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Strategies for Lenders

By Lynn M. LoPucki and Christopher R. Mirick
June 25, 2004

It has become conventional wisdom that bankruptcy — even Chapter 11 — is now largely a process controlled by secured lenders. See, eg, Skeel DA Jr.: Creditors' Ball: The “New” New Corporate Governance in Chapter 11. 152 U. Pa. L. Rev. 917 (2003). Whatever the merits of this view, the undersecured lender is still in an unenviable position as a result of the Supreme Court's holding in Timbers that undersecured creditors who are stayed from foreclosing on their collateral during bankruptcy are not entitled to accrue or collect interest on their claims during the bankruptcy case or otherwise be compensated for their loss. United Sav. Assn. of Texas v. Timbers of Inwood Forest Assocs. (In re Timbers of Inwood Forest Assocs.), 484 U.S. 365, 626 (1988). In addition, Bankruptcy Code ' 502(b)(2) bars claims for “unmatured” (postpetition) interest.

We have found two successful strategies by which lenders can avoid both these limitations. Borrowers are unlikely to resist the use of these strategies because neither has any significant pre-bankruptcy effect on the borrower — or the lender. The form of the loan will be different, but the substance of the loan will be the same. The strategies are 1) to segment the loan, and 2) to cast the loan in the form of an interest rate swap. The use of either strategy will enable the lender to accrue and collect interest on all or a substantial part of its loan during the period the debtor is in bankruptcy.

Segmenting the Loan to Claim Postpetition Interest

Timbers bars undersecured creditors from accruing interest on their loan balances during bankruptcy, but does permit over-secured creditors to do so, to the extent of the value of their collateral. Bankruptcy Code ' 506(b). To illustrate the distinction, a creditor who holds an $80,000 first mortgage providing for interest at 10% per year against property worth $70,000 would not be entitled to accrue or collect any interest during a bankruptcy case. Assuming that the value of the property remained constant, at the end of the case the creditor would hold a secured claim of $70,000 and an unsecured claim of $10,000. If, instead, the property had a value of $90,000, the creditor's claim would have risen to $88,000 in the course of a year-long proceeding.

Under Timbers, it is obviously better to be an over secured creditor than an undersecured creditor. The best way to achieve over secured status is to require that the debtor furnish collateral with a value comfortably in excess of the amount of the debt. But in a competitive lending market, not every creditor can do so.

An effective alternative response to Timbers may be for lenders to “segment” their loans. That is, the creditor should make two loans against the same collateral, one secured by a senior mortgage and the other secured by a junior mortgage.

For example, instead of making an $80,000 first mortgage against collateral worth $70,000, the lender could segment the loan into a $50,000 first mortgage and a $30,000 second mortgage against the same collateral. If the loan had been made as an $80,000 first mortgage, the holder would have been undersecured and entitled to no interest on any part of its claim in an ensuing bankruptcy. But with the segmented loan, a better result is achieved. Although the junior segment of the loan is undersecured and the holder can accrue no interest, the senior segment of the loan is over secured and therefore entitled to accrue interest.

The benefit to the senior segment in this example does not come at the expense of the junior segment. Under Bankruptcy Code ' 506(a), the junior segment will be divided into a secured claim of $20,000 and an unsecured claim of $10,000. The owner of the junior segment will not be entitled to accrue interest on either claim, but will be entitled to adequate protection of the value of the collateral, which is $20,000. Bankruptcy Code ' 361(2) assures against decrease in the “value of such entity's interest in such property.” The Supreme Court stated in Timbers that “We think the phrase 'value of such entity's interest' in ' 361(1) and (2), when applied to secured creditors, means … the value of the collateral.” Timbers, 484 U.S. 365, 372 (1988). In this example the value of the second segment holder's collateral is clearly $20,000. For cases adequately protecting a second mortgage on this theory, see In re McKillips, 81 B.R. 454 (Bankr. N.D. Ill. 1987) (requiring payments to the first mortgage holder in order to adequately protect the second mortgage holder); American Props. v. Topeka Bank & Tr. (In re American Props.), 8 B.R. 68 (Bankr. D. Kan. 1980) (requiring adequate protection payments to the second mortgage holder equal to the amount of interest accruing but not being paid on the first mortgage); In re Rupprect, 161 B.R. 48 (Bankr. D. Neb. 1993) (mortgagee entitled to adequate protection payments in amount equal to unpaid interest accruing on over secured tax claim); In re East-West Assocs., 110 B.R. 675 (Bankr. S.D.N.Y. 1990) (secured creditor entitled to adequate protection payments to the extent that the value of its claim is decreased by interest accruing on valid senior tax liens); c.f. In re McPherson, 225 B.R. 203 (Bankr. D. Idaho 1998) (undersecured junior mortgagee granted relief from stay to foreclose because property lacked equity cushion and debtor was not paying current interest on senior mortgage causing decrease in value available to junior mortgagee). Thus the junior segment of the loan is treated as well as it would have been if it had been part of an $80,000 undersecured loan.

