Default Interest: Is a Mortgagee Entitled to Collect the Contract Rate, or Must It Be Reasonable?

In re Haldes, 503 B.R. 441 (Bankr. N.D. Ill. 2013) –

An oversecured mortgagee’s proof of claim included default interest for the period from the date of the bankruptcy filing through confirmation of a plan of reorganization.  The debtor argued that during this post-petition period the mortgagee was entitled to interest only at the pre-default rate, while the mortgagee argued that it was entitled to interest at the contract default rate.

The debtor was a real estate developer and property manager who owned and operated several commercial and residential buildings.  A loan in the original principal amount of ~$1.7 million was secured by mortgages on what was described as the debtor’s residence together with another commercial property.  The pre-default interest rate was 6.25%, and the default interest rate was 16.25%.  (Yes, 16.25% – that’s not a typo.)

Generally creditors are not entitled to post-petition interest because Section 502(b)(2) of the Bankruptcy Code disallows claims for unmatured interest.  However, under Section 506, if a secured creditor is oversecured, then “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” (emphasis added).

As noted in the opinion, courts are split on whether a secured creditor is entitled to a contract default rate of interest or whether a bankruptcy court can review the default interest for reasonableness.  The argument in favor of allowing review for reasonableness is as follows:  “Default interest… is not true interest at all.  It is a form of late charge and this is a ‘charge’ for purposes of Section 506(b).”  The Haldes court agreed with the view that default interest can be characterized as a “charge,” and thus can be reviewed for reasonableness.  It also commented that a charge is not reasonable if it is compensation for something that has already been compensated for in another way.

In the court’s view, the analysis of default interest turns on the facts and circumstances of each case, and starts with a rebuttable presumption that the contract default rate of interest should be permitted.  However, the presumption can be rebutted where the rate is significantly higher without justification for the spread.

The Haldes court cited another case in which the lender was entitled to a pre-default rate of 13.75% and a default rate of 18.75% under its loan documents.  In that case the court concluded that a 36% increase in the interest rate was not justified where the lender already received a late charge of 5% of the principal.  However, the Haldes court also noted another case in which a rate of 18% was allowed since it was within the range of rates being charged at that time.

In this case, the court found that increasing the 6.25% interest rate by 10% to 16.25% – which it noted was a 160% increase – was sufficient to rebut the presumption that the contract default rate should be allowed.  As an additional consideration, the mortgagee had claimed late charges of ~$85,000 and attorney’s fees of more than $74,000 – which the court viewed as additional compensation for the default.

In response, the mortgagee submitted evidence that its default rate was within the range of rates charged in the commercial market at that time.  However, the court characterized this as in part a construction loan on a single-family residence that was later packaged with commercial property.  It did not view commercial lending practices as determinative.  The court also dismissed as conclusory testimony that the late charges by themselves were insufficient to cover risks and costs of a non-performing loan.  The court further noted that it heard no explanation why the default rate increase “would reasonably forecast the damages expected to occur in the event of a breach by this borrower on this obligation.”

In concluding that the mortgagee was not entitled to the contract default interest rate, the court summarized that (1) the default interest rate was not a reasonable forecast of damages, (2) the 10% increase in the interest rate was “simply too high,” and (3) it was not reasonable because it compensated for injury that had already been compensated for through late charges and attorney fees.

However in “[b]alancing the equities,” the court decided it would be inequitable to award no default interest.  The debtor was solvent and the plan proposed to pay unsecured claims in full.  As a result, the court determined that an increase of 4% for a total default interest rate of 10.25% was reasonable and was the appropriate default rate for purposes of determining the mortgagee’s claim during the post-petition, pre-confirmation period.

As illustrated by this case, it is not a foregone conclusion that an oversecured mortgagee will be entitled recover interest at the default contract rate notwithstanding the language in Section 506(b) that states that a court “shall” allow “interest.”  As also illustrated by this case, it is difficult to predict how a court will react to a particular default rate, although a more moderate interest rate is likely to have a better chance of surviving.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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