This DD is an edited version of Jack Murray's musings on these topics.

Daily Development for Thursday, January 24, 2003

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

BANKRUPTCY; AVOIDANCE: Bankruptcy filing can wipe out default interest.

Platinum Capital Inc. v. Sylmar Plaza, L.P. (In re Sylmar Plaza, L.P), 2002 U.S. App. LEXIS 27123 (Dec. 30, 2002)

The Ninth Circuit here upheld the confirmation of Sylmar Plaza's Chapter 11 reorganization plan, which was filed for the sole purpose of avoiding approximately $1 million of default interest due on a mortgage loan from the debtor to Platinum Capital, Inc. ("Platinum"), as the successor to the original mortgagee.

The original mortgage loan, in the amount of approximately $8 million, was made by Tokai Bank of California to Rita and Roberta Hornwood in 1992, with the collateral consisting of a shopping center owned by the Hornwoods. In 1995, the loan was modified to change the original interest rate to 8.87% and the default rate to 13.87%. The modification also extended the maturity date to April 3, 2009 and prohibited prepayment of the loan. The Tokai Bank also permitted the transfer of the Sylmar Plaza property to revocable family trusts created by the Hornwoods for estate- planning purposes.

In 1997, the Hornwoods defaulted on the loan, and transferred the property (in violation of the due-on-sale clause in the mortgage) to Sylmar Plaza, which was a newly formed limited partnership. Tokai Bank commenced a judicial foreclosure proceeding in state court against the Hornwoods, and during the course of the foreclosure sold its note to Platinum. Sylmar Plaza then filed its Chapter 11 bankruptcy petition one day after the state court issued notice of foreclosure judgment. Platinum immediately filed a motion to lift the automatic stay, prompting the Hormwoods to each file individual Chapter 11 cases. The bankruptcy court ordered the sale of the Sylmar Plaza property for approximately $7 million (which Platinum did not contest) free and clear of Platinum's mortgage lien, notwithstanding that its lien exceeded $10 million. Because the confirmed reorganization plan provided that both Platinum's secured and unsecured claims would be paid in full on the plan's effective date, Platinum was not considered "impaired" under sec. 1129(b) of the Bankruptcy Code and was not entitled to reject the plan or receive "cram down" protections. According to the Ninth Circuit, "[t]he financial significance was to effect a 'cure' of the default so that all interest, including post-petition interest, would be calculated at the

8.87% non-default rate, rather than the 13.87% default rate. The difference in accrued interest calculated between the two rates amounts to approximately $1 million.".

Platinum objected to confirmation of the plan, arguing that it had not been proposed in good faith as a matter of law, because it had no independent economic significance and was filed for the sole purpose of avoiding $1 million of default interest owed to Platinum. Platinum also asserted that the plan was discriminatory because it provided for payment of 10% post-petition interest to all other unsecured creditor classes, while paying only 8.87% interest to Platinum on the unsecured portion of its claim.

The Ninth Circuit rejected Platinum's argument that the debtor's bankruptcy reorganization plan was not filed in good faith. The court noted that sec. 1129(a) of the Bankruptcy Code does not define "good faith," and that good faith is determined case-by-case based on "the totality of the circumstances." The court also stated that "insolvency is not a prerequisite to a finding of good faith, and the fact that "a creditor's contractual rights are adversely affected does not by itself warrant a bad faith finding.". The Ninth Circuit referred to its prior holding in In re Entz-White Lumber and Supply, Inc., 850 F.2d 1338, 1342 (9th Cir. 1988), in which it stated that "It is clear that the power to cure under the Bankruptcy Code authorizes a plan to nullify all consequences of default, including avoidance of default penalties such as higher interest." The court found that "Platinum's proposed per se rule would inject unnecessary rigidity into the good faith inquiry. With respect to the disparity in the interest rate paid to other creditors and the rate paid to Platinum, the court ruled that as an "unimpaired" creditor (i.e., a creditor that received payment in full of its claim) had no standing to contest its treatment under the plan because, under sec. 1126(f) of the Bankruptcy Code, it was conclusively presumed to have accepted the plan.

