One fundamental question in any restructuring relates to the treatment of funded debt obligations, like mortgages. When the cost of prepetition debt is higher than the prevailing market rates, a debtor may seek to refinance its go-forward secured debt as part of its restructuring. The market drives the analysis on options. What happens when the cost of the debtor’s existing funded debt is (well) below the market? This question has arisen more frequently in recent times, given higher interest rates. (A related question is what happens when the debtor is unable to refinance with a third party and, therefore, may need to seek to retain its existing secured debt?)
An option exists in the Bankruptcy Code—specifically, Section 1124—that allows claims to be “reinstated” and left “unimpaired” under a plan of reorganization, even if the debt was accelerated and payable in full as a result of a bankruptcy filing. In other words, the reorganized debtor can keep the debt—even over the objection of the secured creditor—subject to curing certain defaults. Not all types of default need to be cured to reinstate debt. Specifically, Section 1124 references the exceptions set forth in Section 365(b)(2) as defaults that need not be cured as a prerequisite to leaving a claim unimpaired.
Under Section 365(b)(1) of the Bankruptcy Code, which applies to executory contracts and unexpired leases, a debtor may assume an executory contract on which it defaulted prepetition if the debtor cures certain defaults. Section 365(b)(2) provides a carve-out for four categories of default that will not prevent assumption of the contract if left uncured. The fourth of Section 365(b)(2)’s exceptions is “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.” 11 U.S.C. § 365(b)(2)(D). Notably, not all contracts or leases are covered by Section 365, and pertinent to this article, Section 365(c) excludes financial accommodations. The basic premise is that a debtor cannot force a non-debtor to continue to lend money.
The interplay between the reinstatement of funded debt and the curing of defaults was recently addressed by the Bankruptcy Court for the Southern District of New York in In re Golden Seahorse, where Judge Philip Bentley (a former partner in Kramer Levin’s Restructuring and Bankruptcy practice until his appointment to the bench) ruled that, in assessing the ability of the debtor to reinstate the prepetition mortgage debt and address the outstanding default interest, Section 365(b)(2)(D)—as incorporated by Section 1124—did not excuse the debtor hotel owner, Golden Seahorse, from paying default interest to cure its mortgage that was in default prior to the petition date. Accordingly, default interest was required to be paid to reinstate the debtor’s loan agreement as part of its plan of reorganization. See In re Golden Seahorse LLC d/b/a Holiday Inn Manhattan Financial District, Case No. 22-11582-PB (Bankr. S.D.N.Y. July 31, 2023). Though this decision is on appeal, it is instructive on this issue and made timely by the current market and options for, among others, distressed real estate borrowers and the rights of their lenders.
Golden Seahorse is the owner of a 50-story Holiday Inn hotel in downtown Manhattan. In 2018, Golden Seahorse agreed to a 10-year, $137 million loan at a 5.259% interest rate, which was secured by a mortgage on the hotel. Golden Seahorse remained current on its mortgage payments until May 2020, when the hotel closed due to the pandemic. Golden Seahorse’s lenders began to charge default interest and obtained appointment of a receiver in state court. Before the receiver took possession of the hotel, Golden Seahorse filed for Chapter 11 relief in the Bankruptcy Court for the Southern District of New York to avoid seizure.
As part of, and essential to, its plan of reorganization, the debtor sought to reinstate/assume its mortgage agreement—which provided a lower and more favorable interest rate than was otherwise available in the market—without paying the approximately $20 million in accrued default interest and fees. The lenders argued that Golden Seahorse could not assume (i.e., reinstate and render “unimpaired”) the mortgage without curing the default under Section 365(b)(1). The debtor, on the other hand, argued that the penalty/default rates in the agreement fell within Section 365(b)(2)(D)’s exception to Section 365(b)(1)’s cure requirement and that the debtor could, therefore, reinstate the mortgage without paying the default interest.
