In re Charles St. African Methodist Episcopal Church of Bos.

481 B.R. 1

In re CHARLES STREET AFRICAN METHODIST EPISCOPAL CHURCH OF BOSTON, Debtor.

No. 12–12292–FJB.

United States Bankruptcy Court,

D. Massachusetts,

Eastern Division.

Sept. 18, 2012.

D. Ross Martin, Jonathan Lackow, Ropes & Gray LLP, Boston, MA, for Debtor.

MEMORANDUM OF DECISION ON DEBTOR'S OBJECTION TO PROOF OF CLAIM OF ONEUNITED BANK

FRANK J. BAILEY, Bankruptcy Judge.

The matter before the Court is the Objection of the Debtor, Charles Street African Methodist Episcopal Church of Boston (“CSAME”), to proof of claim no. 10 (the “Claim”), filed by OneUnited Bank (“OneUnited”). CSAME objects to the default interest portion of the claim, arguing that it is amounts to an unenforceable penalty. After an evidentiary hearing ¹ and on the basis of the findings and rulings set forth below, I will sustain the objection by disallowing interest in excess of the nondefault rate.

I. FINDINGS OF FACTA. The Church and Construction Loans

On October 3, 2006, Charles Street executed two promissory notes in favor of OneUnited. The first, the “Church Loan,” is a fixed-rate promissory note through which Charles Street refinanced an existing mortgage. Under the Church Loan, CSAME borrowed $1,115,000 for five years at the rate of 7.875 percent per annum,² with principal and unpaid interest due in full on December 1, 2011. Upon maturity or an earlier event of default, the interest rate “shall be increased to the greater of eighteen percent (18%) per annum or 5% greater than the then floating prime rate, if permitted by law.” ³

The second loan, the “Construction Loan” (together with the Church Loan, “the Loans”) was a non-revolving line of credit of up to $3,652,000 for the purpose of constructing a community center, the “Roxbury Renaissance Center” (“RRC”). The promissory note for this loan had a term of 18 months. For the first six months, interest accrued at a fixed rate of 8 percent per annum.⁴ After the first six months, the interest rate would vary according to a floating “Prime Rate” ⁵ but could never be less than 7 percent or greater than 14 percent per annum.⁶ The promissory note further stated that “from and after any Event of Default, the unpaid principal balance of all advances shall, at the Bank's option, bear interest at the rate of eighteen percent (18%) per annum or, if higher, at the floating rate equal to five (5%) percent above the Prime Rate, if permitted by law until paid in full.” ⁷ At the evidentiary hearing, the parties stated that they agreed that, because the promissory note capped the nondefault rate at 14 percent, and the default interest could never be more than 5 percent above that, the default interest rate on the Construction Loan could never be higher than 19 percent per annum. However, there is no evidence that this interpretation was shared by OneUnited at the time of contracting. As the promissory note for the Construction Loan reads, the 14 percent cap applies to the nondefault interest rate but is not part of the definition of “Prime Rate” and does not limit that rate. I must conclude that OneUnited believed at the time of contracting that the default interest provision in the Construction Loan was not subject to a 19 percent cap.

The Loans are secured by real property. The Church Loan is secured by mortgages on 551 and 553–565 Warren Street, Roxbury, Massachusetts and on 70 Summer Street, Milton, Massachusetts. The property at 551 Warren Street is the church building itself. It is undisputed that the current value of the properties securing the Church Loan exceeds the amount of OneUnited's Claim on the Church Loan as of the date of the bankruptcy filing. The Construction Loan is secured by mortgages on 567–575 Warren Street, which is the site of the RRC, and on 5–15 Elm Hill Avenue in Roxbury, Massachusetts.⁸ It is undisputed that the current fair market value of the properties securing the Construction Loan is less than the amount of OneUnited's Claim on the Construction Loan as of the date of the bankruptcy filing.

Before it committed to the Construction Loan, OneUnited generated a Real Estate Loan Underwriting Memorandum (the “Underwriting Memorandum”), in which it assessed the strengths and weaknesses of extending a $3,652,000 line of credit to CSAME.⁹ The Underwriting Memorandum set forth appraised values for the two properties securing the Construction Loan. It stated that the value of the property at 5–15 Elm Hill Avenue was $405,000 and that the value of the property at 567–575 Warren Street—which in 2006 was an undeveloped shell—was approximately $585,000, but that “as constructed” its value would increase to $3,400,000.¹⁰