Segmenting could be accomplished most easily at the time the loan is made. Some financial institutions have been engaged in segmented lending for many years for reasons unrelated to bankruptcy. But segmenting could also be accomplished at the time of a refinancing, including a settlement that takes place in the shadow of bankruptcy. To maximize the likelihood that the transaction will be given the effect described here, the lender probably should sell or assign one of the segments.

Using the 'Interest Rate Swap' Form for Postpetition Advantage

If a lender plans to make a fixed-interest loan to a risky borrower, the lender can gain postpetition advantage by putting the loan in the form of an interest rate swap. The Bankruptcy Code invites this strategy by providing unique protections to the rights of parties to swap agreements. See, eg, Bankruptcy Code ' 362(b)(17) (setoff by swap participant not subject to automatic stay); ' 546(g) (trustee may not avoid prepetition swap payment unless made with actual intent to hinder, delay or defraud creditors); ' 548(d)(1)(D) (swap participant who receives payment takes for value for fraudulent transfer purposes); and ' 560 (contractual right to terminate a swap agreement or offset amounts relating to the agreement “shall not be stayed, avoided, or otherwise limited by operation of any provision of [the Bankruptcy Code] or by order of a court or administrative agency in any proceeding under [the Bankruptcy Code]“). These protections enable lenders who structure their loans to include swaps to recover more in the borrower's bankruptcy than they could recover on a “simple” loan. The Ninth Circuit has recently upheld this strategy, as discussed below.

Assume the lender intends to make a $45 million fixed interest rate term loan. If the borrower files for bankruptcy after the loan is made, the Bankruptcy Code prevents the lender from making a claim for future, or “unmatured,” interest payments (Bankruptcy Code ' 502(b)(2)), and may prohibit the collection of some kinds of penalties (see, e.g., In re 1095 Commonwealth Avenue Corp., 204 B.R. 284 (Bankr. D. Mass. 1997) (oversecured lender could not collect both postpetition default interest and postpetition late fees, as recovering both would not be reasonable under ' 506(b))).

The lender can avoid this outcome by entering into two transactions with the borrower, a variable interest rate term loan (the “loan”) and an interest rate swap agreement (the “swap”). The loan agreement provides that the borrower will pay interest on the $45 million principal calculated according to some variable rate formula. Under the swap, the borrower and the lender agree to make payments to each other based the difference between the variable rate and a fixed rate, calculated on a hypothetical or “notional” amount, in this case $45 million. Once the amounts due under the two contracts are set off against one another, the result is the transaction intended in the first place: the borrower repays the loan at a fixed interest rate, and that is the only money that ever changes hands. The swap agreement can provide that on termination, the non-defaulting party — which will always be the lender — is entitled to a termination fee, calculated as the amount necessary to replace the lost stream of payments under the terminated swap (but not the variable rate portion of the loan). Both the loan and the swap obligations should be secured, if the borrower has available collateral.

If the variable rate is less than the fixed rate (referred to as the swap being “in the money”) when the borrower files for bankruptcy, the lender may be able to recover the termination fee, even though it is effectively a substitute for unmatured future interest that could not have been recovered on a simple fixed rate loan. See In re Thrifty Oil Co., 322 F.3d 1039 (9th Cir. 2003) (early termination damages on a swap agreement were not “unmatured interest” when the loan and swap agreement were treated by the bank as two separate agreements, even though borrower entered the agreements to achieve a net fixed rate loan).

As with postpetition interest on a fixed rate loan, the swap termination fee is secured to the extent of the available collateral. Unlike the fixed rate loan interest, if the termination fee exceeds the available collateral the balance should be treated as an unsecured claim under Bankruptcy Code ' 506(a), rather than disallowed as unmatured interest under Bankruptcy Code ' 502(b)(2). To avoid losing future interest when the loan is fully secured in bankruptcy, the swap contract can provide that the swap obligation converts to an obligation to pay a termination fee only at the option of the lender.

This strategy may sound too good to be true. Termination fees really are unmatured interest. But the debtor raised precisely this issue in Thrifty Oil, and none of the three courts that decided the case were able to understand the debtor's argument. Presented with the argument that allowing the recovery of swap termination fees would lead to undesirable results, the circuit court in Thrifty Oil thought it “exceedingly unlikely that a financial institution could create a profitable enterprise of systematically using interest rate swaps to circumvent section 502(b)(2).” In re Thrifty Oil Co., 322 F.3d at 1053. The authors respectfully disagree. Loans combined with swap contracts are now a privileged lending form, and nearly everyone should be using them.



