How Can US Oversecured Creditors Receive Interest at Default Rate?

This case arose from the relationship between General Electric Capital Corp. (GECC) and Future Media. In March 2005, Future Media went into default on a US$10.5m term loan and a US$5m revolver from GECC. The loans were secured by a first-priority security interest in substantially all of Future Media’s assets. The default caused the interest rate on the loans to increase by 2% per annum. In February 2006, Future Media filed a bankruptcy petition under Chapter 11. Pursuant to a stipulation agreed to by the parties, GECC agreed to allow the debtor to use its cash collateral and the debtor acknowledged that it owed GECC about US$5.4m, which included interest at the default rate. The Creditors’ Committee objected to the stipulation, but to facilitate a resolution of the matter, all of the parties agreed that the debtor’s assets would be sold and about US$5.7m of the proceeds would used to pay off GECC in full, including interest at the default rate through 20 April 2006, subject to a later determination regarding what amount of interest was allowable.

Subsequently, the Creditors’ Committee sought return of US$165,000, representing the amount GECC had collected over the pre-default interest rate. The Bankruptcy Court ruled that GECC was not entitled to interest at the default rate, relying on the Ninth Circuit’s decision in In re Entz-White Lumber & Supply, Inc.¹ GECC appealed and on 3 July, the Ninth Circuit issued its decision reversing the Bankruptcy Court.

The Court’s Analysis

The Ninth Circuit began its analysis by ruling that Entz-White was not applicable. In that earlier case, the court had ruled that if a debtor cures a default under §1123(a)(5)(g), a provision of the Bankruptcy Code dealing with confirmation of a plan of reorganisation, the creditor whose claim is cured is not entitled to interest at the default rate. In other words, according to Entz-White, cure does more than de-accelerate a debt. It nullifies all the consequences of default, including the creditor’s right to a higher rate of interest.² In the Future Media case, however, there was no cure; indeed, there was no plan of reorganisation at all. GECC was paid off through an asset sale under §363 of the Bankruptcy Code.

The court then extracted guidance from the Supreme Court’s decision last year in Traveler’s Casualty & Surety Co. of America v. Pacific Gas & Electric Co.,³ in which the Court ruled that attorneys fees incurred post-petition in litigating issues of federal bankruptcy law are includable in a creditor’s claim if provided for in a contract with the debtor. The Ninth Circuit read Traveler’s to mean that GECC’s claim to default-rate interest, like any other contract-based claim, should be allowed subject only to the substantive law governing the loan agreement or a contrary provision of the Bankruptcy Code. Because the court found no contrary provision in the Bankruptcy Code, the court reversed the Bankruptcy Court and remanded the case for determination of whether the default rate interest was enforceable under New York law. In doing so, the court expressly rejected contrary decisions by lower courts in the circuit and conformed the law in the Ninth Circuit to the approach adopted by other circuits.⁴

Effect of the Decision

The court’s decision, although remarkably brief, is beneficial to secured lenders. It unquestionably allows oversecured creditors to recover interest on their claims at the default rate, at least in some instances. Still, two related questions remain unanswered.

First, which oversecured creditors are entitled to interest at the default rate? The court’s analysis suggests that the only oversecured creditors not entitled to default-rate interest would be those whose claims to the higher interest rate would be unenforceable under non-bankruptcy law. The court also suggested, however, that its decision was consistent with decisions from the Seventh and Fifth circuits, which expressly allowed bankruptcy courts to assess whether the higher default rate was reasonable or otherwise equitable under the circumstances. It remains unclear whether those earlier decisions survive the Supreme Court’s decision in Traveler’s. Nevertheless, the court did not see fit to even point out, let alone resolve, the tension between its own analysis and the precedent from other circuits that it relied upon. Thus, it may be that a creditor whose loan agreement provides for double or treble interest after default may find its claim disallowed, under either state law or some bankruptcy principle of equity.

Second, if some oversecured creditors are denied interest at the default rate, does that apply only to both pre-petition and post-petition periods, or only to the accrual of interest post petition? Nothing in the court’s decision addresses this question, in part because the court found nothing in the Code prevented GECC from receiving default-rate interest for either period. The Seventh and Fifth Circuit decisions, however, are grounded in Bankruptcy Code §506(b), which authorises oversecured creditors to receive post-petition interest from their equity cushion. If such authorisation is indeed circumscribed by equitable considerations, then presumably that limit applies only to the post-petition period, and interest accrued pre-petition at the default rate is recoverable so long as that rate is enforceable under prevailing nonbankruptcy law.