Curing Default in Chapter 11 Bankruptcy May Require Debtors to Pay Default Interest to Secured Creditors.

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The Ninth Circuit Court of Appeals recently took up the issue of a Chapter 11 Debtor’s requirements to cure a loan default through its Chapter 11 plan.  The result was a ruling that overturned previous law that entitled debtors to avoid certain consequences of the loan default, including higher, post-default interest rates.  In Pacifica L 51 LLC v. New Investments, Inc. (In re New Investments), 840 F.3d 1137 (9th Cir. 2016), the Ninth Circuit held that a secured lender must receive payment at post-default interest rates to effectuate a cure and return to pre-default conditions, rendering void the court’s earlier ruling in Great W. Bank & Trust v. Entz-White Lumber & Supply, Inc. (In re Entz-White), 850 F.2d 1338 (9th Cir. 1988), which provided that a debtor who cures a default is entitled to avoid all consequences of the default including higher post-default interest rates.

By way of background, New Investments, Inc. (“New Investments”), borrowed $3,045.760.51 from Pacifica L 51, LLC (“Pacifica”), to purchase a hotel, giving Pacifica a Note secured by a Deed of Trust.  The Note provided for interest at 8%, a rate that escalated to 13% in the event of a default.  New Investments defaulted, and when Pacifica commenced foreclosure proceedings, New Investments filed for Ch. 11 Bankruptcy protection.  Through its bankruptcy case, New Investments proffered a plan of reorganization that proposed to cure the default by selling the hotel and using the proceeds to pay the outstanding loan balance at the pre-default interest rate.  Pacifica objected to the plan, claiming that it was entitled to be paid at the higher, post-default interest rate.  The bankruptcy court confirmed New Investment’s Chapter 11 Plan over Pacifica’s objection, and Pacifica timely appealed.

The Ninth Circuit Court of Appeals first recognized the Bankruptcy Code’s concept of cure in providing “adequate means for the plan’s implementation,” including “the curing or waiving of any default.”  The court then noted its holding in In re Entz-White, which confirmed a debtor’s power to cure through a plan that nullifies the consequences of default, including avoidance of higher interest even when the terms of the loan agreement called for post-default higher interest.  However, the appellate court went on to observe that its 1988 ruling in In re Entz-White pre-dated Congress’ 1994 enactment of 11 U.S.C. 1123(d), which provides:

Notwithstanding subsection (a) of this section and sections 506(b), 1129(a)(7), and 1129(b) of this title, if it is proposed in a plan to cure a default the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable non-bankruptcy law.

Strictly interpreting § 1123(d), the court cited to the applicable Note, which provided for a higher post-default interest rate, and to Washington State law, which allows for a higher interest rate upon default when the higher rate is set forth in the loan agreement.  Seeing no ambiguity in the underlying agreement, the Ninth Circuit held that the amount necessary to cure New Investment’s default was governed by the applicable security instruments and state law, which required and permitted repayment at the higher, post-default interest rate.  The court stated that the plain language of § 1123(d) compels a holding that a debtor cannot nullify a preexisting obligation in a loan agreement simply by proposing alternative terms for a cure.

The New Investments case demonstrates that § 1123(d) affects how a Chapter 11 debtor returns to pre-default conditions, and the Ninth Circuit’s interpretation thereof establishes that a borrower may not effectuate a cure by simply paying past due principal and pre-default interest.  Of further significance, as set forth by the court, § 1123(d) also entitles secured creditors to recoup late charges, attorney fees, and other costs incurred to cure a default via a Chapter 11 plan as long as the underlying security instruments provide for such charges, fees and costs.

The Ninth Circuit ruling in New Investments is consistent with Congress’ intent in enacting § 1123(d) because it holds the parties to the benefit of their bargain and operates to put the parties in a position as if the default never occurred.  This ruling should encourage creditors as they seek to be made whole on their secured claims against defaulting borrowers in Chapter 11 bankruptcy cases, and should discourage debtors from filing bankruptcy or using the Bankruptcy Code to avoid paying default interest while seeking to cure and reinstate their defaulted loans.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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