Lenders Are Entitled to Default Interest in Chapter 11: Ninth Circuit

Overturning prior pro-debtor precedent, a federal appeals court recently emphasized that secured lenders are entitled to the benefit of their bargains with defaulting borrowers, by making it easier for lenders to collect default-rate interest from a Chapter 11 debtor under a plan of reorganization. Bankruptcy law has long allowed debtors to pay arrearages under a Chapter 11 plan and thereby reinstate the pre-default terms of their loans. Moreover, many courts have allowed debtors to cure loan defaults under Chapter 11 plans and to retain the lender’s collateral, without requiring those debtors to pay higher-rate default interest, a requirement borrowers would not be able to avoid outside bankruptcy.

            However, reversing course after nearly 30 years in In re New Investments Inc., No. 13-36194, 2016 WL 6543520 (9th Cir. Nov. 4, 2016), the Ninth Circuit —whose holdings control the bankruptcy courts in nine Western states, including California —ruled that a debtor may “cure” a default only by fulfilling the debtor’s obligations under its loan agreement, including payment of interest at a higher post-default rate. In doing so, it held that a 1988 Ninth Circuit opinion excusing payment of default interest had been superseded by subsequent amendments to the federal Bankruptcy Code.

            In New Investments, the debtor proposed a reorganization plan under which its default on a mortgage note would be cured by selling the mortgaged hotel and using the proceeds to pay off the mortgage debt at the 8 percent pre-default interest rate. The lender objected, arguing that it was entitled —under the terms of the underlying loan agreement —to receive payment at the higher 13 percent post default interest rate.

            Although the bankruptcy court ruled for the debtor, the Ninth Circuit reversed the bankruptcy court’s confirmation of New Investments’ plan, holding that a debtor’s proposed “cure” must adhere to the terms of the underlying loan agreement. The appellate court determined that the situation was plainly governed by Section 1123(d) of the federal Bankruptcy Code, which was added in 1994 and which states that “the amount necessary to cure [a] default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.”

            Therefore, if the underlying loan agreement does not require a higher, post-default interest rate, bankruptcy law would not impose such a rate; however, the Ninth Circuit ruled that, where the parties in fact bargained for a higher interest rate in the event of a default, the injured lender is entitled to the benefit of its bargain with the debtor, including payment of default rate interest on defaulted loans.

            Lenders in the Ninth Circuit should be aware that default interest rates will be enforced as part of a “cure” required under a plan. They should be certain to include such interest in any proof of claim filed with the bankruptcy court and —most important —carefully review plans of reorganization filed by their borrowers, to ensure that those plans do not allow debtors to escape their bargains with their lenders, and should object to such plans if they do so.

For questions, please contact Thanhan (An) Nguyen at an.nguyen@quarles.com/(312) 715-5058, Christopher Combest at (312) 715-5091/christopher.combest@quarles.com, or your local Quarles & Brady attorney.