WurstCaseScenario

The Ninth Circuit Court of Appeals just joined the majority of circuits in enforcing a default interest rate despite a confirmed plan of reorganization calling to cure the default and roll back to the pre-default contract rate.

In reaching its decision the Ninth Circuit needed to revisit its 1988 decision in Great Western Bank & Trust v. Entz-White Lumber And Supply, Inc. which had held that  “[Borrower/Debtor was] entitled to avoid all consequences of the default-including higher post-default interest rates.”

The Court needed to reconcile two clauses contained in section 1123 of the Bankruptcy Code.

1123 (a) provides: “Notwithstanding any otherwise applicable nonbankruptcy law, a plan shall–…(5) provide adequate means for the plan’s implementation, such as–…(G) curing or waiving of any default…”

However, 1123 (d) provides: “Notwithstanding subsection (a) of this section and sections 506(b), 1129(a)(7), and 1129(b) of this title, if it is proposed in a plan to cure a default the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.”

The debtor was the operator of a hotel in Washington State and obtained a $2.75 million mortgage loan from Frontier Bank.  The debtor failed to repay the loan when it matured and the bank, by its successor, imposed the default rate of interest and commenced a non-judicial foreclosure which was the catalyst for the voluntary Chapter 11 filing.  The debtor then proposed a plan of reorganization that provided for a sale of the hotel as well as deeming the loan to be recast back to the pre-default contract interest rate.  The dispute with the bank’s successor related to the amount of the bank’s secured claim – specifically its right to the default rate of interest.

The confirmed plan treated the bank as unimpaired, but the debtor argued that the pre-default interest rate should apply.  The bank disagreed.  The Bankruptcy Court ruled in favor of the debtor and the bank appealed.  Inasmuch as it was clear that the case would ultimately reach the Circuit Court of Appeals, the Ninth Circuit certified the case negating the need to first appeal to the District Court.  The Ninth Circuit stated:

In Entz-White we observed that the Bankruptcy Code did not define “cure.” …. We borrowed the Second Circuit’s definition: “A default is an event in the debtor-creditor relationship which triggers certain consequences. Curing a default commonly means taking care of the triggering event and returning to pre-default conditions. The consequences are thus nullified. This is the concept of ‘cure’ used throughout the Bankruptcy Code.” ….. We held that “the power to cure under the Bankruptcy Code authorizes a plan to nullify all consequences of default, including avoidance of default penalties such as higher interest.” …. As a result, a debtor whose plan proposed to cure a default would allow him to avoid having to pay a higher, post-default interest rate called for in the loan agreement.

Entz-White was decided in 1988. In 1994, Congress amended § 1123 to add subsection(d)… Subsection § 1123(d) renders void Entz-White‘s rule that a debtor who proposes to cure a default may avoid a higher, post-default interest rate in a loan agreement. Subsection (d) governs here because [Debtor’s] plan proposes to cure a default.

In rendering its decision the Ninth Circuit specifically noted that in adopting 1123(d),Congress specifically intended to overrule the decision of the United States Supreme Court in Rake v Wade (no connection to the famous Roe v Wade), which had held that

a Chapter 13 debtor who proposed to cure a default was required to pay interest on his arrearages to a secured creditor even if the underlying loan agreement did not provide for such interest.  Congress viewed this as an untoward result that allowed for “interest on interest payments.”

The Court noted that its holding might appear difficult in light of the intent of the Bankruptcy Code to provide for a fresh start but was compelled by the clear intent of Congress.  [One might  note that in this case there was no fresh start in that it was a liquidating case and the windfall from the hoped for reduced interest payments would be used to pay administrative expenses and unsecured claims.]  The dissent, however, felt that the bank had not met its burden that Congress’ clear intent was to reverse settled law.

The case stands for the premise that default rate interest cannot be rolled back by a plan of reorganization.  As often is the case, the facts in this case are rare but one can envision a sympathetic judge trying to assist a reorganizing debtor by stepping down default interest rates against an objecting lender.  This case, as well as similar holdings from other Circuits, should block such attempts.

Keep an eye out for more from me on this subject – either on these pages or in my in-print articles.

