ENTITLEMENT TO INTEREST UNDER THE BANKRUPTCY CODE

HeinOnline -- 12 Bankr. Dev. J. 149 (1995-1996)

ENTITLEMENT TO INTEREST UNDER THEBANKRUPTCY CODE1

by

Dean Pawlowitl'

TABLE OF CONTENTS

I. INTRODUCTION................................. 150II. PREPETITION INTEREST ....•••••••.•.•..•.•••.••.. 152

A. Entitlement to Prepetition Interest. . . . . . . . . . . . . . . . .. 152B. Rate ofPrepetition Interest. . . . . . . . . . . . . . . . . . . . . .. 153

III. PENDENCY INTEREST ........•..••••••...•.••..••. 155A. Entitlement to Pendency Interest. . . . . . . . . . . . . . . . . .. 155

1. General Rule - No Pendency Interest 1552. Exceptions............................... 156

a. Debtor Solvent . . . . . . . . . . . . . . . . . . . . . . . .. 156b. Oversecured Claims 157c. Earnings on Collateral 162

B. Rate ofPendency Interest. 1661. Debtor Solvent 1662. Oversecured claims - Section 506(b) 166

IV. PLAN INTEREST • • • . . • . . • • • • • • • • • • . • . . . • . . . . . • • •• 168A. Entitlement to Plan Interest . . . . . . . . . . . . . . . . . . . . . .. 168B. Rate ofPlan Interest 173

1. General................................. 1732. Methods for Determining Current Market Rate . . . . . .. 175

V. ARREARAGES AND 1994 ACT . . . . . . . . . . . . . . . . . . . . . . .. 178VI. CONCLUSION ••.••••••.•••••.••••.•......•...•• 182

I This article is based on a presentation delivered to the Tenth Annual Farm, Ranch andAgri-Business Bankruptcy Institute (1994).

* Professor of Law, Texas Tech University, School of Law; B.A., Creighton University,1970; M.A., Creighton University, 1972;j.D., summa cum laude, Creighton University, 1979.

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150 BANKRUPTCY DEVELOPMENTS JOURNAL

I. INTRODUCTION

[Vol. 12

In a bankruptcy case, interest is the tail of the dog, but it is along tail and it wags a lot. Since the enactment of the BankruptcyCode in 1978,2 three Supreme Court opinions,3 numerous appellateand bankruptcy court opinions, and over twenty law review artic1es4

2 Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549 (codified at 11U.S.C. §§ 101-1330), as amended lTj Bankruptcy Amendments and Federal judgeship Act of1984, Pub. L. No. 98-353, 98 Stat. 333 (codified as amended in various sections of 11 U.S.C.and 28 U.S.C.); Bankruptcy judges, United States Trustees and Family Farmer Bankruptcy Actof 1986, Pub. L. No. 99-554, 100 Stat. 3114 (codified as amended in various sections of 11U.S.C. and 28 U.S.C.); Retiree Benefits Bankruptcy Protection Act of 1988, Pub. L. No, 100334, 102 Stat. 610 (codified as amended in various sections of 11 U.S.C.); Omnibus BudgetReconciliation Act of 1990, Pub. L. No. 101-508, 104 Stat. 1388 (codified as amended in various sections of 11 U.S.C.); Criminal Victims Protection Act of 1990, Pub. L. No. 101-581, 104Stat. 2865 (codified as amended in various sections of 11 U.S.C.); Crime Control Act of 1990,Pub. L. No. 101-647, 104 Stat. 4789 (codified as amended in various sections of 11 U.S.C. and28 U.S.C.);judicial Improvements Act of 1990, Pub. L. No. 101-650. 104 Stat. 5089 (codified asamended in various sections of 11 U.S.C. and 28 U.S.C.); Treasury, Postal Service and GeneralGovernment Appropriations Act of 1990, Pub. L. No. 101-509, 104 Stat. 1389 (codified asamended in various sections of 28 U.S.C.); Department of Commerce, justice, and State, thejudiciary, and Related Agencies Appropriations Act of 1994, Pub. L. No. 103-121, 107 Stat.1153 (codified as amended in various sections of 28 U.S.C.); Violent Crime Control and LawEnforcement Act of 1994, Pub. L. No. 103-322, § 320934, 108 Stat. 1976, 2135; and BankruptcyReform Act of 1994, Pub. L. No. 103-394, 108 Stat. 3146 (codified as amended in various sections of 11 U.S.C., 18 U.S.C., and 28 U.S.C.) [hereinafter Bankruptcy Code or Code].

, Rake v. Wade, 113 S. Ct. 2187 (1993); United States v. Ron Pair Enters., Inc., 489 U.S.235 (1989); United Savings Ass'n of Texas v. Timbers of Inwood Forest Assocs., Ltd., 489 U.S.365 (1988).

• Warren E. Agin, How Lenders Can Maximize the Acaual of Pastpetition, PreconjirmationInterest in Bankruptcy Proceedings: An Analysis of the Law in Light ofthe u.s. Supreme Court s Decisionin Rake v. Wade, 13 ANN. REv. BANKING L. 325 (1994); Craig H. Averch et al., "The Right ofOversecured Creditors to Default Rates of Interest from a Debtor in Bankruptcy, 47 Bus. LAw. 961(1992); Walter J. Blum, Treatment of Interest on Debtor Obligations in Reorganizations Under theBankruptcy Code, 50 U. CHI. L. REv. 430 (1983); Paul D. Boynton, Claims ofHome Mortgage Lenders Against Chapter 13 Debtors: Should FuU Payment Indude Interest on Arrearages Repaid over Time?97 COMM. L. J. 384 (1992); C. Frank Carbiener, Present Value in Bankruptcy: The Search for anAppropriate Cramdown Discount Rate, 32 S.D. L. REv. 42 (1987); David G. Carlson, OversecuredCreditors Under Bankruptcy Code Section 506(b): The Limits ofPastpetition Interest, Attorneys' Fees, andCollection Expenses, 7 BANKR. DEY. J. 381 (1990); David G. Carlson, Pastpetition Interest Under theBankruptcy Code, 43 U. MIAMI L. REv. 577 (1989); Thomas O. Depperschmidt, Choasing the Pr0per Interest Rate in Bankruptcy Proceedings: Resolution of Special Issues in the Sixth, Eighth, and NinthCircuits, 18 N. KENT. L. REv. 457 (1991); Thomas O. Depperschmidt & Nancy H. Kratzke, TheSearch for the Proper Interest Rate Under Chapter 12 Family Farmer Bankruptcy Act, 67 N.D. L. REv.455 (1991); Thomas O. Depperschmidt & Nancy H. Kratzke, The Proper Interest Ratefor AllowedSecured Claims in Bankruptcy Proceedings: The Sixth Circuit in United States v. Arnold, 21 U. TaL. L.REv. 459 (1990); Paula A. Franzese, Secured Financings Uneasy Place in Bankruptcy: Claims for


1995] Entitlement to Interest 151

have addressed the treatment of interest under the BankruptcyCode. Even Congress was moved to join the fray, and in the Bankruptcy Reform Act of 1994 (the "1994 Act") ,5 it took aim at the Supreme Court's most recent sally.6 The purpose of this paper is toanalyze the treatment of interest under the Bankruptcy Code and toreport on the skirmishes that have shaped its borders.

Except for a qualification introduced by the 1994 Act, the rightto interest under the Bankruptcy Code is most easily viewed fromthree perspectives: (1) interest accrued prior to the filing of a petition under the Bankruptcy Code (prepetition interest), (2) interestaccrued after the filing of a petition but prior to the effective date ofa reorganization plan (pendency interest), and (3) interest to accrueunder the terms of a reorganization plan (plan interest).7 As discussed in part II, prepetition interest is allowable, generally to theextent and at the rate permitted under applicable nonbankruptcylaw. Part III explores pendency interest, which is generally not allowed, except to the extent permitted under the well-establishedexceptions for a solvent debtor (at the "legal rate") and for anoversecured creditor (in most instances at the rate provided by applicable nonbankruptcy law). Part IV discusses plan interest, which is

Interest in Chapter 11, 19 HOFSTRA L. REv. 1 (1990); Kathryn R Heidt, Interest Under Section506(b) oj the Bankruptcy Code: The Right, the RIlte and the Relationship to Bankruptcy Policy, 1991UTAH L. REv. 361 (1991); RobertJ. Kressel, Calculating the Present Value oj Deferred PaymentsUnder a Chapter 12 Plan: A New Twist to an Old Problem, 62 AM. BANKR. LJ. 313 (1988);John C.McCoid, II, Pendency Interest in Bankruptcy, 68 AM. BANKR. LJ. 1 (1994); Aneel M. Pandey, Determining Interest and Discount RIlles Applicable to Secured Claims in the Specter oj Bankruptcy Law, 30SAN DIEGO L. REv. 549 (1993); ToddJ. Zywicki, Cramdown and the Code: Calculating CramdownInterest RIlles Under the Bankruptcy OJde, 19 T. MARSHALL L. REv. 241 (1994); James F. DesMarais, Note, The Paper Discount RIlte Under the Chapter 11 Cramdown Provision: Should SecuredCreditors Retain Their State Law Entitlements? 72 VA. L. REv. 1499 (1986); Julia A. Jansen, Comment, An Oversecured Creditor's Right to Pastpetition Interest on Mortgage Arrearages: the InterplayBetween Bankruptcy OJde Sections 506(b), 1322(b) and 1325(a)(5)(B), 71 WASH. U. L.Q. 151 (1993);David K. McPhail, Note, Bankruptcy: Determination ojan Appropriate Cram-down Interest RIlteJor theFamily Farmer, 41 OKLA. L. REv. 489 (1988); Todd W. Ruskamp, Comment, In the Interest oJFairness: Interest Payments in Bankruptcy, 67 NEB. L. REv. 646 (1988); Waltraud S. Scott, Comment,Deferred Cash Payments to Secured Creditors in Cram Down ojChapter 11 Plans: A Matter ojInterest, 63WASH. L. REv. 1041 (1988).

5 PUB. L. No. 103-394, 108 Stat. 4106 (1994) [hereinafter the 1994 Act].6 See 140 CONGo REc. HI0,752-Ql, HI0,770 (daily ed. Oct. 4, 1994) (section-by-section

analysis of 1994 Act inserted by Sen. Jack Brooks) ('This section will have the effect of overruling the decision of the Supreme Court in RIlke v. Wade, 113 S. Ct. 2187 (1993).").

7 The terms "prepetition interest," "pendency interest," and "plan interest" are suggestedin ELIZABETH WARREN & JAY WESTBROOK, THE LAw OF DEBTORS AND CREDITORS 461-66 (2d ed.1991).


152 BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 12

provided for under the reorganization chapters of the Code at thecurrent market rate in order to assure that deferred payments undera reorganization plan provide for the present value of certain minimum amounts required to be paid under the plan.

