The Appropriate Interest Rate Under ' 506(b)

“A loaf of bread, a container of milk, and a stick of butter.” This Sesame Street sound bite, lodged in the deepest recesses of our brains, to be sure, came to mind after reviewing the recent decision rendered by Judge Martin Glenn of the U.S. Bankruptcy Court for the Southern District of New York in the Chapter 11 cases of Residential Capital, LLC (ResCap) on the oft-disputed issue of the appropriate interest rate calculation under Section 506(b) of the Bankruptcy Code. We heard in our minds Judge Glenn repeating, over and over, “rebuttable presumption, equitable considerations, and a balancing of the equities.”

We all know what the issue is. Section 506(b) of the Bankruptcy Code provides that over-secured creditors are entitled to receive post-petition interest, but it does not tell us what interest rate should be applied. Aye, there's the rub. Indeed, Congress' failure to provide the appropriate interest rate has triggered numerous disputes in many different jurisdictions as to whether: 1) the appropriate rate should be the contract rate, the Federal judgment rate, or some other rate altogether; and 2) regardless of which rate is selected, will the award of post-petition interest harm other creditors? This article explores the specific facts and circumstances that Judge Glenn considered and ultimately relied upon when deciding to rule in favor of Citibank, playing the role of secured creditor in the case, granting, for the most part, its request to receive post-petition interest at the default rate governed by its contract.

The ResCap Facts

Prior to the commencement of the Chapter 11 cases on May 14, 2012, GMAC Mortgage, LLC entered into a $700 million revolving credit facility with Citibank (the Citibank Facility), with ResCap signing on as a guarantor. The Citibank Facility initially had a maturity date of Aug. 31, 2010, but, as a result of 10 separate facility amendments, was extended until May 30, 2012. The Citibank Facility established a non-default interest rate of LIBOR plus 6%, which was later increased to LIBOR plus 8.5% as part of the tenth amendment. Two provisions, among others, remained constant throughout each of the facility amendments: 1) the default rate always added 4% to the non-default rate; and 2) the commencement of a bankruptcy case always constituted an event of default.

Subsequent to the ResCap petition date, which, as noted, constituted an event of default, the bankruptcy court entered a final cash collateral order which confirmed that Citibank was over-secured and therefore entitled to interest and fees. The failure to repay Citibank on the May 30, 2012 maturity date, just 16 days after the petition date, resulted in a second event of default.

In January 2013, ResCap closed on the sale of its mortgage origination and servicing platform to Ocwen Loan Servicing LLC and Walter Investment Management Corp., and at that point repaid Citibank $152 million, the full amount of the outstanding principal, plus interest at the contractual non-default rate. Citibank, however, argued that it was entitled to accrued interest at the contract default rate. According to Citibank, the differential between the non-default interest which it received and the default interest it claimed was $4.5 million. The dispute was preserved until the post-effective date of the plan.

Section 506(b) and the Rebuttable Presumption

As noted, section 506(b) governs the provision of interest to over-secured creditors, and provides, in pertinent part, as follows:

to the extent that an allowed secured claim is secured by property the value of which ' is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim , and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.

11 U.S.C. ' 506(b) (emphasis added).

Because 506(b) is silent regarding the appropriate interest rate calculation, courts in the Second Circuit have applied a rebuttable presumption that the contract default rate applies. In other words, courts are to presume that the contract interest rate applies post-petition and a debtor bears the burden of rebutting that presumption. Relying upon this rebuttable presumption, as well as the U.S. Supreme Court's holding in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., 549 U.S. 443 (2007) ' i.e., a creditor's rights in bankruptcy derive from the substantive law creating those rights subject to qualifying or contrary provisions of the Bankruptcy Code ' Citibank, not surprisingly, argued in favor of applying the contract default rate it would have been entitled to receive had ResCap defaulted outside of bankruptcy. The ResCap Liquidating Trust took a different position, arguing that the Travelers decision was not controlling because: 1) post- Travelers courts have denied post-petition interest at the contract default rate on equitable grounds; and 2) the rebuttable presumption applied in the Second Circuit was in fact subject to such considerations.

