Daily Development for
Wednesday, January 27, 1999

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
randolphp@umkc.edu

BANKRUPTCY; INTEREST; DEFAULT INTEREST: Default interest rate of 36% may be collected by oversecured creditor postpetition, but creditor may not also collect late charges.

Florida Asset Financing Corp. v Dixon (In re Dixon), 1998 WL 896972 (W.D. Va. 12/9/98).

This dispute, amazingly, centered on a business loan of $150,000, guaranteed by that individual's corporation and secured by various assets said to be worth in excess of $1 million. The cost of disputation and appeal of this case must have approximated the monies at stake. The note had an 18% interest rate, a 5% late payment penalty, and a 36% default rate of interest.

The circumstances preceding the trial of this case are equally bizarre. The creditor, pursuant to an assignment for security, seized all the stock of the debtor and an individual guarantor in another corporation. Later, the guarantor sued to enjoin the seizure, but not until after it was completed. Simultaneously, the creditor was proceeding to foreclose on certain real estate also given to secure the loan. Subsequently, the guarantor filed bankruptcy. In a partial settlement arrangement, the creditor relinquished the shares of stock in exchange for a payment into escrow of the total amount of principle and accrued interest at the note rate $161,000.

The creditor, however, still insisted upon default interest, late charges, $35,000 in attorney's fees, and other costs.

The bankruptcy court denied the default rate of interest, finding it to be "punitive" and not commercially reasonable or consistent with industry practices. It reduced the attorney's fee claim to $7500 and granted only half the claimed attorney's costs.

On appeal, the District Court reversed the trial court on the issue of default interest, denied the claimed late charges, and remanded for a determination of whether its reversal of the default interest ruling warranted a different view of attorney's fee question pursuant to the multifaceted Johnson test used in federal courts.

On the question of the default interest, the court pointed to the language of Bankruptcy Code 11 U.S.C. 506b, which permits oversecured creditors "interest on each claim" and goes on to provide for "reasonable fees, costs or charges provided for under the agreement." The Supreme Court, in Ron Pair decided that the modifier "provided for under the agreement" does not apply to the term "interest on each claim." The Court therefore concluded that interest can be collected even when not provided for in the agreement.

But the Court in Ron Pair, at least in the view of the instant court, said nothing about whether oversecured creditors were entitled to the contract right of interest if the agreement did set a rate. The district court concluded that the vast majority of courts that have considered the issue have concldued that the creditor can collect the contract rate of interest.

The cases that have focussed on the "contract rate,' however, have not necessarily addressed the issue of special default rates set forth in the debt instruments. Different standards apply to default rates. Default rates cannot be collected on debts that have, in essence been "cured." Apparently the trial court, which denied late fees, concluded that the payment of $161,000 into escrow effected the necessary "cure" and precluded late fees. The district court on appeal, however, apparently concluded that the creditor was entitled to postdefault late fees pursuant to Section 506b. This obviated the "cure" theory, and left the court to focus upon whether default interest was available under "general equitable principles."

The court referred to precedent holding that "[t]he facts and equities specific to each case . . . prove determinative in the analysis of default rates. . . Within this analyis, the contract default rate is neither irrelevant nor predictive."

Despite this language establishing a general equitable discretion in bankruptcy courts on this matter, the instant court rejected the notion that the creditor always has a responsibility to justify the amount of default interest charges. The court concluded that where there are no demonstrated equities justifying a deviation from the contract interest rate, and state usury limits do not apply, a bankruptcy court is bound to award the default interest provided for in the loan instruments.

The court described certain of the equitable factors that might drive a court to look more deeply into the validity of a default interest rate. If the rate was "unconscionable," it cannot be collected (although the court gives no clue as to what constitutes an "unconscionable rate." Further, if the collection of default interest would divert funds away from unpaid creditors, even unsecured creditors, there is an equitable issue. The court noted that there were no such creditors here. Finally, if there is an undue consequence upon the debtor, preventing the debtor from recovering from the wounds of economic distress, a court might seek further equitable justification to award default interest. But here the debtor had already set aside the money to pay the debt, and there was no indication that payment of default interest would be a great burden. (The debtor in fact had yet to file a reorganization plan, and the court clearly suspects that it will not do so following this ruling.

The court, however, then went on to conclude that the late charges, which it otherwise viewed as appropriate, could not be collected. The court holds categorically that both late charges and default interest are intended to comepnsate the creditor for the same loss, and that a creditor cannot collect both. Here, although it is the existence of unpaid late charges that made it possible for the creditor to argue that the debt had not been cured, it did not press for such charges on this appeal and did not get them.

Comment 1: In Metlife Capital Financial Corp. v. Washington Avenue Associates, L.P., 1998 WL 352602 (N.J. Super. A.D.) (Unpublished opinion.), which has a lot of play on DIRT and in other discussions of real estate issues recently, a New Jersey Appellate court held that a 15% default interest rate was invalid because it did not satisfy the applicable test for liquidated damages. Certainly if the state court in which the bankruptcy court's case arises follows such an approach, one might expect a different result from the bankruptcy judge.

Comment 2: Even given the fact that the court did not have state court authority limiting it, this case appears to represent a tightening of the noose on debtors as compared to other bankruptcy opinions it cites, which would apparently have reviewed a wider range of equitable factors in evaluating the appropriateness of this charge.

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