U.S. District Court in Connecticut Navigates Supreme Court Precedent Barring Recovery of Certain Postpetition Default Interest

BACKGROUND
Bankruptcy Code section 506(b) provides that oversecured creditors can recover postpetition interest and other fees, costs and charges up to the value of their collateral as follows:

To the extent that an allowed secured claim is secured by property the value of which, after any recovery under subsection (c) of this section, is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.

11 U.S.C § 506(b).

In United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241 (1989) the Supreme Court held that interest under section 506(b) can be awarded to an oversecured creditor in the absence of agreement or state statute because the last clause of section 506(b) (“under the agreement or State statute under which such claim arose”) only qualifies the recovery of other fees, costs and charges. Beyond that textual distinction between interest and other amounts, the Supreme Court provided no additional guidance on how to calculate the interest rate for oversecured claims. Furthermore, as Latex Foam notes, neither the Bankruptcy Code nor its legislative history provides any guidance. Accordingly, because the enactment of section 506(b) in 1978 is treated as codification of pre-existing law, courts now rely on pre-existing caselaw to decide whether and at what rate to allow default interest in the absence of more recent binding precedent.

That pre-Code caselaw includes Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156 (1946). In Vanston, the Supreme Court held that “equitable principles” apply to determine whether an oversecured creditor of an insolvent debtor is entitled to default interest. Default interest, in that case comprising “interest on interest,” was triggered by commencement of a federal receivership and the subsequent failure by the borrower or receiver to repay the indebtedness. The Supreme Court focused on two principles in its equity analysis: (1) whether the debtor was legally authorized to pay the secured creditor to avoid the default, and (2) whether unsecured creditors would be harmed by requiring payment of default interest. The Supreme Court found that the obligation to pay the secured creditor was “suspended” by the receivership. The presiding court had issued an order directing the receiver and debtor to cease paying ordinary debt service. While nothing in Vanston suggested that the receiver or debtor could not have obtained relief from the district court to pay the debt service, the Supreme Court nevertheless held that the fact that there was no payment authority weighed against requiring payment of default interest. The Supreme Court further reasoned that, since the debtor was insolvent (with insufficient funds to pay all of its debts), paying default interest to the oversecured creditor would result in unsecured creditors suffering a “corresponding loss,” which “is not consistent with equitable principles.” As such, the court denied the oversecured creditor its default interest. The Vanston opinion does not identify the “spread” between non-default and default interest (rather referring to it as “interest on interest,” apparently a doubling of the (unstated) interest rate).

On what appear to be materially similar facts, though referring to Vanston, the district court in Latex Foam reached a different result and awarded the oversecured creditor its default interest. Bankruptcy was the sole trigger for the oversecured creditor’s default interest claim, and the debtor did not seek relief from the court to pay the oversecured creditor until after the court ordered the sale of its collateral. And, because the debtor in Latex Foam was insolvent, other creditors would go unpaid to the extent of the default interest paid to the oversecured creditor.

The bankruptcy court in Latex Foam overruled the official committee of creditors’ challenge to the oversecured creditor’s default interest, and on appeal the district court affirmed. Saying that it would review all relevant equitable considerations, the district court found that (1) the oversecured creditor had not engaged in any misconduct by enforcing its legal rights in the case, (2) the default interest was not unenforceable as a penalty, (3) unsecured creditors were not unduly harmed, and (4) failing to enforce default-rate interest would dissuade credit extensions. Importantly, the court noted that the financing in Latex Foam was extended to enable the debtor to emerge from a prior chapter 11 thirteen years earlier. In reaching its conclusion, the court rejected the committee’s argument based upon a body of law, including In re 53 Stanhope, LLC, 625 B.R. 573, 583 (Bankr. S.D.N.Y. 2021), which has held that oversecured creditors whose claims, including non-default interest and principal, are paid in full, should not recover default interest.

The Latex Foam court also held that the default interest was not an unenforceable penalty. The court noted that the default rate spread was 3 percentage points above the non-default rate, while citing spreads enforced by other courts of 5, 8.8 and 12 percentage points. Another metric considered in some cases is the percentage increase in rate upon default. For example, with a non-default annual interest rate of 2%, a spread of 4 percentage points would result in a default rate of 6%, a 300% increase over the basic annual interest rate. And some cases find a default rate to be an unenforceable penalty when there is evidence that the increased rate is intended to “coerce performance” by the debtor, as in In re Parker, No. 12-03128-8-SWH, 2014 WL 6545025 (Bankr. E.D. N.C. 2014). In Parker, the court found unreasonably high a nominal annual default rate of 25%, a 67% differential (and 10 percentage point spread) over the non-default annual interest rate of 15%. The court in Parker noted additional factors that supported its conclusion, including that the effective default rate was even higher than the nominal rates due to interest charged on undisbursed funds.

CONCLUSION
The Latex Foam decision is not binding authority for other cases; only a decision of a higher court would be binding authority. However, bankruptcy courts in Connecticut may feel compelled to follow it. While oversecured creditors may take some comfort from the decision that they will recover their postpetition default interest, they should be equally mindful that a different court could very well reach the opposite conclusion, whether based upon any or all of: (i) variations among states in applicable underlying law, (ii) variations in facts, (iii) the full-payment principle reflected in 53 Stanhope and other decisions throughout the country, or (iv) a stricter reading of the Supreme Court’s decision in Vanston.

(This is another in our series of client alerts related to the intersection of bankruptcy and issues affecting real estate.)