Federal Common Law's Long Shadow: Shedding Light on State Law Rights to Postpetition Default Interest.

Date01 January 2023
AuthorMiller, Evan

    Historically, the law imposed harsh penalties on debtors who could not meet their obligations. (1) One regime dismembered the debtor's body and proportionally distributed it to creditors. (2) Rejecting these draconian penalties, the United States Constitution empowered Congress to enact federal bankruptcy legislation. (3) Bankruptcy laws in the United States helped the "unfortunate" debtor get a fresh start while providing creditors with "prompt and effectual" administration of the debtor's unmet obligations. (4) In order to accomplish these policy objectives, Congress granted equitable powers to bankruptcy courts. (5) These powers allow bankruptcy courts to occasionally adjust parties' rights under non-bankruptcy law and fairly distribute the debtor's assets among creditors. (6) The process of balancing equities between the debtor and her creditors, as well as between creditors, is a central inquiry of bankruptcy law analysis. (7)

    Unfortunately, the equitable nature of bankruptcy courts catalyzed an unpredictable process--different federal bankruptcy courts faced similar fact patterns but reached different outcomes each time based on the equities of a case. (8) Despite the Supreme Court's disfavor of "federal common law," (9) the federal common law casts a shadow over bankruptcy law. (10) Of particular concern, bankruptcy courts patched together a federal common law governing interest maturing after the debtor files a bankruptcy petition, a claim referred to as postpetition default interest. (11) Section 506(b) of the Bankruptcy Code governs postpetition default interest. (12) In relevant part, [section] 506(b) states:

    To the extent that an allowed secured claim is secured by property the value of which,... is greater than the amount of such claim, there shall be allowed... interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose. (13) A recent case, In re Family Pharmacy, highlighted the issues plaguing [section] 506(b). (14) The bankruptcy court applied equities to a claim for postpetition default interest, which the appellate court condemned on review, breaking from the majority position on postpetition default interest. (15) This Note argues that Family Pharmacy was correct in its analysis of equitable principles but fell short in its general analysis of claims for postpetition default interest. (16) Part II examines the history of bankruptcy law and [section] 506(b), which illustrate why the dispute in Family Pharmacy occurred in the first place. Part III takes an in-depth look at Family Pharmacy, Law v. Siegel, and Rodriguez v. FDIC, recent controversies that bring [section] 506(b) to center stage in the grand bankruptcy drama. Finally, Part IV offers a state law solution to dispel the shadow of federal common law obscuring [section] 506(b) and the future of postpetition default interest.


    A debtor initiates bankruptcy proceedings by filing a petition in bankruptcy court. (17) This petition creates the debtor's "estate," comprised of her assets, from which the creditors may satisfy their claims. (18) When the debtor files a bankruptcy petition, creditors' activities against debtors must cease. (19) In lieu of seeking payment through typical channels of collection, creditors file a proof of claim with the bankruptcy court to collect from the debtor. (20) Any right to payment arises under the substantive law that formed the obligation between the debtor and the creditor. (21) Bankruptcy courts apply the Bankruptcy Code to disburse the assets of the bankruptcy estate to the creditors. (22)

    The Code does not allow creditors to collect unmatured interest after the debtor files the bankruptcy petition. (23) However, the Code provides an exception for oversecured creditors--i.e., creditors whose liens on a debtor's property are lesser in value than the debtor's property as a whole. (24) Section 506(b) of the Code overrides the statutory prohibition against unmatured interest to allow oversecured creditors to collect unmatured interest on their claims after the debtor files for bankruptcy. (25) Bankruptcy courts generally agree that [section] 506(b) allows creditors to collect simple interest at the contract rate, but they have approached default interest with greater trepidation. (26) The history of bankruptcy law lays a foundation for contemporary cases that dealt with postpetition default interest and federal common law.

