A recent case in the Eighth Circuit, In re Family Pharmacy[1] involved a sale of the debtor’s pharmacy business in a chapter 11 bankruptcy case. There were three secured lenders and the stalking horse bidder was scheduled to make an offer not large enough to pay off the first lien. The third-lien lender provided post-petition DIP financing and the senior, first position lender neither objected to the lack of post-petition debt service, declared the loan to be in default, or made a claim for interest at the default rate, which was 18%.
The auction was a success and the final bid was enough to pay the first and second lienholders in full at the nondefault contract rate. With a surplus of about $550,000 to pay part of the third-lien lender’s claim the first lien lender made a claim for more than $440,000 in post-petition interest at the default rate just before the auction.
Although Judge Norton said the caselaw was “murky,” she denied the claim for default interest under both Missouri and Federal law.
State law
While Section 506(b)of the Bankruptcy Code entitles a fully secured creditor to the payment of interest, Judge Norton said that the rate must be enforceable under state law. In addition, she said that “most courts” presume the allowability of default interest if the rate is enforceable under state law.
Judge Norton stated that there are no Eighth Circuit cases to say whether the lender’s claim for default interest could be denied as a penalty or for equitable reasons under Missouri or bankruptcy law. However, Missouri will not enforce liquidated damages that amount to a “penalty.” To avoid being tagged as a penalty, liquidated damages under state law must not be unreasonably disproportionate to the amount of harm anticipated when the contract was made.
The senior lender had not, Judge Norton said, produced evidence to show that increasing the interest rate after default by some 14% was “either intended or a reasonable prediction of any harm” caused by default. The senior lender, she said, “in fact adduced no evidence of any harm.” So, Judge Norton concluded that default interest on the facts of the case was an unenforceable penalty under Missouri law.
Federal Law
According to Judge Norton, all circuits confronting the question “either hold outright or at least suggest that courts may consider equitable factors” in the allowance of postpetition interest. More specifically, she said that the Second, Third, Fifth, Seventh and Ninth Circuits hold that equitable factors may be considered.
The Eighth Circuit, Judge Norton said, “has not definitively answered the question,” but she said the lender made “no persuasive argument why the Eighth Circuit would likely buck this consensus.” She therefore concluded that “a party’s contract default rate of interest is presumed enforceable, [but] the presumption may be rebutted and default interest disallowed when allowance would be inequitable.”
Failing to inform the parties and the court earlier about a claim of more than $400,000 in default interest “greatly compounds the injustice,” Judge Norton said. The delay “weighs heavily against the Bank,” she said.
Judge Norton observed that DIP financing provided by the third-lien lender enabled the debtor to hold a successful auction when it initially appeared as though the senior lender would not even recover its principal in full.
Judge Norton therefore held that “the equities of this case under applicable federal bankruptcy law mandate disallowance of default interest.”
This case can be used as advice on both sides: For secured lenders –declare the loan in default as soon as bankruptcy is filed (assuming the loan documents provide as much), assert your right to default interest early and often (both in writing to the debtors’ counsel and in court pleadings). For creditors – object to a senior lender’s claim for default interest because it could very well be seen as inequitable after this case, and if you do not raise an objection it is deemed waived.
Debtors’ and creditors’ rights, obligations, and potential liabilities under the Bankruptcy Code can be hard to navigate. If you need assistance understanding how to safely proceed in Bankruptcy Court, contact the experienced litigation attorneys at Goosmann Law in our Sioux City, Sioux Falls, and Omaha offices.
[1] In re Family Pharmacy Inc., 18-60521 (Bankr. W.D. Mo. July 3, 2019).
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