As discussed in part V the 1994 Act effectively creates a fourthcategory of interest - arrearage interest (for want of a better term).If a reorganization plan proposes to cure a default under the plan,then, notwithstanding the rules relating to pendency and plan interest, section 305 of the 1994 Act requires that the amount necessaryto cure the default be determined in accordance with the underlyingagreement and applicable nonbankruptcy law.s

II. PREPETITION INTEREST

A. Entitlement to Prepetition Interest

Very little controversy exists concerning the allowance of a timely filed claim for prepetition interest. The rules with respect toprepetition interest are found in section 502 of the BankruptcyCode.9 Under section 502(a), a claim is allowed unless a party ininterest objects.1O Section 101(5) defines a claim to mean a "rightto payment."1J Accordingly, if there is a right to payment of interestunder applicable nonbankruptcy law, then interest is included in thedefinition of a claim.12

Assuming nonbankruptcy law provides for interest, a claim forsuch interest is allowed under section 502(a) unless there is an objection. If a party does object, section 502(b) directs the court todetermine the amount of the claim as of the date of the filing of thepetition and to allow the claim subject to a number of enumerated

8 Bankruptcy Refonn Act of 1994, PUB. L. No. 103-394 § 305, 108 Stat. 4106, 4134(1994).

• II U.S.C. § 502 (1994). See II U.S.C. § 103(a) (1994) (providing that chapters I, 3,and 5 of the Bankruptcy Code apply in a case under chapter 7, II, 12, or 13).

10 II U.S.C. § 502(a) (1994).II II U.S.C. § 101(5) (1994).12 See In re Larson, 862 F.2d II2, II9 (7th Cir. 1988); Princeton OverlookJoint Venture v.

Zaitz (In re Princeton Overlook Joint Venture), Adv. No. 92-2343, 1993 WL 280456, at *9(Bankr. D.NJ. March 16, 1993). Under pre-Code law, also, prepetition interest was governedby applicable nonbankruptcy law. See Debentureholders Protective Comm. of Continentallnv.Corp. v. Continentallnv. Corp., 679 F.2d 264, 268 (1st Cir. 1982) (citing Vanston BondholdersProtective Comm. v. Green, 329 U.S. 156, 161 (1946», cert. denied, 459 U.S. 894 (1982).



exceptions.13 Two exceptions are most likely to be invoked with respect to a claim for interest: that the claim is unenforceable underany applicable agreement or law, or that the claim is for unmaturedinterest.14 Thus, a claim for prepetition interest, whether secured orunsecured, is allowable under the Bankruptcy Code so long as: (1)the claim is enforceable under the agreement, if any, and underapplicable nonbankruptcy law, and (2) the amount of the claim isdetermined as of the date of the petition and does not include interest accrued or to accrue after the petition date.

B. Rate ofPrepetition Interest

Few cases discuss the rate of prepetition interest, but it is accepted that applicable nonbankruptcy law determines not only the rightto, but also the rate of prepetition interest. Based upon the definition of a claim and section 502's direction that a bankruptcy court"shall allow" a claim except for expressly enumerated exceptions,15this seems to be a fair implication. Following this analysis, at leastone bankruptcy court has concluded that it "does not have the power to modify accrued prepetition interest."16 This does not differfrom pre-Code practice,17 and with respect to fixed liabilities, theBankruptcy Act of 1898 expressly allowed interest ''which would havebeen recoverable" at the date of the filing of the bankruptcy petition. IS

One issue that has arisen is the effect of a postpetition cure ona prepetition default rate of interest. Under the general rule statedabove, a claim for prepetition interest would be allowed at a higherdefault rate if that would be the result outside of bankruptcy.19 Un-

IS 11 U.S.C. § 502(b) (1994).1< See 11 U.S.C. § 502(b) (1), (2) (1994). Under § 502(b) (2), prepaid interest that repre

sents an original discounting of the claim and that would not have been earned on the petition date is also disallowed. H.R. REp. No. 595, 95th Cong., 1st Sess. 352-53 (1977), reprinted in1978 U.S.C.CAN. 6307, 5308-09; S. REp. No. 989, 95th Cong., 2d Sess. 62-63 (1978), reprintedin 1978 U.S.C.CAN. 5787, 5848-49.

I" 11 U.S.C. § 502 (1994).16 Princeton Overlook Joint Venture v. Zaitz (In re Princeton Overlook Joint Venture),

Adv. No. 92-2343, 1993 WI.. 280456, at *9 (Bankr. D.NJ. March 16, 1993).17 See Debentureholders Protective Comm. ojContinental Inv. Corp. v. Continental Inv. Corp., 679

F.2d 264, 268 (1st Cir. 1982) (distinguishing prepetition from postpetition interest on interest), cert. denied, 459 U.S. 894 (1982).

18 Bankruptcy Act of 1898 § 63(a)(I), 11 U.S.C. § 103 (repealed 1978).19 See In re Pinebrook, Ltd., 92 B.R. 948 (Bankr. M.D. Fla. 1988) (allowing prepetition

interest at default rate of 24% rather than predefault rate of 12%).



der the reorganization chapters of the Bankruptcy Code, however, aplan of reorganization may provide for the curing of any default.20

If the default which triggered the increased interest rate is cured,will the cure nullify the increased interest rate?

''Yes,'' the Ninth Circuit has answered, with respect to bothprepetition and postpetition interest rates. In Flmida Partners Corp. v.Southeast Co. (In re Southeast Co.) ,21 the Ninth Circuit Court of Appeals ruled that section 1124(2) "authorizes a plan to nullify allconsequences of default, including avoidance of default penaltiessuch as higher interest."22 The court previously had reached thisconclusion with respect to postpetition default interest,23 and inSoutheast Co. it extended the analysis to prepetition default interest.24 To allow prepetition interest at the default rate after a cure,the court reasoned, "would completely eliminate the benefits of curein this case, as it would fail to nullify a significant consequence ofthe default. "25 The court's conclusion does not appear to be limitedto chapter 11 cases, as it quoted with approval In re Taddeo,26 achapter 13 case in which the Second Circuit defined the concept ofcure as used throughout the Bankruptcy Code to include a return topredefault conditions.27

As discussed in part V, however, the 1994 Act may have theeffect of overruling Southeast Co. and sustaining a high default rate ifpermitted under the agree~ent and applicable nonbankruptcylaw.28

20 11 U.S.C. §§ 1123(a)(5)(G), 1124(2), 1222(b)(3) and (5), 1322(b)(3) and (5) (1994).21 868 F.2d 335 (9th Cir. 1989).22 Id. at 336 (quoting In re Entz-White Lumber & Supply, Inc., 850 F.2d 1338, 1342 (9th

Cir. 1988».23 See Entz-Vllhite, 850 F.2d 1338; see also In re Johnson, 184 B.R 570 (Bankr. D. Minn.

1995) (holding than an oversecured creditor is entitled to pendency interest at nondefaultrate where the debt has matured by its own terms prepetition and the plan cures all defaultson the debt).

24 See Southeast Co., 868 F.2d at 339.25 Id.2fi 685 F.2d 24 (2d Cir. 1982).27 Southeast Co., 868 F.2d at 338 (quoting Taddeo, 685 F.2d at 26-27). For further discus

sion of Southeast Co. and the use of cure to nullifY default interest, see Johnson, 184 B.R at 574;Averch et al., supra note 4; Franzese, supra note 4, at 22-30.

2ll See infra part V.


1995] Entitlement to Interest

III. PENDENCY INTEREST

155

A. Entitlement to Pendency Interest

The general rule under pre-Code law was that interest stops asof the date of the filing of the bankruptcy petition.29 The law recognized three exceptions: (1) the debtor proved to be solvent, (2) thecreditor was secured and the value of the collateral was sufficient topay both principal and interest, and (3) the creditor was securedand the collateral earned income after the filing date.so For themost part, the Bankruptcy Code codifies the pre-Code law, and nothing in the legislative history evidences an intent to change theserules.3

) It is questionable, however, whether the exception relatingto earnings on collateral survives the Bankruptcy Code in the samemanner in which it was applied under pre-Code law.32 Also, as discussed in part V, a different rule now applies to interest onarrearages proposed to be cured under a reorganization plan.

1. General Rule - No Pendency Interest

As already discussed, section 502(b) directs a court to determinethe amount of a claim as of the date of the filing of the petition andtherefore does not include interest as part of a claim accrued afterthe petition date.33 Removing any doubt over this issue, section502(b) (2) flatly prohibits the allowance of unmatured interest.34

Thus, these avo provisions of section 502 continue the basic rulethat interest stops running as of the petition date.

.. United States v. Ron Pair Enters., Inc., 489 U.S. 235, 246 (1989); Vanston BondholdersProtective Comm. v. Green, 329 U.S. 156, 163 (1946); Sexton v. Dreyfus, 219 U.S. 339, 344(1911). For a general history and discussion of pendency interest, see McCoid, supra note 4.

so Ron PairEnters., 489 U.S. at 246; McCoid, supra note 4, at 1... See McCoid, supra note 4, at 8-9.!2 See id.; see also infra part III(A) (2) (c)." See supra part II(A).$I 11 U.S.C. § 502(b) (1994).


156

2. Exceptions

BANKRUPTCY DEVELOPMENTS JOURNAL [Vol. 12

a. Debtor Solvent

The first exception to this rule, that pendency interest is payable if the debtor proves to be solvent, is not commonly encountered. Congress addressed this happy event in section 726(a) (5) ofthe Bankruptcy Code.3s That section calls for the distribution ofproperty of the estate in payment of interest on certain claims afterthe payment of priority claims, allowed unsecured claims, and claimsfor penalties, but prior to any distribution to the debtor. Under thisprovision, interest is payable at the "legal rate"36 from the date ofthe filing of the petition.

Although by its terms, section 726(a)(5) does not provide forinterest on secured claims that are not claims for penalties, the Supreme Court has suggested that this result was unintended andcould be avoided in the case of a solvent debtor by the creditor'swaiver of collateral.37 Also, although section 726 applies directly toonly chapter 7 cases,38 it applies indirectly to cases under the reorganization chapters by virtue of the best interest test.39

S> 11 U.S.C. § 726(a) (5) (1994) (providing for "interest at the legal rate from the date ofthe filing of the petition, on any claim paid under paragraph (I), (2), (3), or (4) of this subsection").

