Section 1124(2) of the Bankruptcy Code gives chapter 11 debtors a valuable tool for use in situations where long-term prepetition debt carries a significantly lower interest rate than the rates available at the time of emergence from bankruptcy. Under this section, in a chapter 11 plan, the debtor can "cure" any defaults under the relevant agreement and "reinstate" the maturity date and other terms of the original agreement, thus enabling the debtor to "lock in" a favorable interest rate in a prepetition loan agreement upon bankruptcy emergence.
For decades, however, courts have struggled to determine exactly what a debtor must do to cure defaults, for purposes of cure and reinstatement in a chapter 11 plan, where payment terms under the loan agreement have been accelerated and the agreement requires the payment of a higher default rate of interest. Certain Bankruptcy Code provisions added by Congress in 1994 left uncertain whether a debtor must pay the default rate of interest to cure and reinstate a lender's claim under such an agreement.
On the one hand, section 1123(d) of the Bankruptcy Code provides that, if a chapter 11 plan proposes to cure a default under a contract, the cure amount must be determined in accordance with the underlying agreement and applicable nonbankruptcy law. This provision facially suggests that a debtor must pay a contractual default rate of interest to cure and reinstate a lender's prepetition claim, to the extent the payment of default interest is in accordance with non-bankruptcy (usually state) law.
On the other hand, section 365(b)(2)(D) of the Bankruptcy Code—which Congress incorporated into section 1124(2)—provides that curing defaults for purposes of the debtor's assumption of an executory contract or unexpired lease does not require the debtor to satisfy "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). Debtors frequently point to section 365(b)(2)(D) in arguing that cure and reinstatement under section 1124(2) of the Bankruptcy Code should not require payment of a contractual default interest rate.
A substantial majority of courts, including the U.S. Courts of Appeals for the Ninth and Eleventh Circuits, have held that such a cure amount must include any default-rate interest required under either the contract or applicable nonbankruptcy law. However, the arguable dissonance between section 1123(d) and section 365(b)(2)(D) of the Bankruptcy Code has long been a source of consternation in the bankruptcy courts.
The U.S. Bankruptcy Court for the Southern District of New York addressed this conundrum in In re Golden Seahorse LLC, 652 B.R. 593 (S.D.N.Y. 2023). The court ruled that, based upon a close examination of sections 365(b)(2)(D), 1123(d), and 1124(2) of the Bankruptcy Code, a debtor was obligated to pay default-rate interest to cure a monetary default under a loan that would be reinstated in a chapter 11 plan.
Cure and Reinstatement Under a Chapter 11 Plan
Upon the occurrence of an event of payment default under a loan agreement, the lender generally has the right to accelerate the loan and exercise its legal and contractual collection remedies. However, if the borrower files for chapter 11 protection, the lender must refrain from exercising such remedies unless it obtains relief from the automatic stay to do so. As long as the stay remains in place, the borrower as a chapter 11 debtor-in-possession can propose a plan that decelerates a defaulted loan, "cures" any defaults (with certain exceptions), and reinstates the original terms of the debt—in effect, "roll[ing] back the clock to the time before the default existed." MW Post Portfolio Fund Ltd. v. Norwest Bank Minn., N.A. (In re Onco Inv. Co.), 316 B.R. 163, 167 (Bankr. D. Del. 2004); see also 11 U.S.C. § 1123(a)(5)(G) (providing that a plan shall provide adequate means for its implementation, such as "curing or waiving of any default").
To the extent that its claim is not "impaired" under the terms of the proposed plan, the lender will be deemed to have accepted the plan and will not be entitled to vote on it. See 11 U.S.C. § 1126(f). Even though the lender is precluded from enforcing its contractual right of acceleration, the lender's claim will be deemed unimpaired if the plan: (i) cures any defaults, "other than a default of a kind specified in section 365(b)(2) … or of a kind that section 365(b)(2) expressly does not require to be cured"; (ii) reinstates the pre-default maturity of the debt; (iii) compensates the lender for any damages sustained due to reasonable reliance on its contractual or legal ability to accelerate the debt; (iv) compensates the lender for any actual pecuniary loss arising from the debtor's failure to perform a nonmonetary obligation; and (v) does not "otherwise alter the legal, equitable, or contractual rights" of the lender. See 11 U.S.C. § 1124(2).
