• Borrower's Bankruptcy Defeats Default Interest
  • July 29, 2003 | Author: Harris Ominsky
  • Law Firm: Blank Rome LLP - Philadelphia Office
  • A recent case in California shows how a borrower can use the Bankruptcy Code to avoid $1 million in default interest. In re: Sylmar Plaza, L. P.; Platinum Capital, Inc. v Sylmar Plaza, L. P., 2002 U.S. App. LEXIS 27123 (9th Cir. December 30, 2002). The Ninth Circuit Court of Appeals upheld the conformation of Sylmar Plaza's Chapter 11 reorganization plan that had been filed for the sole purpose of avoiding approximately $1 million of default interest due on the debtor's mortgage.

    The dispute arose over a mortgage loan of approximately $8 million secured by the Sylmar Plaza Shopping Center that carried an interest rate of 8.87% and a default interest rate of 5% more (13.87%). When the borrower encountered cash flow problems, it made its last payment on the loan, allowed taxes to become delinquent and then, in violation of the loan, it transferred the shopping center to a new limited partnership. The lender then foreclosed in state court and the day after that court issued its Statement of Intended Decision in favor of the lender, the borrower filed for bankruptcy.

    $1 Million Saved

    The bankruptcy court permitted the Sylmar Plaza to be sold for approximately $7 million free and clear of the mortgage lien, even though the lender claimed that its lien then exceeded $10 million. Because the lender did not appeal the sale order, its claim was bifurcated into a secured claim measured by the net proceeds of the sale and an unsecured claim for the balance.

    The confirmed plan of reorganization provided for payment of both the lender's secured claim and its unsecured claim in full (at 8.87% interest) on the effective date of the plan. The court explained how this plan cured the default:

    The procedural significance of this treatment was that Platinum's claims would not be "impaired" under the plan and it would, therefore, not be entitled to reject the plan or receive "cram down" protections, including protection against "unfair discrimination" under 11 U.S.C. Section 1129(b). The financial significance was to effect a "cure" of the default so that all interest, including post-petition interest, would be calculated at the 8.87% non-default rate, rather than the 13.87% default rate. The difference in accrued interest calculated between the two rates amounts to approximately $1 million. All other unsecured claims were to be paid 10% interest retroactive to the filing date of the bankruptcy case.

    Plan in "Good Faith"

    As expected, the lender objected to the confirmation contending that the plan had not been "proposed in good faith" as required under the Bankruptcy Code, and it made two arguments. First, it contended that the various classes of claims proposed under the entire plan was conceived as a "sham" that had no material economic impact other than to deprive the mortgage lender of the $1 million in default interest. Second, it argued that paying all other unsecured classes 10% post-petition interest, while it would receive only 8.87% post-petition interest, was so unfairly discriminatory as to cast doubt on the plan's "good faith."

    According to the court, the original borrowers on the loan, the Hornwoods, had a diverse real estate portfolio worth more than $55 million in which they had a net equity exceeding $15 million. In support of its argument that the plan lacks good faith, the lender argued that the plan leaves the Hornwoods solvent while permitting them to avoid paying post-petition interest at the default interest rate.

    The circuit court pointed out that the Bankruptcy Code does not define "good faith" and that even insolvency is not a prerequisite to a finding of good faith under Section 1129(a). It held that an adverse effect on a creditor's contractual rights "does not by itself warrant a bad faith finding." Also, in enacting the Bankruptcy Code, Congress determined that debtors should have the opportunity to avail themselves of the number of Code provisions that adversely alter creditors' contractual and nonbankruptcy rights. Therefore, it is not bad faith to take advantage of a particular provision of the Code for the purpose of capping the amount of a creditor's claim. It cited earlier precedents that one of the powers to cure defaults under the Bankruptcy Code is the power to avoid default penalties such as higher interest.

    The circuit court also determined that the bankruptcy courts should determine a debtor's good faith on a "case-by-case basis," taking into account the particular features of each plan. Therefore, it rejected the lender's argument that the court should apply a "per se rule" which would automatically find bad faith under these circumstances. It also rejected the lender's argument that it would be receiving only 8.87% on its mortgage, while other unsecured creditors would be getting 10%. It held that as an "unimpaired creditor," the lender had no standing to complain of discrimination, because under Section 1126(f) the lender is "conclusively presumed to have accepted the plan." Apparently, the failure of the plan to include $1 million of default interest was not considered an "impairment" of the lender.

    Deference to Bankruptcy Court

    The decision is not surprising based on the cited precedent which grants bankruptcy courts wide discretion in deciding whether a particular reorganization plan is filed in good faith. The circuit court here showed its deference to the bankruptcy court's finding on this issue.

    However, some will be disturbed by the appearance that the borrower here "got away" with something. The case highlights a legal system in which a wealthy business entity, presumably represented and advised by lawyers and financial consultants, borrows millions of dollars and agrees to various terms for paying back the loan that may be disregarded by a court. Under this case, a borrower can violate a due-on-transfer clause in a mortgage and transfer the property to another entity which then files for bankruptcy. In that way the original borrower can avoid some of the negative publicity and the stigma of going into bankruptcy itself.

    Also, by this tactic, a borrower used bankruptcy as a tool, solely to avoid $1 million in default interest it would have been obligated to pay under a state court foreclosure proceeding, and all of this was done in the face of that decision pursuant to a bankruptcy petition filed only one day after the state court had acted. Moreover, under the circumstances the unsecured creditors are entitled to receive interest at the rate of 10%, which is more than the mortgage lender is now entitled to receive under this decision.