Collection of Default Interest Upheld Under Bankruptcy Code
 
October 21, 2008
 
Robert Harig - Chicago

General Electric Capital Corporation (GECC) and Future Media Productions Inc. entered into a Loan and Security Agreement dated August 13, 2004. The loan agreement provided for a $10.5 million term loan as well as a $5 million revolving line of credit from GECC to Future Media. Interest accrued on the loans at GECC’s index rate plus 1.5 percent per annum, with interest after default accruing at 2 percent in excess of the pre-default rate. The loans made under the loan agreement were secured by a perfected
first priority security interest in substantially all of Future Media’s assets.

Future Media initially defaulted on the loans from GECC in March of 2005. After additional defaults, Future Media concluded that an orderly liquidation of its assets would be in its best interest and, on February 14, 2006, filed a petition for relief under Chapter 11 of the
Bankruptcy Code.

After the filing of its Chapter 11 petition, Future Media needed cash to wind down its business and sell its assets. GECC was in an over-secured position and agreed to Future Media’s use of GECC’s cash collateral in order to proceed with an asset sale under Section 363 of the Bankruptcy Code, subject to the terms and provisions of a stipulation mutually agreed and executed by GECC and Future Media on February 15, 2006. In the stipulation, Future Media represented that it had entered into an agreement for an auction of its assets that was guaranteed to produce at least $7.6 million in net proceeds, consented to the total amount of its outstanding GECC debt obligation and agreed that it would not assert any defense of any kind to the obligation. Future Media filed a motion in the bankruptcy court requesting approval of the stipulation and the bankruptcy court provisionally approved it on February 21, 2006.

An Official Committee of Unsecured Creditors was formed in the Chapter 11 case and on March 2, 2006, the Committee objected to the stipulation. Following the execution of an amended stipulation by GECC and Future Media, the Committee withdrew its objection, with the issue of whether GECC was entitled to receive interest payments at the default rate to be litigated separately.

The final cash collateral order was entered by the bankruptcy court on May 4, 2006, and GECC was paid $5,728,584.20 which represented the amount owed for unpaid principal, loan fees, reimbursable expenses and interest as provided under the loan agreement. It included default interest that had accrued since the initial default by Future Media.

On August 28, 2006, the Committee filed a motion in the bankruptcy court requesting a determination of the interest rate applicable to GECC’s secured claim and asserting that GECC should return the amount it had collected in excess of the pre-default rate, a differential in the amount of $164,995. On November 15, 2006, the bankruptcy court ruled that GECC was entitled to interest only at the pre-default rate pursuant to the Ninth Circuit’s holding in In re Entz-White Lumber and Supply, Inc., 850 F.2d 1338 (9th Cir. 1988) and ordered GECC to return the default rate differential. GECC appealed the bankruptcy court’s ruling to the Ninth Circuit for the United States Court of Appeals.

The decision of the Ninth Circuit is dated August 7, 2008. See, General Electric Capital Corporation v. Future Media Productions Inc., 536 F.3d 969 (9th Cir.2008).

The Court began by citing the U.S. Supreme Court’s statement that “creditors entitlements in bankruptcy arise from the underlying substantive law creating the debtor’s obligation, subject to any qualifying or contrary provisions of the Bankruptcy Code.” Travelers Cas. & Sur. Co. of Am. V. Pac. Gas & Elec. Co., 127 S.Ct. 1199, 1204-05 (2007). It stated that it read Travelers to mean that the default rate should be enforced in conformity with the substantive law governing the loan agreement, unless a provision of the Bankruptcy Code provides otherwise.

The Court observed that in Entz-White it had, in fact, identified such a “qualifying or contrary provision” of the Bankruptcy Code. In that case, the issue of the debtor’s proposed treatment of the oversecured creditor’s claim was presented in the context of a Chapter 11 plan. The Court noted that the provision allowing “cures” under Chapter 11 authorized a plan to nullify all consequences of default, including default penalties such as default interest. Therefore, the Court permitted the debtor in Entz-White to nullify the interest owed at the default rate because the Code allows the debtor to “cure” defaults under a Chapter 11 plan.

The Ninth Circuit, however, distinguished the GECC/Future Media fact pattern from that of Entz-White in that there was never any question of whether Future Media needed to cure a default to render it unimpaired for voting on a Chapter 11 plan. Instead, GECC’s oversecured claim was paid through a sale of assets governed by Section 363 of the Bankruptcy Code, which is outside the context of a Chapter 11 plan. The Court thus held that the rule of Entz-White was inapplicable and remanded the case to allow the bankruptcy court to determine whether any applicable non-bankruptcy substantive law prevented the enforcement of the default rate of interest under the loan agreement.

What’s the Point?

The decision in GECC v. Future Media Productions is correct. Since the concept of a cure of default is not present in a sale of assets under the Bankruptcy Code outside of a Chapter 11 plan, the default rate of interest provisions contained in a prepetition contract should be allowed and enforced.

For more information, contact:

Robert E. Harig
312.578.6699
robert.harig@hklaw.com
toll free: 1.888.688.8500