Article courtesy of Kevin P. Braun of Morgan, Lewis & Bockius LLP
District Court affirmed the Bankruptcy Court’s order awarding an oversecured creditor payment of default interest, because it did not engage in misconduct, the unsecured creditors were not unduly harmed by the payment of default interest at the 3% contractual rate and default interest alone did not constitute a penalty. In re Latex Foam International, LLC, et al., Debtors Official Committee of Unsecured Creditors of Latex Foam International, LLC et al., Appellant v. Entrepreneur Growth Capital, Appellee, 2023 WL 2403757 (March 8, 2023)
Latex Foam International, LLC, doing business as various entities (collectively, the “Debtors”) and SummitBridge National Investments IV, LLC (“SummitBridge”) entered into an amended and restated loan and security agreement (the “Loan Agreement”) to provide Debtors with funding to exit the Debtors’ Chapter 11 bankruptcy case. The terms of the Loan Agreement provided that (a) an event of default includes the filing of a voluntary bankruptcy petition and (b) upon the occurrence of an event of default, the default interest rate shall be 3% in excess of the rate otherwise applicable under the Loan Agreement. In March 2017, SummitBridge transferred its rights as the secured party under the Loan Agreement to Entrepreneur Growth Capital, LLC (“Secured Party”).
Each of the Debtors again filed voluntary Chapter 11 bankruptcy petitions, which were consolidated into one case. As of the petition date, Secured Party, as the Debtors’ principal secured creditor, had a claim of over $9 million. The Debtors subsequently sold substantially all of their assets at a sale approved by the Bankruptcy Court, the proceeds of which would allow the Debtors to pay Secured Party the principal amount of its claim and interest at the non-default rate under the Loan Agreement. Secured Party moved for payment of its secured claim, including default interest accruing from the petition date. Three of the largest unsecured creditors of the Debtors created an official committee of unsecured creditors (the “Committee”) and objected to Secured Party’s motion on the grounds that Secured Party was not entitled to default interest. The Bankruptcy Court granted Secured Party’s motion and awarded Secured Party payment of its secured claim, including default interest. The Committee appealed and following remand, the Bankruptcy Court issued an articulation explaining that Secured Party was entitled to default interest because (a) Secured Party was an “oversecured” creditor, (b) as an oversecured creditor, Secured Party was entitled to interest on its claim under Section 506(b) of the Bankruptcy Code and (c) an event of default under the Loan Agreement occurred that justified awarding Secured Party default interest. The Committee appealed the Bankruptcy Court’s order and articulation.
On appeal, the District Court (the “Court”) first analyzed whether the Bankruptcy Court erred in granting default interest to Secured Party. Section 506(b) of the Bankruptcy Code permits an oversecured creditor to recover “interest on [its] claim, and any reasonable fees, costs or charges provided for under the agreement or state Statute under which the claim arose.” Section 506(b)’s lack of instruction with respect to calculating interest on an oversecured creditor’s claim (compared to its clear instruction for awarding fees, costs or charges that are reasonable and provided for under the agreement or state Statute under which the claim arose) led the Court to look to legal precedent and subsequently the legislative history regarding the rate of postpetition interest an oversecured creditor is entitled to receive. Finding none of the foregoing, the Court looked to pre-Code cases, which adopted a “presumption in favor of applying a contractual default rate of interest, subject to equitable considerations.” The Court then performed a balance of equities test, considering whether (a) the secured creditor is guilty of misconduct, (b) granting default interest would harm unsecured creditors and (c) the default interest rate constitutes a penalty.
Regarding misconduct, the Committee argued that Secured Party was an “opportunistic investor,” suggesting it was unfair for an investor who purchases a loan agreement to benefit from Section 506(b) and that Secured Party was hostile to the Chapter 11 process by not providing the Debtors with post-petition financing. The Court rejected these arguments and noted that “it would be unfair to deny a secured creditor the value of its asset simply because it was not the original lender.” Further, the Court explained that a secured creditor is not guilty of misconduct by refusing to loan more money to a debtor in bankruptcy and it would be “inequitable to deny an oversecured creditor’s rights to the terms of its contract simply because it was unwilling to extend post-petition financing.”
With respect to harm to unsecured creditors, the Committee argued that the Bankruptcy Court misapplied the law relied on by the Bankruptcy court and erred in finding that the award of default interest to Secured Party would not harm the unsecured creditors. The Court explained that courts “have awarded default interest even when the unsecured creditors would not be paid in full” and therefore, the question is “not whether the unsecured creditors are harmed, but rather whether they are unduly subordinated or harmed by the secured creditor’s priority status.” The Court found that it was clear from the Bankruptcy Court’s decision that the Bankruptcy Court weighed the equities of creditor versus creditor and understood that while the Debtors were insolvent and would not be able to pay their unsecured creditors in full, the default interest rate was merely 3% over the non-default interest rate and awarding Secured Party default interest would reduce the available distributable assets by only two-hundredths of a percent. Therefore, the Court rejected the Committee’s arguments against the Bankruptcy Court’s findings on the harm to unsecured creditors.
As to whether the default interest rate constitutes a penalty, the Court upheld the Bankruptcy Court’s finding that the 3% contract default interest rate did not constitute a penalty because such default interest rate was compensatory. The Court noted that a default interest provision “is a bargained-for risk-management provision of a repayment contract that benefits both borrowers and lenders” and “on its own does not constitute a penalty.” Further, the Court noted that even if a significant spread between the non-default and default interest rates could constitute a penalty, such spread under the Loan Agreement was only 3%.
The Court also analyzed whether the Bankruptcy Court erred in finding that an event of default occurred under the Loan Agreement that justified awarding Secured Party default interest. The Committee argued that the filing of a voluntary petition is a “technical default.” However, the Court noted that SummitBridge and the Debtors specifically negotiated the default interest rate and the Loan Agreement provided that the 3% contract default interest rate was “a specific and material aspect” of the Loan Agreement, without which SummitBridge would not have entered into the Loan Agreement. Therefore, the Court concluded that “to deem unenforceable the provisions of a negotiated agreement” would unfairly limit “the power of parties to fairly contract.” For the foregoing reasons, the Court affirmed the Bankruptcy Court’s granting of Secured Party’s motion for repayment of its secured claim, including the award of contractual default interest.
