The United States Court of Appeals for the First Circuit rendered an important decision regarding the long-running bankruptcy case of SW Boston Hotel Venture, the developer of the W Boston Hotel.
Four years ago, in April 2010, SW failed to make a mandatory quarterly payment to its senior secured creditor, the Prudential Insurance Company of America ("Prudential"). Shortly thereafter, SW and certain affiliates sought chapter 11 protection in the United States Bankruptcy Court for the District of Massachusetts. In addition to its obligations to Prudential under a $192.2 million construction loan agreement, SW also was obligated to The City of Boston under a $10.5 million loan secured by a junior lien on most of the assets securing the Prudential loan.
The W project, located in Boston's Theater District, consists of a 235-room hotel, 123 luxury condominium units, an underground parking garage, a restaurant, a spa and related retail space and a bar. The hotel opened in October 2009, but the sale of the luxury condominiums was hit hard by the recession and did not keep pace with terms of the January 2008 Prudential loan agreement. In addition as of April 2010, construction of the restaurant, spa, and bar had not been completed, and SW lacked sufficient funding to complete such items.
Shortly after SW filed for chapter 11 relief, Prudential sought relief from the automatic stay to seek to foreclose on its collateral. After lengthy hearings, the Bankruptcy Court denied Prudential such relief concluding that Prudential was "adequately protected" by its entire collateral package and that the value of Prudential's secured claim was not declining. While the legal wrangling played out in Bankruptcy Court, SW continued construction, selling additional units and paying over a portion of proceeds to Prudential. In addition, approximately one year into the case, in the Spring of 2011, SW obtained Bankruptcy Court approval of a sale of the hotel and garage to a third party for $89.5 million. Approximately $88.3 million was paid over to Prudential as a result of that sale.
SW then filed a proposed chapter 11 reorganization plan which provided, among other things, for Prudential to be paid the remaining portion of its claim but without any provision for the payment of interest during the period after the petition date and before the effective date of the confirmed plan. Prudential objected to that proposed treatment and numerous other issues.
Accordingly, Prudential filed a motion in April 2011 seeking a determination that it was oversecured and thus entitled to postpetition interest and that such interest should be paid at the contractual default rate of 14.5%. SW argued that the Prudential became oversecured only upon the hotel sale and thus could only receive postpetition interest starting on that date – not the date of the chapter 11 petition. Further, SW argued that any postpetition interest should accrue at the contractual non-default rate of 9.5%.
The Bankruptcy Court agreed with SW as to the timing question – ruling in the Fall of 2011 that Prudential was only entitled to post-petition interest from the time of the hotel sale in the Spring of 2011 and not at any earlier point. However, the Bankruptcy Court sided with Prudential on the calculation question – ruling that Prudential was entitled to post-petition interest at the default rate of 14.5%. The Bankruptcy Court subsequently confirmed SW's proposed chapter 11 plan over the objection of Prudential.
Prudential appealed to the Bankruptcy Appellate Panel which reversed the Bankruptcy Court on the timing issue -- determining that Prudential was entitled to post-petition interest from the chapter 11 petition date. The BAP affirmed on the calculation issue – agreeing with the Bankruptcy Court that the proper rate to apply was the contractual default rate of 14.5%. However, unlike the Bankruptcy Court which ordered that such rate was not compounding, the BAP ruled that the interest should in fact compound.
Section 506(b) of the Bankruptcy Code allows a secured creditor to collect postpetition interest if the value of its collateral is worth more than the amount of its secured claim. Specifically, the secured creditor can collect post-petition interest on its claim up to the amount of the difference. The First Circuit noted that SW and Prudential agreed that Prudential was oversecured for at least a portion of the postpetition period but the parties differed on when Prudential became oversecured and the rate at which interest was required to be calculated.
