Authored Articles & Publications Sep 05, 2017

Best in Law: Which Interest Rate Applies in Bankruptcy?

With Low Federal Rates, It Matters, BB&K Attorney Thomas Eastmond Writes in the Press-Enterprise

Best in Law: Which Interest Rate Applies in Bankruptcy?

By: Thomas J. Eastmond

While the question of what interest rate applies to a claim in bankruptcy might seem, at first glance, to be straightforward — it is not. Depending on the circumstances, a creditor might be entitled to no interest at all, interest at the very low federal judgment interest rate, a judgment interest rate set by state law, or even a case-specific rate set by the bankruptcy court.
 
Over the past two decades, as the Federal Reserve has adopted an extraordinarily loose monetary policy, federal interest rates have fallen to historic lows. The divergence between these low rates and state statutory judgment interest rates has made the question of which interest rates, if any, apply to bankruptcy claims, extremely relevant. With the difference between the federal judgment interest rate (0.33 percent, as of this writing) and (to take one example) the California statutory judgment rate of 10 percent making the difference between $3,300 per year versus S100,000 per year on a S1 million claim, it is no surprise that this question attracts a great deal of attention — and litigation.
 
As a general rule, under Bankruptcy Code section 502, creditors are not entitled to post-judgment interest. However, there are exceptions. One exception arises under section 506(b). Put simply, the exception says that when a creditor has a security interest in an amount greater than his or her claim, that "oversecured" creditor is entitled to interest on the claim as well as repayment of principal.
 
However, the Bankruptcy Code doesn't identify what interest rate applies under section 506(b). Some courts have used the federal interest rate, others the state rate. Still others use a similar formula to the one the United States Supreme Court used in 2004 in Till v. SCS Credit Corp., which takes the prime rate and adds to it to compensate for the specific risks associated with the debtor.
 
The consensus of the U.S. Ninth Circuit of Appeals opinion (applicable in California) uses a variant on the state-rate approach - but then proceeds to complicate it. In cases involving Chapter 11 and 13 reorganization plans (as distinct from Chapter 7 liquidations), the rate that applies, and who bears the burden of establishing its applicability, varies depending on whether the rate applies before or after the confirmation of a reorganization plan.
 
For the "pendency" period between the filing of the bankruptcy petition and the confirmation of a reorganization plan, the applicable interest rate is the "contract" rate (this includes the statutory rate on a claim based on a court judgment) - but only up to the point where that becomes sufficient to compensate the creditor for the time value of money and risk from a payment stream as opposed to immediate payment in full. The debtor has a chance to challenge the application of that rate, and may submit evidence that a lower rate than the "contract" rate is adequate to afford the creditor the full present value of its claim.
 
As for post-confirmation interest, the Ninth Circuit has held that the applicability of section 506 (b) ends at the time a plan is confirmed. After confirmation, the key requirement is the basic standard of section 1129 that requires a creditor to receive the value of its allowed claim before junior classes can receive anything, and the Supreme Court's Till approach applies.
 
Under the Till approach, a stream of payments is assigned a "prime-plus" interest rate based on the federal prime rate (currently 4.25 percent), plus an adjustment to account for the increased risk presented by a bankrupt debtor as opposed to a prime commercial borrower. The burden is on the creditors to demonstrate the appropriate risk adjustment, based on factors such as the circumstances of the estate, the nature of the security, and the duration and feasibility of the reorganization plan.
 
On the other hand if a claim is unsecured, then section 502 does not apply. However, an unsecured creditor is not necessarily prevented from recovering post-petition interest. Another exception applies under 11 U.S.C. § 726 when a debtor is solvent. This will occasionally happen in the context of a Chapter 11 or 13 reorganization, or when a case under one of those chapters has been converted to a Chapter 7 liquidation. In the 2002 case of In re Cardelucci, the Ninth Circuit ruled that where a debtor in bankruptcy is solvent, an unsecured creditor is entitled under section 726 to "payment of interest at the legal rate from the date of the filing of the petition" prior to any distribution of remaining assets to the debtor. In that case, the Ninth Circuit also ruled that the "legal rate" meant the federal rate."
 
As noted previously, that rate is 0.33 percent — not quite nothing, but barely more. While better than nothing, the difference between that rate, and the higher amounts recoverable by an oversecured creditor, reinforces the importance of timely obtaining and maintaining any appropriate security for an obligation. Conversely, the disparity in rates is a powerful motivation to debtors' counsel and bankruptcy trustees to contest or avoid any security interests they properly can.

This article first appeared in The Press-Enterprise on Sept. 3, 2017. Republished with permission.

Thomas Eastmond is no longer with BB&K. If you have questions about this issue please contact Franklin Adams at franklin.adams@bbklaw.com.

Continue Reading

Related Practices

Related Industries

Subscribe