[co-author: Caroline Tart]

A New York Bankruptcy Judge held that a debtor must pay default-rate interest and fees to a secured lender as a condition to reinstatement of defaulted and accelerated debt under a chapter 11 plan.

TAKEAWAYS

• A debtor must pay default-rate interest and all outstanding fees and charges to reinstate defaulted and accelerated debt under a chapter 11 plan.
• Although Bankruptcy Code section 1124(2)(A) exempts a debtor from curing “default[s] of a kind” that need not be cured under Bankruptcy Code section 365(b)(2) as a prerequisite to reinstatement, the exemption does not cover default-rate interest.
• Bankruptcy Code section 365(b)(2) applies to default provisions under any agreement, including a loan agreement (not only executory contracts and unexpired leases) and only excuses a debtor from paying penalties for nonmonetary defaults, not monetary defaults.

For distressed borrowers seeking to reorganize, the Bankruptcy Code provides multiple options, including reinstatement of prepetition defaulted and accelerated debt. Given recent staggering increases in interest rates, reinstatement can be an attractive option because it allows a debtor to de-accelerate a defaulted loan and reinstate the loan’s original terms, including the original interest rate, over a creditor’s objection by making the creditor’s claim “unimpaired.” Although reinstatement can be beneficial, courts are split on whether a debtor must pay a secured lender default-rate interest and fees as a condition to reinstating a loan under a chapter 11 plan.

While some courts have ruled that such payments are required to make the lender’s claim unimpaired, others have reached the opposite conclusion, finding that payment of all outstanding non-default rate interest and other charges under a chapter 11 plan effectively cures all aspects of a prepetition loan default. Citing the mixed decisions as lacking a thorough analysis of the default-rate interest issue, the Bankruptcy Court in In re Golden Seahorse LLC, 652 B.R. 593 (Bankr. S.D.N.Y. 2023), recently undertook a surgical analysis of the interplay of three relevant Bankruptcy Code provisions, finding that a debtor must pay all outstanding interest at the default rate and fees to reinstate the original terms of a loan under a chapter 11 plan.

Background
Golden Seahorse (the “Debtor”) owns and operates a hotel. In 2018, the hotel obtained a $137 million loan at a 5.259% non-default rate interest secured by a first-lien commercial mortgage. The Debtor made all payments under the loan until it defaulted during the COVID-19 pandemic. Upon occurrence of the payment default, the lenders accelerated the loan, charged the Debtor 10.259% interest at the default rate, and had a receiver appointed in state court. Before the receiver took over the hotel, however, the Debtor filed for bankruptcy and proposed a chapter 11 plan that, among other things, reinstates the loan at the non-default interest rate and pays all outstanding amounts owed to the lenders other than approximately $20 million in default-rate interest and fees.

Interplay of Statutory Provisions
The lenders filed multiple bankruptcy claims against the Debtor and objected to the chapter 11 plan, arguing that default-rate interest and fees must be paid to reinstate the loan. The Debtor claimed it was excused from paying default-rate interest and fees because of Bankruptcy Code sections 1124(2)(A) and 365(b)(2)(D), even though section 1123(d) states otherwise.

Section 1123(d) provides that if a plan proposes to cure a default, the underlying agreement and state law determine what default-rate interest the debtor must pay to cure and reinstate a loan. Section 1124(2)(A), on the other hand, leaves a creditor’s claim unimpaired if a chapter 11 plan proposes to cure a pre-bankruptcy default (i.e., outstanding principal and non-default rate interest and other charges) “other than a default of a kind specified in section 365(b)(2)” or a default “of a kind that section 365(b)(2) expressly does not require” a debtor to cure. In plain terms, section 1124(2)(A) incorporates carveouts of certain defaults of section 365(b)(2) that debtors need not cure to continue to perform under executory contracts or unexpired leases post-bankruptcy. For example, section 365(b)(2)(D) exempts a debtor from curing defaults relating to “the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.”

For decades, the interplay of these bankruptcy statutes has divided courts on whether a debtor must pay a lender default-rate interest from the date of default to reinstatement to reinstate a loan. Some courts, including the Court of Appeals for the Ninth Circuit in In re Entz-White Lumber and Supply, Inc., 850 F.2d 1338, 1342 (9th Cir. 1988), have held that a lender could not recover default-rate interest because all aspects of a loan default are nullified when a plan proposes to cure outstanding non-default rate interest and other charges. Others, including a decision by the same appellate court that overruled Entz-White, In re New Investments, Inc., 840 F.3d 1137, 1141 (9th Cir. 2016), have held that a debtor must pay default-rate interest to reinstate a loan under a chapter 11 plan because section 1123(d) mandates such payment. However, none of those decisions thoroughly analyze how the three statutes intersect to address the default-rate interest dilemma.

