Secured Creditors Receive the Benefit of Their Bargain in Chapter 11: The Court of Appeals for the Ninth Circuit Gives Secured Creditors Leverage in Objecting to Debtors’ Chapter 11 Plans
On November 4, 2016, the United States Court of Appeals for the Ninth Circuit determined—in a divided opinion—that a debtor’s chapter 11 plan of reorganization should not have been confirmed by the bankruptcy court over a secured creditor’s objection because the plan, in violation of 11 U.S.C. § 1123(d), provided to “cure” the debtor’s pre-bankruptcy default by paying the pre-default interest rate as opposed to the default interest rate as stated in the loan documents. Pacifica L 51 LLC v. New Investments Inc. (In re New Investments Inc.), ___ F.3d ___, 2016 WL 6543520 (9th Cir. Nov. 4, 2016). In re New Investments Inc. and § 1123(d) therefore provide secured creditors the benefit of their bargain to receive the default interest rate—if provided for in the loan documents and pursuant to non-bankruptcy law—from debtors’ chapter 11 plans if the debtors propose to “cure” their pre-bankruptcy default.
- Extremely General Chapter 11 Primer
In an effort to fully explain the holding and usefulness of In re New Investments Inc., it may be helpful to understand, generally, the process of a chapter 11 filing and the right provided by the Bankruptcy Code at issue in the case. A chapter 11 bankruptcy is a means for businesses—as big as Lehman Brothers to as small as the local fruit stand—and even individuals, to propose a plan to restructure its obligations and to repay creditors. Generally speaking, a debtor begins this process by filing a chapter 11 petition with the bankruptcy court. The debtor lists all its creditors in court filings and each creditor is given the opportunity to file proofs of claim demonstrating the debt the creditors are owed and establishing that the creditors are entitled to receive distributions under an eventual plan. The debtor then proposes a plan that groups similarly situated creditors into “classes” and proposes terms to repay the creditors. The Bankruptcy Code provides a debtor with many rights to restructure its debt. One of these rights is the ability to “cure” or avoid the debtor’s prepetition default on a secured debt. See 11 U.S.C. § 1123(a)(5)(G). The Code does not define the concept of “cure”, however, it has been held that a debtor cures a prepetition default by resolving the triggering event of default (e.g. paying the arrearage amount due under the loan) to return to compliance under the loan documents. In this way the debtor may unwind the consequences of its default as provided under the loan documents. This provision typically allows a debtor to retain ownership of real property that frequently secures the debt to a creditor.
If a creditor is to receive less under the plan than they were originally entitled outside bankruptcy or the creditor’s rights are otherwise modified under the plan (also known as “impaired” under the Bankruptcy Code), that creditor is entitled to vote on whether to accept or to reject the plan. If the debtor obtains acceptances of the plan by all impaired classes of creditors voting as a group or, with additional proceedings, the debtor obtains at least one class of impaired creditors voting in favor of the plan; then the plan can be confirmed by the bankruptcy court.
While creditors are subject to their rights being impaired by the plan, creditors are not helpless to fight against this eventuality. Chapter 11 gives creditors’ rights that may be protected through negotiations with debtor’s counsel and, if negotiations fail, through an objection to confirmation of the debtor’s plan. With this very basic background in chapter 11, the facts of In re New Investments Inc. set the stage for the important right given to creditors in § 1123(d) and highlighted by the Ninth Circuit.
- Facts of In re New Investments Inc.
New Investments Inc. purchased a hotel property in Kirkland, Washington through a loan in the amount of $3,045,760.51 from Pacifica L 51, LLC’s predecessor in interest. The promissory note, secured by a deed of trust, provided for an interest rate of 8 percent. In the event of default, the default interest rate would increase 5 percent to 13 percent according to the note. In addition, the note provided that the default interest rate, if triggered, would apply to the entirety of the note and not just to the amount New Investments was in arrears.
In 2009, New Investments defaulted on the note. Pacifica commenced a non-judicial foreclosure, and in response, New Investments filed its chapter 11 petition. New Investment’s chapter 11 plan proposed to “cure” the default that occurred prepetition by selling the hotel property to a third party purchaser and to use the proceeds of the sale to pay the outstanding balance of the loan owed to Pacifica at the pre-default interest rate.