Reporter's Comment 1: This decision is not surprising based on the Bankruptcy Code and existing case law, which grant bankruptcy courts wide discretion in deciding whether a particular reorganization plan was filed in good faith. Appellate courts show great deference to the bankruptcy courts in this area, because of the subjective nature of the determination. The bankruptcy court stated that "the plan has been proposed in good faith, given the . . . facts in the record and . . . history of the case as well." The BAP, in turn, as noted by the Ninth Circuit, determined "that the bankruptcy court did not clearly err in finding that the plan met sec.

1129(a)(3)'s good faith requirement." .

Many bankruptcy judges are hostile to the concept of a bad-faith filing and will seldom dismiss a bankruptcy case on such grounds. Bankruptcy courts often shy away from the concept of bad faith, even if "objective" standards are satisfied. Nonetheless, if the court recognizes the filing (especially in a single-asset case) as having been made in bad faith, it may allow the debtor no more than the 120-day exclusive period in which to propose a plan of reorganization. See, e.g., In re Love, 957 F.2d 1350 (stating factors that are relevant in determining good faith).

Reporter's Comment 2: Although perhaps not technically objectionable, there is something inherently distasteful, from an equitable standpoint, about a commercial debtor using bankruptcy as a tool for the sole purpose of depriving its principal creditor of a contractually agreed-upon default rate. The lender would certainly be able to claim the default amount in its foreclosure proceeding outside of bankruptcy.

[Note- the balance of these comments deal with cram-down and manipulation fo secured creditors, and are not necessarily central to a discussion of the case. They are so thoughtful and well annotated, however, that I couldn't leave them out. Ed.]

Reporter's Comment 3: Whether a class of creditors is impaired or unimpaired is critical to the question of whether a proposed reorganization plan can be "crammed down" on a secured creditor. Manipulation of the plan to make parties other than the secured party "impaired" but still accepting of the plan is important, since if one impaired class accepts the plan, it can be crammed down.

Section 1123(a) of the Bankruptcy Code provides (in relevant part) that "a plan shall -- (5) provide adequate means for the plan's implementation, such as -- (G) curing or waiving any default." Section 1126(f) provides (in relevant part) that "a class that is not impaired under a plan . . . [is] conclusively presumed to have accepted the plan." Section 1129(b)(1) provides (in relevant part) that the court "shall confirm the plan . . . if the plan does not discriminate unfairly .

. . with respect to each class of claims . . . that is impaired . . . ." If all of the legal requirements of a Chapter 11 reorganization plan are met, with the exception of a successful confirmation vote by creditors, the plan may still be confirmed under sec. 1129(b) of the Bankruptcy Code over the objection of a dissenting class, or "crammed down"" on the impaired class that votes against the plan In a cramdown, the debtor may (1) reduce the principal amount of the secured claim to the value of the collateral; (2) reduce the interest rate; (3) extend the maturity date; or (4) alter the repayment schedule. See secs. 506(a), 1123(a)(5) (f) and (h) of the Bankruptcy Code. The debtor may also make a minimal payment on the unsecured claim. Under the Bankruptcy Code a cramdown is permissible when the plan provides a dissenting secured class with consideration equal to the amount of its claim or when no class below the dissenting unsecured class participates under the plan.

Unimpaired classes are not allowed to vote for or against the confirmation of a plan. Under Sec. 1122(a) of the Bankruptcy Code, treatment of unimpaired claims must comply with one of the following standards: (1) the plan must not alter the legal, equitable, and contractual rights of claims holders in the class; or (2) the plan must cure all pre-bankruptcy arrearage, reinstate the maturity of the claims, and compensate the claims holders for damages incurred as a result of reasonable reliance on their contractual provisions.