To resolve this issue, the Court in Golden Seahorse considered whether: (i) sections 1124(2)(A) and 365(b)(2)(D) create an exception to section 1123(d), (ii) the carveout of certain defaults in section 1124(2)(A) applies to loan agreements or just executory contracts and unexpired leases, and (iii) section 365(b)(2)(D) excuses a debtor from paying all penalty rates or those relating to non-monetary defaults only.

Opinion
After considering the text of each section and applicable statutory interpretation principles, the Court held that the Debtor must pay default-rate interest and fees owed to the lenders to reinstate the loan under its chapter 11 plan. The Court initially concluded that the specific provisions of sections 1124(2)(A) and 365(b)(2)(D) created an exception to the general provision of section 1123(d), and it is settled law that specific statutes govern more general statutes.

Next, the Court held that the incorporation of section 365(b)(2) into section 1124(2)(A) applied to loan agreements. The lenders had argued that section 1124(2)(A)’s “of a kind” reference to defaults excused under section 365(b)(2) do not apply to loan agreements because Bankruptcy Code section 365 focuses on executory contracts and unexpired leases, and because that section only addresses those contracts, section 365(b)(2) applies to defaults arising from such contracts only.

The Court disagreed with the lenders’ interpretation of section 1124(2)(A), finding that the “of a kind” reference applied to default provisions addressed in section 365(b)(2), not the types of contracts governed by section 365. The default provisions addressed in section 365(b)(2) are ipso facto default provisions automatically triggered by a debtor’s bankruptcy and other non-monetary default provisions regarding a debtor’s financial condition or the appointment of a trustee or receiver before or after a debtor’s bankruptcy. These defaults, the Court explained, are not curable because a debtor cannot reverse the act of commencing a bankruptcy.

Finally, after examining the text and legislative history of section 365(b)(2)(D), the Court concluded that the statute applies to penalty rates and provisions relating to nonmonetary defaults only, not monetary defaults. According to the Court, section 365(b)(2)(D) created only a cure exception for nonmonetary defaults and legislative history supported that view, not the Debtor’s.

The Court’s decision has been appealed directly to the Court of Appeals for the Second Circuit.

Aftermath
The decision clarified whether the Debtor must pay the $20 million in default-rate interest and fees, an amount it cannot fund under its chapter 11 plan. After the ruling, the lenders increased their default-rate interest and fees claim to $28 million, and the parties agreed to mediation to resolve the default-rate interest issue but have been unable to reach a resolution.

While the appeal is pending, the Debtor has pivoted from reinstatement to a cram-down chapter 11 plan that would allow the Debtor, if it cannot raise funds to reinstate the loan, to pay the lenders $10 million on the effective date of the plan and refinance the balance of their claim estimated at approximately $158 million (inclusive of the $28 million default-rate interest and fees if allowed) by issuing new 10-year loan at a regular interest rate of 6.5%.

The Debtor has objected to the allowance of the lenders’ claim for default-rate interest and fees, citing legal defenses of force majeure, frustration of purpose, and impossibility or impracticability because the pandemic caused the hotel to close and triggered the loan default. The claim objection provides another avenue to expunge the lenders’ claim for default-rate interest and fees or reduce that claim because, if the Court’s decision is affirmed on appeal and the loan is reinstated, the debtor would be required to pay only the reduced portion of default-rate interest and fees that survives the claim objection.

Observations
The Golden Seahorse decision applies to debtors seeking to reinstate defaulted and accelerated debt through a chapter 11 plan to continue favorable terms, including capturing historically low interest rates likely no longer available in the current lending environment. Although just a Bankruptcy Court decision, it could become binding authority for courts within the Second Circuit if upheld on appeal, and influence bankruptcy-filing jurisdictional decision making for borrowers seeking to reinstate by considering other judicial districts that do not require payment of default-rate interest to reinstate defaulted and accelerated debt. Regardless of the jurisdiction, the decision’s scholarly insights on the default-rate interest issue will likely become increasing persuasive authority and may cause distressed borrowers to rethink prepetition planning to manage debt service while increasing leverage for lenders negotiating with distressed borrowers to restructure loan agreements outside of bankruptcy.

[View source.]