B. The Guarantee on the Construction Loan

The Underwriting Memorandum indicated that monthly debt service on the Construction Loan would be $24,913 and noted that CSAME did not have sufficient excess cash flow to meet this obligation. Although the Underwriting Memorandum foresaw that CSAME would have difficulty with repayment, it noted that this problem was mitigated by the involvement of the First Episcopal District of the African Methodist Episcopal Church (“FEDAME” or “First Episcopal District”) in two respects.¹¹ First, FEDAME pledged a certificate of deposit in the amount of $850,000 to secure the Construction Loan, which certificate was deposited with OneUnited and would help to cover deficiencies in debt service on the Construction Loan. Second, FEDAME executed a guaranty of CSAME's performance under the Construction Loan (the “Guaranty”).¹² The Guaranty provides that, “[u]pon any default by [CSAME] in the full and punctual payment and performance of the Obligation, the liabilities and Obligation of the Guarantor [i.e., FEDAME] hereunder shall, at the option of [OneUnited], become forthwith due and payable to [OneUnited] without demand or notice of any nature.” ¹³

C. The Loans Go Into Default

Construction on the RRC began in November, 2006.¹⁴ The contractor, Thomas Construction Company, Inc., submitted drawdown requests on the Construction Loan directly to OneUnited and did draw down on the loan, though not to its full extent. Construction was plagued by delays and by June 1, 2008, the date upon which Charles Street was to repay all sums advanced under the Construction Loan, the RRC was not complete. The parties extended the Construction Loan several times, most recently to December 1, 2009.¹⁵ OneUnited formally declared the Construction Loan in default on April 19, 2010, at which time interest began to accrue at the default rate of 18 percent. ¹⁶

On December 1, 2011, when the Church Loan matured and CSAME was unable to make the required balloon payment, OneUnited declared that loan too in default. ¹⁷ OneUnited began the foreclosure process on the properties securing the Church Loan in February, 2012.¹⁸ According to OneUnited, the Church Loan has accrued interest at the default rate of 18 percent since December 1, 2011.¹⁹

In order to avert OneUnited's foreclosure on several of the mortgaged properties, including the church in which it conducts its religious services, CSAME filed a petition for relief under Chapter 11 of the Bankruptcy Code on March 20, 2012.²⁰ On June 1, OneUnited filed its Claim, asserting an outstanding balance on the Church and Construction Loans totaling $5,004,358.60 as of the date of CSAME's bankruptcy filing.²¹ This total includes “default/maturity interest” of $792,425.92 on the Construction Loan and of $58,416 on the Church Loan. In addition to the prepetition balances on the Church and Construction Loans, OneUnited's Claim also asserts entitlement to “post-petition interest, attorney's fees and costs, pursuant to 11 U.S.C. § 506(b).” OneUnited has not offered evidence on these postpetition amounts.

D. Setting the Default Interest Rate

OneUnited's president and chief operating officer, Teri Williams, testified as to the Bank's policy-making decisions in 2006 and spoke in general as to how OneUnited set its interest rates at that time. At the time OneUnited made the Church and Construction Loans, Ms. Williams served on the Asset Liability Committee (“ALCO”) and the Senior Loan Committee and was involved in determining and setting interest rates for OneUnited's commercial loans. ²² Default interest rates were determined in the first instance by the ALCO; the ultimate approval of loans was made by the Senior Loan Committee.

In setting the non-default rate of interest on the Loans, the ALCO looked at the market prime rate and the ten-year treasury rate. Risk was also a factor. The ALCO considered the borrower's ability to repay the Loans, but “we try to keep our rates low because we focus on community development lending, and a lot of our borrowers don't have a lot of resources.” ²³ On cross, Ms. Williams testified that OneUnited considered the Construction Loan to be riskier than the Church Loan.²⁴ She also stated that the ALCO took the FEDAME Guaranty into consideration in setting the 7 to 14 percent range for the non-default interest rate on the Construction Loan.²⁵

At several points in her testimony, Ms. Williams indicated that risk was also a factor in setting the default interest rates on loans.²⁶ However, she did not explain how risk can be viewed as an element of damages, a loss to be recovered or compensated for. Nor did she explain how this factor affected the quantification of the default rate (if at all). From her testimony it appears that risk, when it was a factor at all, did not affect the default rate itself but only whether the loan would include a default interest rate at all.²⁷

Ms. Williams did not testify that the default rate was designed in part to recover for OneUnited either the benefit of its bargain (such as interest that would accrue during prematurity periods of default) or the time value of money (the cost to it of the money it had loaned and not been repaid) or lost opportunity costs (profits it would have made with the principal had it been timely repaid). Nonetheless, from the default...