Prior to the passage of the 1994 Bankruptcy Reform Act, sec. 1124(3) of the Bankruptcy Code provided that a class was considered to be unimpaired if, on the effective date of the plan, the class members received cash for the allowed amount of their claims. However, sec. 213 of the 1994 Reform Act deleted sec. 1124(3) of the Bankruptcy Code with the intention of forcing debtors to pay interest to unsecured creditors if the creditors' allowed unsecured claims were paid in full. Congress deleted this section to overrule a 1994 bankruptcy decision, In re New Valley Corp., 168 B.R. 73 (Bankr. D. N.J. 1994), which held that under certain circumstances the claims of unsecured creditors could be considered paid in full and unimpaired, even though no post- petition interest was to be paid on such claims.

Unfortunately, the deletion of this provision may make it easier for a single-asset debtor to impair unsecured creditors and confirm a plan. Arguably a debtor can now pay allowed unsecured claims in full upon confirmation of the plan without paying interest and still treat the class as impaired for voting purposes. Prior to deletion of this provision, the debtor avoided paying interest only by paying less than 100% of such claims or by paying the impaired unsecured creditors in full within an extended period of time-for example, ninety days after the effective date of the plan. This possibility led to a greater risk that the class would reject the plan.

Now, as a result of this new possible strategy, the unsecured creditors get fully paid, and have no reason to object to the plan, but are still treated as impaired. Since an impaired class therefore will vote for the plan, it can be crammed down on the secured creditor despite that creditors objection.

Reporter's Comment 4: A cramdown is the single biggest workout and bankruptcy threat to a lender. However, the confirmation and other requirements that a debtor must satisfy in order to cram down both a secured and an unsecured claim, particularly in the case of a single-asset real estate bankruptcy, impose such burdens on a debtor that few Chapter 11 debtors who propose cramdown plans successfully achieve reorganization by cramming down the lender.

Although, even in a cram down plan, a mortgagee may be entitled to retain all of its rights under the mortgage, the mortgagee in such a plan will not necessarily receive an obligation with level periodic payments. It should be noted, however, that the present value requirement necessitates the use of an interest rate in such cases. This rate varies in each jurisdiction and can be either the contract rate or a market rate based on Treasury bill rates plus a court determined upward adjustment for risk factors.

The debtor's plan may also propose negative amortization of the lender's secured claim. Negative amortization occurs when part or all of the interest on the claim is deferred, allowed to accrue, and added to the principal periodically to be paid at a later date when the income from the property has increased or its value has appreciated. Bankruptcy courts have held that negative amortization is not per se impermissible, but courts will closely scrutinize plans proposing this form of payment on a case-by-case basis.

A class of secured creditors can also be crammed down if each secured creditor receives the indubitable equivalent of the claim. A secured creditor receives the indubitable equivalent of the claim when the secured creditor receives a return of part of its collateral while the remainder of its secured claim continues to be secured by the remaining collateral, and when the debtor proposes to pay the present value of the remaining secured claim over a period of time.

Reporter's Comment 5: Creditors also must think about the possibility of electing "1111b treatment" in these cases. As noted in the Ninth Circuit's opinion in this case, "Sylmar's claim was bifurcated into a secured claim measured by the net proceeds of the sale of Sylmar Plaza (plus funds in the hands of the receiver appointed by the state court) and an unsecured claim for the balance." The claim of an undersecured creditor is divided into two claims: (1) a secured claim equal to the value of its collateral, and (2) an unsecured deficiency claim for the balance. Under sec. 1111(b)(2)of the Bankruptcy Code , an undersecured creditor may elect to have the entire claim treated as fully secured. Section 1111(b) enables an undersecured, non-recourse creditor to avoid being cashed out at the depressed value of the secured collateral and enables the creditor to share in any future appreciation in such value.

The following are two important aspects of making the sec. 1111(b)(2) election: (1) the undersecured creditor loses the right to vote regarding the previously unsecured (deficiency) claim; and (2) the undersecured creditor must make the election before the conclusion of the hearing on the disclosure statement. Often, this second requirement forces the undersecured creditor to elect before adequate disclosure has been made concerning the plan and the proponent's intentions. By making a sec. 1111(b)(2) election, a creditor may significantly affect whether the amount of deferred cash payments proposed under a plan and the present value of those payments satisfy the cramdown confirmation standards of sec. 1129(b). For example, assume that a creditor has a $5 million claim secured by collateral worth $3 million. Under sec. 1129(b)(2)(A)(i)(II), the plan would have to provide the secured creditor with deferred cash payments that total at least $3 million (the amount of the allowed secured claim) and that have a present value of at least $3 million. These cash payments may continue over five years and would total $4.5 million at a 10% rate of interest. Expecting the confirmation of a cramdown, the debtor would be likely to propose some treatment of the $2 million unsecured deficiency claim. Usually, the debtor proposes to pay the deficiency claim at a fraction of the face amount over a period of time, such as 20% over five years.