Equitable Considerations Could Adjust the Rebuttable Presumption

In the wake of the Travelers decision, a number of courts, including some in the Second Circuit, have concluded that the rebuttable presumption is subject to certain equitable considerations embodied in section 506(b) which, under appropriate circumstances, could support disallowance of the requested default interest rate. Those equitable considerations include, among others: 1) where the secured creditor is guilty of misconduct; 2) where the application of the contractual interest rate would harm the unsecured creditors; 3) where the application of the contractual interest rate would impair the debtor's fresh start; or 4) where the contractual interest rate constitutes a penalty. See In re 785 Partners LLC , 470 B.R. 126, 134 (Bankr. S.D.N.Y. 2012).

Hanging its hat on these post- Travelers decisions, the Trust advanced the following two arguments in support of its proposition that application of the contract default interest rate would be inequitable: 1) application of the contract default interest rate would harm unsecured creditors; and 2) Citibank was adequately protected and compensated both pre- and post-petition. Both of these arguments ultimately failed, and we discuss each one in turn below.

Potential Harm to Unsecured Creditors

The Trust's primary objection focused on whether unsecured creditors would be harmed by an award of the contract rate because ResCap was insolvent, noting that no Second Circuit cases involving insolvent debtors have awarded over-secured creditors contractual default interest. When addressing this threshold question, the bankruptcy court acknowledged that consideration of a debtor's solvency is important in deciding whether to apply the contract default rate, but it also noted that solvency is not the determinative factor, that no court has adopted a bright-line rule ' and the bankruptcy court refused to adopt such a rule ' and that the contract default rate should be refused in all insolvent debtor cases.

As the court noted in In re Madison 92nd St. Assocs. LLC, 472 B.R. 189, 200 (Bankr. S.D.N.Y. 2012), “most [C]hapter 11 cases involve insolvent debtors, and such an exception would swallow up the rule that the over-secured creditor is presumptively entitled to the 'contract rate.'” The question that must be asked whenever this issue arises is straightforward: Does the balance of equities favor awarding contract default interest?

Judge Glenn's answer to the balance of equities question in ResCap was yes, Citibank was entitled to contract default interest, except for the 16-day period between the petition date and the final maturity date, and this is why. The harm to unsecured creditors was not inequitable when viewed in the context of the distributable asset pool. Let's take a step back and look at the arguments advanced by each of the parties.

The Trust argued very simply that awarding Citibank the contractual default interest rate would diminish unsecured creditor recoveries dollar for dollar. Citibank argued in opposition that the rate would only have a miniscule impact on unsecured creditor recoveries, as such creditors were recovering from a $2.5 billion pool. The court, however, took its analysis up to 10,000 feet in order to view the totality of the circumstances. From that elevated perspective, the court viewed the tenth and last amendment to the Citibank Facility ' negotiated and executed by sophisticated parties in the weeks leading up to, and certainly in contemplation of, the bankruptcy filing ' as one essential piece of ResCap's complicated post-petition financing package.

When viewed in that light, the bankruptcy court questioned whether unsecured creditor recoveries were in fact diminished from what they would have been if ResCap had been forced to liquidate immediately after the commencement of the Chapter 11 cases, considering the absence of sufficient DIP financing. In other words, it was easy for the Trust to argue that every additional dollar that went to Citibank meant one less dollar available for unsecured creditors.

But the reality, at least as Judge Glenn perceived it, was that all creditors benefited from ResCap's continuing to operate post-petition as a going concern. Although he rejected Citibank's “miniscule” argument, Judge Glenn did ultimately conclude that awarding the contract interest rate would diminish the distributable asset pool by approximately two-tenths of a percent. Balancing the equities, the court concluded that such a reduction was not sufficient to overcome the rebuttable presumption.

The Rebuttable Presumption Prevailed over Other Equitable Factors

In addition to the equitable factors considered above, the Trust raised the following three equitable factors unique to the specific facts of the case: 1) Citibank received adequate protection post-petition in the form of timely interest payments at the non-default rate; 2) repayment of the amounts due under the Citibank Facility was never at risk because stalking-horse contracts were executed pre-petition; and 3) Citibank's exposure to any super-priority claims was minimized due to ResCap's agreement to lower the commitment amount and its pre-petition $124 million pay down of the Citibank Facility.

While the bankruptcy court acknowledged and accepted as undisputed facts each of the foregoing factors, it also concluded that the contract default rate was a feature of the deal ResCap specifically agreed to in the context of negotiations with many sophisticated parties ' and which ultimately benefited the unsecured creditors because it allowed ResCap to, quoting Judge Glenn, “proceed into bankruptcy with a semblance of order.”