Our parents taught us that playing with fire is dangerous. Throughout my career I have emphasized to my clients that playing with usury is dangerous. A recent New York case (Pearl Capital Rivis Ventures, LLC v. RDN Construction, Inc. and Robbie Neely, ____N.Y.S.3d ___, 2016 WL 6245103, 2016 N.Y. Slip Op. 26344) highlights the risk and should serve as a lesson.

Increased regulation in the banking industry has created opportunities for non-bank lenders, some of whom have succeeded in obtaining very high returns – often at usurious rates. At times these high rates are obtained through loans that are exempt from usury laws. In other instances the loan, together with its usurious interest, is repaid without incident. The recent New York case demonstrates the risk.

Pearl Capital Rivis Ventures, LLC made a $9,000 loan to RDN Construction, Inc., which loan was guaranteed by Robbie Neely. The loan was to be repaid by installment “payments of $198 …made every weekday, excluding legal holidays, until there was a total payback of $13,050.00, i.e., a period of approximately 13 weeks. Pearl had access to debit electronically the aforesaid payments from RDN’s bank account, into which RDN was supposed to deposit its receivables.” In addition, Pearl charged a $2,500 default fee and $665 in bounced debit fees.

When Pearl brought its action, RDN and its guarantor defaulted and a default was taken. However, in the context of an inquest to set the amount of the judgment, the judge, sua sponte [on his own in lawyer talk] drilled in to determine whether the loan was usurious and determined that the interest rate was 180% per annum.

Pearl argued that they had actually purchased receivables and that the transaction was not a loan. However, when pressed by the Court Pearl could not cite any “non-recourse” provision in its agreement. Despite Pearl’s claim to the contrary, the Court concluded the transaction to be a usurious loan.

In New York (as well as in many other jurisdictions) the penalty for criminal usury is not only a loss of interest but also a loss of principal and costs. The Court concluded:

For the reasons set forth above, it is the Court’s decision and order that plaintiff is not entitled to recover principal or interest, nor is it entitled to recover any of the other fees or costs requested, or arising out of, this matter.

The amount at issue here was not large. Thus, the experience may be well worth the lesson learned.

Watch for more from us on usury.

A recent decision from the Bankruptcy Court for the District of New Jersey (In re Packaging Systems LLC, 2016 WL 57877239, 09/30/2016) is a good wake up call for factors, lenders and practitioners representing them.  The lesson learned is to assure that your rights under a Chapter 11 Super Priority Claim are properly asserted during a subsequent Chapter 7 proceeding.

The case involved a  debtor-in-possession factoring facility.  The Final Order approving the post-petition factoring facility provided the Factor with a typical super-priority administrative claim, senior to all other administrative claim as follows:

[Factor] is hereby granted a super-priority administrative claim under Section 364(c)(1) of the Bankruptcy Code over any and all administrative expenses incurred and priority claims arising in this case for the obligations of the Debtor to [Factor] under the Pre-Petition Factoring Agreement, as amended by the Amendment, and Post-Petition Factoring Agreement, including all pre-petition and post-petition debt existing at the time of the Debtor’s assumption of the Pre-Petition Factoring Agreement, subject and subordinate only to the following: (a) the quarterly fees required to be paid to the U.S. Trustee; and (b) the fees and expenses incurred by counsel for the Debtor as approved by the Court, up to the sum of $25,000.

The order also granted the Factor a broad lien on all assets other than Chapter 5 recoveries:

[Factor] is hereby granted, and all loans, advances, obligations and amounts due or hereafter becoming due and owing by the Debtor to [Factor] are hereby secured by, valid and perfected first and senior security interests and liens in favor of [Factor] in and on all existing and after acquired assets of the Debtor and the Debtor’s estate, and the proceeds thereof, wherever located, excluding recoveries from actions brought pursuant to the provisions of Chapter 5 of the Bankruptcy Code.

The Chapter 7 Trustee pursued six adversary proceedings to recover for preferential and fraudulent transfers under Chapter 5 and ultimately recovered about ninety thousand dollars.

