Can a debtor reinstate a defaulted loan under a Chapter 11 plan without paying default rate interest? This question was analyzed thoroughly in a recent Southern District of New York Bankruptcy Court decision by Judge Philip Bentley.
He ruled in the case In re Golden Seahorse LLC (Golden Seahorse), 652 BR 593 (Bankr. SDNY 2023), that where default rate interest and penalties were triggered by a monetary default, the debtor would have to pay the default rate interest and penalties as provided under New York law and the governing loan documents in order to reinstate the loan. Although not an issue in the case, it seems near certain that a court applying Judge Bentley’s logic in a case where acceleration of the loan was triggered by a non-monetary default would allow the loan to be reinstated without the payment of default rate interest and penalties.
In Golden Seahorse, the debtor owned and operated a Holiday Inn with a $137 million, 10‑year, 5% mortgage. It failed to make mortgage payments, and the lender called the default, accelerated the loan, and demanded all amounts due, including default rate interest (an additional 5%), and other penalties. The debtor then filed for bankruptcy and proposed a plan of reorganization that cured the missed payments but not the default rate interest and penalties (totaling approximately $20 million).
In the debtor’s view, since the missed payments were proposed to be paid in full, the loan would be unimpaired and would “ride through” the bankruptcy—and because the lender’s claim was unimpaired, the lender would have no vote on the plan.
Is the lender’s claim truly unimpaired, and can the plan be confirmed over the lender’s objection? Judge Bentley said no, but arriving at this result took a detailed analysis of three Bankruptcy Code provisions.
The court first considered Bankruptcy Code § 1123(d), which provides that the amount necessary to cure a default is to be determined in accordance with the underlying agreement and applicable nonbankruptcy law. Addressing the plain terms of this section but recognizing the procedural posture of the case, Judge Bentley deferred ruling on whether the particular loan documents in issue and governing New York law would allow default rate interest.[1]
The court next considered Bankruptcy Code § 1124(2)(A), which governs when and how accelerated payment obligations can be de-accelerated, and is equally clear: the debtor does not have to cure a default “of a kind specified in section 365(b)(2) . . . or of a kind that section 365(b)(2) expressly does not require to be cured” in order to reinstate accelerated debt and render it unimpaired.
The court also considered whether the reference to § 365(b)(2) in § 1124(2)(A) meant that the exception applies only to defaults under executory contracts and unexpired leases—the contracts that are the subject of §365—or whether defaults under loan agreements are as well. The court held that the phrase “of a kind specified in section 365(b)(2)” refers to the kinds of default provisions covered by § 365(b)(2) and not to the kinds of contracts covered by § 365(b)(2).
Finally, the court considered § 365(b)(2)(D), which provides that the obligation to cure defaults under executory contracts or unexpired leases does not apply to the satisfaction of any penalty provisions relating to a failure by the debtor to perform nonmonetary obligations. Based on the text, legislative history, and the purpose of Chapter 11, the court held that § 365(b)(2)(D) creates an exception to the cure requirement for penalties triggered by non-monetary defaults only; penalties triggered by monetary defaults must be cured for the loan to be reinstated and ride through the bankruptcy.
In Golden Seahorse, the default that triggered the acceleration and default interest was a monetary (payment) default, and the court ruled that the debtor would have to pay it to the extent required under New York law and the loan agreement. Since the debtor was unable to pay the full amount under its plan, it would have to propose a new, confirmable plan. The debtor has appealed the bankruptcy court’s decision and the question has been certified to be heard directly by the US Court of Appeals for the Second Circuit.
The question of whether the payment of default rate interest would be required to cure and reinstate the loan if the underlying default was a nonmonetary default (for instance, a financial covenant default or a reporting default) was not before the court in Golden Seahorse. However, Judge Bentley’s “of-a-kind” analysis would indicate that a debtor whose loan was accelerated due to a non-monetary default might not have to pay default rate interest to cure and reinstate its loan.[2]
As a practical matter, some lenders are reluctant to accelerate based on non-monetary defaults, and Golden Seahorse indicates that they may not be giving up default interest by not accelerating prepetition—although this is not certain.
On the other hand, the Golden Seahorse decision reinforces lenders’ entitlement to default rate interest when loan accelerations are triggered by monetary defaults, and this may serve to increase lenders’ negotiating positions in subsequent bankruptcy proceedings.
[1] The debtor previewed this issue to the court soon after filing, but it remained unresolved until the debtor’s exclusivity period neared expiration. The debtor filed a plan that, as noted, provided for the restatement of the mortgage loan and treatment of the loan as unimpaired. Before scheduling a vote or further confirmation proceedings, the debtor and lender asked the court to rule solely on the threshold question of whether default interest had to be paid under the Bankruptcy Code; the state law and contract issues were not addressed.
[2] Note that Golden Seahorse did not consider the case of a prepetition demand for default interest based on a prepetition acceleration for a non-monetary default. This may be a reason to act quickly to accelerate and demand default interest as soon as possible.