It has been stated that under general equitable principles of insolvency law, interest ceases to accrue at the beginning of a bankruptcy case.  Three reasons have been given for this rule: (1) postpetition interest is a penalty imposed for a delay of payment required by law to allow the preservation and protection of the estate for the benefit of all interests, (2) the rule avoids the administrative inconvenience of continuously recomputing claims, and (3) it avoids the gain or loss as between creditors whose obligations bear different interest rates or who receive payment at different times.  See, In re 785 Partners LLC, 470 B.R. 126 (Bankr. S.D.N.Y. 2012) citing Vanston Bondholders Prot. Comm. v. Green, 329 U.S. 156, 163-64 (1946).  Section 502(b)(2) of the Bankruptcy Code, which disallows a claim for unmatured interest, embodies this concept.

There are exceptions to this rule.  Section 506(b) of the Bankruptcy Code entitles the holder of an oversecured claim to recover interest on its claim up to the value of its collateral.  This section states:

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.

However, Section 506(b) does not specify the rate of interest to be applied.  In General Elec. Capital Corp. v. Future Media Production Inc., 536 F.3d 969, 973-75 (9th Cir. 2008), the court noted that the outcome differs when the issues arises under a plan which “cures” the default.  The court noted as follows:

In Entz-White we identified such a qualifying or contrary provision of the Bankruptcy Code. There, the debtor’s proposed treatment of the oversecured creditor’s claim was presented in a Chapter 11 plan. A creditor’s claim is considered impaired for purposes of voting on a Chapter 11 plan unless the plan leaves the creditor’s legal, equitable, and contractual rights unaltered, or the debtor cures any default that occurred prior to or during the bankruptcy case. See 11 U.S.C. §1124(1)-(2).  We have explained that the provision allowing cures under Section 1124(2)(A) authorizes a plan to nullify all consequences of default, including avoidance of default penalties such as higher interest. Southeast Co., 868 F.2d at 338 (quoting Entz-White, 850 F.2d at 1342).  Because the Code allows the debtor to cure defaults under a Chapter 11 plan, we permitted the debtor to nullify the interest owed at the default rate. See id.  In the case before us today, however, there was never any question of whether the debtor needed to cure a default to render it unimpaired for voting on a Chapter 11 plan.  Instead, GECC’s oversecured claim was paid through a sale of assets governed by §363, outside the context of a Chapter 11 plan.  As a result, the facts of Entz-White are distinguishable, and thus our per se rule from that case is inapplicable

As it concerns default interest, two different approaches appear to exist to determining whether such interest is allowable as part of the secured claim of an oversecured creditor.  See, In re Cliftondale Oaks, LLC, 357 B.R. 883 (Bankr. N.D.Ga. 2006).

The first approach is reflected in the decisions of the Fifth and Seventh Circuit Courts of Appeal which have stated that in determining the appropriate interest rate under Section 506(b), there is a presumption in favor of the contract rate of interest, including any default rate, subject to certain equitable considerations as to whether to apply the non-default contract rate.  Under this approach, the party opposing the payment of the default interest has the burden of rebutting this presumption.  The factors considered when determining whether the presumption has been rebutted may include whether (i) the spread between the default and non-default interest rates is reasonable, (ii) junior creditors will be harmed by the payment of default interest; and (iii) the secured creditor seeking the default interest obstructed the debtor’s attempts to propose and confirm a plan.  Id. at 886.  See, In re Laymon, 958 F.2d 72, 75 (5th Cir.1992), rehearing denied, 964 F.2d 1145, cert. denied, Crozier V. Bradford, 121 L.Ed.2d 247 (1992); and In re Terry, Ltd. Partnership, 27 F.3d 241, 243 (7th Cir.1994), cert. denied, Invex Holdings N. V. V. Equitable Life Ins. Co. of Iowa, 130 L.Ed.2d 313 (1994).  The Seventh Circuit in In re Terry, Ltd. Partnership, 27 F.3d 241, 243 (7th Cir.1994) noted the following:

Bankruptcy courts have construed Ron Pair to require analyzing default rates based on the facts and equities specific to each case. In re Consolidated Properties Ltd. Partnership, 152 B.R. 452, 457 (Bankr. D.Md. 1993); In re DWS Invs., 121 B.R. 845, 849 (Bankr. C.D.Cal. 1990). This does not render the contracted-for default rate irrelevant. [D]espite its equity pedigree, [bankruptcy] is a procedure for enforcing pre-bankruptcy entitlements under specified terms and conditions rather than a flight of redistributive fancy.” In re Lapiana, 909 F.2d 221, 223 (7th Cir. 1990). Creditors have a right to bargained-for post-petition interest and “bankruptcy judges are not empowered to dissolve rights in the name of equity.” Id. at 224. What emerges from the post-Ron Pair decisions is a presumption in favor of the contract rate subject to rebuttal based upon equitable considerations. In re Courtland Estates Corp., 144 B.R. 5, 9 (Bankr. D.Mass. 1992); In re Hollstrom, 133 B.R. 535, 539 (Bankr. D.Colo. 1991); DWS Invs., 121 B.R. at 849 (Bankr. C.D.Cal. 1990).

In In re Vest Associates, 217 B.R. 696 (Bankr. S.D.N.Y. 1998), the court confirmed that “[t]he developing consensus is a presumption in favor of the contract default rate subject to equitable considerations.” Id. at 702.  These considerations include whether the default rate was “inordinately high” in absolute terms or in relation to the non-default rate, and whether the debtor was solvent.  “If a debtor is solvent, there is much more leeway to grant the default rate because other creditors will not be injured.” Id. at 703.

A similar position was taken in the Matter of Bohling, 222 B.R. 340 (Bankr. D.Neb. 1998).  Here, the court found that the presumption in favor of the contract rate had been rebutted.  In balancing the equities, the court concluded that the bank should be allowed interest at the basic contract rate of 9.75 percent and not the 19 percent default rate.  The court gave five reasons for reaching this conclusion.  First, allowance of interest at the default rate was determined to be inherently unfair because, in theory, it permitted a double recovery to the secured lender.  This was so because under Nebraska law, attorney’s fees are not allowed.  However, a lender is permitted to recover interest at the default rate, thus being reimbursed by the extra interest for the costs of foreclosure and collection.  Second, the court noted that this was a Chapter 7 liquidation case.  An important policy consideration is the fair and equitable distribution of assets to creditors.  That policy would be undercut if secured creditors were allowed interest at a default rate because it reduces the amount paid to unsecured creditors and pays secured creditors more than they would recover under Nebraska law.  (Again, Nebraska law does not allow attorney’s fees in lieu of allowing default rates of interest.)

Third, the default rate in Bohling was nearly twice the base contract rate.  The court determined that this would provide the secured lender an extra-ordinarily high yield on its loan. Fourth, on the facts of Bohling, the secured lender was substantially over-secured and had experienced virtually no risk of loss on the loan – it had simply been delayed from enforcing its loan.  Finally, the secured lender’s loan was not in default on the date the bankruptcy was filed but fell in default on a post-petition basis.

In In re 785 Partners LLC, 470 B.R. 126 (Bankr. S.D.N.Y. 2012), the court held that Section 506(b) did not state that an oversecured creditor is entitled to collect post-petition, or pendency, interest at the contract rate.  The court stated that “[p]endency interest is not based on contract and fixing the appropriate rate rests with the ‘limited discretion’ of the bankruptcy court.” Id. at 134.  Nevertheless, a rebuttable presumption exists that an oversecured creditor is entitled to default interest at the contract rate subject to adjustment based on equitable considerations. Id. However, the “power to modify the contract rate based on notions of equity should be exercised sparingly and limited to situations where the secured creditor is guilty of misconduct, the application of the contractual interest rate would harm the unsecured creditors or impair the debtor’s fresh start or the contractual interest rate constitutes a penalty.” Id.