Under section 365(b) of the Bankruptcy Code, if there has been a default in an executory contract or unexpired lease, the trustee or chapter 11 debtor-in-possession may not assume the contract or lease without, among other things, curing the default (or providing adequate assurance of prompt cure):
other than a default that is a breach of a provision relating to the satisfaction of any provision (other than a penalty rate or penalty provision) relating to a default arising from any failure to perform nonmonetary obligations under an unexpired lease of real property, if it is impossible for the trustee to cure such default by performing nonmonetary acts at and after the time of assumption… .
11 U.S.C. § 365(b)(1)(A). In addition, Congress added section 365(b)(2)(D) to the Bankruptcy Code in 1994. As noted above, that section provides that section 365(b)(1)'s cure obligation does not apply to any default that is a breach of a provision pertaining 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." 11 U.S.C. § 365(b)(2)(D).
The Meaning of "Cure"
Prior to 1994, the Bankruptcy Code did not provide guidance as to the meaning of the term "cure," and courts were split as to whether payment of default-rate interest was required in order to cure a default under an executory contract, an unexpired lease, or a loan agreement.
In 1994, however, lawmakers added section 1123(d) to the Bankruptcy Code, which provides that, notwithstanding the entitlement of oversecured creditors to collect postpetition interest under section 506(b), the "best interests" requirement of section 1129(a)(7), and the cramdown requirements of section 1129(b), "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 nonbankruptcy law." 11 U.S.C. § 1123(d).
Section 1123(d) was enacted to abrogate the U.S. Supreme Court's decision in Rake v. Wade, 508 U.S. 464 (1993). In Rake, the Court held that, in order to cure a mortgage default under a chapter 13 plan, the mortgagee must be paid interest on the defaulted payments, including "interest on interest," regardless of whether such interest was provided for in the agreement or under state law. Congress overruled the decision by enacting section 1123(d) because the ruling "had the effect of providing a windfall to secured creditors at the expense of unsecured creditors by forcing debtors to pay the bulk of their income to satisfy the secured creditors' claims," which would include interest on interest, late charges, and other fees, "even where applicable law prohibits such interest and even when it was … not contemplated by either party in the original transaction." H.R. Rep. No. 103-835, at 55 (1994).
Most courts have interpreted section 1123(d) of the Bankruptcy Code to require the payment of default-rate interest as a condition of cure to the extent that it is required by the underlying agreement or applicable nonbankruptcy law. See, e.g., In re Lewisberry Partners, LLC, 2022 WL 2398694, at **15-16 (Bankr. E.D. Pa. July 1, 2022); In re Moshe, 567 B.R. 438, 444-45 (Bankr. E.D.N.Y. 2017); In re 1 Ashbury Court Partners, LLC, 2011 WL 4172010, at **4-5 (Bankr. D. Kan. Oct. 5, 2011); In re General Growth Props., Inc., 451 B.R. 323, 328 (Bankr. S.D.N.Y. 2011); In re Schatz, 426 B.R. 24, 27 (Bankr. D.N.H. 2009); In re Moody Nat'l SHS Houston H, LLC, 426 B.R. 667, 672 (Bankr. S.D. Tex. 2010); see generally Collier on Bankruptcy ¶ 1123.04 (16th ed. 2023) (noting that "[a] majority of courts have held that to cure and reinstate a claim under a plan, the debtor must pay postdefault interest to the extent provided under the debtor's agreement with the creditor").
However, in light of its legislative history, some courts have determined that section 1123(d) should not be interpreted to require payment of default-rate interest, even where the contract provides for it. According to these courts, support for this interpretation can be found in: (i) section 365(b)(2), which, as noted previously, was also added to the Bankruptcy Code in 1994 and provides that a "penalty rate" related to the debtor's failure to perform nonmonetary obligations need not be satisfied to cure a default under an executory contract or an unexpired lease; and (ii) section 1124(2), which does not require the holder of a claim to be paid default-rate interest for the claim to be rendered unimpaired by expressly incorporating section 365(b)(2)(D)'s cure carve-out. See In re Phoenix Bus. Park Ltd. P'ship, 257 B.R. 517, 522 (Bankr. D. Ariz. 2001); accord Brody v. Geared Equity, LLC, 2014 WL 4090549,*3 (D. Ariz. Aug. 6, 2014).
