On April 9, 2012, the US Bankruptcy Court for the Southern District of New York issued its decision in In re 785 Partners LLC, a case concerning the enforceability in bankruptcy of loan agreement interest provisions that required the debtor to pay default interest and a late payment premium following an event of default under the loan agreement. The Court held that the lender was entitled to prepetition interest at the loan agreement's default rate and, applying section 506(b) of the Bankruptcy Code to the facts of the case, that the lender, as an oversecured creditor, was also entitled to postpetition interest at the default rate. The lender was not entitled to the late payment premium specified in the loan agreement.

The Debtor in this case, 785 Partners LLC, is an entity owning a single real estate asset. It received a loan from two banks to finance the construction of a building. The two banks later assigned their loans to First Manhattan. The base interest rate under the loan documents was 5%, with a default rate of an additional 5% if the loan was not repaid at maturity or if an event of default occurred (the Default Rate). The loan documents also included a 5% late payment fee for all payments under the loan agreement made more than five days after their due dates.

The Debtor filed for bankruptcy protection and First Manhattan filed a proof of claim seeking payment of all interest, legal fees, costs and charges accrued and accruing under the loan documents. The Debtor did not challenge most of First Manhattan's claim and the dispute focused on First Manhattan's claim for interest at the Default Rate (prepetition and postpetition), as well as the late payment premium.

The Debtor argued that the Default Rate interest and the late payment premium were unenforceable penalties and were also inequitable and unreasonable.

Prepetition interest, including interest at a contractually agreed default rate, is generally allowed in a bankruptcy proceeding at the rate provided for in the underlying agreement to the extent permitted under applicable nonbankruptcy law. Even if the court believes that the default rate is high, it cannot alter the unambiguous terms of the agreement that was negotiated by sophisticated parties at arm's length unless there is clear evidence of overreaching by the lender.

While equitable principles of insolvency law prevent the accrual of interest at the beginning of a bankruptcy case, section 506(b) of the Bankruptcy Code contains an exception for oversecured creditors. There is a rebuttable presumption under insolvency law that oversecured creditors can receive postpetition interest to the extent that the value of their collateral exceeds the amount they are owed, subject to adjustment based on equitable considerations.

The court's power to modify the contract rate of interest that an oversecured creditor may receive depends on the debtor proving that:

The Court held that First Manhattan was entitled to prepetition and postpetition interest at the Default Rate. The Court noted that a higher interest rate triggered by a default is common and reflects the allocation of risk as part of the bargain between the parties. Borrowers benefit from the inclusion of a higher post-default interest rate because lenders would otherwise charge higher interest rates throughout the life of the loan to compensate for the risk of a default at some time during the loan's term.

The Court allowed First Manhattan's claim for prepetition Default Rate interest because the loan agreement was unambiguous and negotiated at arm's length by sophisticated parties. The Court found no evidence of overreaching by First Manhattan. The Court did not exercise its discretion to prevent First Manhattan from collecting postpetition interest at the Default Rate because the Debtor was unable to show any of the following:

The Court found that under New York law, a 5% differential between the non-default rate and the default rate fell within the range of reasonableness and it was therefore not an unenforceable penalty. It also noted that default rates of interest necessarily have some penal effect by compelling the borrower to comply timely with its payment obligations under its loan agreement; if the borrower defaults, it must pay more.

The Court disallowed First Manhattan's 5% late payment fee. Upon confirmation of the Debtor's plan of reorganization, all rights and obligations of the parties under the loan agreement were extinguished and replaced by the plan. Accordingly, the Debtor would never make a late payment under the prepetition loan agreement which was extinguished under the plan and replaced by an amended and restated note. All subsequent payments by the Debtor would be made under the amended and restated note.

The Court noted that this outcome is consistent with decisional law which holds that because late fees and default interest are designed to compensate the lender for the same injury, awarding both would amount to double recovery. Oversecured creditors are therefore entitled to receive payment of either default interest or late charges, but not both.

The case serves as a reminder that courts will rarely adjust a contractual default rate of interest that was negotiated by sophisticated parties. Therefore, borrowers should be aware during loan agreement negotiations that their agreed contractual interest rates may follow them into bankruptcy. However, additional costs incurred by a lender in handling payments, late or otherwise, during a borrower's bankruptcy are covered by default rates of interest and contractual administrative fees. Any additional charge in the form of a late payment fee would provide double recovery and be disallowed in bankruptcy.

For more information on the rights of oversecured creditors to postpetition interest, see Practice Note, Postpetition Interest, Fees, Costs, and Charges in Bankruptcy.