This article was sourced from JD Supra Business Advisor. Article by Kevin Brodehl.
Can a defaulted borrower avoid paying default interest by filing for bankruptcy protection?
The answer to that question has evolved from 1988 to the present, starting with the 9th Circuit’s decision in In re Entz-White Lumber & Supply, Inc. (9th Cir. 1988) 850 F.2d 1338, followed by the enactment of 11 U.S.C. section 1123(d), and culminating with the 9th Circuit’s recent decision In re New Investments, Inc. (9th Cir. 2016) 840 F.3d 1137, which overruled Entz-White.
The New Investments decision clarifies that bankruptcy does not shield a borrower from contractual default interest.
Entz-White: Borrowers can avoid default interest through bankruptcy reorganization plans
The Bankruptcy Code, just like common law, includes the concept of “cure.” Curing a default allows the borrower to avoid the continuing consequences of default and return the loan relationship to pre-default conditions. Chapter 11 of the Bankruptcy Code requires that a debtor’s plan of reorganization must provide for the “curing or waiving of any default.” (11 U.S.C. §1123(a)(5)(G).)
In the Entz-White opinion published in 1988, the Ninth Circuit held that a debtor who cures a default “is entitled to avoid all consequences of the default — including higher post-default interest rates.”
As such, under Entz-White, even if the parties’ promissory note or loan agreement provided for a higher interest rate in the event of a default, a debtor who “cured” would be entitled to repay the past due amounts at the lower, pre-default interest rate. Thus, a bankruptcy plan’s “cure” of a default could essentially nullify the parties’ contractual default interest provisions.
11 U.S.C. Section 1123(d): The loan agreement and state law govern
In 1994, Congress amended section 1123 to add subdivision (d), which provides: “… 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.” (Emphasis added.)
New Investments, Inc.: Bankruptcy plans cannot be used to avoid contractual default interest
In the New Investments opinion, the Ninth Circuit held that in light of recently enacted 11 U.S.C. §1123(d), Entz-White was no longer good law.
The court analyzed the following facts:
New Investments, Inc. borrowed over $3 million to purchase a hotel property in the State of Washington. The note, which was secured by a deed of trust on the property, provided for an interest rate of 8 percent, but also stated that in the event of default the interest rate would increase by an additional 5 percent.
New Investments defaulted on the note in 2009.
When the lender initiated nonjudicial foreclosure proceedings, New Investments filed for Chapter 11 bankruptcy. New Investments’ plan of reorganization proposed to cure its default by selling the property to a third party and using the sale proceeds to pay the outstanding amount of the debt at the pre-default interest rate. The lender objected to the plan, contending it was entitled to the post-default interest rate.
The bankruptcy court confirmed New Investments’ plan over the lender’s objection, and the lender appealed.
The Ninth Circuit reversed, holding that in light of 11 U.S.C. §1123(d), Entz-White was no longer valid. The Court held: “By its terms, §1123(d) tells us to look to the promissory note and Washington law to determine what amount New Investments must pay to cure its default. Here, that analysis requires the payment of post-default interest.” The Court observed that its conclusion “holds the parties to the benefit of their bargain.”
The New Investments decision confirms that bankruptcy is not a borrower antidote for a loan’s “default interest” provisions.
For specialist advice regarding your specific circumstances, please contact the BCR team.
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