If, however, the creditor makes the sec. 1111(b)(2) election, the deferred cash payments for the secured claim must equal $5 million (the allowed amount of the entire claim) and have a present value of $3 million (the value of the collateral). Thus, in this example, if the undersecured creditor makes this election, the creditor is entitled to a total of $2 million of additional deferred cash payments, not just a fraction of this amount. However, this requirement is often met by lengthening the term of the deferred payments. Here, seven years of payments at 10% would total $5.1 million and would satisfy sec.1111(b)(2).

Under sec. 1111(b)(2), the creditor will never get less than the full mortgage amount, but also will never get more than the net present value of the collateral on the plan date. On the other hand, a cramdown plan could provide a market rate of return on the collateral value plus a potential benefit in the form of a share of the excess cash flow, sharp depreciation upon a subsequent sale or refinancing, or a scheduled payment on the unsecured portion of the claim. By making the sec. 1111(b)(2) election, the creditor becomes secured and, therefore, loses the right to vote in the unsecured class. In other words, the creditor loses one opportunity to vote against the plan. By foregoing the unsecured claim, the undersecured creditor also foregoes the opportunity to assert any potential classification, unfair discrimination, and fair-and-equitable objections. These objections could prove fatal to the confirmation of the debtor's plan. Thus, the undersecured creditor could be relinquishing major litigation advantages by making the sec.1111(b)(2) election. Nevertheless, a secured creditor should consider making a sec.1111(b)(2) election when the deficiency claim is small and unlikely to dominate voting in the secured creditor's class. In this instance, losing a vote as a consequence of making the sec. 1111(b)(2) election may not be a factor that the creditor needs to consider. The right to make the sec.1111(b)(2) election belongs solely to the secured creditor. This election cannot be made by the debtor on behalf of the secured creditor.

Reporter's Comment 5: Now, what about that default rate? Under sec. 506(b) of the Bankruptcy Code, a creditor with an allowed secured claim that is greater than the value of the property is entitled to "interest on such claim, and any reasonable fees, costs, costs, or charges provided for under the agreement under which such claim arose." Several bankruptcy cases have dealt with the issue of what is an enforceable default rate of interest that may be charged by a oversecured creditor. See In re 1095 Commonwealth Ave. Corp., 204 B.R. 284, 304-05 (Bankr. D. Mass. 1997) (allowing recovery at default rate of interest but precluding recovery of late fees because "[b]oth the late charge and the default rate of interest are intended to compensate the lender for the increased costs of administration caused by the borrower's failure to make payment as and when it is due"); In re Vest Assocs., 217 B.R. 696, 701 (Bankr. S.D.N.Y. 1998) ("oversecured creditors may receive payment of either default interest or late charges, but not both"); In re Udhus, 218 B.R. 513, 517 (9th Cir. B.A.P. 1998) (holding that a cure pursuant to an approved Chapter 11 plan of reorganization prevents application of default interest; the court stated that "since the loss of opportunity costs is the same as the loss of default interest, it would be unreasonable to include this part of the claim as an allowable administrative expense"); In re Hollstrom, 133 B.R. 535, 539-40 (Bankr. D.Colo. 1991) (ruling that a 36% rate of interest would be deemed a penalty where the non-default rate was 14% and there was no evidence presented to justify application of the default rate); In re White, 88 B.R. 498, 511 (Bankr. D. Mass. 1988) (finding that a 48% default rate of interest was unreasonable, and therefore a penalty, where the non-default rate was 16.5% and grossly disproportionate to the damages resulting from the breach); In re Boardwalk Partners, 171 B.R. 87, 92-93 (Bankr. D. Ariz. 1994) (holding that a