O’Brien v. Presidents Holdings, LLC, 2014 WL 12931380 (D.Conn. February 10, 2019), also followed this line of authority.  Citing to In re South Side House, LLC, 474 B.R. 391, 414 (Bankr. E.D.N.Y. 2012), it stated that some of the factors which should be considered in determining whether default interest should be charged, and the rate, were (1) the difference between the default and non-default rates; (2) the reasonableness of the differential between the rates; (3) the relative distribution rights of other creditors and whether enforcement of the higher rate will do injustice to the concept of equitable distribution of the estate’s assets; and (4) the purpose of the higher interest rate. Id. at *3.  The debtor’s solvency was also an important factor.

Here, the debtor did not argue that creditor committed any misconduct, or that the application of the default rate would impair the debtor’s fresh start since it appears he would have sufficient funds to meet the obligations of the estate.  And although the debtor did point out that there was a significant spread between the non-default rate of 6.25% and the default rate of 24%, he also did not argue that the default rate constitutes a penalty. Id. at *4.  However, the court reduced the default rate to a point that would allow repayment of unsecured creditors in full, largely, but not exclusively due to the insolvency of the debtor.

Several of the other factors commonly relied on by courts weigh in favor of a reduction of the interest rate in this case.  There is a 17.75% spread between the non-default rate of 6.25% and default rate of 24% in the contract.  Courts in other circuits have held that similar spreads and similarly high default rates constituted unreasonable penalties.  Therefore, based on the insolvency of the estate, the magnitude of the default interest rate, and the size of the spread between the non-default and default interest rates, the Court affirms the Bankruptcy Court order allowing post-petition default interest, but reduces the award of post-petition interest to the highest amount that allows Appellant to repay its unsecured creditors in full.

A second approach holds that default interest is allowable in bankruptcy as long as it would be enforceable under state law.  Id. at *5.  In re Liberty Warehouse Associates Ltd. Partnership, 220 B.R. 546 (Bankr. S.D.N.Y. 1998) may follow this approach in part.  The court allowed a default rate of 22.8% in lieu of the contract rate of 14%.  In doing so, the court noted that the debtor was solvent.  “It will pay the allowed claims of unsecured creditors in full, with interest, irrespective of whether it pays Associates pendency interest at the default or non-default rate under its loan.” Id. at 551.  Moreover, the court concluded that the default rate was neither “illegal” nor usurious.  Finally, the court was satisfied that the default rate of interest was not a disguised penalty.

An almost identical conclusion was reached in In re Dixon, 228 B.R. 166 (W.D.Va.1998) where the court allowed a default interest rate of 36%.  In explaining it analysis, the court stated: “where the circumstances necessitating an equitable deviation are plainly absent and the contract interest rate does not violate state usury laws, function as a penalty, or exceed the value of the collateral, the presumption in favor of the contract rate has not been rebutted.”  “Circumstances necessitating an equitable deviation” did not exist.  First, the contract default rate in question did not violate either state or federal law.  Second, the interest sought when added to the principal amount of the lenders claim did not exceed the value of the collateral securing the claim.  Third, the court noted that no junior creditors, secured or unsecured, would be prejudiced by an award of the default term, as all other creditors were to be paid in full (the debtor was solvent).  Finally, the default interest rate charged was not a penalty.  In reaching this last conclusion, the court noted that a default interest rate acts as a penalty when it is intended to coerce performance by the debtor, rather than as a means of compensating the non-breaching party.

