March 14, 2023

Affirming Bankruptcy Judge Julia A. Manning, a district judge in Connecticut upheld an award of “default interest” to a secured lender when the chapter 11 estate was insolvent but the collateral fully covered the lender’s principal, default interest and counsel fees.

Notably, District Judge Vanessa L. Bryant of Hartford, Conn., did not eliminate or reduce the higher rate of interest, even though the secured creditor had opposed the chapter 11 process and refused to allow use of its cash collateral voluntarily.

A lender made a secured loan enabling the debtor to emerge from a prior chapter 11 reorganization. The loan agreement called for interest after default at two percentage points above the contract rate.

In block capital letters, the exit financing agreement said that 2% default interest, as we shall call it, was a material aspect of the agreement. Without default interest, the loan agreement said that the lender would not have provided exit financing.

Before the second chapter 11 filing, the originating lender sold the loan at a discount. We shall refer to the purchaser of the loan as the secured lender.

In the second bankruptcy, the secured lender filed a claim for almost $10 million. The bankruptcy court approved a sale of the debtor’s assets for a price sufficient to cover the secured claim in full, with something left for unsecured creditors.

Bankruptcy Judge Manning approved payment of the secured claim in full together with default interest at 2%. The official creditors’ committee appealed, but District Judge Bryant upheld Judge Manning in an opinion on March 8th.

The Equitable Factors

Judge Bryant said that the secured creditor was entitled to interest under Section 506(b), but the section does not specify the rate. For an over-secured creditor, the section says that the lender “shall be allowed . . . interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.”

Judge Bryant said there was no controlling authority from the Second Circuit or the Supreme Court. However, the Supreme Court said in United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241 (1989), that the recovery of interest by an over-secured creditor is “unqualified.”

Also finding no legislative history on point, Judge Bryant turned to decisional law under the prior Bankruptcy Act. Among the “few precedents,” she found “equity” to be the “common theme” where courts balance the equities between creditor and creditor or between creditors and the debtor.

Citing the First and Seventh Circuits, Judge Bryant said that “circuit courts have uniformly recognized that the amount of default interest to be awarded is subject to equitable considerations.”

Citing decisions from the Southern District of New York, Judge Bryant said that “a majority of courts in this circuit have adopted ‘a presumption in favor of applying a contractual default rate of interest, “subject to equitable considerations.”’”

Examining “all relevant” equitable considerations, Judge Bryant confirmed the finding by Bankruptcy Judge Manning that the secured creditor was not guilty of misconduct. Specifically, she said there was no precedent for the idea that purchasing the loan at discount was inequitable.

To the contrary, Judge Bryant said “[i]t would be unfair to deny a secured creditor the value of its asset simply because it was not the original lender.” In the same vein, she said it was not “inequitable” for the secured creditor to have been “hostile” to the chapter 11 process while being paid adequate protection and counsel fees.

Again agreeing with Bankruptcy Judge Manning, Judge Bryant said it was “not hostile for a secured creditor to refuse to loan more money to a debtor in bankruptcy and try to limit the loss of its asset by using the tools the Code provides.” On the contrary, she said,

It would be inequitable to deny an over-secured creditor’s rights to the terms of its contract simply because it was unwilling to extend post-petition financing or acquiescence in all of the debtor’s financial management decisions.

Similarly, Judge Bryant upheld the finding by Judge Manning that 2% default interest was not a penalty.

Regarding harm to unsecured creditors, Judge Bryant said that unsecured creditors were not “unduly subordinated or harmed by the secured creditor’s priority status.”

Judge Bryant reflected on how default interest was included in the exit financing. She said that advancing exit financing “can be risky.” Refusing to allow default interest “would dissuade creditors from extending credit to debtors in bankruptcy to reorganize.”’

Ending the opinion and observing that the provision for default interest was in bold, block capital letters, Judge Bryant said it “would be an unfair limitation on the power of parties to fairly contract” if she were “to deem unenforceable the provisions of a negotiated agreement that expressly contemplated the circumstances present here.”

Judge Bryant affirmed Bankruptcy Judge Manning’s allowance of default interest.

Official Creditors’ Committee v. Entrepreneur Growth Capital (In re Latex Foam International LLC), 21-01311 (D. Conn. March 8, 2023).

Leave a Comment

Your email address will not be published. Required fields are marked *