The Trust's “Hail Mary” argument finally gave Judge Glenn an opportunity to limit, albeit slightly, Citibank's request for contract default interest. The Trust argued that the only default under the Citibank Facility during the 16-day period from the petition date to the final maturity date was the technical default of the filing of the bankruptcy, which, by itself, did not prejudice Citibank because it received an adequate protection package.

Balancing the equities once again, Judge Glenn agreed with the Trust, determining that awarding Citibank the contract default rate during the 16-day period from the petition date to the maturity date would, in fact, be inequitable because: 1) during that time, ResCap was current on the loan and Citibank was entitled to recover its costs, fees and expenses; and 2) bankruptcy policy should not penalize a debtor for filing by awarding default interest when the only default was the filing itself. Once the debtors defaulted by failing to pay Citibank at the maturity date, however, Citibank became entitled to recover post-petition interest at the contract default rate. Bottom line: Citibank received interest at the non-default rate for the 16 days from the petition date to the final maturity date and thereafter at the default rate.

Lessons Learned?

Another round in the battle for post-petition interest for over-secured creditors under section 506(b) is in the books, with Citibank laughing all the way to, well, itself. And unless and until Congress decides to amend section 506(b) to include a specific interest rate, this battle will continue. The important takeaways from this latest decision, at least in the Second Circuit, are as follows: 1) the rebuttable presumption that the contract default rate applies is alive and well; 2) the rebuttable presumption can be adjusted based upon equitable considerations; 3) courts will balance the equities to determine the appropriate interest rate by considering the totality of the circumstances; and 4) Judge Glenn declined to adopt a bright-line rule refusing to enforce contract default interest for over-secured creditors of insolvent debtors. Now, if you come across this issue in the future, just remember: “rebuttable presumption, equitable considerations, and a balancing of the equities ' rebuttable presumption, equitable considerations, and a balancing of the equities.”

Steven B. Smith is counsel in the Financial Restructuring & Bankruptcy practice of Dickstein Shapiro LLP in New York. A member of this newsletter's Board of Editors, he focuses on complex corporate restructuring and creditors' rights. Shaya M. Berger is a New York-based associate in the Financial Restructuring & Bankruptcy practice. They may be reached at [email protected] and [email protected], respectively.

“A loaf of bread, a container of milk, and a stick of butter.” This Sesame Street sound bite, lodged in the deepest recesses of our brains, to be sure, came to mind after reviewing the recent decision rendered by Judge Martin Glenn of the U.S. Bankruptcy Court for the Southern District of New York in the Chapter 11 cases of Residential Capital, LLC (ResCap) on the oft-disputed issue of the appropriate interest rate calculation under Section 506(b) of the Bankruptcy Code. We heard in our minds Judge Glenn repeating, over and over, “rebuttable presumption, equitable considerations, and a balancing of the equities.”

We all know what the issue is. Section 506(b) of the Bankruptcy Code provides that over-secured creditors are entitled to receive post-petition interest, but it does not tell us what interest rate should be applied. Aye, there's the rub. Indeed, Congress' failure to provide the appropriate interest rate has triggered numerous disputes in many different jurisdictions as to whether: 1) the appropriate rate should be the contract rate, the Federal judgment rate, or some other rate altogether; and 2) regardless of which rate is selected, will the award of post-petition interest harm other creditors? This article explores the specific facts and circumstances that Judge Glenn considered and ultimately relied upon when deciding to rule in favor of Citibank, playing the role of secured creditor in the case, granting, for the most part, its request to receive post-petition interest at the default rate governed by its contract.

The ResCap Facts

Prior to the commencement of the Chapter 11 cases on May 14, 2012, GMAC Mortgage, LLC entered into a $700 million revolving credit facility with Citibank (the Citibank Facility), with ResCap signing on as a guarantor. The Citibank Facility initially had a maturity date of Aug. 31, 2010, but, as a result of 10 separate facility amendments, was extended until May 30, 2012. The Citibank Facility established a non-default interest rate of LIBOR plus 6%, which was later increased to LIBOR plus 8.5% as part of the tenth amendment. Two provisions, among others, remained constant throughout each of the facility amendments: 1) the default rate always added 4% to the non-default rate; and 2) the commencement of a bankruptcy case always constituted an event of default.