    1. American Bankruptcy History

      The constitutional mandate of uniformity in bankruptcy law across the several states faced early challenges. (27) After several unsuccessful iterations, (28) Congress passed the Bankruptcy Act in 1898. (29) The Bankruptcy Act provided relief to the "meritorious and unfortunate debtor," (30) by requiring an exchange of the debtor's assets for a fresh start unimpaired by creditors. (31) In an early test of the Act's uniformity, a New York bank challenged the Act, claiming that it was unconstitutional. (32) The bank argued that the Act lacked uniformity because it allowed state provisions to determine the extent to which some assets entered the bankruptcy estate. (33) The Supreme Court upheld the Act, concluding that bankruptcy laws are "geographically uniform," (34) and that Congress was well within its rights to recognize certain local laws dealing with state property rights. (35) Despite the bank's pleas to the contrary, bankruptcy courts could reach only property available to them through non-bankruptcy law. (36) The respect accorded to state law entitlements might produce different outcomes in different states, but those differences are acceptable because courts were normally confined to non-bankruptcy law when satisfying creditors' claims. (37) Unlike other courts, however, Congress endowed bankruptcy courts with equitable powers. (38) These equitable powers were on a collision course with state law. (39)

      The Bankruptcy Act established the equitable powers of bankruptcy courts. (40) Bankruptcy courts prioritize substance over form and prevent technicalities from thwarting justice. (41) In 1946, the Supreme Court explained the role of equitable powers and federal law in a trio of cases. In American Surety Company of New York v. Sampsell, the Court held that federal law--which allows courts to exercise equitable principles--provides the rule of decision in distributing assets of the bankrupt. (42) In Heiser v. Woodruff, the Court held that bankruptcy courts were not required to "adopt local rules of law in determining what claims are provable, or to be allowed." (43) And finally, in Vanston Bondholders Committee v. Green, the Court clarified that bankruptcy courts need not look to state laws to understand whether a claim is enforceable, but rather bankruptcy law alone is sufficient. (44) According to the Court, the congressional intent behind the Act licensed bankruptcy courts to use equitable principles to determine which claims should be allowed. (45) In the Court's view, "the touchstone of each decision on allowance of interest in bankruptcy... has been a balance of equities between creditor and creditor or between creditors and the debtor." (46) Justice Frankfurter argued in a concurring opinion that the first question to ask was whether the state law created an enforceable claim in general. (47) Only after understanding whether a claim exists at all, Justice Frankfurter contended, could a bankruptcy court begin its analysis of whether the claim should be allowed in bankruptcy proceedings. (48) Justice Frankfurter recognized that beginning with state law in a federal court of equity could undo the goals of uniformity found in the Bankruptcy Code, but he believed that the goal of bankruptcy was geographic uniformity, not outcome uniformity. (49)

      Six months before Congress's comprehensive Bankruptcy Code replaced the Bankruptcy Act in 1979, (50) the Supreme Court decided Butner v. United States to resolve a conflict between state law and the application of equitable principles. (51) The Court stated that "[p]roperty interests are created and defined by state law. Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding." (52) According to the Court, the application of state law "serves to reduce uncertainty, discourage forum shopping, and to prevent a party from receiving 'a windfall merely by reason of the happenstance of bankruptcy.'" (53) The Court has subsequently reinforced this principle on other occasions. (54)

    2. The Bankruptcy Code and Postpetition Interest

      Oversecured creditors gained the right to postpetition interest with the passage of [section] 506(b) and the Bankruptcy Code in 1978, (55) which became the subject of intense litigation. (56) In United States v. Ron Pair Enterprises, the Supreme Court interpreted [section] 506(b) and held that the plain language of the statute provided for unqualified recovery of postpetition interest. (57) Specifically, the Court examined the provision which stated that "there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or [s]tate statute under which such claim arose." (58) According to the Court, the grammatical structure of [section] 506(b) indicated that "reasonableness" applied only to "fees, charges, and costs," which was a distinct type of recovery from interest. (59) The Court explained that there was no reason to deviate from the plain meaning of [section] 506(b). (60) First, the Court believed that Congress added [section] 506(b) to make bankruptcy law more consistent than the previous case law. (61) Second, there was no need to repudiate bankruptcy courts' rights to equitably modify postpetition default interest because the...

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