Daily Development for Monday, January 23, 2006
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

Oversecured creditor creditor in bankrutpcy may collect default interest notwithstanding that Debtor is insolvent and that such charges will reduce funds available for other secured and unsecured creditors if interest does not amount to a penalty for nonpyament and is otherwise permitted under nonbankrutpcy law.   

In re Holmes, 330 B.R. 317 (Bankr.M.D.Ga., July 1, 2005).

An oversecured creditor filed proof of claim, seeking, inter alia, payment of post-default interest, a prepayment premium and interest on attorney fees.  Chapter 11 debtor objected.

Debtor had executed two promissory notes secured by two deeds of trust.  The promissory notes provided for, in relevant part, (1) an 18 percent per annum default rate of interest; (2) prepayment premiums should the obligations be prepaid; and (3) payment of reasonable attorney's fees, costs, and expenses if the obligations were referred to an attorney for collection.

In its analysis of whether the oversecured creditor was entitled to pre- and post- default interest, a prepayment premium, attorney fees, and interest on attorney fees, the Court of Appeals stated that "some courts have concluded that a default rate of interest may be denied as an unreasonable charge, rather than as part of the creditor's allowable interest entitlement."  The Court of Appeals found that in general, a default rate of interest is properly a form of interest and that recharacterization of the rate as a "charge" or "penalty" should turn in most instances on nonbankruptcy law. 

The Court of Appeals stated that courts have allowed the compounding of interest -- so called "interest on interest" -- if provided for in the underlying contract and under applicable nonbankruptcy law and have allowed prepayment charges as a form of interest, as well as late charges that serve the function of additional interest.  Its concern is that these, as well as any other form of interest, should not be allowed to the extent that they are invalid under relevant nonbankruptcy law.  Moreover, if an obligation denoted as a form of supplemental interest does not serve the function of providing additional interest and may be recharacterized as a "charge" under applicable nonbankruptcy law, it may be reviewed for reasonableness under federal law as a "charge" under applicable nonbankruptcy law and it may be reviewed for reasonableness under federal law a "charge" under 11 U.S.C.A §506(b).

The general rule is that a senior secured creditor is entitled to recover postpetition interest, fees, costs and charges even if the allowance of these expenses is to the detriment of a junior secured creditor by reducing the value of the junior creditor's interest.  The Court of Appeals is persuaded that the creditor is entitled to the 18 percent default rate of interest as provided for in the promissory notes because the Court of Appeals had previously held that a creditor is entitled to postpetition interest if its claim is oversecured and the agreement provides for the interest.  The Court of Appeals stated that when a creditor is oversecured, the estate need not be solvent for the creditor to be entitled to postpetition interest.

The Court of Appeals held that payment of reasonable attorney fees was acceptable since it was provided for in the notes, but payment of interest on the attorney fees was not since it was not provided for in the notes.

BANKRUPTCY; “REASONABLE CHARGES;” PREPAYMENT PREMIUM:  A creditor fails to show that its requested prepayment premium is reasonable when the two methods that are provided in the promissory notes require complex calculations and respondent offers no further evidence that the prepayment premium charged under either method is reasonable.

In re Holmes, 330 B.R. 317 (Bankr.M.D.Ga., July 1, 2005).

Regarding the pre-payment premium, the Court stated that the general law is that a prepayment premium is a "charge" and must be "reasonable" to be allowable under 11 U.S.C.A §506(b). 

In its analysis the Court stated that some courts, in determining whether a prepayment is reasonable, limit the recovery to actual costs, charges and fees incurred by the creditor because of the prepayment, other courts allow the creditor to recover the difference between the market rate of interest on the prepayment date and the contract rate for the remaining term of the loan, and some courts view a prepayment premium as liquidated damages.  These courts consider whether the charge is so large as to be a penalty rather than damages. 

The Court found the calculation in the notes regarding the prepayment premium were unduly complex.  Since no additional evidence was presented showing that the prepayment premiums were reasonable, the Court held that creditor was not entitled to said prepayment premiums.

Unfortunately, the court does not indicate what the calculations in question were.  It is difficult to know what problems it found, because it already had indicated that, in principle, the notion of a “yield maintenance” prepayment arrangement is acceptable, and, of course, such clauses do require some complex calculation. 

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