Toward the start of a Chapter 11 case, a secured creditor may want to obtain an order lifting the automatic stay to enable it to enforce its state law rights and remedies. In seeking stay relief, it will often be necessary to prove that the secured creditor’s underlying collateral has a value less than the amount of the secured claim (i.e, the debtor has no equity in the collateral) and the property is not necessary for an effective reorganization. While it may be tempting to prevail on such an issue early in the case or to start telling the court the secured creditor’s side of the story, risks and repercussions should also be considered.

A decision earlier this year by the U.S. Court of Appeals for the First Circuit in the bankruptcy cases of SW Boston Hotel Venture and certain of its affiliates¹ (collectively “SW Boston”) provides an important guidepost when formulating case strategy for a secured creditor. SW Boston demonstrates the dangers of arguing the secured creditor is undersecured where it is possible. Later in the case, issues may arise concerning the secured creditor’s entitlement to post-petition interest, or the debtor may attempt to cram down (or reduce) a secured claim into the plan.

Analyze Your Opening Strategy

In April 2010, SW Boston and certain affiliates filed voluntary Chapter 11 cases.² In August 2010, Prudential, the debtor’s senior secured creditor, filed a motion to lift the automatic stay arguing it was undersecured and the debtor did not have the ability to adequately protect its liens.³ During a three-day evidentiary hearing, the secured creditor presented evidence, and the bankruptcy court found the value of the collateral — a hotel and condominiums — was less than the claim; therefore, Prudential was undersecured.⁴ The bankruptcy court ultimately denied the motion based on a finding that Prudential’s secured claim was adequately protected.3

The debtors obtained approval to sell the hotel in May 2011 with the net proceeds of the sale being paid to Prudential; the sale closed in June 2011.6 On March 31, 2011, three days after filing the sale motion, the debtors filed a plan of reorganization providing for payment in full of Prudential’s claim with post-plan effective date interest at the rate of 4.25% per annum, but without any post-petition, pre-plan effective date interest.7 Prudential objected to the plan, and in April 2011 moved for a determination asserting it was oversecured under §506(b) of the Bankruptcy Code and entitled to post-petition interest at the default rate under the applicable loan documents of 14.5% per annum.5 In opposition, the debtors argued Prudential was only oversecured upon the sale of the hotel and that interest, if any, should accrue for the period prior to plan confirmation at the non-default rate under the loan documents of 9.5% per annum.⁵

After conducting another three-day hearing, this time with respect to confirmation of the plan and the §506(b) motion, the bankruptcy court authorized the payment of interest to Prudential at 14.5% per annum commencing on the date of the sale of the hotel.5 The bankruptcy court also confirmed the plan with some modifications.⁶ After an appeal to the Bankruptcy Appellate Panel, the parties appealed to the First Circuit. In considering this appeal, the First Circuit was confronted with the issue of when a creditor is entitled to the accrual of interest during a Chapter 11 case and how the interest should be calculated.

Conflicting Rulings

Generally, creditors are not entitled to interest on pre-petition claims during bankruptcy cases. There is an exception for claims that are oversecured.⁷ Accordingly, if the collateral is worth more than the secured claim, the creditor is entitled to interest on its claim. The interest accrues until the claim is paid or until the effective date of a plan. In SW Boston, the parties agreed that Prudential was entitled to some post-petition interest, but there was disagreement on how to determine entitlement to interest under the Bankruptcy Code, when Prudential became oversecured, and the applicable rate of interest. While the entitlement to post-petition interest is governed by §506(a) of the Bankruptcy Code, the Code does not specify the time for such a determination.⁸ In cases like SW Boston where the claim has been paid down during the case while collateral values have increased, the timing choice can ultimately make the difference.

Although the First Circuit had not previously ruled on this issue, other court rulings demonstrated widely conflicting holdings. Accordingly, the First Circuit noted that:

Courts have split on the timing issue. Several have adopted a ‘single-valuation’ approach, where the determination of oversecurity for §506(b) purposes always occurs at a fixed point in time (generally either the petition date or the confirmation date). Others have adopted a flexible approach, giving the bankruptcy court discretion to determine the appropriate measuring date based on the circumstances of the case.⁹

Both the bankruptcy court and the appellate panel embraced employing a flexible approach to the timing of the valuation, but they disagreed on the evidence.¹⁰ Similarly, they concluded that the hotel sale price was an appropriate measure of value, but the appellate panel concluded that the sale price was evidence that Prudential was oversecured from the commencement of the bankruptcy cases, while the bankruptcy court found that Prudential only became oversecured upon the closing of the sale after the outstanding contingencies to the sale had been satisfied.¹¹ Judges are only human. It is hard to imagine that the bankruptcy judge — whose ruling was not overturned under the applicable clear-error standard — was not influenced by evidence presented at the three-day evidentiary hearing conducted in the cases where Prudential argued that it was undersecured.

