In a scholarly, comprehensive and lengthy opinion written by one of the Southern District of New York’s most recently appointed Bankruptcy Judges, the issue of whether the reinstatement of defaulted and accelerated debt requires the payment of default-rate interest and fees was answered in the affirmative, undoubtedly to the delight of lenders everywhere.
In In re Golden Seahorse LLC,1 the owner of the world’s tallest Holiday Inn hotel located in downtown Manhattan filed a plan of reorganization in its chapter 11 case and proposed to reinstate its lenders’ mortgage loan – in the approximate amount of $137 million – and treat it as unimpaired under section 1124(2) of the Bankruptcy Code. Under the plan, the Debtor proposed paying only the pre-default interest rate on the loan – 5.259% – an attractive rate in today’s increasing interest-rate environment. The lenders, which had declared an event of default and accelerated the loan prior to the Debtor’s bankruptcy filing, asserted that reinstatement would require payment of the default-rate of interest – a rate of 10.259% – as well as the payment of various fees, which in the aggregate would total approximately $20 million. The Debtor claimed that it did not have the financial ability to pay the higher interest rate and fees and, if required to do so, would have to revise its plan by not reinstating the loan, but rather attempting to cram-down the lenders under section 1129(b) of the Bankruptcy Code, leaving the mortgage in place and providing the lenders with a restructured note paying interest at a market rate. In a somewhat unusual procedural move, both the Debtor and the lenders requested that the Court rule on the rate issue prior to the voting on the Debtor’s plan so that, if necessary, the Debtor could file an amended plan consistent with the Court’s ruling. In the interest of efficiency, the Court agreed with that approach.
Although one might assume that the answer to whether a debtor needs to pay the pre-default or default interest rate would be relatively straightforward and dictated by precedent, the question required Judge Bentley to conduct a thorough analysis of the relevant statutes and their legislative history as well as the scant existing case law. According to Judge Bentley, to arrive at his decision, he was first required to answers these three complex questions:
- To determine the amount required to cure defaults and de-accelerate debt, should the Court apply § 1123(d)’s plain terms, which require payment of all cure amounts required by the parties’ agreement and permitted by non-bankruptcy law? Or should the Court instead limit the scope of that section, such as by recognizing an exception for any cure amounts excused by virtue of § 1124(2)’s incorporation of § 365(b)(2)(D)?
- Should the Court read § 365(b)(2)(D)’s cure carve-out, as incorporated by § 1124(2)(A), to apply to loan agreements, or instead to executory contracts and unexpired leases?
- What scope should the Court give to § 365(b)(2)(D)’s cure carve-out? In particular, should it apply that carve-out to all “penalty rates,” or only to penalty rates triggered by non-monetary defaults?
As discussed below, although the Court ruled in the Debtor’s favor on the first and second questions, it ruled against the Debtor on the third question – which proved to be outcome determinative – holding that:
… based on a close review of the governing statutory provisions, the Court concludes that (i) §§ 1124(2) and 365(b)(2)(D) create an exception to § 1123(d)’s otherwise absolute mandate; (ii) § 365(b)(2)(D)’s cure carve-out, as incorporated by § 1124(2)(A), applies to loan agreements; but (iii) § 365(b)(2)(D)’s cure carve-out extends only to penalty rates triggered by non-monetary defaults. Consequently, when the debtor’s default arises from its failure to perform monetary obligations, as it does here, the debtor must pay default interest to the extent provided by its agreement and permitted by non-bankruptcy law in order to reinstate its defaulted debt under § 1124(2).2
Cure and Reinstatement
As bankruptcy professionals know, cure and assumption of defaulted executory contracts and unexpired leases and cure and reinstatement of defaulted debt are both important tools in a debtor’s reorganization playbook. Pursuant to section 365 of the Bankruptcy Code, a debtor may assume – or assume and assign- its executory contracts and unexpired leases, provided that it first cures existing defaults and provides adequate assurance of future performance of its obligations thereunder. Similarly, a debtor who is the obligor on a defaulted loan may reinstate the loan pursuant to a plan of reorganization – even if the loan has already been accelerated – by “de-accelerating” the loan and reinstating its original maturity and other terms. To do so, however, the plan must provide for the defaults to be cured, compensation for certain of the lender’s losses and not otherwise alter the lender’s legal rights. The primary impetus for a debtor to reinstate a loan is to continue to take advantage of the original interest rate if favorable when compared to those available at the time of the confirmation of its plan.
However, not all defaults must be cured. Certain types of defaults – commonly referred to as those arising from “ipso facto” clauses – have always been carved out in the context of both assumption and reinstatement, because such defaults are simply impossible to cure, being non-monetary in nature. The Bankruptcy Code excuses cure of these types of defaults in section 365(b)(2) in relation to assumption of contracts and leases and in section 1124(2) – which exempts defaults “of a kind specified in 365(b)(2)” – from the cure requirements for the de-acceleration of defaulted debt in the context of plan confirmation.
According to Judge Bentley, the cure requirements for assumption and reinstatement were straightforward until 1994, when both sections 365(b) and 1123 of the Bankruptcy Code were amended, which amendments, according to the Judge, “have confounded Courts ever since.” Indeed, the Court found that case law – both within the Second Circuit and elsewhere-provided “little help in resolving the difficult statutory construction issues facing the Court.”