Pacifica objected to the plan and argued that it was entitled to be paid at the higher, 13 % post-default interest rate pursuant to Washington law and the loan documents. Over the objection of Pacifica, the bankruptcy court confirmed the plan of New Investments and allowed New Investments to cure the prepetition default at the pre-default interest rate, and allowed New Investments to extinguish any other late penalties springing from the prepetition default.
III. Ninth Circuit Analysis
Two of the three judges on the panel for the Ninth Circuit in In re New Investments Inc. determined the bankruptcy court improperly confirmed the plan proposed by New Investments even though a prior case by the Ninth Circuit—Great W. Bank & Tr. v. Entz-White Lumber & Supply, Inc. (In re Entz-White Lumber & Supply, Inc.), 850 F.2d 1338 (9th Cir. 1988)—allowed a debtor to cure a default by paying the pre-default interest rate under the loan agreement. The majority determined that the later enacted § 1123(d) invalidated the prior holding of the Ninth Circuit in Entz-White.
Section 1123(d) 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 nonbankruptcy law.” Section 1123(d) was enacted in 1994, while Entz-White was decided by the Ninth Circuit in 1988. The majority reasoned from this timing that what the Court had decided prior to enactment of § 1123(d) was invalid if the statute provided a different result. The majority determined that § 1123(d) did just that holding “[t]he plain language of § 1123(d) compels the holding that a debtor cannot nullify a preexisting obligation in a loan agreement to pay post-default interest solely by proposing a cure.” Therefore, pursuant to the statute, a debtor can return to pre-default conditions under the loan agreement, “which can include a lower, pre-default interest rate, only by fulfilling the obligations and the applicable state law.” The loan agreement at issue in In re New Investments Inc. provided that upon default the interest rate on the loan would increase by 5 % and, importantly, “the increased interest rate applies to the entirety of the note and not just to arrearages.” While the note provided for this interest rate increase after default, state law, in this case Washington law, also allowed this result. Note § 1123(d) states that “the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.” (emphasis added). The majority noted that Washington law provides “that a borrower may cure a monetary default by paying the trustee ‘the entire amount then due under the terms of the deed of trust and the obligation secured thereby, other than such portion of the principal as would not then be due had no default occurred.’” (quoting Wash. Rev. Code Ann. § 61.24.090(1)(a)). Because both requirements of § 1123(d) were satisfied in this case—the note provided for the increase as did applicable nonbankruptcy law—the majority determined New Investments was required to pay the secured Pacifica the post-default rate of interest. “[T]oday’s result holds New Investments to its bargain by adhering to the terms of its loan agreement with Pacifica, as required by § 1123(d).” (emphasis in original).
- Judge Berzon’s Dissent
Judge Berzon dissented from the majority’s decision. She determined that the holding of Entz-White controlled and that § 1123(d) did not invalidate the prior precedent. Judge Berzon stated: “Here, the underlying agreement provides both pre- and post-default interest rates. As [§ 1123(d)] requires, we look to that agreement in determining which rates may apply. And in selecting which provision of the contract governs, we rely on our precedent [Entz-White] and use the pre-default rate.”
- Lessons from In re New Investments Inc.
Secured creditors in Idaho should note well the valuable lessons of In re New Investments Inc. and the rights provided by § 1123(d). If the loan documents provide, as most do, that the debtor is required to pay post-default interest rates, that rate is required to be proposed by a debtor in its chapter 11 plan to “cure” the default. Moreover, if the loan documents provide that the post-default interest rate applies to the entirety of the then existing balance, the debtor must propose a plan that repays the creditor on those terms pursuant to § 1123(d). Finally, Idaho law, like Washington law, allows this result as required under § 1123(d). Idaho Code § 45-1506(12) provides nearly identical language to that of Wash. Rev. Code Ann § 61.24.090(1)(a), as referenced by the majority in In re New Investments Inc.
Secured creditors are entitled to the benefit of their bargain in chapter 11. Careful review of a debtor’s chapter 11 plan is important to insure a debtor lives up to its obligations under the loan documents, applicable nonbankruptcy law, and § 1123(d).
For more information contact our Banking Group at 208.344.6000