Section 506(b) worked as arithmetic: the cushion, the monthly accrual, the month it runs out, and the cents it takes from the unsecured creditors.
An oversecured creditor earns post-petition interest, and reasonable fees its agreement provides for, until its claim grows to the value of its collateral, and not a dollar beyond. On an illustrative $300.0M first lien claim secured by $345.0M of collateral, interest at 9.00 per cent plus $0.40M a month of fees accrues $39.75M over a 15-month case, inside the $45.0M cushion. The cushion runs out after 17.0 months, and every dollar it accrues comes out of the unsecured creditors' recovery.
Worked in full in The Distressed Debt Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
In a US Chapter 11 case, section 502(b)(2) disallows unmatured interest, so interest on unsecured claims stops at the petition date unless the debtor turns out to be solvent. Section 506(b) of the Bankruptcy Code makes an exception for a secured creditor whose collateral is worth more than its claim: it may add interest and reasonable fees, costs or charges provided for under the agreement, up to the value of the collateral. For a distressed investor this is not a legal footnote. It decides how much the first lien is worth at exit, and how much the fulcrum loses while the case runs.
| Input | Value |
|---|---|
| First lien claim at the petition date (principal and accrued interest) | 300.0 |
| Value of the first lien's collateral | 345.0 |
| Contract interest rate (simple, non-default) | 9.00% |
| Default rate under the agreement | 11.00% |
| Lender's professional fees, per month | 0.40 |
| Length of the case | 15 months |
| Total distributable value | 420.0 |
| Unsecured claims | 400.0 |
Cushion = Collateral value − Claim = 345.0 − 300.0 = 45.0
Collateral coverage = 345.0 ÷ 300.0 = 1.15x
The cushion is the ceiling on everything that follows. The collateral value is the contested input: the lender argues it up, the unsecured committee argues it down, and the valuation date and method are often litigated. The rest is arithmetic.
Interest per month = 300.0 × 9.00% ÷ 12 = 2.25
Plus fees = 2.25 + 0.40 = 2.65 a month
Months to exhaust the cushion = 45.0 ÷ 2.65 = 17.0
Over 15 months: interest 33.75 + fees 6.00 = 39.75, below the 45.0 cap
In Excel: =MIN(Collateral-Claim, Months*(Claim*Rate/12+Fees))
At emergence the secured claim is 339.75, with 5.25 of cushion left. Had the case run beyond 17.0 months the lender would have kept accruing on paper and recovered nothing more: from that point the interest has no collateral behind it.
Whether the contract default rate is allowed is argued case by case. If it is, the monthly accrual becomes 300.0 × 11.00% ÷ 12 + 0.40 = 3.15, and the cushion is used up in 14.3 months. Over 15 months the lender accrues 47.25 but can claim only the 45.0 cushion, so the default rate is worth 5.25 more than the contract rate, and 2.25 of what accrued is lost to the cap. A lender with a thin cushion gains little from fighting for default interest; one with a deep cushion and a long case gains a lot.
| Post-petition interest allowed | Secured claim at exit | Left for unsecured | Unsecured recovery, cents |
|---|---|---|---|
| None | 300.00 | 120.00 | 30.0 |
| Contract rate, 15 months | 339.75 | 80.25 | 20.1 |
| Default rate, capped | 345.00 | 75.00 | 18.8 |
The first lien gains what the unsecured lose, dollar for dollar. With $400.0M of unsecured claims, each $1M of post-petition interest costs the class 0.25 cents. Fifteen months of a 9.00 per cent accrual moves the unsecured recovery by almost ten cents, which for a buyer of the notes at 25 is the difference between a gain and a loss. It is also why unsecured committees push for a short case and a low collateral value, and why first lien holders are rarely in a hurry when the cushion is deep.
| Collateral value | Cushion | 9 months | 15 months | 24 months |
|---|---|---|---|---|
| 290.0 (undersecured) | 0.0 | 0.0 | 0.0 | 0.0 |
| 315.0 | 15.0 | 15.0 | 15.0 | 15.0 |
| 345.0 | 45.0 | 23.8 | 39.8 | 45.0 |
| 375.0 | 75.0 | 23.8 | 39.8 | 63.6 |
Two regimes appear. With a thin cushion the cap binds almost at once and the length of the case is irrelevant to the lender: at 315.0 it collects 15.0 whether the case lasts nine months or two years. With a deep cushion the cap never binds and time is what matters: at 375.0 a 24-month case is worth 63.6 against 23.8 for a nine-month one. At 290.0 the lender is undersecured, its secured claim is 290.0, the 10.0 deficiency becomes an unsecured claim, and nothing accrues during the case.
The common mistake is to treat every claim the same way. Modelling a first lien at its petition-date claim understates what it takes at exit when the collateral is rich, and gives the excess to the fulcrum; modelling post-petition interest on an undersecured claim, or past the point where the cushion runs out, does the reverse. The second mistake is to compound by default: whether interest compounds depends on the agreement and the court, and monthly compounding at 9.00 per cent would show 35.58 of interest over 15 months instead of 33.75, so the model should state which convention it uses. As the bondholder claim calculation shows, an unsecured claim stops at the petition date; outside a solvent-debtor case, the oversecured claim is the main one that keeps growing.
Not legal advice. The figures are illustrative. Allowance of default interest, fees and the valuation of collateral depend on the agreement, the court and the facts.
The book's waterfall, which re-identifies the fulcrum as values change, is in the free workbook for this case. How the unsecured claim itself is built to the petition date is worked in how a bondholder's claim is calculated in Chapter 11.
No. Post-petition interest under section 506(b) is paid only out of the cushion between the collateral value and the claim. If the collateral is worth $290.0M against a $300.0M claim, there is no cushion: the secured claim is 290.0, the 10.0 deficiency joins the unsecured class, and no interest accrues on either part during the case.
Sometimes. Whether the contract default rate applies is argued case by case. In the worked case, 11.00 per cent instead of 9.00 per cent raises the monthly accrual from 2.65 to 3.15 and uses up the $45.0M cushion in 14.3 months, so the lender gains 5.25 over the contract rate and the cap absorbs 2.25 of what it accrued.
The classes below it. Every dollar added to the secured claim comes out of value that would otherwise reach the unsecured creditors. With $420.0M of total value and $400.0M of unsecured claims, each $1M of post-petition interest costs the unsecured class 0.25 cents, and the contract-rate accrual moves their recovery from 30.0 to 20.1 cents.
This article is one calculation from The Distressed Debt Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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