What It Means to Cure a Default: Never Take Anything for Granted, the Rules Can Always Change

Pacifica L 51 LLC v. New Investments Inc. (In re New Investments Inc.), 840 F.3d 1137 (9th Cir. 2016)

The debtor proposed a chapter 11 plan that included curing defaults under a mortgage loan. The lender objected because the cure payments were calculated using the pre-default interest rate as opposed to the higher default rate.

The debtor borrowed ~$3 million to purchase hotel property. The note was secured by a deed of trust on the property, and provided for interest at 8%, increasing by 5% in the event of a default. After the debtor defaulted on the note, the lender commenced foreclosure and the debtor filed bankruptcy.

The debtor’s plan of reorganization proposed to cure the loan default by selling the hotel property to a third party and paying off the outstanding loan using the non-default interest rate. The lender objected on the basis that it was entitled to interest at the default rate.

The court began with a general description of loan defaults and cures:

  • A debtor defaults when it fails to comply with a material obligation, such as making timely payments.
  • A default triggers consequences, such as foreclosure of property securing the loan, late fees and penalties, or acceleration of the loan.
  • However, the borrower may also “cure” the defaults, typically by making payments to bring the loan current.
  • The cure generally means the borrower can avoid the consequences of default so that the loan is reinstated and the borrower can keep the property securing the loan.

The court then noted that this process is contemplated by the Bankruptcy Code. Section 1123(a)(5) requires that a plan provide adequate means for implementation, which can include “curing or waiving of any default.” In a case decided in 1988 the 9th Circuit held that a debtor curing a default “is entitled to avoid all consequences of default – including higher post-default interest rates.” So the debtor was entitled to use the non-default interest rate in paying arrearages to bring a loan current.

Unfortunately for the debtor, the court decided in this case that its decision was no longer valid in light of a 1994 amendment to the Bankruptcy Code that added section 1123(d):

Notwithstanding [other sections] of this title, if it is proposed in a plan to cure a default the amount necessary to cure a default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.

In the majority’s view this means that when a debtor proposes to cure a default the court must look to the underlying agreement – i.e. the note, which required payment of a higher interest rate after a default, and “applicable nonbankruptcy law” – i.e. state law that allowed the higher default interest rate. In this case there was a state statute specifically authorizing cure of a monetary default by payment of “[t]he entire amount then due under the terms of the deed of trust and the obligations secured thereby, other than such portion of the principal as would not then be due had no default occurred.” In other words, a borrower can ignore acceleration of the loan, but must otherwise pay what would be due under the loan documents.

The majority acknowledged that the legislative history states that this provision was added to overrule a Supreme Court case that required a debtor curing a default to pay interest on the arrearages even if the underlying loan agreement did not provide for that interest. As stated in the House Report, section 1123(d) would “limit the secured creditor to the benefit of the initial bargain with no court contrived windfall.” It was “the Committee’s intention that a cure pursuant to a plan should operate to put the debtor in the same position as if the default had never occurred.”

However, in the majority’s view the language of the statute was clear, and the legislative history could not limit the effect of the text. The fact that “Congress may not have foreseen all of the consequences of a statutory enactment is not a sufficient reason for refusing to give effect to its plain meaning.”

The majority also concluded that requiring payment of default interest was consistent with the legislative intent because it gave the parties the benefit of their bargain. A borrower cannot cure merely by paying past due installments at the pre-default rate. Rather it must also address other items such as late charges and attorneys’ fees. The majority also viewed this result as consistent with the general balancing of interests of secured creditors and the debtor under the Bankruptcy Code.

Thus, the debtor was required to pay post-default interest in curing defaults, and the bankruptcy court decision confirming a plan of reorganization using a non-default interest rate was reversed.

The dissenting opinion noted that neither section 1123(d) nor any other provision of the Bankruptcy Code defined “cure” in a manner inconsistent with the 9th circuit’s 1988 decision. Thus, the court was bound by precedent which allowed the debtor to cure using the non-default rate.

The dissenting judge also disagreed with the majority’s analysis. Nothing in the statute or legislative history required a conclusion that a cure – which means returning to pre-default conditions – requires paying a penalty triggered by the default. Further, the legislative history was clear that the intent was to overrule a Supreme Court decision, and thus preclude secured creditors from collecting interest on top of interest payments due under the loan documents. The applicable section of the House Report was titled “Interest on Interest” and stated that the effect was to overrule a Supreme Court decision which “‘had the effect of providing a windfall to secured creditors’ by giving them ‘interest on interest payments, and interest on the late charges and other fees, even where applicable laws prohibit[] such interest and even when it was something that was not contemplated by either party in the original transaction.'”

The timing of this decision is interesting: A binding precedent apparently remained unquestioned for more than 25 years. Then a panel declares the holding invalid based on a statutory amendment adopted more than 20 years ago. Just goes to show that it is almost always worth making an argument.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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