First Two Questions: The Debtor Wins
Regarding the Court’s first question – do sections 1124(2)(A) and 365(b)(2)(D) create an exception to what had been considered section 1123(d)’s “plain terms,” the Court found that most courts have applied the section as written, meaning that to determine whether a debtor must pay interest at the default rate to cure and reinstate its loan agreement under a chapter 11 plan, it is necessary to look at the terms of the underlying loan agreement as interpreted by state law. The Court concluded that section 1123(d), “if looked at in isolation, requires payment of all contractually-required amounts.” Nevertheless, according to Judge Bentley,
. . . this does not end the analysis, because § 1124(2)(A) sets forth a conflicting, and equally unambiguous, directive: to de-accelerate defaulted debt and render it unimpaired, the debtor need not cure “a default of a kind specified in § 365(b)(2) of this title or of a kind that section 365(b)(2) expressly does not require to be cured.” Section 365(b)(2)(D), in turn, provides that penalty rates and penalty provisions relating to nonmonetary defaults need not be cured. The conflict with § 1123(d) is unavoidable: either all amounts required by the parties’ contract and permitted by state law must be paid, or this facially absolute rule is subject to an exception for whatever penalty rates and provisions § 365(b)(2)(D) excuses.
Because the Court found that the carve-out created by section 1124(2)’s incorporation of section 365(b)(2)(D) – which excuses payment of penalty rates and penalty provisions triggered by non-monetary defaults – is more specific than section 1123(d)’s requirement that the amount needed to cure is to be governed by the parties’ agreement and non-bankruptcy law, Judge Bentley held that it must be treated as an exception to section 1123(d)’s “facially absolute mandate.”
With regard to the Court’s second question – whether section 1124(2)(A)’s cure carve-out applies to loan agreements or to executory contracts and unexpired leases – the lenders contended that, under section 1124(2)(A), it applied only to defaults arising under executory contracts and unexpired leases and not loan agreements, because the exemption is for defaults “of a kind specified in section 365(b)(2) of this title or of a kind that section 365(b)(2) expressly does not require to be cured,” as those are the only types of contracts that section 365 addresses. The Court, however, disagreed with that interpretation:
In the first place, it rests on a strained reading of § 1124(2)(A)’s “of a kind” reference. § 1124(2)(A) refers to “default[s] of a kind specified in section 365(b)(2),” not “default[s] in contracts and leases of a kind” governed by that section. Thus, the most natural reading of the “of a kind” reference is that it refers to the kinds of default provisions addressed in § 365(b)(2), not to the kinds of contracts and leases governed by that section. That is, it refers to any ipso facto default, and any failure to satisfy a penalty rate or penalty provision relating to a non-monetary default, regardless of the nature of the underlying contract. . . . [T]he Lenders’ interpretation would strip § 1124(2)(A)’s reference to § 365 of any meaning, a result that is strongly disfavored. . . Yet another problem with the Lenders’ interpretation of § 1124(2)(A) is that, by nullifying the effect of that section’s cure carve-out, the Lender’s interpretation would risk making § 1124(2) itself a dead letter. Under the Lenders’ reading, ipso facto default clauses would be excused in executory contracts and unexpired leases, but not in loan agreements. As discussed above, ipso facto provisions are inherently incapable of cure. Consequently, the Lenders’ reading would enable any lender to prevent its borrower from using § 1124(2) to reinstate the loan following a bankruptcy filing, simply by including an ipso facto clause in its loan agreement. . . . The Court need not adopt an interpretation that has consequences of this sort. Instead, the Court adopts the more natural reading of § 1124(2)(A): that it excuses defaults arising under loan agreements, so long as the defaults are “of a kind” addressed by § 365(b)(2) – that is, ipso facto defaults, and failures to satisfy penalty rates and penalty provisions relating to non-monetary defaults.
In sum, with respect to its first two questions, the Court’s “analysis so far has led to two conclusions: first, that §§ 1124(2) and 365(b)(2)(D) must be read to create an exception to section 1123(d)’s otherwise absolute mandate; and second, that section 1124(2)(A)’s cure carve-out applies to loan agreements, not to executory contracts and unexpired leases.”
Third Question: The Lenders Win
The Court then addressed the final question: Does section 365(b)(2)(D) excuse payment of all penalty rates and provisions, or just those associated with non-monetary defaults? According to the Court, the answer depends on the interpretation of a single phrase in section 365(b)(2)(D), which exempts from its cure requirements “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.” Thus, the question is, “does § 365(b)(2)(D) only excuse the satisfaction of penalty rates and penalty provisions relating to breaches of nonmonetary obligations,” as the lenders contended, “or does it excuse the satisfaction of (i) penalty rates relating to both monetary and non-monetary defaults and (ii) penalty provisions relating to non-monetary defaults” as the Debtor contended.
After noting that decisional law on the issue was “sparse,” the Court exhaustively (a) undertook an analysis of the text of section 365(b)(2)(D), (b) reviewed that section’s historical and statutory context; (c) examined the legislative history of the 1994 and 2005 amendments to that section; and (d) considered the Debtor’s argument that the Court should construe the section “in a way that furthers chapter 11’s broader purposes.” The Court then concluded that “§ 365(b)(2)(D) creates a single cure exception, excusing penalty rates and provisions triggered by nonmonetary defaults,” but that “[i]t does not also create an exception for penalty rates that arise from monetary defaults.” (Emphasis added). Thus, the Court concluded that of the two competing ways of reading the provision, the interpretation creating a single exception to section 365(b)(1)’s cure requirements—rather than two distinct exceptions—was the far more natural reading.
The Outcome: A Knock-Out – Lenders Win
Finally, tying together the answers to the three questions posed at the outset of its inquiry, the Court ruled that to cure and reinstate a loan under a plan of reorganization, the Debtor must pay default interest and fees to the extent required by its loan agreement and prevailing New York law. Given the exhaustive analysis of the relevant issues, it can be expected that Judge Bentley’s opinion will serve as an important precedent on this complex issue, and counsel representing debtors should caution their clients regarding its potentially costly ramifications.