Factor did not take any action to assert its Super Priority Administrative Claim other than to file a request for payment of administrative claim annexed to the approximately $183,000 Proof of Claim it filed, despite a note contained in the Official Form with a caveat against using the Proof of Claim for such purpose.  Instead, Factor raised its Super Priority Administrative Claim as part of its objection to the Trustee’s Final Report, which reported that substantially all of the recovered funds would be used to pay the Trustee’s administrative expenses incurred

The dilemma that faced the Court was whether the Trustee could be paid his administrative expenses in light of Factor’s Super Priority.  Ultimately the Court focused on Factor having failed to properly submit a request for payment of its administrative claim as well as its failure to bring its Super Priority to the Trustee’s attention, and “invoked its equitable powers to conclude that the Trustee [was] entitled” to be paid from its recoveries.

The drafting of the DIP orders were somewhat less than they should have been.  Typical provisions addressing these issues are as follows:

Pursuant to §§ 364(c) and 364 (d) of the Code, any and all obligations and liabilities of the Debtor owing to BANK and arising after the date of this Order, together with accrued interest and charges incidental thereto, shall have priority in payment over any other obligations or liabilities now in existence or incurred hereafter by the Debtor and of all expenses of the kind specified in Sections 503(b), 506(c), 507(b) and 552(b) of the Code.

No expenses of administration of the Debtor’s Chapter 11 case or any future proceeding which may result from such case, including liquidation in bankruptcy or other proceedings under the Code, shall be charged against the BANK Collateral pursuant to § 506(c) of the Code, or otherwise, without the prior written consent of BANK and no such consent shall ever be implied from any other action, inaction or acquiescence by BANK.

The Court had the correct conclusion (even if its reasoning was less than perfect).  Except in rare circumstances, the Chapter 5 claims are preserved for the Debtor’s estate and are neither part of the secured creditor’s collateral nor Super Priority Administrative Claim.  It would have been unfair to the Trustee [am I really saying this?] had he expended considerable effort in effecting Chapter 5 recoveries only for the benefit of the secured creditor.  Had the Factor intended to assert the claim it ultimately pursued, it would have been wise to first approach the Trustee and work out an arrangement.

Now for what was not an issue in the case but became apparent during my review of the orders.

The Factoring and Security Agreement appears to be a true sale non-recourse factoring agreement.  However, the orders approving the post-petition factoring arrangement (both an interim order authorizing a post-petition factoring agreement and a final order authorizing the Debtor to assume the pre-petition factoring agreement) fail to address the nature of the factoring arrangement and merely authorize the Debtor to borrow money from and grant post-petition security interests to Factor.  The simple solution would have been to have the order also authorize the Debtor to sell its accounts to Factor pursuant to Section 363 of the Bankruptcy Code in addition to the traditional Section 364 (c) and (d) provisions that were included in the order.

 

 

An interesting case comes out of the Eighth Circuit Court of Appeals concerning competing interest in collateral after the senior secured creditor foreclosed upon the debtor’s assets securing the loan made by it.  Bayer CropScience, LLC v. Stearns Bank Nat’l Ass’n 2016 WL 5030340 (8th Cir. 2016).

In 2010, Stearns Bank foreclosed its 2002 Deed of Trust given as security for loans it made to Texana Rice Mill and Texana Rice Inc. (collectively, “Texana”).  After the foreclosure Stearns Bank was still owed nearly $4 million.   In 2007, Texana granted Amegy Bank a security interest in a tort claim Texana was pursuing against Bayer CropScience, LLC in order to secure a $2 million unsecured loan that had defaulted.  The commercial tort claim was for damages Bayer CropScience caused to Texana’s property and crops.  In 2012, after Texana and Bayer reached a settlement, Stearns Bank applied for Writs of Garnishment and served them upon Bayer.  Bayer brought an interpleader action to determine whether Stearns Bank or Amegy Bank was entitled to the proceeds of the tort claim.

Under UCC 9-204, an after acquired provision in a granting clause does not cover a commercial tort claim.  In addition, 9-108(e) requires that the commercial tort claim be specifically described.  Thus, a commercial tort claim that arises after the loan has been documented may not be covered by the loan documents.  Amegy Bank was granted a specific interest in the tort claim against Bayer CropScience.

