The following is a case update written by Monique D. Jewett-Brewster, an attorney with Hopkins & Carley, ALC, analyzing a recent decision of interest:

SUMMARY

The Bankruptcy Appellate Panel for the Eighth Circuit has held that contractual default interest provision is not subject to a liquidated damages analysis under Missouri or bankruptcy law and therefore is allowed as part of a secured claim. [In re Family Pharmacy, Inc., No. 19-6025, 2020 WL 1291112 (8th Cir. BAP Mar. 19, 2020)]

To view the entire opinion, click here.

FACTS

Between July 2014 and March 2018, the Bank of Missouri (BOM) made eight loans in the total amount of approximately $11 million to Family Pharmacy, Inc. and four related entities (Debtors). The debt to BOM was secured by a first position lien on Debtors’ assets, consisting primarily of inventory, equipment and real estate used in operating their pharmacies. Debtors’ assets were also encumbered by two other secured creditors, in order of priority: Cardinal Health, $1 million, and J M Smith Corporation and Smith Management Services, LLC (collectively, Smith), $18 million.

The individual notes evidencing the BOM debt contained non-default interest rates ranging between 3.65% and 7.5%. The BOM notes also contained provision for default interest in the amount of 18% per annum, applicable any time after “Borrower fails to make a payment when due under this Note.” Other than the non-default interest rates and the maturity dates which varied from loan to loan, the relevant terms of the BOM notes were identical.

In April 2018, Debtors filed for bankruptcy protection under Chapter 11. They subsequently sold their assets at auction free and clear of all liens. The bankruptcy court entered a sale order approving Smith as the purchaser with a final bid of $13,975,000. BOM received $11,300,440.67, including estimated interest at the non-default rate. BOM, as an oversecured creditor, later filed its motion under 11 U.S.C. § 506(b) seeking allowance of $442,843.51 in interest calculated at the 18% default rate. The bankruptcy court denied BOM’s motion, holding that the default rate constituted an unenforceable liquidated damages penalty under Missouri law. The bankruptcy court also held that the default interest rate could not be enforced based on equitable considerations. On appeal, the Eighth Circuit Bankruptcy Appellate Panel reversed.

REASONING

Citing to United States v. Ron Pair Enterps., Inc., 489 U.S. 235, 109 S.Ct. 1026, 103 L.Ed.2d. 290 (1989), the Eighth Circuit Bankruptcy Appellate Panel began its analysis by acknowledging that all oversecured creditors are entitled to postpetition interest. The BAP observed that since Ron Pair, most courts have concluded that such postpetition interest should be computed at the rate provided in the contract. It also noted that the parties had agreed that the substantive law of the state of Missouri applied to the BOM notes. Missouri statutory law permits parties to loans like those at issue to agree in writing to “any” rate of interest, fees and other terms and conditions.

The BAP then framed the issue as whether the BOM loans’ default interest rate would be subjected to a liquidated damages analysis under Missouri law to determine whether the default rate might be unenforceable as a penalty. The bankruptcy court acknowledged that the 18% default interest rate was per se legal under Missouri law. However, the court went one step further, analyzing the “reasonableness” of the default rate as a liquidated damages provision. Ultimately, the bankruptcy court concluded that the default rate constituted an invalid liquidated damages penalty because it was not “reasonable” due to a number of factors, including (i) the cross-default nature of the loans and (ii) the spread between the default and non-default rates ranged from 10.5% to 14.5%.

The Panel rejected the bankruptcy court’s analysis. Carefully differentiating between the two, the BAP pointed out that liquidated damage provisions provide for a fixed amount of damages in the event of a breach, while default interest clauses cause the interest rate on the remaining indebtedness at the time of default to escalate to a higher percentage. Acknowledging that the default rate of interest in the BOM notes was lawful under Missouri law, the BAP found that BOM was entitled to recover postpetition interest at the contractual default rate without a liquidated damages analysis.

The BAP observed that the bankruptcy court, following the majority of courts post-Ron Pair by applying equitable considerations to its analysis, had ruled that the equities of the case mandated disallowance of the default interest. The BAP reversed that ruling as well, noting that “no section of the Bankruptcy Code gives the bankruptcy court authority, equitable or otherwise, to modify a contractual interest rate prior to plan confirmation.” It concluded that absent some compelling reason to the contrary, BOM should be permitted to collect interest at the higher rate if the notes were in default.

AUTHOR’S COMMENT

Citing to In re 3MB, LLC, 609 B.R. 841 (Bankr. E.D. Cal. 2019), the Eighth Circuit BAP observed that courts from other jurisdictions also have found that default interest provisions are not subject to a liquidated damages analysis. Indeed, while the court in 3MB alternatively ruled that default interest at the rate of 4% above the ordinary contract rate was enforceable as a liquidated damages clause, it primarily was guided by the Ninth Circuit’s instruction that “the default rate should be enforced, subject only to the substantive law governing the loan agreement, unless a provision of the Bankruptcy Code provides otherwise.” See GE Capital Corp. v. Future Media Prods., 536 F.3d 969, 973 (9th Cir. 2008). In addition, the Central District of California recently held that a default interest provision is not subject to a liquidated damages analysis under Civil Code section 1671(b) if the provision applies to matured obligations. East West Bank v. Altadena Lincoln Crossing, LLC, 598 B.R. 633 (C.D. Cal. Mar. 6, 2019).

While the enforceability of contractual default interest provisions will likely continue to be heavily disputed in bankruptcy cases, decisions like those in Family Pharmacy, 3MB and Altadena Lincoln Crossing strongly support an oversecured creditor’s ability to recover default interest according to the contract’s terms without the need for any liquidated damages analysis.

For discussions of cases involving similar issues, see:

• 2020-3 Comm. Fin. News. NL 5, California Bankruptcy Court Holds Contractual Provision Authorizing Lender to Recover Default Interest at Rate 4% Above Ordinary Contract Rate is Unenforceable.

• 2018-30 Comm. Fin. News. NL 59, Default Interest Rate is Unenforceable Penalty Because Loan Agreements Did Not Contain Estimate of Probable Costs to Lender Resulting from Borrower’s Default.

These materials were authored by Monique D. Jewett-Brewster, an attorney with Hopkins & Carley, ALC, a member of the ad hoc group and 2018-19 Chair of the CLA Business Law Section. Editorial contributions were made by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal, Ret.), also a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.