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Ninth Circuit Rules on Default Interest Rates in Chapter 11 Bankruptcy

Bankruptcy offers a way to obtain relief when one’s available income is not sufficient to cover one’s required debt payments. Federal bankruptcy law offers several options for businesses, including a restructuring of debts through Chapter 11 of the Bankruptcy Code. The goal of a Chapter 11 bankruptcy is to create a plan that pays down much of a business’ debt, discharges some remaining debts, and allows continued business operations once the bankruptcy case closes. Creating a Chapter 11 reorganization plan can be a complex task, depending on the size of the business and the extent of its debts. The Ninth Circuit recently considered a question about whether a default interest rate should still apply after a Chapter 11 debtor cures the default. The court reversed its own precedent, ruling that curing the default does not wipe out the default interest rate. In re New Investments, Inc., No. 13-36194, slip op. (9th Cir., Nov. 4, 2016).

Many secured loan or credit agreements require a debtor to pay a higher interest rate after a default. Almost 30 years ago, the Ninth Circuit held that a debtor who cures the default could eliminate their obligation to pay the default interest in a Chapter 11 bankruptcy. In re Entz-White Lumber & Supply, Inc., 850 F.2d 1338 (9th Cir. 1988). The court based its decision in part on language in the Bankruptcy Code stating that a Chapter 11 bankruptcy plan “shall…provide adequate means for the plan’s implementation, such as…curing or waiving of any default.” 11 U.S.C. § 1123(a)(5)(G).

The Bankruptcy Code does not define “cure,” so the court applied the common meaning of “taking care of the triggering event and returning to pre-default conditions.” Entz-White, 850 F.2d at 1340 (internal quotations omitted). It held that the interest owed by the debtor should be “at the market rate or at the pre-default rate provided for in the contract,” rather than the higher default interest rate. Id. at 1343.

The Bankruptcy Reform Act added a subsection to the section cited by the Ninth Circuit in Entz-White that affects default cures. Pub. L. 103-394 § 305(a), 108 Stat. 4134 (Oct. 22, 1994). The new subsection states that a Chapter 11 plan must base “the amount necessary to cure the default” on “the underlying agreement and applicable nonbankruptcy law.” 11 U.S.C. § 1123(d).

The debtor in New Investments borrowed about $3 million from the creditor with a promissory note secured by a deed of trust. The note established an eight-percent interest rate, which would increase to 13 percent in case of default by the debtor. The debtor defaulted in 2009, and it filed for Chapter 11 bankruptcy after the creditor initiated a non-judicial foreclosure. The bankruptcy court eventually confirmed a plan that provided for the sale of the property securing the debt, followed by payment of the creditor at the pre-default interest rate. The creditor appealed.

The Ninth Circuit ruled that the default interest rate must apply. In so ruling, it effectively overturned Entz-White on the ground that the 1994 amendments to the Bankruptcy Code required it to do so. One justice dissented, noting in part that the Bankruptcy Code still provides no clear definition of “cure,” leaving the matter open to debate.

For the past 40 years, Cirrus Law PC has represented businesses and business owners in the Bay Area in a variety of transactional and litigation matters. Contact us today online or at (925) 463-1073 to schedule an initial confidential consultation.

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