No provision of the Bankruptcy Code specifies how a Court should determine the exact date on which an oversecured party should be entitled to collect postpetition interest. SW argued that Prudential became oversecured only at the time of the Spring 2011 hotel sale. Prudential argued that it was oversecured from the date of the chapter 11 petition. The Bankruptcy Court sided with SW but the Bankruptcy Appellate Panel reversed that order and adopted Prudential's view. The First Circuit was thus confronted with two completely divergent views of a question with multimillion dollar consequences.
The First Circuit began its analysis by noting that courts have split on the timing issue with some courts adopting a "single valuation" approach (such as the petition date) with others utilizing a "flexible approach" affording a bankruptcy court discretion to set a date depending on the circumstances of the case. After evaluating the two approaches, the First Circuit concluded that "We agree with the bankruptcy court and the BAP that, at least in the circumstances presented here, a bankruptcy court may, in its discretion, adopt a flexible approach." Further, the First Circuit determined that in applying such an approach to the particular facts, the Bankruptcy Court did not commit clear error in its factual determination and that the Bankruptcy Court's consideration of all the relevant facts – including the improvements to the project during the chapter 11 case -- was well founded. Accordingly, the First Circuit reversed the BAP decision and upheld the Bankruptcy Court decision which granted Prudential postpetition interest only from the date of the hotel sale.
2. Calculation Methodology
Just as the Bankruptcy Code does not dictate when postpetition interest must begin to be paid to an oversecured creditor, neither does the Code set forth how that interest is to be calculated. The First Circuit decision expresses agreement with the general approach used nationally: although the appropriate rate is within the limited discretion of the bankruptcy court, contractual interest rate terms should presumptively apply so long as they are enforceable and equitable considerations do not dictate otherwise.
Applying that general approach to the facts in the SW case, the First Circuit held that both the Bankruptcy Court and the BAP correctly concluded that the default rate was permissible under Massachusetts law and federal bankruptcy law and such rate was not unenforceable on any equitable grounds. The First Circuit did reverse the BAP on the compounding question, ruling that the Bankruptcy Court order refusing compounding should be allowed to stand. Although Prudential's loan agreement explicitly provided for compounding, the First Circuit held that the Bankruptcy Court did not abuse its discretion (or commit clear error) in refusing to allow compounding when Prudential did not request compounding until after the Bankruptcy Court issued its ruling on the interest calculation question. The First Circuit observed: "Prudential cannot claim entitlement to compounding where it -- whether by inadvertence or in an attempt to sandbag the Debtors and mislead the bankruptcy court we cannot say -- did not seek compound interest until after the bankruptcy court granted it post-petition interest at the default rate running from the hotel sale date."
The First Circuit's opinion is noteworthy for its detailed discussion of the issues impacting a secured lender arising from the financing of a significant real estate development. The underlying fact pattern was atypical as collateral values appreciated during the pendency of the case which oftentimes is not the case. Prior to the bankruptcy filing in 2010, the parties engaged in discussions about the lending relationship which broke down. After the developer sought Chapter 11 relief, the lender was unable to convince the Bankruptcy Court to grant relief from stay to allow the lender to commence foreclosure. Instead, the developer continued developing the project and ultimately paid the lender a substantial portion of its claim through a sale transaction. The developer sought to pay the balance of the claim under a chapter 11 plan but without the postpetition interest calculated at a rate that the lender believed it was entitled to receive.
The litigation leading to the First Circuit decision reveals the uncertainty that can exist in any bankruptcy context. On certain fundamental points involving the timing and calculation of interest, the law affords flexibility and a certain degree of discretion to the judge presiding over the bankruptcy case. Parties that are unable to reach a mutually agreeable resolution will be left to litigate their positions which can take years and produce a trail of sometimes conflicting court decisions. Sometimes, the dollars involved are so large – and the differences between the parties so widespread -- that it is incumbent on the parties involved to press their points judicially. In other situations, the parties would be well served to take into full consideration the time, expense and uncertainty of litigation in formulating their negotiating strategy and desired outcomes. Lenders and borrowers will both want to understand the First Circuit's decision as a critical guidepost in setting reasonable expectations in negotiations involving distressed commercial loans going forward.