25% default rate of interest, which constituted a 14.5% spread over the non-default rate, was a penalty); In re DWS Investments, Inc., 121 B.R. 845, 849 (Bankr. C.D. Cal. 1990) (25% default interest rate deemed a penalty); Fischer Enters, Inc. v. Geremia (In re Kalian), 178 B.R. 308, 309 (Bankr. D. R.I. 1995) (holding that a spread of 18% between the default rate and the non-default rate constituted a penalty); In re Boulders on the River, Inc., 169 B.R. 969, 975 (Bankr. D. Or. 1994) (disallowing a claim for default interest at a rate 5% higher than the contract rate because the court was not "persuaded that the default rate of interest constitutes anything but a mere penalty"); Key Bank Nat'l Ass'n v. Milham (In re Milham), 141 F.3d. 420, 423 (2nd Cir. 1998), cert. denied, 119 S.Ct. 169 (1998) ("Most courts have awarded pendency interest at the contractual rate; but nevertheless, however widespread the practice may be, it does not reflect an entitlement to interest at the contractual rate"); Bradford v. Crozier (In re Laymon), 958 F.2d 72, 75 (5th Cir. 1992), cert. denied, 506 U.S. 917, 113 S.Ct. 328 (1992) (holding that the "rate of interest [chargeable under 506(b)] should be determined 'by examining the equities involved in the bankruptcy proceeding').

But see In re Route One West Windsor Limited Partnership, 225 B.R. 76 (Bankr. D.N.J. 1998), in which the court, applying New York law (the parties had stipulated New York law would apply in a choice-of-law provision in the loan agreement), held that a provision in the debtor's mortgage-loan agreement with an oversecured creditor to pay interest following default at the post-default rate of 15.125% was not an unenforceable penalty and must be paid by the debtor.

The court found that the increased default rate of interest was justifiable and reasonable because it merely compensated the mortgagee for the increased risk and expense of collection. The court also held that the allowance of default interest on a claim in bankruptcy is determined by federal law, but noted that state law would be relevant because if the amount exceeded the allowable legal rate, then the bankruptcy court would not permit the mortgagee to recover such a windfall amount in a bankruptcy proceeding. The court also noted that the principal of the debtor was a sophisticated businessman who had knowingly and freely allowed the debtor partnership to contract for the post-default interest rate. The court further found that no other non-insider creditors of the debtor would bear the adverse effects of the increased rate of interest paid to the mortgagee. The court, citing Metlife Capital, supra, noted that "under New Jersey law default interest rates that are penalties are unenforceable." Id. at 88. The court distinguished Metlife Capital, stating that "There is no question that default interest is generally permitted under New York law and is difficult to obtain under New Jersey law. Under New Jersey law a liquidated damages clause is only valid if (1) the amount fixed is related to the actual damage that is likely to be suffered, and (2) the amount of the damage caused by the breach is of the type which is incapable or very difficult to actually estimate." Id. at 99, fn.2. The bankruptcy court also noted that under New York law default interest rates as high as 25% had been consistently held to be reasonable. However, the court held that the mortgagee would not be permitted to receive both interest at the post-default rate and late charges. The court therefore upheld the enforceability of the default-interest provision but not the provision for the payment of late charges by the debtor.

Finally, the court also ruled that the mortgagee would not be permitted to receive interest on the default interest that accrued post-petition. The court noted in support of this specific holding that the loan documents did not provide for the payment of such interest-on-interest and that the allowance of such additional amounts would not be equitable. In a similar decision issued by a bankruptcy court, In re Dixon, 228 B.R. 166, 177 (Bankr. W.D. Va. 1998), the court held that, although the default interest rate of 36% (double the pre-default rate) was high, it would accept the creditor's representation -- without requiring testimony or evidence -- that the default rate was proportionate to the reasonably anticipated damage from default and was not a penalty. The court stated that it did not have the "power to alter commercial contracts or to substitute [its] judgment for that of the parties" where the transaction was lawful, no other creditors were harmed, the default rate did not violate state usury laws, and there was no threat to the reorganization of the debtor by imposition of the default rate. Id. at 174. The court, citing In re Terry Ltd. Partnership, 27 F.3d 241, 243 (7th Cir. 1994), cert. denied sub nom Invex Holdings, N.V. v. Equitable Life Ins. Co. of Iowa, 513 U.S. 948, 115 S.Ct. 360 (1994) and In re Consolidated Properties Ltd.

