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November Surprise? Ninth Circuit Resurrects Post-Default Interest

The additional “default interest” owed when a borrower defaults under a loan agreement is a technical but highly critical part of any lending arrangement. This important “default interest” was the subject of a recent Ninth Circuit decision in which the Circuit made a nearly 180 degree u-turn away from its prior precedent.  Earlier this month in a case called In re New Investments, Inc. the Ninth Circuit adopted a new rule which may significantly constrain the ability of distressed companies to reorganize by restructuring their debt.

In that case, two members of a three judge Ninth Circuit panel reversed a bankruptcy court’s decision, and ruled that the chapter 11 debtor could not cure a default under its loan agreement by paying only the contractual pre-default interest but instead must pay interest at the higher post-default rate. This ruling is contrary to the Circuit’s prior decision in In re Entz-White Lumber & Supply, Inc. 850 F. 2d 1138 (9th Cir. 1988), and represents a dramatic shift in the Bankruptcy Code’s balance of power away from debtors and towards secured creditors.  The decision makes it much more difficult for a debtor to cure a loan default as part of a plan of reorganization.

In 1988, in the Entz- White decision, the Ninth Circuit held that a debtor who proposes to cure a loan default through a plan of reorganization is entitled to avoid all consequences of the default including higher post-default interest rates.  At that time, the Court acknowledged that under the Bankruptcy Code, a plan of reorganization “shall provide adequate means for the plan’s implementation, such as curing or waiving of any default.”  The Court recognized that there was no definition of “cure” in the Bankruptcy Code, and adopted the following definition, which had been used by the Second Circuit:

“A default is an event in the debtor-creditor relationship which triggers certain consequences. Curing a default commonly means taking care of the triggering event and returning to pre-default conditions. The consequences are thus nullified. This is the concept of “cure” used throughout the Bankruptcy Code.”

In 1994, six years after the Entz-White decision, Congress enacted section 1123(d) of the Bankruptcy Code.  Section 1123(d)  provides that if a plan of reorganization proposes to cure a default, the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.  Commentary and the legislative history of section 1123(d) reflect that the new section was intended to benefit debtors by overruling a U.S. Supreme Court decision entitled Rake v. Wade, 508 U.S. 464 (1993) so that a debtor’s plan could cure a default without paying interest on interest, unless the contract or plan so provided and if doing so was consistent with applicable state law. Despite the legislative history, a number of courts around the country, including the 11th Circuit, interpreted the language of 1123(d) to mean that even if a debtor was curing a loan default under a plan, interest must be paid at the post-default rate if the loan agreement provided for a different post-default interest rate, and if such a provision was lawful under the state law which governed the agreement.  In New Investments, two out of the three Ninth Circuit judges agreed with those decisions, and found a way to avoid being constrained by the Ninth Circuit’s earlier decision in Entz-White.

Circuit Judge Murguia, writing for the majority, stated that the plain language of new section 1123(d), which did not exist when Entz-White was decided, compelled the holding that the debtor could not nullify the loan agreement’s post-default interest provision by proposing to cure the default.  The majority also found that the legislative history could not overshadow the statute’s plain language.  As a result, the majority found that that the new statute compelled them to deviate from the holding in Entz-White.

In a vigorous dissent, Circuit Judge Berzon argued that because neither Congress nor the US Supreme Court had set forth a definition of the term “cure” which was different than the definition adopted in Entz-White, there was no basis to overrule the Ninth Circuit’s earlier decision.  Judge Berzon argued that neither the text of the statute nor the legislative history supports the departure from precedent and that the lender failed to carry its burden of showing that Congress intended to change the law settled by Entz-White.  For this reason, according to the dissent, the majority was wrong in overruling established Ninth Circuit law.

It is too early to tell if the debtor in Entz-White will seek an en banc review of this split decision by 11 judges from the Ninth Circuit.  In the meantime, or if no further review is requested, the impact on debtors in California and other parts of the Ninth Circuit is significant.  Loan agreements often have post-default interest rate provisions requiring payments which are 5 percent or more higher than the pre-default interest rate. That additional interest burden makes it that much harder for a debtor to cure a default and move forward.  And even if a Debtor could afford to do so, the increased payments to the lender will result in less money available for unsecured creditors.   On the other hand, lenders will have more assurance that they are going to receive the benefit of their bargain and that bankruptcy judges will not be able to write agreed- upon default interest provisions out of the parties’ loan agreements.

The lending community in California and the other western states making up the Ninth Circuit will be watching closely for any further developments in this case.