In Matter of Southland Corp, 160 F.3d 1054 (5th Cir. 1998), the Credit Agreement provided for a Default Rate of Interest which was “2% per annum in excess of the rate of interest otherwise applicable under the agreement.”  The Court started its analysis by stating that a default rate of interest is generally allowed, unless “the higher rate would produce an inequitable result.”  Id. at 1059-60.  In other words, the debtor carries the burden of proof to establish that the default rate of interest is inequitable.  Under the facts of Southland, the Court found that the default rate was not inequitable.  The Court stated that the 2% spread between the default and pre-default interest rates was relatively small.  The Court further found that no junior creditors would be harmed if the secured lender was awarded default interest.

In In re Trinity Meadows Raceway, Inc., 252 B.R. 660 (Bankr. N.D.Tex. 2000) the court provided several factors to consider in weighing the equities when deciding whether to allow default interest.  These factors included the spread between the contract rate and the default rate; whether the creditor obstructed the reorganization process; whether creditors junior to the secured creditor would be harmed if the court applied the default rate of interest; and whether or not other classes would be impaired. Id. at 668-69.  The court then found that the equities weighed in favor of denying the default rate of interest.  The court noted that there was a large spread (10%) between the contract rate of interest and the default rate of interest.  And while there was no evidence that the secured creditor obstructed the liquidation process, other creditors would be harmed if the court applied the default rate of interest as the debtor was insolvent. Id.

In General Elec. Cap. V. Future Media Productions, 536 F.3d 969 (9th Cir. 2008), interest under the loan accrued prior to default at the Index Rate plus 1.5% per annum, with additional interest of 2% per annum after default.  In evaluating whether default interest should be allowed, the court cited to Travelers Cas. & Sur. Co. of Am. V. Pac. Gas & Elec. Co., 127 S.Ct. 1199, 1204-05 (2007) for the proposition that “[c]reditors entitlements in bankruptcy arise from the first instance from the underlying substantive law creating the debtor’s obligation, subject to any qualifying or contrary provision of the Bankruptcy Code.”  The court interpreted this to provide that default interest should be enforced, subject only to the substantive law governing the loan agreement, unless a provision of the Code provided otherwise. Id. at 973.  In other words, “[t]he bankruptcy court should apply a presumption of allowability for the contracted for default rate, ‘provided that the rate is not unenforceable under applicable bankruptcy law.’” Citing to 4 Collier on Bankruptcy, ¶506.04[2][b][ii] (15th Ed.1996).

In In re 8110 Aero Drive Holdings, LLC, 2017 WL 2712961 (Bankr. S.D.Cal. May 8, 2017), the contract rate was 5.977% and the default rate was 10.977%.  In determining whether the lender was entitled to default interest, the court stated that it had to consider the amount of default interest, with the other consequences of default, in the context of state law, here Cal.Civ.Code Section 1671(b).  This statute provides that liquidated damages clauses in commercial, non-consumer contracts are valid unless the party seeking to invalidate the provision establishes “that the provision was unreasonable under the circumstances existing at the time the contract was made.”  The court then cited to the California Law Revision Commission Comments to Section 1671(b) which described how courts should approach the issue:

[Section 1671(b)] gives the parties considerable leeway in determining the damages for breach.  All the circumstances existing at the time of the making of the contract are considered, including the relationship that the damages provided in the contract bear to the range of harm that reasonably could be anticipated at the time of the making of the contract.  Other relevant considerations in the determination of whether the amount of liquidated damages is so high or so low as to be unreasonable include, but are not limited to, such matters as the relative equality of the bargaining power of the parties, whether the parties were represented by lawyers at the time the contract was made, the anticipation of the parties that proof of actual damages would be costly or inconvenient, the difficulty of proving causation and foreseeability, and whether the liquidated damages provision is included in a form contract.