,. See infra part III (B) (1).S1 United Savings Ass'n ofTexas v. Timbers of Inwood Forrest Assocs., Ltd., 484 U.S. 365,

379 (1988).3S 11 U.S.C. § 103(b) (1994).59 See 11 U.S.C. §§ 1129(a)(7), 1225(a)(4), 1325(a)(4) (1994). See also In re Schoeneberg,

156 B.R. 963, 969-73 (Bankr. W.O. Tex. 1993) (applying § 726(a) (5) in context of §1129(a)(7»; In re BiIlman, 93 B.R. 657 (Bankr. S.D. Iowa 1988) (discussing § 726(a)(5) incontext of § 1225(a)(4»; Boyer v. Bernstein (In re Boyer), 90 B.R. 200 (Bankr. D.S.C. 1988)(applying § 726(a) (5) in context of § 1129(a) (7».

An interesting twist may occur under chapter 11, since under § 1129(a)(7) the best interest test appears to apply only to an impaired class of claims. See In re New Valley Corp., 168B.R. 73, 77-80 (Bankr. D.NJ. 1994). If unsecured claims are paid in full on the effective dateof the plan, for example, the New Valley court has held that the claims are not impaired, thebest interest test does not apply, and interest therefore is not payable even though the debtoris solvent. Id. Depending on the circumstances, however, the court noted that interest may berequired under the good faith test of § 1129(a) (3). Id. at 80-81.

In response to New Valley, the 1994 Act amended § 1124 so that a claim is no longerunimpaired solely because the amount of the claim (which may not include pendency interestunder the general rule) is paid on the effective date of the plan. See 140 CONGo REc. HI0,768(daily ed. Oct. 4,1994) (statement of Rep. Brooks).



b. Oversecured Claims

The second exception permits pendency interest to the extentthat a secured creditor's claim is less than the value of the collateralfor the claim. Under section 506(b) of the Bankruptcy Code, interest "shall be allowed" on a secured claim to the extent that the valueof the collateral, after deducting any costs of preserving or disposingof the collateral, exceeds the amount of the secured claim.40 ThreeSupreme Court decisions have addressed issues relating to this exception,41 and, as discussed in part V, the 1994 Act creates a newrule for interest on arrearages proposed to be cured under a reorganization plan.42

The first decision, United Savings Association of Texas v. Timbers ofInwood Forest Associates, Ltd.,43 came to the Court in the guise of anundersecured creditor's motion for relief from the automatic stay oradequate protection under section 362 (d) (1). The undersecuredcreditor argued that it was entitled to adequate protection in theform of interest payments on the value of its collateral for the delayin foreclosing caused by the automatic stay.44 The Supreme Courtdisagreed, giving as its first reason section 506(b).45 According tothe Court, section 506(b) has two substantive effects.46 The first andmost obvious is that pendency interest shall be allowed to the extentthat the value of the collateral exceeds the amount of the securedclaim; that is, to the extent that a "security cushion" exists.47 Thesecond substantive effect of section 506(b) is that pendency interestshall not be allowed if a security cushion does note exist.48 Accord-

~ 11 U.S.C. § 506(b) (1994). The Eleventh Circuit has ruled that payment of pendencyinterest to an oversecured creditor should await the conclusion of a reorganization case, because until that time the value of the collateral, and thus the creditor's secured status, mayfluctuate. See Orix Credit AIliance, Inc. v. Delta Resources, Inc. (In re Delta Resources, Inc.), 54F.3d 722, 729-30 (11th Cir. 1995). See also Ford Motor Co. v. Dobbins, 35 F.3d 860, 869-71 (4thCir. 1994) (holding that determination of secured status for purposes of § 506(b) should bebased on sale price of collateral, if sold, and not some earlier valuation).

41 See Rake v. Wade, 113 S. Ct. 2187 (1993); United States v. Ron Pair Enters., Inc., 489U.S. 235 (1989); United Savings Ass'n of Texas v. Timbers of Inwood Forest Assocs., Ltd., 484U.S. 365 (1988).

42 See infra part V.~3 484 U.S. 365 (1988).H Id. at 369-71.45 Id. at 371-74.-l<l See id.47 See id. at 372-73.4" Id.



ingly, the Timbers Court relegated an undersecured creditor to thegeneral rule disallowing pendency interest.49

The second decision, United States v. Ron Pair Enterprises, Inc.,50settled the narrow dispute as to whether section 506(b) allows interest on only consensual oversecured claims, such as a contract claimsecured by a voluntary security interest, or also extends tononconsensual oversecured claims, such as a tax claim secured by aninvoluntary lien fixed by operation of law.51 In Ron Pair, the Courtruled that all oversecured claims, whether consensual ornonconsensual, are to be similarly treated for purposes of pendencyinterest under section 506(b).52 Based on the plain language of section 506, including an analysis of its grammatical structure, theCourt stated that the right of an oversecured creditor to pendencyinterest is unqualified.53

Rake v. Wade,54 the third of the decisons, was a consolidatedcase which involved an oversecured55 creditor's right to pendencyinterest (and plan interest) on arrearages to be paid under chapter13 plans proposed by several debtors. Arrearages typically refer tomortgage payments or other installment loan payments that are pastdue. Ordinarily, the underlying loan agreement allocates a portionof such payments to principal and a portion to ,interest. The principal portion of such a payment is part of the creditor's prepetitionclaim under section 502, and to the extent the interest portion accrued prior to the petition date, so is the interest portion. As part ofthe prepetition claim, therefore, arrearages should be subject to thesame rules with respect to prepetition, pendency, and plan interestas any other claim. This conclusion is complicated, however, by the

.9 Id. See also Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156, 164 (1947)(noting that under pre-Code law it was thought to be inequitable to unsecured creditors toallow pendency interest to an undersecured creditor); Sexton v. Dreyfus, 219 U.S. 339, 343-46(1911) (holding that under pre-Code law undersecured creditors generally were not entitledto pendency interest).

:Ill 489 U.S. 235 (1989)." Id. at 240.52 Id. at 248.03 Id. at 241.M 113 S. Ct. 2187 (1993).55 Id. Rake addressed only oversecured claims for arrearages, and a number of courts

(with mixed results) are beginning to struggle with the issue of an undersecured creditor'sright to pendency interest and plan interest on arrearages. See, e.g., In re Arvelo, 176 B.R. 349(Bankr. D.NJ. 1995); In reJones, 168 B.R. 146 (Bankr. E.D. Tex. 1994); In re Harned, 166 B.R.255 (Bankr. E.D. Pa. 1994); In re Brycki, 161 B.R. 915 (Bankr. D.NJ. 1993). See also infra notes64, 138-42, 18lHl7, and accompanying text.



Code provisions that expressly permit reorganization plans to provide for the curing of defaults56 and by the chapter 13 provisionthat prohibits modification of certain home mortgages.57 For instance, if a chapter 13 plan provides for the curing of arrearages andthe maintenance of payments on an oversecured home mortgage,how should the requirements for pendency and plan interest undersections 506 and 1325 interrelate with the ability to cure and theprohibition on modification under section 1322?

This is the issue Rake addressed. In that case, the debtors proposed to cure defaults under their home mortgages by paying offthe arrearages over the terms of the plans.58 The loan documentsdid not provide for the payment of interest on arrearages, and theplans did not propose to pay either pendency or plan interest on thearrearages.59 Previous courts had split on this issue. Some courtshad held that allowing interest on arrearages is incident to the cureunder section 1322(b) (5) (which by its terms is excepted from theno modification rule of section 1322 (b) (2) ), and that sections506(b) and 1325(a)(5) both indicate that interest is allowable.50

Other courts, conversely, had "construed the 'cure' and'modification' provisions of section 1322(b) so broadly as to rendersections 506(b) and 1325(a) (5) inapplicable to the curing of defaults on home mortgages. "61

In Rake, the Supreme Court concluded that the cure provisionsof section 1322 give no indication that arrearages cured under aplan may not include interest otherwise available as part of anoversecured claim,62 and that although curing arrearages may modify a home mortgag~ claim, such a modification is permitted underthe terms of section 1322(b) (5), notwithstanding the "no modification" rule under section 1322(b)(2).63 Eschewing a broad readingof the cure or "no modification" provisions of section 1322, the

56 See 11 U.S.C. §§ 1123(a) (5) (G), 1124(2), 1222(b) (3), (5), 1322(b) (3), (5) (1994).>7 See 11 U.S.C. § 1322(b)(2) (1994);· see also 11 U.S.C. § 1123(b)(5) (amended by 1994

Act).5-' Rake, 113 S. Ct. at 2189.~ Id.ro See, e.g., Cardinal Fed. Sav. & Loan Ass'n v. Colegrove (In re Colegrove), 771 F.2d 119,

122 (6th Cir. 1985).61 Rake, 113 S. Ct. at 2191 (citing Landmark Fin. Servs. v. Hall, 918 F.2d 1150, 1153-55

(4th Cir. 1990».62 Id. at 2191-92.63 Id. at 2193 n.9.



Court held that the holder of the mortgages was entitled to: (1)pendency interest under section 506(b) because the holder's claimswere oversecured,64 and (2) plan interest under section 1325(a)(5)because the arrearages were part of the allowed secured claims "provided for" by the plans.55 Af5 discussed in part V, the Rake Court'sconclusion that the cure provisions of section 1322 do not dictatethe terms of a cure has been altered by the 1994 Act.56

With respect to pendency interest under section 506(b), at leastthree general principles can be abstracted from the Rake decision.First, the Rake Court construed its statement in Ron Pair that theright of an oversecured creditor to pendency interest is unqualifiedto mean that such right exists "regardless of whether the agreementgiving rise to the claim provides for interest. "67 Thus, it was unimportant to the Court that the loan documents in Rake did not provide for interest on arrearages.68 This represents an extension ofthe holding in Ron Pair, because Ron Pair did not involve an agreement at all, but rather a tax lien fixed by operation of law for whichinterest was provided by statute.69 Rake, however, makes it clear thatsection 506(b) allows pendency interest independent of the entitlement to such interest under applicable nonbankruptcy law,7° unlikethe rule with respect to prepetition interest under section 502.71 Af5

already mentioned, the 1994 Act affects this ruling with respect tothe amount necessary to cure a default.72

Second, with respect to pendency interest, the Rake Court permitted the allowance of interest on interest, because the dispute in-

&l Id. at 2191-92. Although Rake addressed only arrearages that were part of anoversecured claim, most post-Rake courts have applied the same analysis to conclude that §506(b) applies to the cure of arrearages that were part of an undersecured claim, See, e.g., In reArvelo, 176 B.R 3<19,354-355 (Bankr. D.NJ. 1995); In reJones, 168 B.R 146,149 (Bankr. E.D.Tex. 1994). Because § 506(b) does not allow pendency interest if there is not a security cushion, these courts have not aIlowed pendency interest on such undersecured arrearages. SeeArvelo, 176 B.R 349;Jones, 168 B.R 146.

