration would have the effect of penalizing the lenders for attempting to negotiate a consensual resolution when such result is not clearly mandated by the Bankruptcy Code.  Thus, the court determined that the loan had been automatically accelerated.

The court went on to state that the creditor was also entitled to post-petition interest at the default rate.  Since the presumption that an over-secured creditor is entitled to interest at the contractual rate can be overcome, the bankruptcy court reviewed the circumstances in which courts have typically modified the contractual arrangements between private parties: (a) creditor misconduct, (b) the default rate would be unfair and cause harm to unsecured creditors, (c) the default rate was a penalty and (d) the default rate would hinder a fresh start.  The court determined that such facts did not apply, and therefore it held that the presumption was not rebutted and the creditor was entitled to default interest.

While these decisions are currently on appeal, they should still give secured creditors comfort that their contractual rights for default interest upon a bankruptcy default are likely to be upheld if the debtor is solvent.  Underlying both of these decisions is the fact, undisputed by any party, that the debtors were exceedingly solvent upon their emergence from the bankruptcy cases, so the ultimate result may differ greatly depending on the debtor’s solvency.  (The possibility of ultimately not having the right to default interest, of course, may be a relevant consideration to lenders considering how to structure their compensation in an out-of-court restructuring that could give a currently solvent debtor that is losing money and headed to insolvency more time to “turn it around.”)

Finally, these decisions serve as a useful reminder that a creditor should insist, whether as a sole lender, part of a “club deal” or a member of a syndicated financing, that the documentation governing its loans provide that all of the loans are automatically accelerated upon a bankruptcy default to preclude any argument that acceleration is not effective without sending a notice that could be prohibited by the automatic stay.

Epilogue: General Growth Properties’ brief in support of its appeal is due on May 18, 2012.  Briefing will continue this spring and summer.  We will keep readers apprised of any developments and of the decision when it is issued.

George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP.  George can be reached at grmesires@uhlaw.com.  Don Schwartz is the chair of Ungaretti & Harris’ Finance and Restructuring practice, and can be reached at dlschwartz@uhlaw.com.  Rob Drobnak is a partner in the practice group, with a focus on lending and restructuring, and can be reached at radrobnak@uhlaw.com.