Partnership, 152 B.R. 452, 457 (Bankr. D.Md. 1993), also stated that "[d]efault interest rates are also necessarily higher than basic interest rates in order to compensate creditors for both the predictable and unpredictable costs of monitoring the value of collateral in default situations."

However, the court noted that "[e]ven when the late charge is reasonable . . . a creditor may be denied recovery where it also asserts a claim to a default rate of interest". Id. at 172. In In re Southland Corp., 160 F.3d 1054, 1060 (5th Cir. 1998) Judge Edith Jones (one of the author's heroes) emphatically confirmed her belief in the inviolate right of secured creditors to collect contractual default interest rates in a bankruptcy case. Judge Jones held that recovery by the debtor of the contractual postpetition default rate was not inequitable where the 2% spread between the default and non-default rate was "relatively small," the mortgagee was "not obstructing the [bankruptcy] process," and no junior creditors would be harmed if the mortgagee was awarded default interest. See also; In re Liberty Warehouse Assoc. Ltd. Partnership, 220 B.R 546, 551-52 (S.D.N.Y. 1998) (stating that "[the mortgagee] is entitled to accrue pendency interest on its claim because it is oversecured" and finding that the default rate of 22.8% was reasonable and not a "disguised penalty," where the non-default rate was 14%; the court, citing In re Ace-Texas, Inc., 217 B.R. 719,721 (Bankr. D. Del. 1998), also held that where the underlying debt has matured by its own terms, there is nothing for the mortgagor to reinstate and any attempt by the mortgagor to "cure" the default and reinstate the original terms would constitute an impairment of the mortgagee's right to immediate payment); Bruce v. Martin, 845 F.Supp. 146 (S.D.N.Y. 1994) (ruling that a default rate of 24.9% was allowable under New York Penal Law and was not usurious); In re Terry Ltd. Partnership, 27 F.3d 241, 243 (7th Cir. 1994) (finding that there is "a presumption in favor of the contract rate subject to rebuttal based on equitable considerations"); Melanie Rovner Cohen, Jeff J. Marwell, Richard A. Gerard, Entitlement of Secured Creditors to Default Interest Rates Under Bankruptcy Code Sections 506(b) and 1124,

45 Bus. Law. 415 (1989).

Reporter's Comment 6: It is interesting when things started going bad for the Hornwoods, they transferred the mortgaged property to a new entity, Sylmar Partnership, without bothering to get the required permission from the lender. In Travelers Ins. Co. v. Corporex Properties, Inc., 798 F. Supp. 423 (E.D. Ky. 1992) (a case with which the author was intimately involved as in-house counsel for The Travelers Insurance Company ("Travelers")), the court expressly upheld a pre- negotiation agreement entered into between Travelers and the borrower in connection with a proposed negotiated workout of a $6.4 million nonrecourse commercial mortgage loan on an office building in Covington, Kentucky. Because the borrower had conveyed the mortgaged property during the negotiation discussions to a corporation controlled by the borrower in violation of the due-on-sale clause in the mortgage, to better position the borrower for a "new debtor" bankruptcy, to avoid negative publicity, and to put the borrower, in its own words, "in a better position to negotiate on an even basis," the court, in an unusual form of relief awarded to Travelers, ordered a reconveyance of the property to the original borrower. The borrower appealed the court's decision to the U.S. Sixth Circuit Court of Appeals based solely on the court's order of reconveyance, but Travelers and the borrower subsequently reached a settlement providing for conveyance of the property to Travelers by a deed in lieu of foreclosure, and the appeal was dismissed with prejudice.