Judge Bentley’s Decision
The court held that, to reinstate its mortgage, the debtor must pay the default interest and fees. Bentley’s analysis involved interpreting three Bankruptcy Code provisions: Sections 1123(d), 1124(2) and 365(b)(2)(D). Section 1123(d) provides that the cure amount for an agreement proposed to be cured under a Chapter 11 plan must be determined in accordance with the parties’ agreement and applicable law. 11 U.S.C. § 1123(d). Sections 1124(1) and (2) state that claims and interests are impaired unless their rights are unaltered or, with respect to agreements or applicable law that entitle the holder to accelerated payments upon default, the debtor cures such default, other than the kinds specified in Section 365(b)(2), which are not required to be cured. 11 U.S.C. § 1124(1), (2). As discussed above, Section 365(b)(2) requires that defaults be cured prior to a debtor’s assumption of an executory contract or unexpired lease in default, and it sets forth four exceptions to this cure requirement, including an exception for the satisfaction of any default penalty under an executory contract or unexpired lease. See 11 U.S.C. § 365(b)(2)(D). In reconciling these three Bankruptcy Code sections, the court reasoned as follows.
First, the court found that Section 1123(d) plainly requires payment of default interest. Applying the canon of statutory interpretation that the specific governs the general and to avoid an interpretation that would render Section 1124(2) meaningless, Bentley held that Section 1124(2) was more specific than Section 1123(d) and that, therefore, Section 1124(2) incorporates Section 365(b)(2)’s exceptions to cure for assumption into Section 1123(d)’s mandate.
Second, having determined that Section 1124 incorporates Section 365’s exceptions into Section 1123’s cure mandate, the court addressed whether these exceptions apply in the Section 1123 context only to executory contracts and unexpired leases, which are addressed in Section 365(b)(2), and not to loan agreements, such as the mortgage being assumed in the case, which are not otherwise covered by Section 365 as executory contracts under Section 365(c)’s exclusion of financial accommodations. The court determined that the carve-out as incorporated does apply to loan agreements and not simply to executory contracts and unexpired leases whose assumption is governed by Section 365.
Bentley rejected the lenders’ arguments that Section 365(b)(2)’s cure exceptions apply only to executory contracts and unexpired leases but not to loan agreements. Rather, the court explained that Section 1124(2) refers to a “default of a kind specified in section 365(b)(2)” and not to contracts “of a kind specified in section 365(b)(2).” Bentley found fundamentally problematic the lenders’ interpretation that the carve-out would render Section 1124(2) meaningless.
Finally, upon a review of Section 365(b)(2)(D)’s text, the statutory amendments and their legislative history, the court concluded that Section 365(b)(2)(D) provides only a single exception for penalty rates and provisions relating solely to nonmonetary defaults, and therefore, it does not create any exception for penalty rates arising from, as in this case, monetary (payment) defaults. The court found no basis to conclude that the legislative history behind amendments to the Bankruptcy Code in 1994 and 2005 supported Golden Seahorse’s reading of Section 365(b)(2)(D), nor did it accept the debtor’s argument that such a reading would compellingly promote the purposes of Chapter 11 and the Bankruptcy Code.
Why This Case is Interesting
The issue presented in Golden Seahorse has significant ramifications for debtors in bankruptcy with funded debt (e.g., mortgages) in default prior to the petition date. Given the ongoing distress and disruption in commercial real estate (especially given the substantial amount of underutilized office space), both borrowers and lenders need to assess their options in restructuring existing debt. The current rapid rise in interest rates has caused some mortgages secured at pre-pandemic rates to become increasingly more attractive to retain (despite defaults) and relatively cheaper financing than may be available currently. As noted by Bentley, these rate hikes, coupled with the sharp uptick in commercial mortgage defaults due to the COVID-19 pandemic and the state of the market generally, make this issue likely to arise more as debtors seek to leave unimpaired and reinstate (i.e., assume) defaulted loan agreements with more attractive interest rates. Under this decision, the cost of reinstatement includes interest on payment defaults. Notably, the court left the door open for Golden Seahorse to come back and argue that the underlying defaults should be excused because, under New York law, the COVID-19 pandemic made keeping up with its payments impossible. However, that does not change the impact of the court’s legal ruling that reinstatement of a mortgage requires the payment of default rates under Section 365(b)(2)(D) as incorporated in Section 1124.
As noted above, the debtor filed an appeal to Bentley’s decision and indicated that it intends to seek certification to appeal directly to the Second U.S. Circuit Court of Appeals. Stay tuned.