November 14, 2016

Default Interest No Longer Wiped Out by a "Cure" in Chapter 11 Cases

Pacifica L 51 LLC v. New Investments, Inc.

Debtors can no longer use “cure” provisions in Chapter 11 reorganization plans to wipe out contractual default interest owed on secured loans, according to a November 4, 2016 decision from the 9th U.S. Circuit Court of Appeals (Pacifica L 51, LLC v. New Investments, Inc., 2016 WL 6543520).

Secured creditors in Chapter 11 bankruptcy cases in the 9th Circuit have long-faced the risk of losing their contractual right to recover default interest. Debtors could use a Chapter 11 plan to “cure” loan defaults with a sale or refinance that paid all the non-default charges on the loan and then completely eliminate accrued default interest. No longer.

In 1988, the case of In re Entz-White Lumber & Supply, Inc., 850 F.2d 1338 (9th Cir. 1988), the 9th decision allowed defaulting debtors to eliminate default interest and encouraged the use of Chapter 11 for the purpose of wiping default interest off the loan ledger. In 1994 Congress passed an amendment to the Bankruptcy Code that stated:

  •  . . . 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.

“Applicable nonbankruptcy law” invariably means state law. Virtually every state enforces default interest charges as long as they do not violate usury laws and are not so radically high as to be deemed an illegal penalty. This amendment to the Code was a very clear directive by Congress that all charges on a loan must be paid to accomplish a cure.

Bankruptcy courts in the 9th Circuit were bound by the Entz–White case. It took more than 20 years to confront the 9th Circuit with the conflict between the statute and the decision in Entz-White. Pacifica L 51 LLC, represented by Dillon Jackson of Foster Pepper, brought the matter to the 9th Circuit and urged that the clear language of the statute required payment of default interest. A majority of the 9th Circuit panel agreed and Entz-White was overruled.

What does this development mean to secured lenders?

A debtor cannot use Chapter 11 to avoid payment of reasonable default interest. Lenders can seek enforcement of the full interest obligations contained in their loan documents under state law or in bankruptcy.

Default interest can significantly increase the recovery by a secured creditor. Taking the Entz-White cure option out of the debtor’s play book is helpful in workouts and negotiations on defaulted credits.

If a lender has been subject to application of Entz-White and loss of default interest in the last 12 months, the confirmation was based on a “void” decision and is subject to reversal under Fed. R. Civ. P. 60.

Pacifica L 51 LLC is represented by Dillon E. Jackson of Foster Pepper PLLC. For more information on this Chapter 11 development, please contact Dillon Jackson.

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