Until 2016, courts in the Ninth Circuit were outliers in this debate, adhering to an approach articulated more than three decades ago—well before the enactment of section 1123(d)—
by the Ninth Circuit in Great Western Bank & Trust v. Entz-White Lumber and Supply, Inc. (Entz-White Lumber and Supply, Inc.), 850 F.2d 1338 (9th Cir. 1988). In Entz-White, the Ninth Circuit held that the payment of default-rate interest is not required to cure and reinstate a defaulted secured debt under a chapter 11 plan because cure effectively nullifies all aspects of the default and rolls back the status quo to a time prior to its occurrence. In so ruling, the Ninth Circuit relied on the Second Circuit's pre-1994 amendment ruling in DiPierro v. Taddeo (In re Taddeo), 685 F.2d 24, 27, 29 (2d Cir. 1982), where the court held in a chapter 13 case that curing a default under a home mortgage "return[s the parties] to pre-default conditions" and "nullifies" the consequences of default. The Second Circuit also noted that "'curing a default' in Chapter 11 means the same thing as it does in Chapter 7 or 13; the event of default is remedied and the consequences are nullified." Id. at 29.
Despite the enactment of section 1123(d) and the weight of judicial authority in other circuits rejecting the Entz-White approach, Ninth Circuit courts, including the court of appeals, remained faithful to the Entz-White rule for 28 years, albeit sometimes reluctantly.
However, the primacy of Entz-White in the Ninth Circuit finally ended in 2016. In In re New Invs., Inc. (Pacifica L 51 LLC v. New Invs., Inc), 840 F.3d 1137 (9th Cir. 2016), a divided three-judge panel of the Ninth Circuit held that "Entz-White's rule of allowing a curing debtor to avoid a contractual post-default interest rate in a loan agreement is no longer valid in light of § 1123(d)."
In so ruling, the Ninth Circuit aligned itself with the Eleventh Circuit, which in 2015 rejected the Entz-White approach in JPMCC 2006-LDP7 Miami Beach Lodging, LLC v. Sagamore Partners, Ltd. (In re Sagamore Partners, Ltd.), 620 F. App'x 864 (11th Cir. 2015). In Sagamore, the court ruled that "the clear mandate of § 1123 … allows a creditor to demand default-rate interest as a condition for reinstating [a defaulted] loan," to the extent that the loan agreement provided for the payment of interest at the default rate.
Golden Seahorse
Golden Seahorse LLC (the "debtor") owned a 50-story hotel in Manhattan encumbered by a $137 million non-amortizing 10-year mortgage with an annual interest rate of 5.259% and a default interest rate of 10.259%. In May 2020, the debtor committed a payment default, and the lenders accelerated the loan. A state court later granted the lenders' motion to appoint a receiver for the property. However, in November 2022, before the receiver could take possession of the hotel, the debtor filed for chapter 11 protection in the Southern District of New York.
In its chapter 11 plan, the debtor proposed to reinstate the loan under its original terms, including the non-default interest rate (which was then significantly below market), and to treat the lenders' claim as unimpaired under section 1124(2). Alternatively, if the bankruptcy court were to conclude that the payment of default-rate interest were required (nearly $18 million), the debtor proposed to "cram down" the lenders' claim by leaving the mortgage in place and giving the lenders a restructured note bearing interest at the market rate.
The debtor and the lenders asked the bankruptcy court to rule on this issue in anticipation of the confirmation hearing.
The Bankruptcy Court's Ruling
In a painstakingly detailed opinion addressing the interaction among sections 365(b)(2)(D), 1123(d), and 1124(2) of the Bankruptcy Code, the bankruptcy court held that "to cure and reinstate its loan under a plan of reorganization, the Debtor must pay default interest and fees to the extent required by its loan agreement and New York law." Golden Seahorse, 652 B.R. at 616.
