Default Interest Rate Inequitable

The lender’s default interest rate was inequitable under both sections 502(b) and 506(b) where, among other factors, the lender was oversecured, ran no realistic risk of loss, and was more financially sophisticated than the debtors. In re Parker, No. 12-03128 (Bankr. E.D. N.C. Nov. 19, 2014). The debtors owned several tracts of real property that they intended to develop and sell. Upon the advice of professional financial advisors they took out loans with Georgia Capital (GCAP) to serve as a bridge loan while awaiting funding from HUD. The loan was secured by real property, and the contract had a fixed interest rate of 15%, a default rate of 25%, and a 4% late charge. In addition GCAP withheld funds from the loans to cover risk and other expenses, such that only approximately one half of the loan was actually disbursed to the debtors. A second loan with GCAP had similar contractual terms, collateral, and withholding of funds.

Ultimately, the debtors never obtained the HUD loan and GCAP foreclosed on the loans. The debtors filed chapter 11 bankruptcy and objected to GCAP’s claim to the extent that it was at the default interest rate. After a hearing, the court sustained the debtors’ objections.

The court began its analysis with section 502(b) which governs determination of the pre-petition interest rate. Under that section, once the debtor challenges a proof of claim with countervailing evidence, the presumption of validity falls away and the lender has to show, by a preponderance of the evidence, that the claim is valid. The court cited four factors to be considered: “whether: (1) the creditor faces a significant risk that the debt will not be paid; (2) the lower non-default rate of interest is the prevailing market rate; (3) the difference between the default and non-default rate is reasonable; and (4) the purpose of the default rate is to compensate the creditor for losses sustained as a result of the default or whether it is simply a disguised penalty.”

In this case a number of factors led to the court’s finding that application of the default interest rate would be inequitable: 1) the loan was oversecured and GCAP had withheld large sums from the face value of the loans, 2) the effective non-default rate (based on the amount actually disbursed to the debtor rather than the face amount of the loan) was approximately 20% (the effective default rate was 39%) and was, therefore, substantially above the market rate; (3) the differential between the non-default rate and the default rate (67%) was unreasonably large especially given that typically the differential is between 3 and 9%; (4) finally, and most important, the court found that the default interest rate was intended to coerce payment or penalize the debtors for default rather than compensate the lender for the costs resulting from default. The court was persuaded in part by the fact that GCAP compensated itself in advance by withholding funds, reserving fees and charging interest on interest. Application of the default interest rate would therefore amount to double recovery. The court was further persuaded by the disparity in financial sophistication between the parties. The debtors had no accounting or financial education and relied on third parties to guide them in financial matters.

Having found that the debtors successfully challenged the pre-petition interest rate, the court turned to the post-petition rate. Though the debtors’ burden under section 506(b) is heftier—“the  debtor bears the burden of rebutting this presumption by proving that the equities weigh in favor of its objection”—the court found that the same evidence that rebutted the creditor’s claim under section 502 sufficed to prove the inequity under section 506.

Parker Bankr ED NC opinion