65 Rake, 113 S. Ct. at 2192-93. See infra part IV (discussing plan interest).66 See infra part V.(i/ Rake, 113 S. Ct. at 2190..., See id. at 2191-92.6'1 See Ron Pair, 489 U.S. at 246; see also McCoid, supra note 4, at 13 (noting that federal

tax law requires accrual ofinterest on overdue taxes and questioning whether § 506(b) createsan independent obligation to pay interest where none exists outside of bankruptcy).

70 But if. McCoid, supra note 4, at 13 (questioning whether § 506(b) creates an independent obligation to pay interest where none exists outside of bankruptcy).

71 See supra part II(A).72 See infra part V.



volved arrearages, and arrearages consist of, among other things,missed payments of principal and interest.73 The Court reached thisresult because section 506(b) allows pendency interest onoversecured claims, and the arrearages (which include interest) "areplainly part of respondent's oversecured claims."74 At least in part,therefore, Rake overrules Vanston Bondholders Protective Committee v.Green,75 which had concluded under pre-Code law that as a matterof equity, pendency interest should not be allowed on interest.76

Based on this portion of Rake, the amount of an allowed securedclaim upon which section 506(b) interest is allowed should includenot only prepetition principal, but also prepetition interest.77 Withrespect to plans proposing to cure arrearages, however, the 1994 Actmust again be consulted.78

Third, the Rake Court made it clear that section 506(b) governsonly pendency interest, that is, interest to accrue after the filing of apetition but prior to the confirmation or effective date of a rehabilitation plan.79 As discussed in part II, prepetition interest is providedunder section 50280 and, as discussed in part IV, plan interest isprovided under the reorganization chapters of the Code.S

!

To summarize the case law relating to the exception for pendency interest on oversecured claims under section 50b(b), Timbersruled that pendency interest shall be allowed to the extent thatthere is a security cushion and shall not be allowed if there is none.Ron Pair concluded that pendency interest extends to nonconsensualoversecured claims as well as consensual claims. Rake decided that (i)arrearages are part of a creditor's oversecured claim and are subjectto the general rules governing pendency interest, (ii) the right topendency interest under section 506(b) is not dependent on the

7S See Rake, 113 S. Ct. at 2189, 2193 12; see also Agin, supra note 4, at 353-55.7< Rake, 113 S. Ct. at 2191; see also supra part I1(A) (noting that prepetition interest is part

of the definition ofa claim under § 101(5) and allowable under § 502).75 329 U.S. 156 (1947).76 Id. at 165.77 See Rake, 113 S. Ct. at 2193 n.12. Cf. United States Trust Co. of N.Y. v. LTV Steel Co.

(In re Chateaugay Corp.), 150 B.R. 529, 536-40 (Bankr. S.D.N.Y. 1993) (deferring to state lawwith respect to the enforceability of compound interest agreements).

7Il See infra part V.7D Rake, 113 S. Ct. at 2190-91 (stating that interest allowed by § 506(b) accrues from the

petition date until the confirmation or effective date of the plan). See supra part I (definingpendency interest).

"" See supra part II.AI See infra part IV.



right to interest under an agreement or applicable nonbankruptcylaw, (iii) pendency interest under section 506(b) is allowed on interest as well as principal, and (iv) pendency interest under section506(b) applies to the period from the petition date until the confirmation or effective date of the plan. As discussed in part V, the 1994Act affects only the first part of the Rake holding, that arrearagesproposed to be cured under a plan are subject to the general rulesgoverning pendency interest.

c. Earnings On Collateral

Under pre-Code law, the third exception to the general rulethat interest stops as of the filing date was that interest is allowable ifthe creditor is secured and the collateral earns income after thefiling date. Under this exception, even an undersecured creditor isallowed pendency interest to the extent of any postpetition incomeearned on its collateral.

In Sexton v. Dreyjus,82 for example, the Supreme Court heldthat undersecured creditors generally were not entitled to pendencyinterest, but the Court expressly recognized an exception to this ruleto the extent that the collateral earned income after the filingdate.ll3 Applying the general rule to the facts of that case, the SextonCourt refused to permit undersecured creditors to apply the saleproceeds from their collateral first to interest, then to principal, andthen to file an unsecured claim for the balance.ll4 Rather, the proceeds were required to be applied to principal and no claim forinterest was allowed.8

;; To the extent that the collateral earned income, however, the Court applied the exception to the rule "and forthis reason permitted some of the same undersecured creditors toapply the income first to interest.86

This exception is not codified in the Bankruptcy Code,87 andits rationale has been questioned.88 Section 552(b) of the Bankruptcy Code does provide that a prepetition security interest may extend

II:! 219 U.S. 339 (1911).II! Id. at 346... See id. at 343-46.R5 Id.R6 Id. at 346.K7 See McCoid, supra note 4, at 9.... Id. at 19 ("Neither the English nor American cases ever offered any satisfactory justifi

cation for this exception to the basic rule.").



to postpetition "proceeds, product, offspring, rents, or profits" of thecollateral, but this provision does not address the allowance of interest on the claim.89 Plainly read, section 552 (b) merely "enlargeswhat is the collateral. ngO Under the other exceptions to the "nopendency interest" rule, interest would be allowed only to the extentthat the debtor is solvent or the value of the collateral exceeds theprepetition amount of the claim.91 Thus, a difficult issue is presented concerning the viability under the Code of the Sexton exceptionfor earnings on collateral.

Although not often analyzed in these terms, this is the preciseproblem that has arisen in a number of cases in which anundersecured creditor has a lien on property, most typically a realestate project, that earns income postpetition.92 If the creditor'sprepetition claim is $1 million, and the collateral is valued at$800,000 as of the petition date, then, under sections 502 and506(a), as of the petition date the creditor has a claim of $1 million,consisting of a secured claim of $800,000 and an unsecured claim of$200,000. If the creditor has a perfected assignment of rents, andthe collateral earns postpetition rentals, is the creditor entitled topendency interest?

The cases are not in agreement. One view suggests, at least, thatsection 552 (b) does allow pendency interest, even to anundersecured creditor, to the extent that the creditor has a lien onpostpetition earnings.93 Although the cases suggesting this view donot cite Sexton,94 that would be the outcome if the Sexton exceptioncontinues under the Code.95

This approach is not consistent, however, with the Timbers hold-

... 11 U.S.C. § 552(b) (1994).00 McCoid, supra note 4, at 9.91 See id.; see also supra part III (A)(2)(a), (b).9'l See In re Veeco Inv. Co., 170 B.R. 149 (Bankr. E.D. Mo. 1994); In re KaHan, 169 B.R.

503 (Bankr. D.R.I. 1994); Mutual Life Ins. Co. of New York v. Paradise Springs Assocs. (In reParadise Springs Assocs.), 165 B.R. 913 (Bankr. D. Ariz. 1993); In re Bloomingdale Partners,160 B.R. 93 (Bankr. N.D. 111. 1993); In re Birdneck Apartment Assocs., II, L.P., 156 B.R. 499(Bankr. E.D. Va. 1993); In re Vermont Invest. L.P., 142 B.R. 571 (Bankr. D.D.C. 1992); In reIPC Atlanta L.P., 142 B.R. 547 (Bankr. N.D. Ga. 1992); In re Oaks Partners, Ltd., 135 B.R. 440(Bankr. N.D. Ga. 1991); In re Landing Assocs., Ltd., 122 B.R. 288 (Bankr. W.D. Tex. 1990); Inre Reddington/Sunarrow L.P., 119 B.R. 809 (Bankr. D.N.M. 1990); In re Flagler-At-First Assocs.,Ltd., 114 B.R. 297 (Bankr. S.D. Fla. 1990).

9' See Birdneck Apartment Assot:S., 156 B.R. at 505; Vennont Invest., 142 B.R. at 573-76.!It See supra note 93.9:' See supra notes 82-86 and accompanying text.



ing that section 506(b) not only allows pendency interest onoversecured claims, but also bars pendency interest on undersecuredclaims.96 Applying the Timbers rule to the above hypothetical, anumber of courts conclude that pendency interest should never beallowed to a creditor that is undersecured on the date of the petition, even if the creditor has a continuing lien on postpetition earnings under section 552(b).97 Instead, these courts value the securedclaim as of the petition date and allocate any payments to the creditor from postpetition earnings to a reduction of the claim (measured as of the petition date, and in some cases credited against thesecured portion of the claim and in other cases credited against theunsecured portion) or to a prepayment of plan payments.98

A logical extension of this analysis would be to permit a debtorto create an equity cushion out of the creditor's postpetition collateral and at the same time deny the creditor any pendency interestfrom the equity cushion.99 Thus, this second approach fails to takefull account of section 552(b) (since this approach values the secured claim only as of the petition date) and creates an incentive forthe debtor to delay confirmation of a plan (because it permits application of postpetition earnings to the secured claim, which is valuedas of the petition date).

More persuasive is a third line of cases, which gives full effect toboth section 506(b), as construed by Timbers, and section 552(b).100Returning to the hypothetical (which posits a prepetition claim of $1million, collateral valued at $800,000 on the petition date, and a perfected lien on postpetition rentals), these cases indicatethe following analysis. Assuming section 552(b) otherwise applies,then the value of the collateral will increase to the extent of anypostpetition rentals. If $100,000 of rentals are received, then, undersection 506(a), the creditor has (as of that date) a secured claim of$900,000 and an unsecured claim of $100,000. At this point, nointerest would be allowable under section 506(b), and the effect ofthe postpetition lien on rentals would be to increase the securedportion and reduce the unsecured portion of the creditor's claim by

96 See supra notes 45-49 and accompanying text.97 See Killian, 169 B.R at 505-07; /PC Atlanta, 142 B.R at 558-59; Oaks Partners, 135 B.R at

449-51; Reddington/Sunarruw, 119 B.R at 813-14.!l8 See supra note 97.99 See Vennont Invest., 142 B.R at 574.

100 See Veeco, 170 B.R at 151-53; Paradise Springs, 165 B.R at 924-26; Bloomingdale, 160 B.R.at 97-99; Landing Assocs., 122 B.R at 297; Flagler-At-First, 114 B.R at 297.



a like amount. If these rentals are paid to the creditor, the creditor'sclaim would be reduced to $900,000, consisting of a secured claim of$800,000 and an unsecured claim of $100,000, and there would beno allowance of pendency interest at this time.

At the point the rentals exceed the unsecured claim, however,section 506(b) would allow interest to the extent of the excess. Thus,if $300,000 of rentals are received, the total value of the collateralwould be $1.1 million, the creditor would become oversecured, andinterest would be allowable to the extent of $100,000. Assuming theinterest accruing on the claim was at least equal to the amount ofthe rentals, the creditor's secured claim would in effect be increasedto $1.1 million (reflecting the prepetition claim of $1 million andthe allowance of $100,000 in pendency interest). If the $300,000 inrentals are paid to the creditor, then the creditor's claim would bereduced to $800,000, fully secured by the remaining $800,000 valueof the collateral.