In adopting a flexible approach to valuation and in considering the contrasting approaches of different courts, the First Circuit observed that:

…rather than yielding the fairest result, a rigid single-valuation approach guarantees an all-or-nothing result that hinges more on fortuity than reality. For example, if the petition date were the required measuring date, a creditor that first became oversecured even one day later would be allowed no post-petition interest, even though it was oversecured throughout almost the entire bankruptcy and even though it could receive substantial post-petition interest under a flexible approach. Conversely, if the confirmation date were the required measuring date, a creditor that first became oversecured just one day earlier would be allowed post-petition interest for the entirety of the bankruptcy proceeding (up to the amount of the equity cushion). We do not believe that Congress intended entitlement to post-petition interest to depend so heavily on chance. Nor do we believe that Congress intended to restrict the bankruptcy courts’ equitable discretion without explicitly saying so. The availability of a flexible approach strikes us as more likely to produce fair outcomes than allowing post-petition interest for the entire bankruptcy, or not at all, based on a rigidly defined one-shot vantage point.¹²

In applying the flexible approach to the facts, the First Circuit agreed with the bankruptcy court; Prudential had satisfied its burden in establishing it was oversecured as of the date the hotel sale closed, but not at any prior time.¹³ The First Circuit also noted and held that valuations at one point in a bankruptcy case are not binding on valuations performed at other stages.¹⁴

Endgame: A Mixed Ruling

While the First Circuit acknowledged the sale price paid is generally better evidence of value than an appraisal performed at the same time, it found this did not establish collateral values at other times, and that a one-size-fits-all valuation poorly reflects reality where the value of collateral is changing.14 In ruling that Prudential’s claim would only be treated as oversecured upon the date of the sale closing, the First Circuit — undoubtedly influenced by evidence presented at the lift stay hearing early in the case — noted Prudential’s declining claim and the collateral’s increasing value may have “crossed paths” at some point before the sale closed, but Prudential had not met its burden to establish when that occurred.¹⁵

The First Circuit then, turning its attention to the appropriate rate of interest to charge, noted the Bankruptcy Code does not directly dictate how to calculate the appropriate rate.¹⁶ Nonetheless, it embraced the established rule that contractual provisions on interest rates should be applied if enforceable and consistent with equitable considerations.¹⁶ Accordingly, the court held that interest accrued from the sale closing date at the default rate of 14.5% interest, and that under federal equitable principles, the application of that rate would not be inequitable and that the debtors had not rebutted the enforcement of the contractual provision.¹⁷

The First Circuit declined to enforce the provisions of the loan documents providing for interest to be compounded monthly. In so holding, the court noted, “Prudential cannot claim entitlement to compounding where it — whether by inadvertence or in an attempt to sandbag the debtors and mislead the bankruptcy court — did not seek compound interest until after the bankruptcy court granted its post-petition interest at the default rate running from the hotel sale date.”¹⁸ Presumably, Prudential had previously decided against making an argument based on the old adage that pigs get fatter, but hogs get slaughtered. Again, a tactical decision may have dictated this.

Lessons in Strategy

The First Circuit’s ruling in SW Boston holds many lessons. It affords bankruptcy judges with a great deal of discretion on issues that require the application of equity. Yet, a Chapter 11 bankruptcy case often provides a great deal of uncertainty on many issues critical to secured lenders. Moreover, bankruptcy litigation can be extremely expensive and time-consuming, sometimes involving two separate levels of appellate review.

Nevertheless, the First Circuit in SW Boston established a precedent that is extraordinarily useful in defining the reasonable expectations of secured creditors in bankruptcy cases. Prior to a filing, secured creditors should ensure that loan documents are crystal clear on all issues, including entitlement to interest, interest at the default rate and when interest should be compounded. After a filing, secured creditors must carefully measure their moves so that the same theme can be driven home to the court throughout the case. Of course, market factors and unexpected changes in circumstances often require a change in plans, but taking a position on value too early in a case may result in significant losses.

When circumstances change, secured creditors should adjust. If oversecured, they should consider exploiting opportunities to obtain as much post-petition interest as possible. If undersecured, they should have the stay lifted. In any case, secured creditors should be mindful that, as the facts change during the proceeding of a bankruptcy case, their legal entitlement to interest may also change. These decisions should be made while considering future ramifications and with full awareness that if a secured creditor goes for checkmate and misses there may be adverse consequences later in the case.

Richard A. Robinson is partner at Reed Smith LLP.

Footnotes:

<sup>1. The Prudential Insurance Co. of America v. SW Boston Hotel Venture LLC (In re SW Boston Hotel Venture, LLC), 748 F. 3d 393 (1st Cir. 2014)↩
2. Id. at 398 -99↩
3. Id. at 399. ↩
4. Id. at 399-400.↩
5. Id. at 400.↩
6. Id. at 401.↩
7. Id. at 403 (citations omitted).↩
8. Id. at 404-5 (citations omitted).↩
9. Id. at 405 (citations omitted).↩
10. Id. at 406.↩
11. Id. at 408-12.↩
12. Id. at 407.↩
13. Id. at 411-12.↩
14. Id. at 411.↩
15. Id. at 412.↩
16. Id. at 413.↩
17. Id. at 414-15.↩
18. Id. at 415-16.↩</sup>