Lynn M. LoPucki Christopher R. Mirick [email protected]

It has become conventional wisdom that bankruptcy — even Chapter 11 — is now largely a process controlled by secured lenders. See, eg, Skeel DA Jr.: Creditors' Ball: The “New” New Corporate Governance in Chapter 11. 152 U. Pa. L. Rev. 917 (2003). Whatever the merits of this view, the undersecured lender is still in an unenviable position as a result of the Supreme Court's holding in Timbers that undersecured creditors who are stayed from foreclosing on their collateral during bankruptcy are not entitled to accrue or collect interest on their claims during the bankruptcy case or otherwise be compensated for their loss. United Sav. Assn. of Texas v. Timbers of Inwood Forest Assocs. (In re Timbers of Inwood Forest Assocs.), 484 U.S. 365, 626 (1988). In addition, Bankruptcy Code ' 502(b)(2) bars claims for “unmatured” (postpetition) interest.

We have found two successful strategies by which lenders can avoid both these limitations. Borrowers are unlikely to resist the use of these strategies because neither has any significant pre-bankruptcy effect on the borrower — or the lender. The form of the loan will be different, but the substance of the loan will be the same. The strategies are 1) to segment the loan, and 2) to cast the loan in the form of an interest rate swap. The use of either strategy will enable the lender to accrue and collect interest on all or a substantial part of its loan during the period the debtor is in bankruptcy.

Segmenting the Loan to Claim Postpetition Interest

Timbers bars undersecured creditors from accruing interest on their loan balances during bankruptcy, but does permit over-secured creditors to do so, to the extent of the value of their collateral. Bankruptcy Code ' 506(b). To illustrate the distinction, a creditor who holds an $80,000 first mortgage providing for interest at 10% per year against property worth $70,000 would not be entitled to accrue or collect any interest during a bankruptcy case. Assuming that the value of the property remained constant, at the end of the case the creditor would hold a secured claim of $70,000 and an unsecured claim of $10,000. If, instead, the property had a value of $90,000, the creditor's claim would have risen to $88,000 in the course of a year-long proceeding.

Under Timbers, it is obviously better to be an over secured creditor than an undersecured creditor. The best way to achieve over secured status is to require that the debtor furnish collateral with a value comfortably in excess of the amount of the debt. But in a competitive lending market, not every creditor can do so.

An effective alternative response to Timbers may be for lenders to “segment” their loans. That is, the creditor should make two loans against the same collateral, one secured by a senior mortgage and the other secured by a junior mortgage.

For example, instead of making an $80,000 first mortgage against collateral worth $70,000, the lender could segment the loan into a $50,000 first mortgage and a $30,000 second mortgage against the same collateral. If the loan had been made as an $80,000 first mortgage, the holder would have been undersecured and entitled to no interest on any part of its claim in an ensuing bankruptcy. But with the segmented loan, a better result is achieved. Although the junior segment of the loan is undersecured and the holder can accrue no interest, the senior segment of the loan is over secured and therefore entitled to accrue interest.

The benefit to the senior segment in this example does not come at the expense of the junior segment. Under Bankruptcy Code ' 506(a), the junior segment will be divided into a secured claim of $20,000 and an unsecured claim of $10,000. The owner of the junior segment will not be entitled to accrue interest on either claim, but will be entitled to adequate protection of the value of the collateral, which is $20,000. Bankruptcy Code ' 361(2) assures against decrease in the “value of such entity's interest in such property.” The Supreme Court stated in Timbers that “We think the phrase 'value of such entity's interest' in ' 361(1) and (2), when applied to secured creditors, means … the value of the collateral.” Timbers, 484 U.S. 365, 372 (1988). In this example the value of the second segment holder's collateral is clearly $20,000. For cases adequately protecting a second mortgage on this theory, see In re McKillips, 81 B.R. 454 (Bankr. N.D. Ill. 1987) (requiring payments to the first mortgage holder in order to adequately protect the second mortgage holder); American Props. v. Topeka Bank & Tr. (In re American Props.), 8 B.R. 68 (Bankr. D. Kan. 1980) (requiring adequate protection payments to the second mortgage holder equal to the amount of interest accruing but not being paid on the first mortgage); In re Rupprect, 161 B.R. 48 (Bankr. D. Neb. 1993) (mortgagee entitled to adequate protection payments in amount equal to unpaid interest accruing on over secured tax claim); In re East-West Assocs., 110 B.R. 675 (Bankr. S.D.N.Y. 1990) (secured creditor entitled to adequate protection payments to the extent that the value of its claim is decreased by interest accruing on valid senior tax liens); c.f. In re McPherson, 225 B.R. 203 (Bankr. D. Idaho 1998) (undersecured junior mortgagee granted relief from stay to foreclose because property lacked equity cushion and debtor was not paying current interest on senior mortgage causing decrease in value available to junior mortgagee). Thus the junior segment of the loan is treated as well as it would have been if it had been part of an $80,000 undersecured loan.