As its first step in determining whether the default interest provision was an unreasonable liquidated damage clause, the court evaluated the true function and character of the clause, “i.e., whether it operate[d] as a liquidated damages clause or an alternative performance provision.” Id. at *10.  Here, it noted that the lender tried to justify the default interest as necessary to compensate additional risk and expenses upon default, which are “difficult to quantify at the time a particular loan is made.”  However, the court found that risky aspects of the loan i.e. that the loan was secured by a ground lease and debtor’s income relied on a franchise agreement, were not generated by the default.  The court also noted that the lender justified the default rate stating that it “compensat[ed] [Lender] for the added perils and overhead costs not otherwise covered by the loan documents that are necessarily triggered or incurred when a loan changes from one that is performing into one that is in default and not performing.  In response, the court stated:

However, the Agreement has numerous provisions which protect Lender from “added perils and overhead costs” in the case of breach, including funding reserve and escrow accounts, late charges, a defeasance fee, and a broad indemnity clause to cover all costs incurred with securing Debtor’s “ongoing performance.”  The only potential costs excluded from the indemnity are those incurred from Lender’s gross negligence or willful misconduct, none of which are at issue here.  The court can find no cost of default not covered given the breadth of the indemnity provision and the wide array of reimbursement expenses sought by Lender as part of the cure[.]

Id. at *10.  The court stated that the debtor agreed to repay the principal owed at the applicable interest rate of 5.977%.  This is a single, definite performance. Under the default interest clause of the loan agreement, the debtor then agreed that upon default it would be charged the default interest rate. This is an “additional charge contingent on the breach.”  This provision was a liquidated damages clause, not an alternative performance. Id. at *11.

8110 Aero then concluded that the default interest was included to coerce timely payment.

Since Lender was otherwise compensated for any expenses resulting from Debtor’s default and had numerous protections against any additional risk, it is a reasonable inference that the default interest had nothing to do with covering expenses or compensating for any additional risk but was instead intended to increase revenue.

* * * *

Since the evidence does not support a finding that the default interest rate provision was intended to provide Debtor a “free rational choice” as to how to perform its obligations when the Loan was made, the court concludes it is a liquidated damages provision. As such, the default interest is unenforceable unless it is reasonable.

Id. at *12.  In determining whether the default interest rate was an unreasonable penalty, the court stated that the primary factors that must be considered are (1) whether the provision is disproportionate to the actual losses suffered by the lender as a result of the default and (2) whether the interest was the result of a reasonable endeavor to approximate the reasonably anticipated harm at the time of the making of the contract. Id. at *12.  The first factor was whether the default interest was disproportionate to the anticipated damages.  Here, the court noted that the default interest of $673,206.85 plus the late charge of $64,997.50 was a 151.47% increase over the $293,556.80 in missed payments, even ignoring the other consequences of default.  Therefore, the default interest was not proportional to lender’s losses, and this factor is easily met.

Turning to the second factor, the evidence indicated that the parties did not discuss the reasonably anticipated damages.  The court stated that the fact that default interest is common in the industry did not save it from being considered a penalty.  Further, the fact that the loan was commercial did not prevent the default interest from being considered a penalty. Id. at *13.  The court found that the default interest rate was an unenforceable penalty.

In In re Yeshivah Ohel Moshe, 567 B.R. 438 (Bankr. E.D.N.Y. 2017) the court dealt with this issue in the context of a Chapter 11 plan under which the debtor proposed to cure a default and reinstate the loan by paying the arrears and costs at the non-default interest rate on the effective date of the plan.  The court stated that this issue implicated Section 1123(d) of the Bankruptcy Code. Section 1123(a)(5)(g) of the Bankruptcy Code states that a Chapter 11 plan “shall … provide adequate means for the plan’s implementation, such as … curing or waiving of any default.”  Section 1123(d), in turn, provides that “if it is proposed in a plan to cure a default the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.”

The court stated that this means that in proposing a Chapter 11 plan, a debtor cannot disregard Section 1123(d) and cure a default under Section 1124(2) of the Bankruptcy Code by paying the arrears at the non-default rate of interest. Id. at 446.

