Wells Fargo Bank, N.A. v. Beltway One Development Group, LLC (In re Beltway One Development Group, LLC), 547 B.R. 819 (9th Cir. BAP 2016) –

A creditor objected to confirmation of a chapter 11 plan of reorganization because it did not include default interest for the period prior to the effective date of the plan. The bankruptcy court approved the plan over the creditor’s objections, and the creditor appealed to the 9^th Circuit Bankruptcy Appellate Panel (BAP).

The dispute involved the amount of interest, if any, allowed for the period from the date the bankruptcy petition was filed through the effective date of the confirmed plan of reorganization.

The debtor borrowed $10 million secured by a first lien on its property. Two years later the lender sent a default notice based on the loan-to-value covenant. It contended that the value of the property was $10.15 million and demanded that the debtor tender payment of ~$2.8 million to reduce the loan balance so that it complied with the LTV ratio. The debtor was not able to comply with the demand and was not able to negotiate a resolution with the lender.

In addition, the debtor failed to pay the loan in full when it matured a year later. The lender sent a letter declaring a default and acceleration of the debt with a total due of the ~$9.8 million. After the lender took initial steps to commence a foreclosure, the debtor filed bankruptcy.

During the bankruptcy case the debtor made monthly adequate protection payments pursuant to a stipulated cash collateral agreement. However, that did not resolve the details of the lender’s claim. In the meantime the lender filed a proof of claim that included default interest.

The loan documents called for an interest rate of LIBOR plus 2.1%, with an additional 3% upon default. The debtor’s plan of reorganization proposed to (1) extend the loan term for another 5 years, (2) impose a cram down interest rate of 4.25%, and (3) eliminate some of the loan covenants (including the LTV covenant). The plan also provided that the lender would “not be entitled to any default interest, late fees, or other charges resulting from a default occurring prior to the Effective Date [of the plan].” Further, any pre–effective date defaults were “deemed to have been ‘cured.'”

In opposing the plan the lender contended that it did not pass the “fair and equitable” cramdown test because it deprived the lender of its right to default interest, late fees and other charges from defaults prior to the plan effective date. It also argued that the debtor could not “magically cure” the maturity date default.

With respect to interest accruing during the pendency of the bankruptcy case (referred to as “pendency interest” by the court), the lender was oversecured. Consequently, it was entitled to interest under section 506 of the Bankruptcy Code (to the extent that the interest did not cause the lender’s claim to exceed the value of the collateral).

In response the debtor acknowledged that it was creating a new loan by restructuring the debt as opposed to curing the original loan, and generally did not dispute that the lender was entitled to pendency interest to some extent.

In denying the request for pendency interest, the bankruptcy court cited a case in which the 9^th Circuit held that an oversecured creditor was not entitled to default interest where its claim was paid in full under the terms of a plan of reorganization. According to the 9^th Circuit a Bankruptcy Code cramdown provision allowing cures “authorizes a plan to nullify all consequences of default, including avoidance of default penalties such as higher interest.” In considering this case the BAP noted that although the 9th Circuit appeared to establish a bright line test of no default interest when there is complete cure, the 9^th Circuit also recognized in a footnote that the bankruptcy court had “broad equitable discretion” in awarding post-petition interest.

In considering the appeal, the BAP identified 3 categories of interest: (1) prepetition interest, (2) pendency interest (i.e. after the bankruptcy petition is filed through the effective date of the plan), and (3) interest that accrues under the plan. It framed the issue as whether the bankruptcy court was required to apply the contract default rate of interest during the pendency of the bankruptcy case. While section 506 allows an oversecured creditor to receive pendency interest, the statute does not specify the applicable rate.

The court began by finding that to the extent that the bankruptcy court applied the confirmation “fair and equitable” test, it was in error because the issue of the amount of the allowed claim is a separate and distinct issue from confirmation. To the extent that the bankruptcy court relied on the 9^th Circuit case, the BAP agreed with the lender that the case was not applicable since the loan was not fully cured.

Instead, the BAP looked to another case holding that if the loan is not cured the lender is entitled to default interest that “reasonably compensates it for losses arising from the default.” In other words, as a starting point:

The bankruptcy court should apply a presumption of allowability for the contracted for default rate, “provided that the rate is not unenforceable under applicable nonbankruptcy law.”

However, it noted that this rule is also subject to equitable considerations. (The BAP did not expand on what this means.)

Consequently, the BAP reversed the denial of default interest and remanded the case to the bankruptcy court to apply the rules as articulated by the BAP and to make appropriate findings.

This issue does not come up if the loan is underwater. However, if the loan is oversecured the entitlement to default interest during the bankruptcy case will likely to be a topic of interest. In addition to questions such as whether the default interest is unenforceable under state law as a penalty and whether there are equitable considerations that weigh against allowing default interest, note that the lender must establish that there was a default under the loan documents in the first place. The loan documents may require a lender to give notice in order to trigger a default, and reliance on a provision that a bankruptcy filing is an automatic default can raise arguments about whether the provision is an unenforceable ipso facto clause.

Vicki R Harding, Esq.