Based upon this third reading and application of sections 506and 552, whether interest is allowable to a creditor who isundersecured at the petition date but who has a postpetition lien onearnings from the collateral depends on the amount of the initialdeficiency and the amount of postpetition preconfirmation earnings.Under this analysis, the Sexton exception is substantially modifiedunder the Code. Pendency interest would be allowed under section506(b) only to the extent that an equity cushion is created by thepostpetition lien on earnings, and section 552(b) is given full effectby enlarging the value of the collateral to the extent of anypostpetition earnings subject to the creditor's lien. It is also arguablethat this approach better accommodates the concern expressed bythe Supreme Court in Dewsnup v. Timm101 that any increase in

the value of collateral during bankruptcy "rightly accrues to the benefit of the creditor, not to the benefit of the debtor and not to thebenefit of other unsecured creditors."102

101 112 S. Ct. 773 (1992).10'1 Id. at 778; see also Bloomingdale, 160 B.R. at 97 (quoting Dewsnup, 112 S. Ct. at 778).



B. Rate ofPendency Interest

1. Debtor Solvent

If the debtor proves to be solvent, section 726(a)(5) providesfor "payment of interest at the legal rate from the date of filing. "103

The Code does not define the term "legal rate," and the cases havefollowed one of two paths. The first approach is that Congress intended no change in pre-Code practice by this language and thatpendency interest generally is "payable either at the contract rate, atthe statutory rate (if a specialized statute establishes a specializedrate of interest for a particular creditor), or, if there is no applicablestatute and no rate was contracted for, at the state judgmentrate."I04

The second view is that Congress intended interest at "the" legalrate to mean a single uniform rate, the federal judgment rate. I05

This approach finds further support by comparison with the language of section 506(b), the other provision of the Code that permits pendency interest. With respect to an oversecured claim, section 506(b) provides that "there shall be allowed. " interest onsuch claim, and any reasonable fees, costs, or charges provided forunder the agreement."106 If sections 506(b) and 726(a) (5) were intended to refer to the same rate, the question is thus raised as towhy "at the legal rate" is specified in one section and not the other.

2. Oversecured Claims - Section 506(b)

As stated above, section 506(b) provides that there shall be allowed to the holder of an oversecured claim "interest on such claim,and any reasonable fees, costs, or charges provided for under theagreement." Unlike section 726(a) (5), section 506(b) does not referto a rate of interest, and neither does the legislative history to thissection.I07 Based on Ron Pair and Rake, however, section 506(b)

10' 11 U.S.C. § 726(a)(5) (1994).IOf In re Schoeneberg, 156 B.R. 963, 972 (Bankr. W.O. Tex. 1993).105 See In re Chiapetta, 159 B.R. 152. 16lJ.61 (Bankr. E.D. Pa. 1993); In re Melenyzer, 143

B.R. 829, 832-33, (Bankr. W.D. Tex. 1992); In re Godsey, 134 B.R. 865, 867-68 (Bankr. M.D.Tenn. 1991).

106 11 U.S.C. § 506(b) (1994).107 Bradford v. Crozier (In re Laymon), 958 F.2d 72, 74 (5th Cir. 1992), reh'g denied, 964

F.2d 1145, cert. denied, 113 S. Ct. 328 (1992).



represents a substantive right to pendency interest independent ofthe entitlement to such interest under applicable nonbankruptcylaw. l08 It has been suggested, therefore, that determination of therate of interest under section 506(b) is similarly independent ofapplicable nonbankruptcy law.109

Most recent cases, however, reject this invitation and concludethat because both section 506(b) and the legislative history are silentas to the rate of interest, Congress did not intend to effect a majorchange in pre-Code practice.110 Prior to enactment of the Code,the majority of courts applied nonbankruptcy law to determine therate of interest allowed to oversecured creditors, but subject to equitable principles governing bankruptcy distribution.1l1 Following thispractice, an oversecured creditor holding a contract claim, for example, is ordinarily allowed interest under section 506(b) at the contract rate,112 and an oversecured creditor holding a state law tax

claim is allowed interest at the applicable state statutory rate. l13 Inthe instance of default rates of interest under contracts, or possiblypenal rates of interest under tax statutes, however, most courts haveemphasized that the allowance of interest on claims in a bankruptcycase is a matter of bankruptcy law and that the adoption of applicable nonbankruptcy law for the rate of interest is subject to "a balance of equities between creditor and creditor or between creditorsand the debtor. "1l4

,0.' See supra part III(A) (2) (b). As discussed infra in part V, the 1994 Act does not by itstenns change the case law constructions of section 506(b) except as applied to the curing ofdefaults.

'09 See Laymon, 958 F.2d at 74 (concluding that Ron Pair did not address this issue); Agin,supra note 4, at 362; Carlson, supra note 4, at 397-98.

110 See, e.g., Laymon, 958 F.2d at 74-75; Foss v. Boardwalk Partners (In re Boardwalk Partners), 171 B.R. 87, 91-92, (Bankr. D. Ariz. 1994); Building Technologies Corp. v. Hannibal (Inre Building Technologies Corp.), 167 B.R. 853, 858-59 (Bankr. S.D. Ohio 1994).

III Laymon, 958 F.2d at 75.112 See, e.g., In re Foertsch, 167 B.R. 555, 563-65, (Bankr. D.N.D. 1994); In re Dumond, 158

B.R. 309, 311 (Bankr. D. Me. 1993).lIS See, e.g., Galveston Indep. School Dist. v. Heartland Fed. Say. and Loan Assoc., 159 B.R.

198, 203-05 (S.D. Tex. 1993).II~ Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156, 165 (1946). See In re

Terry Ltd. Partnership, 27 F.3d 241, 243 (7th Cir. 1994), cert. denied, 115 S. Ct. 360 (1994);Laymon, 958 F.2d at 74-75; Building Technologies, 167 B.R. at 858-59. But if. Franzese, supra note4, at n.118 (citing cases that pennit postpetition interest at enhanced default rates). For a listof factors that courts have often considered in detennining whether to enforce a contractualdefault rate, see In reJohnson, 184 B.R. 572, 573 (Bankr. D. Minn. 1995).

If a plan proposes to cure a default, that may decide this issue. See Johnson, 184 B.R. at574. One effect of cure may be to nullify all consequences of default, including interest at a



Thus, the developing rule is that the rate of interest under section 506(b) is a matter of federal bankruptcy law, but that applicablenonbankruptcy law will be adopted as the federal rule. If in a particular case this rate appears excessive, the court will determinewhether another rate should apply based upon an examination ofthe specific facts and equities.

IV. PLAN INTEREST

A. Entitlement to Plan Interest

Plan interest refers to interest to which a creditor may be entitled under a plan of reorganization for the period following theeffective date of the plan. Plan interest is not referenced directlyanywhere in the Code, but is implied from a number of provisionsunder the reorganization chapters.1I5 Each of these provisions require a plan to distribute to specified creditors a minimum amountto be measured either on or as of the effective date of the plan. 116

For example, under the "best interest" test, a court shall confirm achapter 13 plan if "the value, as of the effective date of the plan, ofproperty to be distributed under the plan on account of' an unsecured claim is not less than the amount that would be paid in aliquidation.117 With respect to an allowed secured claim "providedfor by a plan,"118 a court shall confirm a chapter 13 plan if theholder of such claim accepts the plan, or the debtor surrenders thecollateral, or the holder retains the lien and "the value, as of theeffective date of the plan, of property to be distributed . .. underthe plan on account of such claim is not less than the allowedamount of such claim."119 The same or similar language is used toestablish analogous conditions for confirmation under chapters 11and 12.120

In each instance, courts have read the quoted language "the

default rate. See id; supra notes 19-28 and accompanying text. But if. part V (discussing effect of1994 Act).

IJ5 See 11 U.S.C. §§ 1129(a)(7), (9), (b)(2), 1225(a)(4), (5), 1325(a)(4), (5) (1994).IIG See supra note 115.117 11 U.S.C. § 1325(a)(4) (1994); see also 11 U.S.C. §§ 1129(a)(7), 1225(a)(4) (1994).11K See Rake v. Wade, 113 S. Ct. 2187, 2192-93 (1993) ("provide[d] for by a plan" includes

establishing repayment schedules for the satisfaction of arrearages and does not refer exclusively to the modification ofa claim) (quoting 11 U.S.C. § 1325(a)(5) (1994».

119 11 U.S.C. § 1325(a)(5) (1994). See also 11 U.S.C. §§ 1129(b)(2)(A), 1225(a)(5) (1994).120 See 11 U.S.C. §§ 1129 (a)(7), (a)(9), (b)(2), 1225(a)(4), (a)(5) (1994).



value, as of the effective date of the plan," to require a present valueanalysis of the amounts the plan proposes to pay over time in connection with the particular section. 121 For purposes of present valueanalysis, bankruptcy cases have not been distinguished on the basisof the chapters under which they were filed, and the concept ofpresent value has been construed to have a single meaning whereverit is used in the Code.122 Legislative history also suggests this reading.123 Consequently, most courts considering the issue have concluded that decisions construing present value under one section orchapter of the Code are equally applicable to the others. l24

Although the Code itself offers no definition of value or presentvalue in this context, the legislative history describes the mechanicalprocess of determining present value in a manner consistent withthe use of the term by the economic and financial community.l25In this sense, present value refers to the sum of an expected futurecashflow discounted to reflect the time value of money.126 In thecase of a reorganization plan, therefore, a present value calculationwould require the determination of the sum of the payments

121 See, e.g., Rake, 113 S. Ct. at 2192 (chapter 13); GMAC v. Jones, 999 F.2d 63 (3d Cir.1993) (chapter 13); Farm Credit Bank v. Fowler (In re Fowler), 903 F.2d 694 (9th Cir. 1990)(chapter 12); United States v. Neal Pharmacal, 789 F.2d 1283 (8th Cir. 1986) (chapter 11).

122 In re Collins, 167 B.R. 842, 845 n.2 (Bankr. E.D. Tex. 1994). See Fowler, 903 F.2d at 697(chapter 11 and chapter 12 provisions similar); United States v. Arnold, 878 F.2d 925, 927-28(6th Cir. 1989) (chapter 11, chapter 12 and chapter 13 provisions similar); United States v.Doud, 869 F.2d 1144, 1145 (8th Cir. 1989) (chapter 11 and chapter 12 provisions similar); NealPharmacal, 789 F.2d at 1285 (similar present value provisions within chapter 11); United Statesv. Southern States Motor Inns, Inc. (In re Southern States Motor Inns, Inc.) 709 F.2d 647. 65051 (11th Cir. 1983), cert. denied, 465 U.S. 1022 (1989) (chapter 11 and chapter 13 provisionssimilar). But rompare 5 COLLIER ON BANKRUPTCY 'l 1129.03(4) (f) (i) (Lawrence P. King et al.eds., 15th ed. 1995) (in a chapter 11 case, present value should be determined by using adiscount rate based on the market interest rate that would be charged by a creditor making aloan to a third party with terms similar to those under the plan) with id. ,1325.06(4)(b)(iii)(B) (in a chapter 13 case, value should be determined by using a discountrate based on the cost of funds to the creditor rather than the rate that would be charged by acreditor making a new loan to the debtor).

