What Constitutes the ‘Legal Rate’ in a Solvent Debtor Bankruptcy Case?

Defining the Legal Rate in a Solvent Debtor Bankruptcy Using Contract Rate and States’ Statutory Rates of Interest

Chapter 11 bankruptcies generally find the debtor insolvent, but not always.

Occasionally, a debtor will emerge from the bankruptcy process as a solvent entity. In those situations, Bankruptcy Code §726(a)(5) may entitle creditors of the debtor’s estate to post-petition interest at the legal rate from the date of filing the petition. [i]

In other words, the Bankruptcy Code affords creditors an opportunity to recoup the time-value for the lost use of the debtor’s assets.

Significantly, the ‘legal rate’ is undefined by the Bankruptcy Code and its legislative history. Accordingly, the courts have been forced to supply meaning to this nebulous term. Fortunately, the judiciary was not writing on a blank slate — analogous provisions contained elsewhere in the US Code provided valuable guidance.

Practically speaking, most courts embrace the statutory post-judgment interest rate contained in 28 U.S.C. § 1961(a) as supplying the ‘legal rate’ for post-petition interest. [ii]   But, it is not the sole rule; there are other arguments to be offered.

On its face, Section 1961(a) explicitly defines post-judgment interest rates, stating that “[s]uch interest shall be calculated from the date of the entry of the judgment, at a rate equal to the weekly average 1-year constant maturity Treasury yield, as published by the Board of Governors of the Federal Reserve System, for the calendar week preceding the date of the judgment.”

The Statutory Post-Judgment Interest Rate Is Typically Low

During periods of low inflation and low interest rates, the federal statutory interest rate is a relative pittance.  To put things in context, prior to 2022, the 1-year Treasury rate hovered under 3% for over a decade. The Financial Forecast Center projects that the rate will fall below 3% to a yield of 2.85% by February 2025, and may fall below 1% by June of that year. If this holds, the rate is unlikely to be sufficient from a creditor’s vantage point.

Against this backdrop, an unsecured creditor has an economic incentive to advance alternative definitions for ‘legal rate’ if they can obtain a return greater than the federal post-judgment rate.

Arguing That Contract Rate = Legal Rate

To effect this outcome, unsecured creditors have argued that the ‘legal rate’ incorporates the pertinent contractual rate of interest that would otherwise have governed the relationship between the debtor and its creditor. [iii] Indeed, this may even translate to interest being calculated at a contractual default rate.

As one court explained, “When a debtor is a solvent, then the presumption is that a bankruptcy court’s role is merely to enforce the contractual rights of the parties, and the role that equitable principles play in the allocation of competing interest is significantly reduced.” [iv]

This once-minority view has gained considerable traction in recent years and has now been embraced by the majority of circuit courts.

Arguments Against Contract Rate = Legal Rate

To be sure, the contractual argument has run into legal headwinds and been rejected on at least three separate grounds.

• First, there is the language of the statute. By its terms, “section 726(a)(5) states that interest on unsecured claims shall be paid at the legal rate as opposed to a legal rate or the contract rate.” [v]
• Second, “the payment of post-judgment interest is procedural by nature and dictated by federal law rather than state law.” [vi]
• Third, “the use of the federal judgment rate promotes two important bankruptcy goals: fairness among creditors and administrative efficiency.” [vii]

Another Argument: Looking to States’ Statutory Rates of Interest

That said, another conceivable ‘legal rate’ of interest might be the statutory rate of interest codified in state laws. For example, Section 5004 of New York’s Civil Practice Law & Rules contains a 9% statutory interest rate. That approach, however, looms as potentially more problematic than the contractual model for determining the legal rate as it lacks textual basis. Indeed, during a period of record low federal post-judgment interest rates, turning to state legal rates would confer an unintended and unimagined windfall to an unsecured creditor.

An Undefined Definition

Although the issue of what constitutes the ‘legal rate’ in a solvent debtor bankruptcy case remains unresolved, most bankruptcy courts, including those in Delaware and New York, look to the federal post-judgment interest rate as a definitional source. Attempts to go beyond 28 U.S.C. § 1961(a) suffer from being at odds with the plain text of Section 726(a) of the Bankruptcy Code and the primacy of federal law in bankruptcy cases.

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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

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This is an updated version of an article originally published on July 15, 2019 and previously updated March 11, 2021 and  February 22, 2022.]

©2024. DailyDAC^TM, LLC. This article is subject to the disclaimers found here.

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References

[i] In re Washington Mut., Inc.,442 B.R. 314, 356 (Bankr. D. Del. 2011).

[ii] In re Washington Mut., Inc., 461 B.R. 200, 241-43 (Bankr. D. Del. 2011), vacated in part, No. 08-12229 (MFW), 2012 WL 1563880 (Bankr. D. Del. Feb. 24, 2012); Onink v. Cardelucci (In re Cardelucci), 285 F.3d 1231, 1234-36 (9th Cir. 2002), cert. denied, 537 U.S. 1072, 123 S. Ct. 663 (2002); In re Energy Future Holdings Corp., 540 B.R. 109, 113-14 (Bankr. D. Del. 2015).

[iii]  See, e.g., In re Dow Corning Corp., 456 F.3d 668 (6th Cir. 2006)

[iv] Id. at 679; In re Dvorkin Holdings, LLC, 547 B.R. 880, 891-92 (Bankr. N.D. Ill. 2016).

[v] Washington Mut., 461 B.R. at 242 (internal quotation marks omitted).

[vi] Id. at 242-43.

[vii] Id. at 243.