Daily Development for Friday, September 21, 2007
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri

BANKRUPTCY; CREDITORS CLAIMS; LENDERS FEES; REASONABLENESS:   When the bankruptcy estate has sufficient cash to pay claims of all creditors, a lender may collect a prepayment premium without regard to whether such premium is reasonable within the meaning of Bankruptcy Code Section 506(b).  The only relevant question is whether the fee is valid under state law, the test for creditors claims under Bankruptcy Code Section 502.

UPS Capital Business Credit v. Gencarelli (In re Gencarelli), 2007 W.L. 2446833 (!st Cir. 8/30/07)

Debtor, a donut maker,  filed a voluntary bankruptcy petition.  Apparently, at that time, there was intense competition regarding the donut business in debtors region, and when Debtors assets were sold at a bankruptcy auction, a bidding war ensued, they produced a three million dollar surplus after all creditors claims were paid (except those at issue here). 

UPS claimed that it was entitled to a prepayment penalty as provided in the instruments.  The penalty was a sliding scale percentage of principal, declining after the first five years.  The trial court ruled that the prepayment fee claim was required to be a reasonable fee or charge within the meaning of 506(b), and conducted two hearings in an attempt to give UPS an opportunity to demonstrate the reasonableness of its fee.  (In re Bess Eaton Donut Flour Co., 2005 Westlaw 1367306 (1/19/05)).At least according to the trial court, UPS failed abysmally to do this:

When asked as to how the questioned penalties were calculated or established, [UPSs witness] stated, surprisingly, that he "had no knowledge," and instead concentrated on the process UPS follows in selling notes in the secondary market. [The witness] testimony turned out to be completely irrelevant to the issue about which the matter was reopened.

The trial court consequently denied the claim for the prepayment fee and the District Court upheld this ruling.

On appeal to the First Circuit Court of Appeals, held: Reversed.

The court ruled that the applicable statutory test for the collectability of a prepayment fee is Section 502, which requires merely that the creditors claim be valid under state law.  The reasonableness test of Section 506 (b) becomes relevant only when the question is whether the claim is secured - in other words whether it enjoys the priority of any security interest securing the note containing the fee language.

Here, of course, there was no question of priority.  Everyone else had been paid and there was still some pudding in the pot. [Donuts in the box??]

The court noted that this interpretation was a matter of first impression in the First Circuit, but that the question had already been resolved the same way in the Eleventh and Ninth Circuits, and, in dicta in the Second Circuit.

It is apodictic that unsecured creditors may recover their attorneys fees, costs and expenses from the estate of a solvent debtor where they are permitted to do so by the terms of their contract and applicable non-bankruptcy law . . . Thus, under the statutory scheme envisioned by the debtor . . . unsecured creditors would be permitted to reap the full benefit of their contractual bargains through the medium of Section 502, while oversecured creditors would be uniquely singled out for unfavorable treatment by the operation of Section 506.  There is no conceivable explanation as to why Congress might have wanted oversecured creditors to be treated in so draconian a fashion. . . .

Let us be perfectly clear.  This is a solvent debtor case and, as such, the equities strongly favor holding the debtor to his contractual obligations as long as those obligations are legally enforceable under applicable non-bankruptcy law.

[The editor larded on this quote largely to write out the word apodictic even though he has no idea what it means.  Obviously the First Circuit panel did.]

Comment 1: So the lender collects the fee - right?  Not so fast, cowboy!!!  The court simply remands for a determination of whether state law would permit the fee.  An important question for state law is whether the fee ought to be construed as a possible penalty.  The answer to that question depends a great deal upon whether the prepayment fee was triggered by default and acceleration under the documents, and whether such default and acceleration actually occurred here.  It may be that the note never went into default and was prepaid merely to facilitate the bankruptcy sale.  Neither of the opinions the editor has read explains what happened on this score.

If, indeed, there was an acceleration and the fee is payable as a consequence of that, then the creditor in most jurisdictions would have to show that the fee met the test for liquidated damages.  As the fee provided for a sliding scale percentage of the loan amount, the lender will have to work relatively hard to demonstrate that the fee approximated any damages to the lender resulting from the prepayment. [Apparently the loan was intended to be sold and was sold on the secondary market, making the problem even murkier.]

If the prepayment could be characterized as voluntary, then the only question is whether the documents clearly provide for it.  Most jurisdictions view a voluntary prepayment as an option for which the parties are entitled to require the borrower to pay an additional fee. 

Comment 2: Of course, this is a relatively unusual case because of the surplus resulting from the auction.  More typically, secured creditors will have to deal with Section 506(b).  On this score, the court holds clearly that 506(b) is an independent federal test.  The fact that state law might have authorized the fee, even as a reasonable liquidated damages provision, appears to be irrelevant to the First Circuit. 

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