Mortgage Claims: Sometimes the Debtor Wins, and Sometimes the Lender Wins

Brandywine Townhouses, Inc. v. Fed. Nat’l Mortgage Ass’n (In re Brandywine Townhouses, Inc.), 518 B.R. 671 (Bankr. N.D. Ga. 2014) –

The debtor objected to a secured creditor’s claim on a number of grounds: it did not default, if it defaulted it was entitled to an opportunity to cure, the prepayment penalty was unreasonable, default interest was calculated incorrectly, and a lender cannot recover both default interest and late charges.  The debtor actually won one of these arguments.

The debtor was a nonprofit company that had been in operation for more than 40 years.  It owned a low and moderate income housing co-op that served as collateral for loans of ~$4.3 million.

In late 2010 the debtor discovered that its management company had not been paying its utility bills so that it had significant delinquent water and sewer bills.  In early 2011 it hired a new management company and began making payments to reduce the balance owed.  In June 2013 it met with the city to negotiate a payment plan.  The debtor understood that it was required to make an initial payment of ~$42,000 in order to be able to pay the remaining balance over a 36-month period.

The debtor asked the lender to allow it to draw the $42,000 from certain reserve funds.  It believed that once this payment was made the city would enter into a payment plan.  However, the parties never reached agreement, and in August 2013 the debtor received a notice that its water and sewer services would be disconnected unless it made a payment of ~$440,000, with full payment due approximately two weeks later.

The lender made an advance that was intended to prevent disconnection of service. It followed with a notice of default, demand and acceleration letter.  The lender then sought appointment of a receiver.  The receiver cured the outstanding delinquent charges, and a month later the debtor filed bankruptcy.

The court identified several loan provisions that were relevant to its analysis:

  • The lender had an option to cure the borrower’s defaults, and any amounts paid by it would be added to principal and bear interest at the default rate.
  • The debtor was required to pay the expenses of operating the property, including utilities, before any penalty or interest was charged.
  • Any failure to pay an amount required by the loan documents was a default.
  • Any default (other than specified defaults) that continued for 30 days after notice without cure was a default.
  • As long as a default existed, the lender was entitled to accelerate the debt.

The lender filed a proof of claim totaling ~$5 million.  It included a prepayment penalty of ~$1.2 million, default interest at 4% over the normal rate, and attorney fees and costs of ~$22,500.

Under Section 502 of the Bankruptcy Code, a filed proof of claim is deemed allowed unless there is an objection.  The debtor’s first objection was that it was not in default.  However, the loan documents clearly required it to pay utilities, and it did not pay its water bills on time.  The debtor further argued that even if it was in default, it was entitled to a 30-day cure period.  However, the notice and cure rights did not apply to the failure to pay utilities.

As for the prepayment penalty, under applicable state law the parties must stipulate to prepayment penalties in the contract for them to be valid.  In this case, the note stipulated that a prepayment penalty was due upon either voluntary or involuntary prepayment.  The court noted that prepayment penalties are intended to protect the lender from a loss due to changing interest rates between the time of prepayment and maturity of the loan.  In this case the amount was ~36% of the principal balance.  The amount was based on the difference between the interest rate the lender would have received under the note and the yield rate for a US Treasury security for a similar period. The court found that this was reasonable.

However. there was an issue since the lender’s witness could not come up with a consistent answer when asked to calculate the amount.  It also appeared that the calculation used the wrong default date and thus the wrong yield rate.  Consequently, the court reduced this element of the claim by ~$50,000 and allowed a prepayment penalty of ~$1.2 million.

As for the default rate, state law allowed contracts involving more than $250,000 to establish any rate of interest, although rates over 60% annually were usurious under a criminal law.  Here the ~10.7% default rate was valid.  Subject to adjusting for the correct default date, this element of the claim was allowed.

Finally the debtor objected to allowing both late charges of 5% of the amount owed and default interest.  The court agreed with cases concluding that this was in essence double recovery.  Under Section 506 of the Bankruptcy Code, an oversecured lender is entitled to interest and reasonable costs and expenses, including post-petition.  Since the lender was already being compensated through the default interest, adding late charges would be unreasonable.  However, under applicable precedent, fees that are otherwise valid under state law but not treated as part of a secured claim due to being unreasonable, would be treated as an unsecured claim.

The remaining issue concerned the value of the collateral, and thus whether the lender was undersecured.  The debtor claimed that the lender had previously valued the property at $2.5 million.  However that was hearsay.  The only evidence for the court to consider was a county board of assessor’s valuation at $8,330,000, and the debtor’s scheduled value of $6,790,000.  In either case the lender’s claim of ~$5 million was oversecured.

The result in this case was not particularly surprising, although admittedly courts can go either way on several of these issues.  For example, other courts might have been inclined to second guess the amount of the prepayment penalty, although a formula tied to the lender’s opportunity cost is generally upheld.  Some courts might allow both late fees and default interest if it is permissible under state law, and some courts that would disallow late fees as part of the secured claim, would also disallow them as an unsecured claim.

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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