[T]he underlying loan agreement requires – and New York State law permits – the payment of the default interest rate following a default.  The loan agreement provides that in the event Yeshivah fails to make payments towards the principal and interest prior to the Maturity Date, Yeshivah will pay “expenses, charges and damages … at a rate equal to the lesser of (i) twenty-four (24%) percent per annum or (ii) the maximum rate of interest permitted by applicable law on the principal sum to such date of actual payment.”  And under New York law, “[i]t is well settled that an agreement to pay interest at a higher rate in the event of default or maturity is an agreement to pay interest and not a penalty.”  Courts have held that a contract term that provides for a default rate of 24 percent is enforceable under New York state law.

Id. at 446-47.  A default rate of interest will be considered as a “penalty” if it is inordinately high relative to non-default rate.  Default rates were found to be impermissible penalties in the following decisions: In re Phoenix Business Park Ltd. Partnership, 257 B.R. 517, 521 (Bankr. D.Ariz. 2001) (“[T]he Court has little difficulty concluding that a default rate of 24% – against a contract rate of 10.75% – as well as monthly late charges of $1,056.00, should be construed as ‘penalty rate[s]’ within the meaning of this statute.” [applying Sectoin 1123(d) relating to curing defaults.]) In re Kalian, 178 B.R. 308, 316 (Bankr. D.R.I. 1995) (36% default rate deemed “unreasonable” charge); In re Broadwalk Partners, 171 B.R. 87, 92-93 (Bankr.D.Ariz.1994) (24% default rate of interest deemed a penalty); In re DWS Investments, Inc., 121 B.R. 845 (Bankr. C.D.Cal. 1990) (25% default rate of interest deemed a penalty); In re Hollstrom, D.C., 133 B.R. 535, 539-40 (Bankr. D.Colo. 1991) (36% default rate of interest deemed penalty where non-default rate was 12% and there was no evidence to justify default rate); and In re White, 88 B.R. 498, 511 (Bankr. D.Mass. 1988) (48% default rate of interest was deemed penalty where non-default rate of interest was 16.5% and default rate was unreasonable or unconscionable).

The following decisions determined that the default rates were reasonable.  In re Vanderveer Estates Holdings, Inc., 283 B.R. 122, 134 (Bankr. E.D.N.Y. 2002) (Holding the default rate was reasonable, stating “[b]oth the default interest rate of 12.56%, and the differential of 5% between the default rate and non-default rates, are well within the range of default rates that have been allowed as reasonable charges under §506(b).”); In re Cliftondale Oaks, LLC, 357 B.R. 863 (Bankr.N.D.Ga.2006) (Default rate of 5% over the non-default contract rate reasonable.)

In the Ninth Circuit, bankruptcy courts have been unable to award default interest when a debtor cures defaults on or before the plan effective date with respect to its obligations to a creditor.  See, In re Hassen Imports Partnership, 256 B.R. 916, 924 (9th Cir.BAP 2000).  Where a debtor does not cure defaults, a creditor is entitled to default interest upon demonstrating that the default interest meets certain requirements.  In In re Casa Blanca Project Lenders, L.P., 196 B.R. 140, 146-47 (9th Cir.BAP 1988) the court imposed the evidentiary burden on a creditor to demonstrate the reasonableness and compensatory nature of the default rate.  Under Casa Blanca, “consideration of whether a given default rate is within the range of a generally acceptable level of interest is not determinative.”  Rather, the creditor must demonstrate that the default rate is equivalent to damage by “evidence or proof of a tangible nature.”  In Hassen, the court ruled that even if the more liberal test of the Seventh Circuit were followed, the initial presumption can be overcome by introducing deposition testimony that “one of the reasons” for imposing the default rate was to encourage timely payment.  By showing that the rate was – at least in part – punitive in nature, the debtor shifted the burden to the creditor to demonstrate that the default rate reasonably compensated the creditor for losses arising from the default. In re Hassen Imports Partnership, 256 B.R. at 925.


Matthew T. Gensburg