Client Alerts

Three for the Lenders

Client Alerts | May 27, 2020 | Creditors’ Rights and Bankruptcy Litigation | Special Situations and Credit

A series of recent decisions may provide boosts for the positions of lenders.

Post-Petition Interest on an Oversecured Claim

In re Family Pharmacy, Inc. held that Missouri law, like New York law, distinguishes between permissible default interest and impermissible penalties. However the case diverges from the majority view adopted by several circuit courts of appeal insofar as it decided that the bankruptcy court cannot use its equitable powers to modify the terms of the contract as it relates to post-petition interest.

The question raised in this case is whether an oversecured lender could assert, as part of its claim, post-petition interest at an 18% default rate. The bankruptcy court (W.D. Mo.) denied the lender’s claim for post-petition default-rate interest, reasoning that while oversecured creditors are entitled to post-petition interest under Bankruptcy Code section 506(b), the lender’s claim for the default rate should be denied because: (1) under Missouri law the default interest rate constituted an unenforceable penalty, and (2) under section 506(b) the court had the power to adjust the interest rate based on equitable considerations.

On appeal, the Eighth Circuit Bankruptcy Appellate Panel reversed on both grounds, ruling that (1) Missouri law distinguishes between default rate interest and penalties, and permits non-usurious default interest rates, and (2) under section 506(b) a bankruptcy court should not be permitted to adjust, on equitable grounds, an interest rate that is contained in the contract and permitted under state law.

The Family Pharmacy ruling on the state law issue places Missouri law in accord with the law in other states. The decision cited with approval a 2012 decision of a New York bankruptcy court, In re 785 Partners LLC, that found that under New York law a variable interest rate that increases following default is not penalty, as well as a California bankruptcy decision, In re 3MB, LLC, that reached a similar conclusion under California law.

The panel’s ruling on a bankruptcy court’s equitable power is potentially in conflict with rulings in other parts of the country. The majority rule, adopted by many courts around the country, including the courts of appeal in the Fifth, Seventh and Ninth Circuits, and also by many lower courts in the Second Circuit, is that there is a presumption that the contract rate will be used, but that the rate is subject to adjustment based on equitable factors. The Family Pharmacy decision, by contrast, after noting that there was no binding Eighth Circuit precedent, ruled that an oversecured lender is entitled to post-petition interest at the contract rate as long as the contact rate is permitted under state law.

It is not clear how much the Family Pharmacy rule differs from the majority rule in practice. The majority rule is limited by the precept that, as stated in 785 Partners, “[t]he 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.” In Family Pharmacy the BAP supported its ruling by noting that there were no allegations of lender misconduct. Still, the Family Pharmacy standard is the more lender-friendly of the two, and should be cited by lenders in cases to come.

Cap on Clawback Recoveries

In re DSI Renal Holdings, LLC, a Delaware bankruptcy court determined that recoveries on fraudulent conveyance actions brought in chapter 7 cases should be for the benefit of the creditors, and not other parties.

The decision concerned a fraudulent conveyance action brought against former officers and directors of the debtors and also against the lenders that financed a corporate restructuring. The complaint sought a total of $678 million, which was alleged to be the total amount paid by the debtor in the restructuring. The defendants noted that the total amount of claims asserted in the chapter 7 case was $166 million, and argued that it was improper for the trustee to seek to recover more than would be necessary to pay all creditors in full.

The court ruled that the question was governed by section 550 of the Bankruptcy Code, which provides that recoveries on avoidance actions must be “for the benefit of the estate.” In a chapter 7 case any surplus goes to the debtor’s equity holders, and the court reasoned that payments to equity holders would not be for the benefit of the estate, and that the fraudulent conveyance laws are to protect creditors, not equity. Accordingly, the court capped the recoveries at the amount needed to pay creditors in full, with interest.

In reaching its decision the court distinguished several decisions (Tronox Inc. v. Anadarko Petroleum Corp. (In re Tronox, Inc.) [SDNY], Kipperman v. Onex Corp.[N.D. Ga.], and PAH Litig. Trust v. Water St. Healthcare Partners, L.P. (In re Physiotherapy Holdings, Inc.)[D. Del.]), in which recoveries were not capped at the amount of claims. The distinction was that those cases involved litigation brought under confirmed chapter 11 plans, such that the proceeds of the litigation would go to the reorganized debtor based on the specifications of the plan and not to equity holders under the chapter 7 distributive scheme. Accordingly, the effect of DSI Renal may be limited to litigations brought in chapter 7 cases.

Non-Judicial Foreclosure

A New York Supreme Court justice has ruled that Governor Cuomo’s executive order suspending foreclosures does not apply to non-judicial foreclosures under the Uniform Commercial Code (UCC). The ruling will be helpful to lenders whose collateral consists of pledged shares of a holding company or of co-op shares. However, the relevance of the decision may be of limited duration, because the executive order is due to expire on June 18 (although it may be extended).

The case, 1248 Associates Mezz II LLC v. 12E48 Mezz II LLC, involved a foreclosure by a mezzanine lender under the UCC. The lender had noticed the foreclosure and scheduled it to take place in a virtual setting over Webex and teleconference. The plaintiff sought an injunction halting the foreclosure, arguing that it was contrary to Governor Cuomo’s March 20 executive order regarding foreclosure actions, which states that there shall be “no enforcement of either an eviction of any tenant residential or commercial, or a foreclosure of any residential or commercial property for a period of ninety days.”

The court disagreed. It reasoned that the executive order addresses enforcement of judicially ordered foreclosures, but that UCC foreclosures are non-judicial in nature. The opinion also noted that the executive order does not expressly mention UCC foreclosures.