Subsequent to the ResCap petition date, which, as noted, constituted an event of default, the bankruptcy court entered a final cash collateral order which confirmed that Citibank was over-secured and therefore entitled to interest and fees. The failure to repay Citibank on the May 30, 2012 maturity date, just 16 days after the petition date, resulted in a second event of default.

In January 2013, ResCap closed on the sale of its mortgage origination and servicing platform to Ocwen Loan Servicing LLC and Walter Investment Management Corp., and at that point repaid Citibank $152 million, the full amount of the outstanding principal, plus interest at the contractual non-default rate. Citibank, however, argued that it was entitled to accrued interest at the contract default rate. According to Citibank, the differential between the non-default interest which it received and the default interest it claimed was $4.5 million. The dispute was preserved until the post-effective date of the plan.

Section 506(b) and the Rebuttable Presumption

As noted, section 506(b) governs the provision of interest to over-secured creditors, and provides, in pertinent part, as follows:

to the extent that an allowed secured claim is secured by property the value of which ' is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim , and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.

11 U.S.C. ' 506(b) (emphasis added).

Because 506(b) is silent regarding the appropriate interest rate calculation, courts in the Second Circuit have applied a rebuttable presumption that the contract default rate applies. In other words, courts are to presume that the contract interest rate applies post-petition and a debtor bears the burden of rebutting that presumption. Relying upon this rebuttable presumption, as well as the U.S. Supreme Court's holding in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. , 549 U.S. 443 (2007) ' i.e. , a creditor's rights in bankruptcy derive from the substantive law creating those rights subject to qualifying or contrary provisions of the Bankruptcy Code ' Citibank, not surprisingly, argued in favor of applying the contract default rate it would have been entitled to receive had ResCap defaulted outside of bankruptcy. The ResCap Liquidating Trust took a different position, arguing that the Travelers decision was not controlling because: 1) post- Travelers courts have denied post-petition interest at the contract default rate on equitable grounds; and 2) the rebuttable presumption applied in the Second Circuit was in fact subject to such considerations.

Equitable Considerations Could Adjust the Rebuttable Presumption

In the wake of the Travelers decision, a number of courts, including some in the Second Circuit, have concluded that the rebuttable presumption is subject to certain equitable considerations embodied in section 506(b) which, under appropriate circumstances, could support disallowance of the requested default interest rate. Those equitable considerations include, among others: 1) where the secured creditor is guilty of misconduct; 2) where the application of the contractual interest rate would harm the unsecured creditors; 3) where the application of the contractual interest rate would impair the debtor's fresh start; or 4) where the contractual interest rate constitutes a penalty. See In re 785 Partners LLC , 470 B.R. 126, 134 (Bankr. S.D.N.Y. 2012).

Hanging its hat on these post- Travelers decisions, the Trust advanced the following two arguments in support of its proposition that application of the contract default interest rate would be inequitable: 1) application of the contract default interest rate would harm unsecured creditors; and 2) Citibank was adequately protected and compensated both pre- and post-petition. Both of these arguments ultimately failed, and we discuss each one in turn below.

Potential Harm to Unsecured Creditors

The Trust's primary objection focused on whether unsecured creditors would be harmed by an award of the contract rate because ResCap was insolvent, noting that no Second Circuit cases involving insolvent debtors have awarded over-secured creditors contractual default interest. When addressing this threshold question, the bankruptcy court acknowledged that consideration of a debtor's solvency is important in deciding whether to apply the contract default rate, but it also noted that solvency is not the determinative factor, that no court has adopted a bright-line rule ' and the bankruptcy court refused to adopt such a rule ' and that the contract default rate should be refused in all insolvent debtor cases.

As the court noted in In re Madison 92nd St. Assocs. LLC, 472 B.R. 189, 200 (Bankr. S.D.N.Y. 2012), “most [C]hapter 11 cases involve insolvent debtors, and such an exception would swallow up the rule that the over-secured creditor is presumptively entitled to the 'contract rate.'” The question that must be asked whenever this issue arises is straightforward: Does the balance of equities favor awarding contract default interest?

Judge Glenn's answer to the balance of equities question in ResCap was yes, Citibank was entitled to contract default interest, except for the 16-day period between the petition date and the final maturity date, and this is why. The harm to unsecured creditors was not inequitable when viewed in the context of the distributable asset pool. Let's take a step back and look at the arguments advanced by each of the parties.