UCC 9-617 provides “A secured party’s disposition of collateral after default: (1) transfers to a transferee for value all of the debtor’s rights in the collateral; (2) discharges the security interest under which the disposition is made; and (3) discharges any subordinate security interest or other subordinate lien.

Amegy Bank claimed and the court below ruled that under UCC 9-617 when Stearns Bank foreclosed on its collateral its security interest was discharged – even though after the disposition of the collateral Stearns was still owed nearly $4 million.

The Eighth Circuit  considered whether Stearns Bank had a superior security interest in the settlement funds to the extent they were for damages to its original collateral.  First, it determined that pursuant to UCC § 9-617, a secured creditor’s foreclosure on the debtor’s collateral does not discharge an otherwise valid security interest in the proceeds of that collateral.  Next, the Court determined that the heightened identification requirements for encumbering commercial tort claims under UCC § 9-108 means that the drafters “intended for the proceeds of a commercial tort claim to be excluded from an after-acquired general intangible clause.”  Finally, the Court held that while Stearns had no interest in the proceeds as a “general intangible” it still had a superior interest in the proceeds as original collateral pursuant to the terms of its security agreement, and that this interest  was “not displaced simply because damage to that collateral [gave] rise to a subsequent commercial tort claim.”

It is noteworthy, however, that in 2011, the First Circuit determined (In re: American Cartage, Inc. 656 F3d 82) that a commercial tort claim for damages resulting from conversion of assets, interference with contractual relationships and breach of fiduciary duties was not proceeds of the secured creditor’s collateral but, instead, was an asset of the Chapter 7 estate.

            The good news is that the Eighth Circuit correctly protected the secured party’s rights in remaining collateral after disposition under 9-617.

            The caveat, however, is to beware when taking a specific interest in a commercial tort claim and keep in mind that a pre-exiting security interest in proceeds may be superior to the interest in the commercial tort claim that you are obtaining.

(so, what’s special about that?)

An interesting case comes out of the Bankruptcy Court for the Northern District of Florida regarding attorney’s fees for secured lenders.  Although that case involved an individual chapter 11 debtor, its holding is helpful to those of us who practice in the commercial arena.  Section 506(b) of the Bankruptcy Code provides that:

An over secured creditor is entitled to interest and reasonable fees, costs or charges provided under the agreement or in accordance with state statute.

What this means to our readers is that so long as the collateral securing your loan is in excess of the amount owed to you, including interest, attorney’s fees, etc., and your agreement entitles you to attorney’s fees, then you may recover them from the debtor’s assets.

As we all know, from time to time debtors engage in conduct that require the secured lender and its counsel to expend considerable time and expense to protect the lender’s interest.  It is not uncommon to hear a debtor protest the fees charged to the estate by a secured creditor.  In a decision that came down April 21, 2016, in a case entitled In re:  Earl Bernard Britt, Sr., Debtor[1], debtor’s counsel objected to the secured creditors claim for legal fees because the lender’s legal fees exceeded those of the debtor’s.  The court held:

The debtor’s request for reduction of the Bank’s fees . . . merely because its fees exceed the debtor’s is not justified.  The debtor filed this chapter 11 voluntarily in order to take advantage of the benefits it might provide.  This forced the Bank to retain counsel to protect its interests.  . . .  The debtor cannot have it both ways:  He cannot invoke the provisions of the Bankruptcy Code and then complain when an over secured creditor accrues attorney’s fees as a result.

Notwithstanding, the Court did go on to review the attorney’s fees and found some items to be excessive and made reductions in accordance therewith.

The takeaway from this case is that an over secured creditor is entitled to its attorney’s fees even if those attorney’s fees exceed those of the debtor’s; and in all cases, a secured creditor’s attorney’s fees are subject to review of a reasonableness standard and thus, subject to reduction where a court feels that the fees have gone beyond what is reasonable.

[1] In re:  Earl Bernard Britt, Sr., Debtor 206WL3564222.