Prepetition Default Interest — Take Nothing For Granted

by Pepper Hamilton LLP

This article was published in Law360 on May 1, 2014. © Copyright 2014, Portfolio Media, Inc., publisher of Law360.

The case is In Re Shree Mahalaxmi Inc., 503 B.R. 794 (Bankr. W.D. Tex. 2014). After a mortgage lender learned of a prepetition default during a bankruptcy, it filed an amendment to its proof of claim to add prepetition default interest. The debtor objected to both the original claim and to the addition of prepetition default interest. The court’s decision turned on interpretation of the loan documents under applicable state law.

The debtor owned a hotel, which was subject to a deed of trust in favor of the lender. At some point after the loan was made and prior to bankruptcy, the debtor placed two junior liens on the hotel in favor of a third-party bank.

Originally the lender filed a proof of claim for about $619,000. After the special servicer for the loan put the note up for auction, the auction company notified the lender of the two junior liens. In response, the lender amended its proof of claim to include prepetition default interest on the basis that the junior liens triggered a default under the loan documents. Thus, the claim was increased by about $400,000 for default interest.

The debtor argued that the loan documents required prior notice and an opportunity to cure before imposing default interest, and the note did not provide for automatic accrual of default interest. The lender argued that there was no requirement for notice and that the loan documents did not provide any grace periods for this type of default.

The court began by noting that prepetition claims for interest and fees are allowable as part of the underlying secured claim. The issue is governed by Section 502 of the Bankruptcy Code, which disallows a claim to the extent that it is for unmatured interest. (This is in contrast to the analysis under Section 506, which generally permits post-petition interest only to the extent that the lender is oversecured.)

Thus, the key question was whether the claim for default interest was matured and earned as of the date the bankruptcy was filed. It appears there was no dispute that there was a default under the loan documents. There were provisions in the loan documents prohibiting the debtor from further encumbering the collateral and from incurring additional debt (other than trade debt).

However, the court interpreted the loan documents to require a payment default to trigger default interest. In particular, the note provided (with a similar provision in the deed of trust):

Should the ... (ii) principal amount or any amount thereof, together with any other amounts due and payable hereunder, not be promptly paid on the maturity date or any earlier date when the same shall be due and payable (whether by acceleration or otherwise), then in such event, the rate of interest to be paid on the principal amount and all such other amounts shall be increased to the default rate and shall be computed from the date such amounts were initially due and payable through the date, if any, upon which such amounts are actually and fully paid. ... The foregoing provisions shall not be construed as a waiver by holder of its right to pursue any other remedies available to it under the deed of trust or any other loan document, nor shall it be construed to limit in any way the application of the default rate.

Consequently, a nonpayment default would have to trigger acceleration of the note, which in turn would constitute a payment default, in order to support the claim for default interest. However, the loan documents provided that the lender had discretion to accelerate after an event of default, so that acceleration did not automatically occur.

Thus, to trigger default interest for a nonpayment event of default, the lender first had to exercise its option to accelerate the loan. Under applicable state law, acceleration required two notices: (1) notice of intent to accelerate and (2) notice of acceleration. Since acceleration was viewed as a harsh remedy, the notices were required to be “clear and unequivocal.”

Although parties can choose to waive notice requirements, the waiver must also be clear and unequivocal. The state Supreme Court held that this means the waivers “must state specifically and separately the rights surrendered.” A waiver of “notice” or “notice of acceleration” would be sufficient to waive notice of acceleration, but not of the intent to accelerate. Similarly, a general waiver of all notices would be insufficient to specifically waive the two separate rights.

In this case, the lender obviously did not accelerate since it wasn’t even aware of the default prior to bankruptcy. So, the only way it could prevail was if the waiver provision was sufficient. The note contained a standard waiver provision, including: “Maker hereby expressly waives the right to receive any notice from holder with respect to any matter for which this note does not specifically and expressly provide for the giving of notice by holder to maker.” The court concluded that, at best, this waived the notice of acceleration, but was not sufficient to waive the notice of intent to accelerate.

The lender cited several cases to support its argument that it should be entitled to retroactively apply default interest to its claim. However, those cases were distinguishable in that the lenders had sent out a prepetition notice and/or the loan documents did not require acceleration.

The court’s summary of its decision was that the parties did not provide for automatic default interest upon occurrence of an event of default in the loan documents; and the court declined to rewrite the contracts and instead enforced the terms as agreed.

There is a tendency to assume that default interest will become due whenever there is an event of default. However, as illustrated by this case, the terms of a loan may not be that straightforward. Any time there is an issue, it is worth reviewing the details of the loan documents.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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