123 See Southern States Motor Inns, 709 F.2d at 650; Zywicki, supra note 4, at 246-49.12~ Carbiener, supra note 4, at 45-46.125 Zywicki, supra note 4, at 247 (quoting In re Snider Farms, Inc., 83 B.R. 977, 988 (Bankr.

N.D. Ind. 1988».120 See Rake v. Wade, 113 S. Ct. 2187, 2192 n.8 (1993); United Say. Assoc. of Texas v. Tim

bers of Inwood Forest Assocs., Ltd., 484 U.S. 365, 377 (1988); Irving Fisher, The Theory ofInterest 12 (1930) ("The value of any property, or rights to wealth, is its value as a source of inromeand is found by discounting that expected income."); R. Stephen Sears & Gary L. Trennepohl,Investment Management 546-47 (1993); Carbiener, supra note 4, at text accompanying notes 1423.



promised under the plan, taking into account the amounts of thepayments, the timing of the payments, the length of the plan, andthe rate at which the expected cashflow is to be discounted. 127

To simplify this determination, most plans propose the paymentof a principal amount (determined by reference to the applicablesection of the Code) plus interest at a rate equal to the rate thatotherwise would be used to discount the payments to present value. 128 So long as the proposed interest rate is equal to the requireddiscount rate, the present value of the cashflow wiII equal the principal amount of the promised payments.l29 Thus, the discountingprocess is greatly simplified, and the sole issue becomes whether theinterest rate proposed under the plan is at least equal to the required discount rate. ISO

Construed in this fashion, the "best interest" tests under sections1129(a) (7), 1225(a) (4) and 1325(a) (4) require that with respect toan unsecured claim, the present value of distributions proposedunder a plan must at least equal the amount that would have beenpaid in a liquidation. Stated differently, the holder of an unsecuredclaim, in effect, is not entitled to plan interest on the allowedamount of such claim, but only upon the liquidation value of suchclaim. Hence, if the allowed amount of the unsecured claim is$1,000, but the liquidation value under chapter 7 would be $100,then the best interest test demands a present payment of at least$100 or proposed future payments equal to at least $100 plus interest at the required discount rate.

With respect to a secured claim provided for by a plan, sections1129(b)(2)(A), 1225(a)(5) and 1325(a)(5) require the payment ofplan interest on the allowed amount of such claim.ulI Unless theholder of a secured claim otherwise accepts the plan, or the debtorsurrenders the collateral, these sections provide that the presentvalue of distributions proposed under the plan must at least equal

127 See Sears & Trennepohl, supra note 126, at 54647; Carbiener, supra note 4, at textaccompanying notes 14-23.

128 See Rake, 113 S. Ct. at 2192 n.8; Carbiener, supra note 4, at text accompanying notes 14-23.

129 Carbiener, supra note 4, at text accompanying notes 14-23.ISO For a discussion of the required discount rate, see infra part IV(B).... The language of § 1129(b)(2)(A) differs slightly from that of §§ 1225(a)(5) and

1325(a)(5) in order to accommodate an undersecured creditor that has elected to treat itsclaim as fully secured under § 1111 (b)(2). See 124 CONGo REc. Hll,103-104 (daily ed. Sept. 28,1978); 124 CONGo REc. S17,420-421 (daily ed. Oct 6, 1978).



the allowed amount of the secured claim.132 As discussed above,this is accomplished most typically by the deferred payment of aprincipal amount equal to the amount of the allowed secured claimplus interest thereon at a rate equal to the required discountrate.133

The entitlement to plan interest as summarized above has beenrelatively noncontroversial, subject to only a few exceptions. Underthe best interest test, for instance, questions continue to arise concerning the date that should be used to determine the hypotheticalliquidation value of an unsecured claim.134

With respect to the payment of plan interest on secured claims,it has been questioned whether the determination of the amount ofthe allowed secured claim should include any pendency interestallowed under section 506(b).135 For example, if a claim in theprepetition amount of $1,000 (principal and prepetition interest) isoversecured and pendency interest is allowed in the amount of $100,is the allowed amount of the secured claim upon which plan interestmust be paid $1,000 or $1,100? Although pendency interest was notaddressed directly in Rake the Supreme Court in that case referredto it under section 506(b) as "part of the allowed claim" and as "partof the oversecured claim."136 Moreover, from a policy viewpoint, itwould make sense to treat pendency interest as part of the securedclaim for purposes of plan interest, because pendency interest is asubstantive right granted under the Code which would be subject todilution if payable on a deferred basis without a present value requirement. Also, the option to pay the present value of an allowed

152 Under § 1129(b)(2)(A), the specific alternatives to cash payment are sale of the collateral subject to a lien on proceeds, or the realization by the creditor of the indubitableequivalent of the allowed secured claim. See 11 U.S.C. § 1129(b) (2) (A) (1994).

'ss See supra notes 128-29 and accompanying text.154 See, e.g., In re Schoeneberg, 156 B.R 963, 969 (Bankr. W.D. Tex. 1993). Compare 5 COL

LIER ON BANKRUPTCY, supra note 122, 1 1225.02(4) at 1225-10 (arguing for effective date ofplan) with id. 1 1325.05(2) (a) at 1325-26 (arguing for petition date).

IS> Heidt, supra note 4, at 364 n.16. As previously discussed, the amount of an allowedsecured claim upon which pendency interest is allowed under § 506(b) should include not onlyprincipal, but also prepetition interest. See supra text accompanying notes 73-78. Thus, the issueof whether plan interest should accrue on pendency interest involves the question of intereston interest on interest. This question is not decided under the 1994 Act except with respect tothe curing of arrearages. See infra part V.

156 Rake, 113 S. Ct. at 2191-92. See id. at 2190 ("506(b) 'has the effect of allowing a claimto the creditor'"); see also Prudential Ins. Co. v. Monnier (In 711 Monnier Bros.), 755 F.2d 1336,1338 (8th Cir. 1985); 5 COLLIER ON BANKRUPTCY, supra note 122,1 1225.03(2). As discussed inpart V, the 1994 Act creates a separate rule for the curing of arrearages.



secured claim is presented as an alternative to the surrender of thecollateral.137 To the extent that these alternatives are intended tobe equivalents, the deferred payment of pendency interest under aplan should be subject to a present value requirement, because ifthe debtor had surrendered the collateral, such interest would havebeen paid out of the collateral's proceeds.

Difficulty has also arisen with respect to the availability of planinterest on arrearages proposed to be cured under a reorganizationplan. As previously mentioned, Rake settled this issue for arrearagesthat are part of an oversecured claim, holding that plan interest isrequired under the terms of section 1325(a)(5).I38 Rake did not address undersecured claims, however, and the application of section1325(a) (5) in this context has proved to be difficult. For purposes ofthe Code provisions relating to plan interest, should the arrearagesbe allocated to the secured portion of an undersecured claim, andtherefore entitled to plan interest? Or should they be allocated tothe unsecured portion, thereby precluding entitlement to plan interest? In re Arvelo139 appears to offer the best compromise - calculate the percentage of the entire claim that is secured and use thatpercentage to determine the portion of the arrearages that shouldbe deemed secured for purposes of plan interest.14o If, for example, the entire claim is $100,000, the collateral is valued at $60,000,and the arrearages are $10,000, then the secured portion of thearrearages entitled to plan interest would be deemed to be $6,000,and the unsecured portion of the arrearages not entitled to planinterest would be deemed to be $4,000.141 However, as discussed inpart V below, the 1994 Act expressly changes the rule for determining the amount necessary to cure a default under an agreemententered into after the effective date of the 1994 ACt.142

137 See 11 u.s.c. §§ 1129(b){2){A), 1225(a){5), 1325(a){5) (1994). See also supra note 132(noting that specific alternatives to cash payment under § 1129(b){2)(A) are a sale of thecollateral subject to a lien on proceeds or realization of indubitable equivalent).

,... 113 S. Ct. at 2191-92. See also supra text accompanying note 65. But see 1994 Act § 305(discussed infra part V).

,:59 176 B.R. 349 (Bankr. D.NJ. 1995).'40 Id. at 357-59.14' See id.142 See infra part V.


1995]

B. Rate ofPlan Interest

1. General

Entitlement to Interest 173

Although the entitlement to plan interest invites little argument,the rate of plan interest threatens never to be resolved. With littleexaggeration, one commentator notes that there is a case for almostany method of determining the appropriate rate,143 and he identifies eight "major" lines of authority among the cases that addressthis issue.l44 A few generalizations, however, have emerged fromthe chaos.

Beginning with the statutory language,145 it is apparent thatCongress described the obligation to pay plan interest under thereorganization chaptersl46 in very different terms from the obligations to pay pendency interest under section 506(b) or 726(a) (5). Asdiscussed previously, plan interest is not directly referenced in theBankruptcy Code; rather, it derives from the obligation to pay present value.147 Accordingly, if Congress had intended plan interest tocontinue at the contract rate, as under section 506(b), or at the"legal rate," as under section 726(a)(5), it could have done so as itdid in those sections. Moreover, because the entitlement to receiveplan interest is merely a means to provide for present value, the rateof plan interest must equal the rate of discount that otherwise wouldbe used in such determination. l48 Thus, a search for the appropriate rate of plan interest is a search for the rate at which the expected cash flows would be discounted in order to determine their present value.

From an economic perspective, the discount rate representscompensation for the time value of money.149 In effect, the discount rate is the price or exchange rate that is paid to compensate alender who foregoes current spending or investment opportunitiesto make a loan.150 This compensation includes three components:

BS Carbiener, supra note 4, at text accompanying note 9.1+1 Id. at text accompanying notes 15lH>3.Itl See United States v. Ron Pair Enters., Inc., 489 U.S. 235, 241 (1989) (reminding that all

such inquiries must begin with the language of the statute itself).B6 11 U.S.C. §§ 1129(a)(7), (a)(9), (b)(2), 1325(a)(4), (a)(5) (1994).B7 See supra part IV(A).B" Id.B9 Sears & Trennepohl, supra note 126, at 8-9, 546-47.lroo [d.



