Pacifica L 51, LLC v. New Investments, Inc.: Ninth Circuit Requires Debtor to Cure Default By Paying Post-Default, Increased Interest Rate According to Underlying Agreement and Nonbankruptcy Law | Practical Law

Pacifica L 51, LLC v. New Investments, Inc.: Ninth Circuit Requires Debtor to Cure Default By Paying Post-Default, Increased Interest Rate According to Underlying Agreement and Nonbankruptcy Law | Practical Law

The US Court of Appeals for the Ninth Circuit held, in Pacifica L 51, LLC v. New Investments, Inc. (In re New Investments, Inc.), that the amount necessary to cure a default is governed by the underlying agreement and nonbankruptcy law, requiring payment of interest at the default rate.

Pacifica L 51, LLC v. New Investments, Inc.: Ninth Circuit Requires Debtor to Cure Default By Paying Post-Default, Increased Interest Rate According to Underlying Agreement and Nonbankruptcy Law

by Practical Law Bankruptcy & Restructuring
Published on 28 Nov 2016 • USA (National/Federal)
The US Court of Appeals for the Ninth Circuit held, in Pacifica L 51, LLC v. New Investments, Inc. (In re New Investments, Inc.), that the amount necessary to cure a default is governed by the underlying agreement and nonbankruptcy law, requiring payment of interest at the default rate.
On November 4, 2016, the US Court of Appeals for the Ninth Circuit (Ninth Circuit) held, in Pacifica L 51, LLC v. New Investments, Inc. (In re New Investments, Inc.), that the amount necessary to cure a default is governed by the underlying agreement and nonbankruptcy law, requiring payment of interest at the default rate ( (9th Cir. Nov. 4, 2016)).

Background

New Investments, Inc. (Debtor) borrowed over $3 million from a predecessor in interest of Pacifica L 51, LLC to purchase a hotel property in Kirkland, Washington. The terms of the promissory note for the loan set an interest rate of 8%, and provided that in the event of default, the interest rate would increase to 13%. In 2009, New Investments defaulted on the note. After Pacifica commenced non-judicial foreclosure proceedings against New Investments, the company filed a voluntary Chapter 11 petition.
The Debtor's plan of reorganization proposed to cure the default by using the proceeds of the sale of the hotel property to pay off the loan at the pre-default interest rate of 8%. Pacifica objected to the plan, arguing it was entitled to be paid at the post-default interest rate of 13%.
The US Bankruptcy Court for the Western District of Washington confirmed the Debtor's plan and authorized the sale of the hotel for $6,890,000, from which Pacifica would receive $2,830,877.28, for repayment of the loan at the pre-default interest rate. Pacifica appealed the confirmation order because it applied the non-default interest rate. With the consent of both parties, the Ninth Circuit took a direct appeal of the Bankruptcy Court decision.

Outcome

A majority of the panel for the Ninth Circuit reversed the Bankruptcy Court and held that:
In reaching its decision, the Ninth Circuit overruled its prior holding in Great W. Bank & Trust v. Entz-White Lumber & Supply, Inc. (In re Entz-White Lumber & Supply), 850 F.2d 1338 (9th Cir. 1988). Entz-White provided that a debtor that cures its default avoids all consequences of the default, including post-default interest rates (see Entz-White, 850 F. 2d at 1342).
As part of the appeal, and in light of the enactment of section 1123(d) of the Bankruptcy Code in 1994, after Entz-White was decided, the Ninth Circuit reviewed its decision in Entz-White. Section 1123(d) provides that "the amount necessary to cure the default [as proposed in a plan] shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law." (11 U.S.C. § 1123(d)). Section 1123(d) is inapposite to Entz-White. The Ninth Circuit:
  • Determined that the plain language of the statute compelled its holding to invalidate Entz-White, and noted that the result would have been the same even if the statute was ambiguous.
  • The Ninth Circuit analyzed the legislative history and found that:
    • Congress intended section 1123(d) to invalidate Rake v. Wade and limit creditors to the benefit of their bargain. Rake effectively provided creditors with interest on interest. Rake held a debtor who proposed to cure a default was required to pay interest on the arrearages of its loans even though the loan's underlying agreement did not require the interest payment resulting in an unbargained-for windfall to creditors. (See Rake v. Wade, 508 U.S. 464 (1993));
    • the particular purpose of Congress to invalidate Rake does not limit the effect of the statute. The fact that Congress did not foresee all the consequences of enacting the statute does not limit the statute's "effect to its plain meaning" (see Union Bank v. Wolas, 502 U.S. 151, 158 (1991)). The statute clearly states that courts must consider the underlying loan documents and relevant state law to determine the amount to be paid to cure a default;
    • Congress also stated "a cure pursuant to a plan should operate to put the debtor in the same position as if the default had not occurred." (Di Pierro v. Taddeo (In re Taddeo), 685 F.2d 24, 26-27 (2d Cir. 1982)). Congress did not attempt to alter or define the term "cure." Relying on Restatement (Third) of Property (Mortgages) and Washington state law, a borrower's cure obligations that enable it to return to pre-default conditions may also include penalties and fees, such as late charges, attorneys' fees, and court costs. (Restatement (Third) of Property (Mortgages) § 8.1 & cmt. c (1997); Wash. Rev. Code Ann. § 61.24.090(1)(b)); and
    • under section 1124(2) of the Bankruptcy Code, to cure a default a debtor may not "otherwise alter the legal, equitable, or contractual rights" of the creditor. (11 U.S.C. § 1124(2)(E)). The Ninth Circuit noted that the post-default interest rate is one of Pacifica's bargained-for rights. Only upon payment of the default rate of interest will the debtor have satisfied its obligations under the loan agreement and nonbankruptcy law. At that time, the debtor can resume acting under pre-default conditions.

The Dissent

The dissenting opinion stated that:
  • Neither section 1123(d) nor any other provision of the Bankruptcy Code defined "cure" to be anything but the Entz-White definition that "curing a default means returning to pre-default conditions, such that any consequences of the default are nullified" (Entz-White, 850 F.2d at 1340 (quoting Taddeo 685 F.2d at 26-27)).
  • Neither the text nor the legislative history of section 1123(d) supported a departure from Entz-White, and that Pacifica bears the burden of showing that Congress intended to change settled law by passing section 1123(d).
  • The purpose of section 1123(d) was to reject the US Supreme Court's ruling in Rake and eliminate the possibility of a windfall for creditors contrived by a court.

Practical Implications

This decision will certainly impact negotiations between lenders and borrowers. A borrower who files Chapter 11 must be mindful that if its plan proposes to cure defaults, interest may be charged at the default rate based upon the underlying loan documents and nonbankruptcy law.
It is likely that the decision will be reviewed en banc in light of the fact that the Entz-White decision was overturned and the dissent.