Default Interest: Do Not Take Enforceability for Granted
The chapter 11 debtors obtained prepetition CMBS loans backed by mortgages on commercial and industrial real estate owned by the debtors. The proof of claim filed by the lender included prepetition default interest, which the debtors challenged as unenforceable. The bankruptcy and district courts found in favor of the lender, and the debtors appealed to the 8th Circuit.
Under the promissory notes the default interest rate was 5% plus the non-default rate of 5.04%. The proof of claim filed by the lender included ~$1.5 million in default interest. The debtors objected.
The asset manager for the loans testified at the bankruptcy hearing on the objections about the expenses associated with the default and said that 5% was consistent with the default rate for other loans of a similar type. He contended that, although he was not familiar with the circumstances surrounding execution of these particular loans, “there was no way to know what the damage is [or] what the defaults would have been at that time.”
The chief manager for the debtors also testified. He had 35 years of in commercial real estate experience, and according to him “the additional 5% default interest duplicated other costs associated with defaulting that Debtors were already paying the [lender]. These costs included attorneys’ fees, late fees, and the costs of administration and enforcement.” He claimed that the default interest provision constituted “double debt paying, if not triple debt paying.”
The bankruptcy court evaluated the claim using a liquidated damages approach. Under applicable state law there is a presumption that a default interest provision in a note is a valid liquidated damages provision. The bankruptcy court found that the debtors failed to rebut the presumption, and the district court affirmed.
On appeal the debtors contended that the bankruptcy court misapplied state law because it did not require the lender to prove its actual damages. In the 8th Circuit’s view, the debtors misstated the law: Liquidated damage clauses are presumed valid. To determine if a provision is a valid liquidated damage clause or an impermissible penalty state courts would consider whether “(1) ‘the amount so fixed is a reasonable forecast of just compensation for the harm that is caused by the breach’; and (2) ‘the harm that is caused by the breach is one that is incapable or very difficult of accurate estimation.'” If these conditions are met, a claim can be enforced without proving actual damages. A claim will be enforced if the liquidated damages are “not manifestly disproportionate to the actual damages.”
In making this determination, courts will look to the language of the contract. In this case the notes stated that “it would be extremely difficult or impracticable to determine Lender’s actual damages resulting from any late payment or default, and such late charges and default interest are reasonable estimates of those damages and do not constitute a penalty.” The court also found support in the asset manager’s testimony that the default interest compensated for the costs associated with shifting a loan from performing to nonperforming, such as “the additional risk profile that the loan takes on when it’s defaulted.”
The debtors also argued that the amount of the default interest was “greatly disproportionate to the [lender’s] actual damages because many of the costs the default interest purportedly covers are already provided for in other provisions of the loan.” However, the court noted testimony regarding costs incurred but not otherwise reimbursed “including the special servicer’s salary expenses and overhead, vendor expenses, attorney fees, appraisals, and travel expenses.” The master servicer also advanced principal and interest to the bondholders while the notes were in default, which totaled almost ~$1.8 million. Since the debtors offered no evidence to rebut this testimony, this argument also failed.
Finally, the debtors argued that “actual damages for breach of a promissory note are always ascertainable” citing a state court case that held “It is well-established that when the breached contract involves only the payment of money, the damages are susceptible of definite measurement.” The 8th Circuit concluded that the cited cases were not applicable because they did not involve securitized commercial loans held by a trust and sold to investors. “A default on this type of loan has unique costs that are difficult to quantify, including the increased risk of lending to a defaulted borrower.”
Consequently the 8th Circuit affirmed the bankruptcy court decision.
An interest rate increase of 5% on default does not seem particularly outrageous, and there is probably a tendency to assume that the default rate would be enforceable. However, critical to the result in this case were (1) the state law presumption that default interest is a valid liquidated damages provision (which the debtors did not rebut), and (2) the court’s view that CMBS loans are unique. This leads one to wonder whether there would have been a different result if these had been standard commercial loans, and whether the law in the state applicable in this case is typical of the law in other states.
It is also worth noting that self-serving boilerplate (i.e. the statements in the note about the difficulty of determining damages) may well come in handy.
Vicki R Harding, Esq.
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