In the chapter 11 cases of Adelphia Communications Corp., et al., the U.S. Bankruptcy Court for the Southern District of New York recently denied the claims of secured lenders seeking approximately $187 million of interest that would have been owed had Adelphia accurately reported its financial information.
The contested claims at issue (see In re Adelphia Communications Corp., Case No. 02-41729 (REG) (Bankr. S.D.N.Y. May 15, 2006)) involved the nondefault interest on the lenders’ loans, which was the sum of the floating base rate plus an "applicable margin." The "applicable margin" was ascertained by reference to a "grid," and fluctuated based on Adelphia’s reported financial condition and performance. It was undisputed that Adelphia delivered inaccurate financial information which resulted in lower interest rates.
The secured lenders sought to add to their claims the amount of interest that would have been due and owing had accurate prepetition financial information been reported by Adelphia. The lenders argued these amounts were owed either as a contractual remedy or tort remedy.
Contractual Claim
The lenders reasoned that they were contractually entitled to the incremental interest and that it was recoverable as a secured claim under section 506(b) of the Bankruptcy Code. Section 506(b) provides that oversecured creditors have a claim for interest on their claim "provided for under the agreement under which such claim arose."
The court rejected the lenders’ contract claim after a detailed review of the applicable provisions of the loan agreements, concluding that such provisions failed to explicitly provide that the interest rate could be automatically and retroactively adjusted as a remedy in the event of falsely reported financial information.
"[T]hat is not one of the contractual remedies that any of the bank lenders bargained for," the court stated.
While the loan agreements did provide for the automatic readjustment of the interest rate in the event that Adelphia failed to provide any financial information, they did not provide for any adjustment if such information proved to be inaccurate. Instead, if the financial information was incorrect, the loan agreements provided that the lenders had the right to declare a default and charge the default rate of interest as a remedy. Default interest would exceed the grid interest received if the financial information was correct. However, in connection with providing debtor-in-possession financing to Adelphia, the lenders waived any claim for default interest arising from prepetition defaults.
Accordingly, the court held that the loan agreements failed to provide a contractual remedy for the retroactive adjustment of interest sought by the lenders.
The court maintained that its holding was not meant to "condone defrauding bank lenders, . . .it is only to say that, particularly in a case where the recoveries of the bank lenders come at the expense of other creditors, no party can make a contractual claim that goes beyond its contractual rights."
Tort Claim
The lenders also argued that they were entitled to the additional grid interest on tort theories of fraud or misrepresentation. The court agreed that, if proven, Adelphia would be liable for such claims. The court, however, went on to explain that claims based in tort, as opposed to contract, do not give rise to secured claims under section 506(b). Furthermore, the court held that the tort claims gave rise only to compensatory damages for the lenders’ actual out-of-pocket loss and not the profits they would have realized in the absence of fraud. The court equated the lenders’ actual out-of-pocket loss to the outstanding principal amount of the lenders’ claims. Because the principal amount of the lenders’ claims is to be paid in full upon confirmation of Adelphia’s plan, the court found that the lenders will suffer no compensable damages.
Lastly, because the court found that the secured lenders were not entitled to the additional interest, it did not address the objecting parties’ remaining contentions that the lenders waived the additional interest claims because they failed to include such amounts in their proofs of claim. Because there were no claims to waive, the arguments were deemed academic.
Lesson for Secured Lenders
An oversecured lender’s right to recover interest under section 506(b) is dependent on the explicit language set forth in the loan documents. Secured claims cannot be defined so broadly as to inherently encompass expectancy rights not provided for in the underlying contracts. Accordingly, secured lenders that determine the applicable margin based on information reported by the borrower should ensure that their loan documents include a provision that permits the lender to retroactively recalculate interest if the lender subsequently determines that the information provided by the borrower was false or inaccurate.
This article is presented for informational purposes only and is not intended to constitute legal advice.
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