The Ninth Circuit recently ruled that a Chapter 11 debtor could not avoid the payment of default interest under a promissory note as a condition to curing and reinstating such promissory note under a Chapter 11 plan. In Pacifica L 51 LLC v. New Investments Inc. (In re New Investments, Inc.), 840 F.3d 1137 (9th Cir. 2016), the Ninth Circuit held that its prior rule of allowing a curing debtor to avoid a contractual post-default interest rate in a loan agreement—as decided in Great Western Bank & Trust v. Entz-White Lumber & Supply, Inc. (In re Entz-White Lumber & Supply, Inc.), 850 F.2d 1338 (9th Cir. 1988)—is no longer valid. Under Pacifica, a Chapter 11 debtor that seeks to cure and reinstate a debt can be required to pay default penalties before it can return the debt to its original terms.
In 1988, the Ninth Circuit decided Entz-White and held that a Chapter 11 debtor, by paying arrearages on naturally matured debt, was entitled to avoid “all consequences of the default,” including the payment of “higher post-default interest rates.” Prior to the bankruptcy, Entz-White, as borrower, delivered a $3.17 million promissory note to Great Western, as lender, that provided for an interest rate equal to prime plus 1.5% and a default rate of approximately 18%. Entz-White failed to pay this debt when it matured, triggering the default interest rate under the promissory note.
Thereafter, Entz-White filed for bankruptcy and proposed a plan under which Great Western was paid approximately $3.5 million, which was the full principal balance owed plus interest accrued at the normal rate of 1.5% over prime. Great Western objected and argued that it was entitled to an additional $190,617 in default interest calculated at the 18% rate. The bankruptcy court ruled in favor of Entz-White.
On appeal, the Ninth Circuit held that section 1123(a)(5)(G) of the Bankruptcy Code gave Entz-White the ability to “cure” its default on the note by paying the arrearages on the debt and, as a consequence, nullify “any consequences of the default,” including the “post-maturity higher interest rate.” The Ninth Circuit reasoned that the concept of “cure,” as used throughout the Bankruptcy Code, meant that matters were returned to “pre-default conditions.” Thus, the Ninth Circuit found that by paying all amounts due as of the maturity date plus interest at the normal rate, Entz-White was entitled to “avoid all consequences of the default,” including the higher post-default interest rate, and to treat Great Western as an unimpaired creditor under section 1124 of the Bankruptcy Code.
The question of what “curing a default” means presented itself again to the Ninth Circuit in Pacifica. Prior to the bankruptcy, New Investments borrowed approximately $3 million from Pacifica. The promissory note provided for an interest rate of 8% and a default rate of 13%. New Investments defaulted on the note, triggering the default interest rate.
Thereafter, New Investments filed for bankruptcy and proposed a plan under which Pacifica was to be paid the outstanding amount of the loan at the pre-default interest rate of 8%. Pacifica objected and argued that under the terms of the promissory note, it was entitled to be paid at the higher post-default interest rate of 13%. The bankruptcy court ruled in favor of New Investments and confirmed the plan.
In a 2-1 decision, the Ninth Circuit ruled in favor of Pacifica and held that Entz-White’s rule of allowing a curing debtor to avoid a contractual post-default interest rate was no longer valid in light of section 1123(d) of the Bankruptcy Code.
In 1994, Congress amended section 1123 of the Bankruptcy Code to add subsection (d), which provides that “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). The Ninth Circuit reasoned that since the underlying agreement—i.e., the promissory note—required the payment of a higher interest rate and applicable law—i.e., Washington state law—allows for a higher interest rate upon default when provided for in the loan agreement, New Investments was required to pay interest at the higher default rate in order to cure its default. The panel in Pacifica found that the “plain language of § 1123(d) compels” this result notwithstanding the Ninth Circuit’s prior decision in Entz-White.
The panels in Entz-White and Pacifica agree that a Chapter 11 debtor can cure and reinstate an accelerated debt and return to pre-default conditions for the remainder of the loan term. At issue is how a debtor returns to pre-default conditions, namely, whether default penalties must be paid as a condition to returning to pre-default conditions.
The “cure and reinstatement” provisions and the “cramdown” provisions in Chapter 11 are two of the tools that can be utilized by Chapter 11 debtors when addressing secured debts in bankruptcy. Chapter 11 debtors often consider “cure and reinstatement” in environments where interest rates are rising. Under Pacifica, creditors whose loan documents provide for default interest, attorneys’ fees, and other penalties may be able to obtain higher recoveries in bankruptcy; conversely, Chapter 11 debtors may be required to pay more as a condition to reinstating debt. Pacifica merits serious consideration by both creditors and potential debtors.