The Trust argued very simply that awarding Citibank the contractual default interest rate would diminish unsecured creditor recoveries dollar for dollar. Citibank argued in opposition that the rate would only have a miniscule impact on unsecured creditor recoveries, as such creditors were recovering from a $2.5 billion pool. The court, however, took its analysis up to 10,000 feet in order to view the totality of the circumstances. From that elevated perspective, the court viewed the tenth and last amendment to the Citibank Facility ' negotiated and executed by sophisticated parties in the weeks leading up to, and certainly in contemplation of, the bankruptcy filing ' as one essential piece of ResCap's complicated post-petition financing package.

When viewed in that light, the bankruptcy court questioned whether unsecured creditor recoveries were in fact diminished from what they would have been if ResCap had been forced to liquidate immediately after the commencement of the Chapter 11 cases, considering the absence of sufficient DIP financing. In other words, it was easy for the Trust to argue that every additional dollar that went to Citibank meant one less dollar available for unsecured creditors.

But the reality, at least as Judge Glenn perceived it, was that all creditors benefited from ResCap's continuing to operate post-petition as a going concern. Although he rejected Citibank's “miniscule” argument, Judge Glenn did ultimately conclude that awarding the contract interest rate would diminish the distributable asset pool by approximately two-tenths of a percent. Balancing the equities, the court concluded that such a reduction was not sufficient to overcome the rebuttable presumption.

The Rebuttable Presumption Prevailed over Other Equitable Factors

In addition to the equitable factors considered above, the Trust raised the following three equitable factors unique to the specific facts of the case: 1) Citibank received adequate protection post-petition in the form of timely interest payments at the non-default rate; 2) repayment of the amounts due under the Citibank Facility was never at risk because stalking-horse contracts were executed pre-petition; and 3) Citibank's exposure to any super-priority claims was minimized due to ResCap's agreement to lower the commitment amount and its pre-petition $124 million pay down of the Citibank Facility.

While the bankruptcy court acknowledged and accepted as undisputed facts each of the foregoing factors, it also concluded that the contract default rate was a feature of the deal ResCap specifically agreed to in the context of negotiations with many sophisticated parties ' and which ultimately benefited the unsecured creditors because it allowed ResCap to, quoting Judge Glenn, “proceed into bankruptcy with a semblance of order.”

The Trust's “Hail Mary” argument finally gave Judge Glenn an opportunity to limit, albeit slightly, Citibank's request for contract default interest. The Trust argued that the only default under the Citibank Facility during the 16-day period from the petition date to the final maturity date was the technical default of the filing of the bankruptcy, which, by itself, did not prejudice Citibank because it received an adequate protection package.

Balancing the equities once again, Judge Glenn agreed with the Trust, determining that awarding Citibank the contract default rate during the 16-day period from the petition date to the maturity date would, in fact, be inequitable because: 1) during that time, ResCap was current on the loan and Citibank was entitled to recover its costs, fees and expenses; and 2) bankruptcy policy should not penalize a debtor for filing by awarding default interest when the only default was the filing itself. Once the debtors defaulted by failing to pay Citibank at the maturity date, however, Citibank became entitled to recover post-petition interest at the contract default rate. Bottom line: Citibank received interest at the non-default rate for the 16 days from the petition date to the final maturity date and thereafter at the default rate.

Lessons Learned?

Another round in the battle for post-petition interest for over-secured creditors under section 506(b) is in the books, with Citibank laughing all the way to, well, itself. And unless and until Congress decides to amend section 506(b) to include a specific interest rate, this battle will continue. The important takeaways from this latest decision, at least in the Second Circuit, are as follows: 1) the rebuttable presumption that the contract default rate applies is alive and well; 2) the rebuttable presumption can be adjusted based upon equitable considerations; 3) courts will balance the equities to determine the appropriate interest rate by considering the totality of the circumstances; and 4) Judge Glenn declined to adopt a bright-line rule refusing to enforce contract default interest for over-secured creditors of insolvent debtors. Now, if you come across this issue in the future, just remember: “rebuttable presumption, equitable considerations, and a balancing of the equities ' rebuttable presumption, equitable considerations, and a balancing of the equities.”

Steven B. Smith is counsel in the Financial Restructuring & Bankruptcy practice of Dickstein Shapiro LLP in New York. A member of this newsletter's Board of Editors, he focuses on complex corporate restructuring and creditors' rights. Shaya M. Berger is a New York-based associate in the Financial Restructuring & Bankruptcy practice. They may be reached at [email protected] and [email protected], respectively.