In ruling on a very unfortunate situation (more on that below), Judge Shannon issued an opinion on July 24, 2014 in the Aro bankruptcy, holding that a state court decision concerning the validity of a lien cannot be challenged in Bankruptcy Court. In the opinion in this case issued on January 22, 2015 (the “Opinion”), Judge Shannon analyzed the value of the lien and applicable interest rates. The Opinion is available here. This Opinion provided the lender with an award of interest (as it was oversecured) and computed that interest without annual compounding. In my opinion, the treatment of compound interest is the real lesson from this case.
In 1989 Charles W. Aro signed a mortgage on his personal residence as security for a lease of commercial laundry equipment. After falling on hard times, Aro filed for Chapter 13 bankruptcy in 1994. The laundry equipment, originally purchased for $40,000, was sold for $28,000, leaving Aro’s lender with a secured deficiency claim of $12,000.
Aro filed a complaint in Delaware Superior Court to compel the satisfaction of the mortgage or to declare that a novation had occurred which satisfied the mortgage. Following a bench trial, the Superior Court ruled against Aro, holding that his lender had a valid mortgage on his home. The lender filed a foreclosure action in Superior Court in 2011 to enforce the mortgage, and eleven months later Aro filed the present bankruptcy petition. After Judge Shannon’s July 2014 opinion addressed the validity of the lien, another hearing was held to determine the value of the mortgage.
After quickly dismissing Aro’s argument that the lender had lost its claim by failing to file a proof of claim, Judge Shannon looked to the undisputed record to determine that as of 1994, the lender had a claim for $12,000. The parties disagreed as to the appropriate interest rate to be charged, which leads to the most interesting part of this Opinion, at least to me. While the rate of interest may not seem like a big deal, realize that the interest has been accruing for 20 years.
Aro argued that interest should not be applied since the mortgage contract lacked any interest rate terms (a mistake this lender will no-doubt never make again). Examining the payments made and the term of the contract, however, the lender argued that the appropriate rate of interest was 14%. As Judge Shannon states, it is “inconsistent with business realities” to have an interest rate of zero. Opinion at *4. However, because the lender drafted the lease and the mortgage, Judge Shannon construed the terms strictly against them, holding that the legal rate under Delaware law, 8%, is the appropriate rate. Opinion at *4.
Here is the interesting piece: Having determined that the lender should be awarded 8% interest, I note that over 20 years, compound interest (which is the interest of the real world) would create a total value of $55,931 based on an initial investment of $12,000. However, Judge Shannon held that the principal of $12,000 would be awarded and interest would total only $19,200. Calculating an interest rate of 8% using simple interest means that the lender was awarded a total of $31,200. This equates to a compound interest rate of just 4.89%.
Because legal fees are capped at 20% of an award, this also reduced the legal fees awarded to the lenders. In total, using a compound interest rate (and assuming attorneys’ fees still hit the 20% cap), the lenders would have been awarded $67,117 rather than the $37,440 they were awarded. A compound interest rate would have nearly doubled the lender’s award, increasing its recovery nearly $30,000.
The Delaware Supreme Court addressed the question of whether compound or simple interest rates were appropriate in the case Gotham Partners v. Hallwood Partners, 817 A. 2d 160 (Del. 2002). That Court stated that “Delaware courts have traditionally disfavored compound interest.” Id. at 173. It continued, however, stating that “in Delaware, no rule of simple interest exists in the General Corporation Law and the rule or practice of awarding simple interest, in this day and age, has nothing to commend it — except that it has always been done that way in the past.” Id. (citing Onti, Inc. v. Integra Bank, 751 A.2d 904, 929 (Del. Ch. 1999)). For emphasis – it has “nothing to commend it”.
As the bankruptcy process continues to get more sophisticated, I am interested to see if courts will begin treating compound interest as the rule, rather than the exception. It is my opinion that using simple interest obfuscates the true value of an award of interest. As shown in the Aro case, the lender would have been far better off it it had been paid immediately and could have invested at a true 8% interest rate, rather than the 4.89% that it received pursuant to the Opinion.