In his opinion, U.S. Bankruptcy Judge Philip Bentley identified the three questions before the court as follows:
(i) do §§ 1124(2) and 365(b)(2)(D) create an exception to § 1123(d)'s otherwise absolute mandate?;
(ii) does § 365(b)(2)(D)'s cure carve-out, as incorporated by § 1124(2)(A), apply to loan agreements?; and
(iii) does § 365(b)(2)(D)'s cure carve-out extend to all penalty rates, or only to those triggered by non-monetary defaults?
Id. at 605.
Surveying relevant caselaw, Judge Bentley noted that only a handful of courts—and none in the Second Circuit—have addressed the interrelationship among the three provisions in question, "and those courts have reached varying conclusions." Id. at 604–05. Judge Bentley rejected both the Second Circuit's ruling in Taddeo as well as the Ninth Circuit's (now overruled) decision in Entz-White as authority for the proposition that cure of defaults under a reinstated obligation as part of a chapter 11 plan does not require the payment of default-rate interest. Both cases, he emphasized, pre-dated the 1994 amendments and have been legislatively overruled. Id. at 604. Judge Bentley further noted that the handful of post-1994 decisions from lower courts in the Second Circuit holding that, under section 1123 and 1124, reinstatement of a debt requires the payment of default-rate interest, "curiously" make no mention of section 1124(2)'s express incorporation of the section 365(b)(2) carve-out. Id. (citing In re Depietto, 2021 WL 3287416, at **6-8 (S.D.N.Y. Aug. 2, 2021); Moshe, 567 B.R. at 443-47; In re 139-141 Owners Corp., 306 B.R. 763 (Bankr. S.D.N.Y. 2004), aff'd in part and vacated in part, 313 B.R. 364, 368 (S.D.N.Y. 2004)).
Judge Bentley explained that sections 1123(d), 1124(2)(A), and 365(b)(2)(D) were not part of the Bankruptcy Code when it was enacted in 1978. Instead, he noted, those provisions were either added or amended in 1994 or 2005, "and the congressional purposes underlying these amendments are not always discernable." Id. at *2. Judge Bentley further explained that the "cure requirements for reinstatement and assumption w[ere] straightforward until 1994, when the passage of the Bankruptcy Reform Act threw a wrench into the works." Since that time, he stated, the amendments to sections 365(b) and 1123 "have confounded courts." Id. at 599.
Ultimately, Judge Bentley determined that "the carve-out created by § 1124(2)'s incorporation of § 365(b)(2)(D) must be treated as an exception to § 1123(d)'s otherwise absolute mandate." Id. at 605. He also adopted "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." Id. at 608.
However, addressing the scope of section 365(b)(2)(D), which, as noted, exempts from the cure requirement "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," Judge Bentley applied principles of statutory construction and "conventions of ordinary speech" to conclude that the provision "excuse[s] cure only of penalty provisions, and not also of the underlying defaults." Id. at 610, 615. Thus, because the debtor's default in the case before him involved a penalty rate triggered by a monetary default, rather a penalty rate resulting from failure to perform a nonmonetary obligation, the section 365(b)(2)(D) carve-out did not apply.
The bankruptcy court accordingly held that, to cure and reinstate the lender's loan under the debtor's chapter 11 plan, the debtor was obligated to pay default-rate interest and fees to the extent required by its loan agreement and applicable state law.
Outlook
Golden Seahorse arguably stands alone in its exacting examination of the relevant Bankruptcy Code provisions that govern cure and reinstatement of a defaulted loan under a chapter 11 plan. Unfortunately, although it provides useful guidance, the decision is unlikely to end the debate regarding provisions that are (perhaps needlessly) complex and confusing.
The ruling is no doubt a welcome development for lenders—and an unwelcome one for borrowers faced with the more costly prospect of paying default-rate interest as a condition to reinstating debt in connection with confirmation of a chapter 11 plan. This is particularly the case under current market conditions, where reinstatement of low-interest-rate prepetition debt could be highly beneficial to a debtor emerging from bankruptcy.
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