(1) a real rate (the basic rate established by the demand for borrowing and the supply of capital to compensate for the mere passage oftime, without taking into account expected inflation or risk); (2) anexpected inflation rate (to compensate for the expected loss in purchasing power); and (3) a risk premium (to compensate for theuncertainty regarding the actual return) .151 It is broadly acceptedeconomic theory that the above factors determine market interestrates.152

Consistent with the above, each of the eight circuits that hasaddressed the issue of the appropriate rate of plan interest has concluded that plan interest must reflect, in some fashion, a currentmarket rate of interest on a loan with duration and risk characteristics similar to those of the deferred payments proposed under theplan.153 Although various methods for determining what is the appropriate current market rate have been approved or prescribed by

1:;1 Id.1S2 See, e.g., id. at 571. See generally Fisher, supra note 126.15~ Third Circuit: GMAC v. Jones, 999 F.2d 63, 65 (3d Cir. 1993) (chapter 13) [(rate that

particular creditor would change)].Fourth Circuit. United Carolina Bank V. Hall, 993 F.2d 1126, 1130-31 {4th Cir. 1993)

(chapter 13) (rate based on creditor's lending market, not to exceed contract rate).Fifth Circuit: Heartland Fed. Sav. & Loan Ass'n V. Briscoe Enters., Ltd., II (In re Briscoe

Enters., Ltd., II), 994 F.2d 1160, 1169 (5th Cir. 1993), cert. denied, 114 S. Ct. 550 (1993) (chapter 11) (contract rate not clearly erroneous based on comparison with Treasury bill rate plusan appropriate adjustment for risk).

Sixth Circuit: United States v. Arnold, 878 F.2d 925, 928-30 (6th Cir. 1989) (chapter 12)(prevailing market rate); Cardinal Fed. Sav. & Loan Ass'n. V. Colegrove (In re Colegrove), 771F.2d 119, 122-23 (6th Cir. 1985) (chapter 13) (prevailing market rate not to exceed contractrate); Memphis Bank & Trust CO. V. Whitman, 692 F.2d 427, 431 (6th Cir. 1982) (chapter 13)(prevailing market rate).

Eighth Circuit: United States Dept. of Agric. V. Fisher (In re Fisher), 930 F.2d 1361, 136364 (8th Cir. 1991) (chapter 12) (prevailing market rate); United States V. Doud, 869 F.2d 1144,1150-56 (8th Cir. 1989) (chapter 12) (prevailing rate based on Treasury bond rate plus adjustment for risk); United States V. Neal Pharmacal Co., 789 F.2d 1283, 1285-88 (8th Cir. 1986)(chapter 11) (prevailing market rate); Prudential Ins. Co. V. Monnier (In re Monnier), 755 F.2d1336, 1337-38 (8th Cir. 1985) (chapter 11) (contract rate not erroneous because reflected prevailing cost of funds and inherent risks when negotiated "only some twenty months" beforeconfirmation) .

Ninth Circuit: Farm Credit Bank of Spokane V. Fowler (In re Fowler), 903 F.2d 694, 696-97(9th Cir. 1990) (chapter 12) (market rate derived by applying formula approach: Treasury rate,nature of security, etc.).

Tenth Circuit: Hardzog v. Federal Land Bank of Wichita (In re Hardzog), 901 F.2d 858,859-60 (10th Cir. 1990) (chapter 12) (rate for similar loans in region).

Eleventh CirCllit: United States V. Southern States Motor Inns, Inc. (In re Southern StatesMotor Inns, Inc.), 709 F.2d 647, 650-53 (11th Cir. 1983), cert. denied, 465 U.S. 1022 (1984)(chapter 11) (prevailing market rate).



these courts, most have compared the deferred payments proposedunder a plan to a coerced loan from the creditor, to whom a marketrate of interest must be paid in order to make the coerced loanequivalent to payment of the same principal amount as of the effective date of the plan.1M

As discussed in part V, notwithstanding the reorganization provisions of the Code relating to plan interest, the 1994 Act creates aseparate rule for determining the amount necessary to cure a default.

2. Methods for Determining Current Market Rate

At least three different methods for determining the appropriate current market rate have been approved or prescribed by theappellate courts. Most recently, in a chapter 13 case, the Third Circuit Court of Appeals held that the appropriate rate of plan interestis the rate that the particular creditor would charge, at the time of theeffective date of the plan, for a loan of similar character, amount,and duration.155 The court acknowledged that "the difference between the rates charged by the particular creditor in the regularcourse of its business in a competitive market will not differ materially from those charged by competing creditors in that market,"156

but believed that use of the particular creditor's rates would moreclosely approximate the statutory goal to place each creditor in approximately the same position it would have occupied had it received an equivalent principal amount as of the effective date of theplan.157 The court also thought that if the regularly maintaineddocuments of the particular creditor were the primary focus of thepresent value inquiry, it would reduce litigation costs and encouragestipulations as to interest rate. l58 To further minimize litigation expenses, the Third Circuit imposed a rule of practice that the contract rate, if any, would serve as a proxy for the current rate unlessthere is a stipulation or evidence to the contrary.159

154 &e GMAG, 999 F.2d at 67; United Carolina Bank, 993 F.2d at 1130; Fisher, 930 F.2d at1364; Hardzog, 901 F.2d at 860; AT7UJld, 878 F.2d at 928.

10> Janes, 999 F.2d at 65. Cf. United Carolina Bank, 993 F.2d at 1131. But if. Travelers Ins. Co.,878 F.2d at 358 (value must be determined objectively).

I~ Janes, 999 F.2d at 68.1~7 leI.Ir... leI. at 70.1~9 leI. at 70-71.



As suggested by the Third Circuit, a second method used by anumber of other appelate courts is to determine the prevailing marketrate in the appropriate region for "a loan of a term equal to thepayout period, with due consideration of the quality of the securityand the risk of subsequent default. "160 This method is closely related to the Third Circuit approach discussed above, except that theinquiry extends beyond the rates charged by the particular creditorto the rates charged by other creditors in the market for similarloans.

A third method approved by some appelate courts for determining the appropriate current market rate is the formula method.161

Following a formula approach, the current market rate is based notnecessarily on the rates for similar loans, but on the rates for relatively riskless securities, such as government bonds, to which a premium is added to reflect the risk factors associated with a particularplan, such as the likelihood of repayment and the strength of thecollateral. This approach is based on the theory that governmentbonds with a duration equal to the proposed plan payments are aneasily identified proxy for the first two components of the time valueof money - the real rate and the expected inflation rate - towhich an appropriate addition must be added to reflect only. theincreased risks posed by the particular debtor and collateral. InUnited States v. Doud,t62 for instance, the Eighth Circuit Court ofAppeals held in a chapter 12 case that it was not erroneous to determine the prevailing market rate by utilizing the yield on a treasurybond with a duration matched to the duration of the proposed planpayments, plus a two percent upward adjustment to compensate forthe overall risk associated with a chapter 12 reorganization.I6.~ TheDoud court added that "[i]f the bankruptcy court has correctly considered all of the elements involved in computing a discount rate,determination of the proper discount rate in a particular case is afactual inquiry" subject to the clearly erroneous standard on appeal. l64

160 See 5 COWER ON BANKRUPTCY, supra note 122, i 1129.03(f) (i). See, e.g., Fisher, 930 F.2dat 1363; Fowler, 903 F.2d at 696; Arnold, 878 F.2d at 928, Doud, 869 F.2d at 1145-46; Monnier,755 F.2d at 1339; Southern States, 709 F.2d at 651.

161 See Fowler, 903 F.2d at 696; Doud, 869 F.2d 1145-46. But see Jones, 999 F.2d at 69 n.9;Hardzog, 901 F.2d at 860.

162 869 F.2d 1144.163 Id. at 1145.16< Id. at 1146.



All three of the above methods appear to be reasonable approaches to determining plan interest because their principal objectis to determine present value as of the effective date of the plan.Some rates which the courts of appeals have specifically rejected because they were not consistent with the statutory goal of presentvalue include (1) the rate charged by the government to delinquenttaxpayers under 26 U.S.C. § 6621;165 (2) below market rates extended under special Farmers Home Administration programs;166and (3) the "cost of funds" rate determined by the creditor's borrowing rate and excluding any element of "profit" to the creditor. 167 Ina decision going both ways, the Fourth Circuit Court of Appeals recently emphasized in a chapter 13 case the present value purpose ofplan interest and explained that once this statutory purpose is recognized, "the issue of how the applicable interest rate is to be calculated becomes essentially an economic one."168 In another portion ofthe otherwise well-reasoned opinion, however, the court held thatplan interest may be capped at the contract rate as a matter of equity "so as to eliminate a windfall benefit to the secured creditor."169

One method not yet passed upon by a court of appeals is the"blended rate" method. This approach has been used in severalchapter 11 cases in response to criticism that there is no market for100% loan to value ratio loans, as would be the case in a reorganization plan in which the value of the collateral equals the amount ofthe allowed secured claim.170 In re Bloomingdale Partners7J providesan example. In that case, a creditor had a $10 million allowed secured claim collateralized by property with a value of $10 million.The evidence showed that without any equity cushion there was nomarket for such a loan. Accordingly, the court treated the proposedrepayment of the allowed secured claim as a proposal for, in effect,

165 See Neal Phannaca~ 789 F.2d at 1285-89; Southern States, 709 F.2d at 651-52.It» See Fisher, 930 F.2d at 1363-64; Arnold, 878 F.2d at 925-29.167 See]ones, 999 F.2d at 67; United Carolina Bank, 993 F.2d at 1130-31; Neal Phannaca~ 789

F.2d at 1286. But see In re Collins, 167 B.R. 842 (Bankr. E.D. Tex. 1994) (rejecting coercedloan theory "because it contained many risk elements plus a profit factor inappropriate in abankruptcy context").

16. United Carolina Bank, 993 F.2d at 1130.IGO Id. at 1131.170 See, e.g., Mutual Life Ins. Co. of New York v. Paradise Springs Assocs. (In re Paradise

Springs Assocs.), 165 B.R. 913 (Bankr. D. Ariz. 1993); In re Bloomingdale Partners, 155 B.R.961 (Bankr. N.D. III. 1993); In re Birdneck Apartment Assocs. II, L.P., 156 B.R. 499 (Bankr.E.D. Va. 1993).

•71 155 B.R. 961 (Bankr. N.D. III. 1993).



two loans - a first mortgage loan for $7.5 million, and a secondmortgage loan for $2.5 million. Reducing the court's analysis to itssimplest terms, the court found that the market rate for the firstmortgage loan should be based on the market for oversecured firstmortgage loans, and that the market rate for the second mortgageloan should be based on the market for second lien loans or equityparticipations.172 The court then combined the two rates to determine a weighted blended rate.173 Experts supplied a number ofother checks on this methodology to test the synthesized marketrate.174

In sum, notwithstanding the multitude of decisions addressingthe appropriate rate of plah interest, there is agreement among thecircuits concerning at least three concepts. First, the entire purposeof plan interest is to provide the holder of a claim the present valueof the minimum amount required to be paid under the Code on account of such claim. Second, to achieve this statutory objective, theinterest rate that is selected must compensate the creditor for all ofthe components of the time value of money.175 Third, the interestrate that most nearly approximates the goal of present value is thecurrent market rate for a loan with duration and risk characteristicssimilar to those incident to a particular plan. With respect to themethod for determining a current market rate, however, there isdisagreement, and one must consult applicable authority to identifythe methodologies permitted in a particular jurisdiction.

