When Interest Rates Rise, Consider Bankruptcy Restructuring for Rate Relief

By Ava Schoen and Lauren Bernton

With the Federal Reserve raising interest rates, businesses struggling with floating rate increases and those needing to refinance may find bankruptcy reorganization an appealing alternative to high interest refinancing. Even if a company does not ultimately file Chapter 11, knowing the rate options can aid in negotiating a new deal with your present lender. But which interest rate applies for companies that choose to restructure through bankruptcy?

When a company files for bankruptcy protection, both secured and unsecured creditors can claim interest that is owed to them as of the date the bankruptcy case commenced (also called pre-petition interest) at the applicable non-bankruptcy rate. Usually, that means the creditor can claim pre-petition interest at the rate stated in the contract between the parties.

The treatment is different for interest that comes due after the bankruptcy filing (also called post-petition interest). In restructuring bankruptcies (namely, Chapter 11), the debtor will prepare a plan of reorganization that often involves continuing payments to its unsecured and secured creditors. The terms of the plan can vary widely but interest rate and length of term adjustments are commonplace.

Generally, unsecured creditors are not permitted to claim post-petition interest unless the debtor is solvent (which is not common). The Ninth Circuit Court of Appeals recently clarified in August that when a debtor is solvent, unsecured creditors whose claims are designated as unimpaired (e.g. not modified by the plan) are entitled to receive post-petition interest at the contractual or default state law rate, subject to equitable considerations. By contrast, unsecured creditors whose claims are impaired (e.g. modified by the plan) receive no interest or interest at the federal judgment rate, which is significantly less than market rates.

What may surprise potential debtors and secured creditors is how secured claims may be treated in a Chapter 11 case. As interest rates rise, businesses that cannot meet current debt obligations or successfully refinance, may find relief with Chapter 11. For example, a debtor may be able establish new terms for repaying a secured creditor – even over the objection of the secured creditor – which can include a new interest rate pursuant to a bankruptcy plan. When setting the new interest rate, courts in the Ninth Circuit apply the market rate of interest, where there exists an efficient market. When no efficient market exists, courts employ a formula approach, under which they look to the national prime rate of interest and adjust that rate upwards or downwards, as appropriate, to account for the risks of the plan’s success. The adjustment is usually an additional 1% to 3%. It is this new interest rate that a secured creditor may receive in a bankruptcy case.

In a plan of reorganization, a debtor can also extend out the maturity date of a secured creditor’s debt or decelerate a loan that came due because of a default. In some instances, this can be achieved even when the underlying debt has fully matured. Such measures, however, are subject to certain creditor protections. For example, a debtor’s bankruptcy plan must be “fair and equitable,” a secured creditor must retain a lien securing its claim to the extent of the allowed amount of its secured claim, and a secured creditor must receive deferred cash payments in compliance with statutory guidelines. Setting the appropriate interest rate, referenced above, is part of ensuring that the secured creditor’s treatment is fair and equitable.

Secured creditors often seek to recover post-petition (i.e. post-bankruptcy filing) interest and fees that accrue. Generally, secured creditors can only recover post-petition interest and fees to the extent that the value of their collateral exceeds the amount of their claim. To the extent a secured creditor’s claim (including principle or pre-petition or post-petition interest and fees) exceeds the value of the collateral, that portion of the claim is treated as an unsecured claim. As you might expect, a difference of opinion often arises with respect to the value of the collateral, the reasonableness of the secured creditor’s fees, and the risk factors impacting appropriate interest rates. Issues such as these require specific consideration on a case-by-case basis.

As interest rates rise, and we approach an uncertain economy, it’s important that businesses plan ahead and explore their financial options to best survive and one day thrive again. Pursuing Chapter 11 reorganization may give a business the breathing room it needs.

The above is general information and the particulars of each case require unique analysis. Debtors and creditors facing financial difficulties should contact Tonkon Torp or the attorney you normally work with to learn what options are most suitable for their circumstances.