United States: Ninth Circuit Joins Majority: Permits Creditor To Obtain Interest At Default Rate

The U.S. Court of Appeals for the Ninth Circuit has determined that an oversecured creditor may collect interest at the default rate set by the contract or note. In so holding, the Ninth Circuit has applied the rule followed by a majority of the circuits. General Elec. Capital Corp. v. Future Media Prods., Inc., 530 F.3d 1178 (2008), amended by, 2008 U.S. App. LEXIS 16634 (9th Cir. Aug. 7, 2008) and 2008 U.S. App. LEXIS 16635 (9th Cir. Aug. 7, 2008).

The case arose from a loan made by General Electric Capital Corporation (GECC) to Future Media Productions, Inc. (Future Media), secured by an interest in substantially all of Future Media's assets. Future Media defaulted on the loan in March 2005 and filed a bankruptcy petition under chapter 11 in February 2006.

Pursuant to a post-petition stipulation between Future Media and GECC, Future Media sold its assets at an auction, and used the proceeds to pay GECC in full. This payoff included payment of interest at the default rate specified in the contract, from the date of default until payment from the auction proceeds. The Creditor's Committee demanded that GECC return that portion of the payoff that represented interest at the contract rate, as opposed to interest at the pre-default rate.

The bankruptcy court applied the analysis of an earlier Ninth Circuit decision, In re Entz-White Lumber & Supply Inc., 850 F.2d 1338 (9th Cir. 1988), and concluded that GECC was entitled to only interest at the pre-default rate, not at the default rate.

The Ninth Circuit reversed, holding that the bankruptcy court erred in applying Entz-White to the Future Media case. The court explained that the contract default rate should be enforced pursuant to the state law governing the contract unless a provision of the Bankruptcy Code provides otherwise. In Entz-White, the claim was paid in full, including interest at the pre-default rate, pursuant to the terms of Entz-White's chapter 11 plan.

In contrast, in Future Media's case, GECC was paid in full pursuant to the asset sales, which happened during the bankruptcy case, but outside of a chapter 11 plan. Because a chapter 11 plan implicates provisions of the Bankruptcy Code—but an asset sale outside of the plan does not—the Ninth Circuit held that state law alone governs GECC's entitlement to interest at the default rate.

Majority Rule

The Ninth Circuit remanded the case to the bankruptcy court, with instructions to apply the majority rule in determining whether the default rate should apply. The majority rule presumes entitlement to the contracted for default rate, unless the rate is unenforceable under non-bankruptcy law, or the rate produces inequitable results. Future Media, supra, 2008 U.S. App. LEXIS 16634 at *11-12.

Future Media aligns Ninth Circuit law with the majority of courts, including other circuit courts. The majority of courts have concluded that post-petition interest for an oversecured creditor should be computed at the rate provided in the contract. For example, the U.S. Court of Appeals for the Seventh Circuit has explained the general presumption in favor of applying the default contract rate subject to equitable considerations, and permitted the creditor to collect interest at the default rate. In re Terry Ltd. P'ship, 27 F.3d 241, 245 (7th Cir. 1994).

Likewise, the Fifth Circuit has held that the parties' contract should provide the post-petition rate of interest on an oversecured creditor's claim, and remanded to the bankruptcy court for an examination of the equities in the specific case. In re Laymon, 958 F.2d 72, 75 (5th Cir. 1992). The Second Circuit recognizes the widespread practice of allowing post-petition interest at the contract default rate, but clarified that such award is not an entitlement. Instead it lies in the discretion of the bankruptcy court. In re Milham, 141 F.3d 420, 424 (2d Cir. 1998).

Future Media may benefit oversecured lenders by generally permitting them to recover post-petition interest at the default rate. The Ninth Circuit's decision clearly applies when payment is achieved by way of an asset sale, as were the facts in Future Media. It is less clear if the holding applies when payment is achieved through a sale under a chapter 11 plan, as were the facts in Entz-White.

The Ninth Circuit originally noted in Future Media that the continued validity of Entz-White is questionable, but declined to overrule Entz-White. Future Media, supra, 530 F.3d at 1181 n.2.

The Ninth Circuit amended its opinion in Future Media, however, to remove this footnote—the only change made by the court. General Electric Capital Corp. v. Future Media Productions, Inc., 2008 U.S. App. LEXIS 16634 (9th Cir. Aug. 7, 2008) and 2008 U.S. App. LEXIS 16635 (9th Cir. Aug. 7, 2008). Why the court chose to remove a note explaining that it was not overruling Entz-White is a mystery, given the court's critique of that decision. Perhaps it is signaling that it would overrule Entz-White if given the chance—maybe even in this case if it comes back after remand.

Going Forward

Because of the specific circumstances under which the Future Media rule applies, secured creditors, to increase the chances of collecting the default rate of interest from a debtor, should consider the possibility of moving for relief from stay to conduct a foreclosure auction of the collateral outside the context of a chapter 11 plan. If the sale of the collateral must be addressed in a chapter 11 plan, the secured creditor should object to any plan that does not specify payment of its oversecured claim, including interest at the contract post-default rate.

Additionally, when drafting a loan contract, lenders should be aware that in the event of a bankruptcy filing by debtor, the default rate of interest established in the contract may be scrutinized for "reasonableness" by the bankruptcy court. A significant difference between the pre-default rate and default rate can be used as evidence by the debtor or Creditors Committee to rebut the presumption in favor of permitting the default rate. In re Terry, supra, 27 F.3d at 243-44.

Moreover, a very high default rate may be deemed by the court to amount to an unenforceable and therefore uncollectible penalty. In re Urban Communicators PCS Ltd. P'ship, 379 B.R. 232, 254 (Bankr. S.D.N.Y. 2007). To minimize these risks, the creditor's draftsperson might include in the contact recitals and explanations—expressly agreed to by the debtor—of why the default rate of interest is reasonable and appropriate under the circumstances of a particular loan.

This article is presented for informational purposes only and is not intended to constitute legal advice.