Segmenting could be accomplished most easily at the time the loan is made. Some financial institutions have been engaged in segmented lending for many years for reasons unrelated to bankruptcy. But segmenting could also be accomplished at the time of a refinancing, including a settlement that takes place in the shadow of bankruptcy. To maximize the likelihood that the transaction will be given the effect described here, the lender probably should sell or assign one of the segments.

Using the 'Interest Rate Swap' Form for Postpetition Advantage

If a lender plans to make a fixed-interest loan to a risky borrower, the lender can gain postpetition advantage by putting the loan in the form of an interest rate swap. The Bankruptcy Code invites this strategy by providing unique protections to the rights of parties to swap agreements. See, eg, Bankruptcy Code ' 362(b)(17) (setoff by swap participant not subject to automatic stay); ' 546(g) (trustee may not avoid prepetition swap payment unless made with actual intent to hinder, delay or defraud creditors); ' 548(d)(1)(D) (swap participant who receives payment takes for value for fraudulent transfer purposes); and ' 560 (contractual right to terminate a swap agreement or offset amounts relating to the agreement “shall not be stayed, avoided, or otherwise limited by operation of any provision of [the Bankruptcy Code] or by order of a court or administrative agency in any proceeding under [the Bankruptcy Code]“). These protections enable lenders who structure their loans to include swaps to recover more in the borrower's bankruptcy than they could recover on a “simple” loan. The Ninth Circuit has recently upheld this strategy, as discussed below.

Assume the lender intends to make a $45 million fixed interest rate term loan. If the borrower files for bankruptcy after the loan is made, the Bankruptcy Code prevents the lender from making a claim for future, or “unmatured,” interest payments (Bankruptcy Code ' 502(b)(2)), and may prohibit the collection of some kinds of penalties (see, e.g., In re 1095 Commonwealth Avenue Corp., 204 B.R. 284 (Bankr. D. Mass. 1997) (oversecured lender could not collect both postpetition default interest and postpetition late fees, as recovering both would not be reasonable under ' 506(b))).

The lender can avoid this outcome by entering into two transactions with the borrower, a variable interest rate term loan (the “loan”) and an interest rate swap agreement (the “swap”). The loan agreement provides that the borrower will pay interest on the $45 million principal calculated according to some variable rate formula. Under the swap, the borrower and the lender agree to make payments to each other based the difference between the variable rate and a fixed rate, calculated on a hypothetical or “notional” amount, in this case $45 million. Once the amounts due under the two contracts are set off against one another, the result is the transaction intended in the first place: the borrower repays the loan at a fixed interest rate, and that is the only money that ever changes hands. The swap agreement can provide that on termination, the non-defaulting party — which will always be the lender — is entitled to a termination fee, calculated as the amount necessary to replace the lost stream of payments under the terminated swap (but not the variable rate portion of the loan). Both the loan and the swap obligations should be secured, if the borrower has available collateral.

If the variable rate is less than the fixed rate (referred to as the swap being “in the money”) when the borrower files for bankruptcy, the lender may be able to recover the termination fee, even though it is effectively a substitute for unmatured future interest that could not have been recovered on a simple fixed rate loan. See In re Thrifty Oil Co., 322 F.3d 1039 (9th Cir. 2003) (early termination damages on a swap agreement were not “unmatured interest” when the loan and swap agreement were treated by the bank as two separate agreements, even though borrower entered the agreements to achieve a net fixed rate loan).

As with postpetition interest on a fixed rate loan, the swap termination fee is secured to the extent of the available collateral. Unlike the fixed rate loan interest, if the termination fee exceeds the available collateral the balance should be treated as an unsecured claim under Bankruptcy Code ' 506(a), rather than disallowed as unmatured interest under Bankruptcy Code ' 502(b)(2). To avoid losing future interest when the loan is fully secured in bankruptcy, the swap contract can provide that the swap obligation converts to an obligation to pay a termination fee only at the option of the lender.

This strategy may sound too good to be true. Termination fees really are unmatured interest. But the debtor raised precisely this issue in Thrifty Oil, and none of the three courts that decided the case were able to understand the debtor's argument. Presented with the argument that allowing the recovery of swap termination fees would lead to undesirable results, the circuit court in Thrifty Oil thought it “exceedingly unlikely that a financial institution could create a profitable enterprise of systematically using interest rate swaps to circumvent section 502(b)(2).” In re Thrifty Oil Co., 322 F.3d at 1053. The authors respectfully disagree. Loans combined with swap contracts are now a privileged lending form, and nearly everyone should be using them.



Lynn M. LoPucki Christopher R. Mirick Weil, Gotshal & Manges LLP [email protected]

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