V. ARREARAGES & THE 1994 Acr

Section 305 of the 1994 Act, entitled "Interest on Interest," addsto each of the reorganization chapters a subsection which providesthat notwithstanding certain other sections of the Bankruptcy Code,if a plan proposes to cure a default, the amount necessary to curethe default shall be determined in accordance with the underlyingagreement and applicable nonbankruptey law.176 The sections ofthe Code made subordinate to this addition include section 1123(a)(which specifies the general contents of a chapter 11 plan), sections

172 See id. at 983-86.I7S [d. at 985.174 Id. at 986.175 See supra text accompanying note 151..76 See 11 U.S.C. §§ 1123(d), 1222(d), 1322(e) (1994).



1222(b) (2) and 1322(b) (2) (which permit modification of the rightsof holders of secured claims), section 506(b) (which allows pendency interest on oversecured claims as discussed in part III), and sections 1129(a)(7) , 1129(b) , 1225(a)(5), and 1325(a)(5) (which require plan interest under certain circumstances as discussed in partIV).

According to the legislative history,!77 section 305 of the 1994Act has the effect of overruling Rake v. Wade. 178 As suggested by thetitle of this section, "Interest on Interest," and by the available legislative history, one of Congress' chief concerns was that Rake had theeffect of "giving secured creditors interest on interest... evenwhere applicable law prohibits such interest"179 From this, it mightbe supposed that the object of section 305 is to prohibit the payment of compound interest The language of section 305, however,circumscribes a rule that is at once both broader and narrower thansuch a simple prohibition. First, section 305 is limited to amountsnecessary to cure defaults and therefore does not apply to othertypes of claims, which remain subject to the pendency and planinterest provisions of the Code. Second, section 305 is not a prohibition, but rather a reference to the underlying agreement and applicable nonbankruptcy law. Third, section 305 extends to "theamount" necessary to cure a default and therefore is not limited tointerest on interest.

Returning to the first observation, because section 305 of the1994 Act encompasses only amounts necessary to cure defaults, itsimply creates a separate rule for determining the amount necessaryto cure a default and divorces that rule from the ordinary rules fordetermining prepetition, pendency, and plan "interest. Subject tothat exception, section 305 by its terms has no effect on the statutoryor case law summarized in parts II, III, and IV. Beginning with Rake(the intended object of section 305), the only casualty appears to bethe Court's logical deduction that because arrearages are part of acreditor's oversecured claim they should be subject to the same rulesas those governing oversecured claims in general.180 Whereas prior

177 140 CONGo REc. HlO,770 (dailyed. Oct. 4,1994) (statement of Rep. Brooks).178 113 S. Ct. 2187 (1993). For a discussion of Rake, see supra text accompanying notes 54-

81.179 140 CONGo REc. HI0,770 (daily ed. Oct. 4,1994) (statement of Rep. Brooks).1M 113 S. Ct. at 2191-92. As previously discussed, arrearages typically refer to installment

loan payments that are past due. See supra text accompanying notes 54-57. Under the reorganization chapters, a plan may provide for the curing of such arrearages. See id.



to the 1994 Act the cure provisions of the Code gave no indicationthat the allowed amount of arrearages cured under a plan may notinclude pendency interest otherwise available as part of a securedclaim under section 506(b),181 or plan interest otherwise availableon a secured claim pursuant to the reorganization chapters,182 section 305 of the 1994 Act now so provides. Under section 305, if aplan proposes to cure a default, the amount necessary to cure isdetermined in accordance with the underlying agreement and applicable nonbankruptcy law, notwithstanding section 506(b) or thereorganization provisions relating to plan interest on secured claims.Accordingly, it no longer follows that because arrearages are part ofa creditor's secured claim, arrearages are subject to the rules governing pendency interest under section 506(b) or plan interest underthe reorganization provisions. To this extent, the initial conclusionof Rake is overruled by section 305.

The other conclusions reached by the Rake Court, as well as theholdings of Timbers and Ron Pair, are simply constructions of section506(b) or 1325(a) (5).183 Hence, they are unaffected by section 305except as they apply to the cure of arrearages, which is now governed by the new rule. Section 305, therefore, does not overrule: (i)Timbers' holding that section 506(b) permits pendency interest onoversecured claims and prohibits pendency interest on undersecuredclaims; (ii) Ron Pair's holding that pendency interest under section506(b) extends to nonconsensual oversecured claims as well as consensual claims; (iii) Rake's holding that pendency interest under section 506(b) is not dependent on the right to interest under anagreement or applicable nonbankruptcy law, is allowed on interest aswell as principal, and applies to the period from the petition dateuntil the confirmation or effective date of the plan; or (iv) Rake'sindication that pendency interest is part of an oversecured claim onwhich plan interest therefore may accrue pursuant to the reorganization chapters.184

Next, because section 305 of the 1994 Act is not in the form ofa prohibition, but rather a reference to the underlying agreementand applicable nonbankruptcy law, it does not proscribe interest oninterest (or any other amount) even for purposes of determining the

JRI See supra text accompanying note 62.182 See supra part IV(A) and text accompanying note 138.ISS See supra part III.'84 See supra parts 1II. IV.



amount necessary to cure a default. If the underlying agreement andapplicable nonbankruptcy law provide for interest on interest, thenpursuant to section 305 such amount must be considered in determining the amount necessary to cure a default. Taking the hint, atleast one state has amended its usury law so as to permit interest oninterest on certain claims in bankruptcy. ISS

Lastly, because section 305 of the 1994 Act extends to "theamount" necessary to cure a default and therefore is not limited tointerest on interest, it presumably applies to other costs, such as simple interest, default interest, late fees, and attorney fees. With respect to the issue of simple interest, pendency and plan interest onarrearages proposed to be cured under a plan of reorganization nolonger depend on whether the arrearages are oversecured,undersecured, or unsecured. Rather, interest and any other amountsrelating to a cure of arrearages should be determined pursuant tosection 305 of the 1994 Act in accordance with the underlyingagreement and applicable nonbankruptcy law, notwithstanding section 506(b) or those provisions of the Code relating to plan interest.Thus, with respect to agreements entered into after the enactmentof the 1994 Act,186 section 305 overrules the reasoning of those casesl87 which held that pendency or plan interest is not permitted tosome extent because the arrearages are part of an undersecuredclaim.

Similarly, if an agreement enforceable under applicablenonbankruptcy law provides for a default rate of interest, then section 305 may require interest to be calculated at such higher rate forpurposes of curing a default. This application of section 305 wouldhave the effect of overruling Florida Partners Corp. v. Southeast Co. (Inre Southeast CO.),I88 discussed in part II.B, which held that the cureprovisions of chapter 11 authorize a plan to nullify all consequencesof default, including a default rate of interest.189 On the otherhand, the section-by-section analysis of section 305 of the 1994 Actalso states that "[i]t is the Committees's intention that a cure pursuant to a plan should operate to put the debtor in the same position

185 See 1995 Ga. Laws 432 (S.B. No. 408).106 The amendments made by § 305 of the 1994 Act apply only to agreements entered

into after the date of enactment. 11 U.S.C. § 702(D) (1994).187 See supra note 64 and text accompanying notes 139-41.I.., 868 F.2d 335 (9th Cir. 1989).189 fd. at 336.

'-;;:- :



as if the default had never occurred."190 This statement affirms thebasic premise of Southeast Co. This apparent conflict could be reconciled if the rule were that the rate of interest is determined by theunderlying agreement and applicable nonbankruptcy law, and asthough the default had never occurred.191 The broad language ofsection 305, however, does not make this an easy conclusion.

VI. CONCLUSION

As developed above, the general rules for the determination ofinterest in bankruptcy are relatively few and quickly recited. Exceptfor interest on arrearages, the entitlement to interest and the rate ofinterest under the Bankruptcy Code are classified into three categories corresponding to the progression of the case in bankruptcy.Prepetition interest is allowable, generally to the extent and at therate permitted under applicable nonbankruptcy law. Pendency interest generally is not allowed, except to the extent permitted underthe well-established exceptions for a solvent debtor (at the "legalrate") and for an oversecured creditor (in most instances at the rateprovided by applicable nonbankruptcy law). Plan interest is providedfor under the reorganization chapters of the Code at a current market rate in order to assure that deferred payments under a reorganization plan provide for the present value of certain minimumamounts required to be paid under the plan. Under the 1994 Act,interest (whether prepetition, pendency or plan) on arrearages proposed to be cured under a reorganization plan is determined inaccordance with the underlying agreement and applicablenonbankruptcy law.

At the edges, however, these rules are both stretched andfrayed. For the rules referencing applicable nonbankruptcy law,should an equitable exception exist with respect to default or penalty rates of interest, or interest on interest? Regarding pendency interest, should a creditor be entitled thereto if there is no right tointerest under the underlying agreement or applicablenonbankruptcy law? If so, at what rate? What rate should apply if the

190 140 CONGo REc. H10,770 (daily ed. Oct. 4, 1994) (statement of Rep. Brooks).191 Some support for this approach is found in § 219(a) of the 1994 Act (amending 11

U.S.C. § 365(b)(2». Under this addition to § 365(b)(2), a debtor in possession may assumean executory contract without curing a "default that is a breach of a provision relating to ...(D) the satisfaction of any penalty rate." 11 U.S.C. 365(b)(2)(D) (1994).



debtor proves to be solvent? For the purposes of pendency and planinterest, at what times should the value of a secured claim be measured, and what is the effect of a lien on collateral that earns income after the petition date? Should there be a single method fordetermining the current market rate for purposes of plan interest?As of what date should the hypothetical liquidation value of an unsecured claim be determined? With respect to interest on arrearages,did Congress really intend to fashion a rule completely divorcedfrom the general rules for determining pendency and plan interest?

Although the general rules are easily stated, they are not sufficiently defined to provide clear answers to the above questions. As aresult, courts and practitioners continue to struggle to resolve manyof them, with varying degrees of success and uniformity. In light ofthese problems and the establishment by the 1994 Act of the National Bankruptcy Review Commission,192 the time may be ripe for ageneral review of the subject of interest under the Code, includingthe role that interest should play in accommodating competingbankruptcy policies.

102 11 U.S.C. § 602 (1994).


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ENTITLEMENT TO INTEREST UNDER THE BANKRUPTCY CODE

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