Low Interest Rate Loans in a High Interest Rate Environment: Got to Keep Them Reinstated

In the first rising interest rate environment since before the Great Recession in 2008-2009, reinstatement disputes are likely to become more prominent. Borrowers with pre- and early pandemic debt obligations will likely look to the Bankruptcy Code’s reinstatement powers to preserve these low interest rate obligations as part of a restructuring. But this raises the question: to what extent do borrowers have to honor prepetition contractual obligations to satisfy the Bankruptcy Code’s reinstatement requirements? Southern District of New York Bankruptcy Judge Philip Bentley recently answered one element of that question in the Golden Seahorse LLC bankruptcy case.¹ Judge Bentley found that default interest and fees arising from failure to perform monetary obligations under the loan agreement must be reinstated in order to unimpair the debtor’s loan under a plan of reorganization. The decision holds important implications for distressed borrowers and lenders negotiating loan workouts in the current economic climate.

Background

Golden Seahorse owned the Holiday Inn Manhattan, a hotel in Manhattan’s Financial District. At the time of the bankruptcy filing, the hotel had a mortgage with an outstanding balance of approximately US$87 million, an 5.259% interest rate, and was scheduled to mature in September 2028. Golden Seahorse failed to make the interest payment due in May 2020 causing a payment default on the mortgage loan prior the bankruptcy petition date. By the time the debtor proposed the plan, default interest and fees had totaled US$20 million. The debtor sought to avoid these payments by reinstating the loan, “unimpairing” the lender and thus satisfying one of the confirmation requirements of a plan of reorganization. The lender objected to the plan, arguing that reinstatement required the debtor to pay all default interest and fees. The debtor responded to that argument that the Bankruptcy Code permits a debtor to unimpair a loan without paying any penalties at all. In ultimately siding with the lender, Judge Bentley provided a detailed roadmap for resolving reinstatement disputes with which all lenders and borrowers should familiarize themselves.

Legal Backdrop and Judge Bentley’s Decision

The statutory basis for “reinstatement” under a plan of reorganization involves the interplay of three separate Bankruptcy Code provisions:

• Section 1124(a)(2) addresses “unimpairment” and permits a debtor to treat a creditor as unimpaired (and thus not entitled to vote on a plan) if the plan reinstates a loan’s original maturity, interest, and other terms, provided the plan cures certain defaults and otherwise does not “alter the legal, equitable, or contractual rights” of that claim.
• Section 365(b)(2)(D) (which is expressly incorporated into section 1124(a)(2)), states that if a debtor proposes to assume an executory contract, it must cure all defaults, other than pre-bankruptcy defaults related to the financial condition of the debtor and other related circumstances (so-called “ipso facto” clauses), including penalties relating to the debtor’s failure to perform any non-monetary obligations under the agreement.
• Section 1123(d) states that if a plan proposes to cure a default, “the amount necessary to cure [a] default [in a proposed plan] shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.”

The court then went about harmonizing these three provisions. The first question Judge Bentley needed to resolve is whether “sections 1124(2)(A) and 365(b)(2)(D) create an exception to section 1123(d)’s plain terms.” The court found that it does. Judge Bentley acknowledged that section 1123(d) sets forth a general rule that payment of all contractually-required amounts is necessary to cure a default under a plan. Memorandum Decision. at 22-23. But there is a well-settled New York law principle that specific contractual provisions control over general ones. Because section 1124(2)(A) specifically incorporates section 365(b)(2)(D), which expressly excuses payment of penalty rates and penalty provisions triggered by non-monetary defaults, section 1124(2)(A) specificity must govern over 1123(d)’s general rule that cure payments are calculated by reference to the underlying agreement. Id. at 23.

Judge Bentley then turned to a second question, whether “section 1124(2)(A)’s cure carve-out appl[ies] to loan agreements or only to executory contracts and unexpired leases.” Id. at 24. Even though section 365 only applies to executory contracts (and not loan agreements), the court found that the carve-out section 1124(2)(a) does apply to loan agreements. To find otherwise would render section 1124(2)(A)’s carve-out meaningless, violating the principle that statutes “must, if reasonably possible, be construed in a way that will give force and effect to each of its provisions rather than render some of them meaningless.” Id. at 25 (quoting Puello v. Bureau of Citizenship & Immigr. Servs., 511 F.3d 324, 330 (2d Cir. 2007) (internal quotations omitted)). The court also pointed to section 1124(2)(A)’s “of a kind” language, noting that it must “refer[] to “default[s] of a kind specified in section 365(b)(2),” not “default[s] in contracts and leases of a kind” governed by that section.” Id. at 24. Accordingly, the judge ruled that section 1124(2)(A) “excuses defaults arising under loan agreements, so long as the defaults are “of a kind” addressed by § 365(b)(2) – that is, ipso facto defaults, and failures to satisfy penalty rates and penalty provisions relating to non-monetary defaults.” Id. at 27.

This led to a third and final question, whether “section 365(b)(2)(D) excuse[s] payment of all penalty rates and provisions, or just those associated with non-monetary defaults.” Id. at 27. Commentators have been split on whether to read section 365(b)(2)(D) as (a) “only excus[ing] the satisfaction of penalty rates and penalty provisions relating to breaches of non-monetary obligations” or (b) “excus[ing] the satisfaction of (i) penalty rates relating to both monetary and non-monetary defaults and (ii) penalty provisions relating to non-monetary defaults.” Id. Judge Bentley agreed with the former interpretation, holding that section 365(b)(2)(D) “creates a single cure exception, excusing penalty rates and provisions triggered by nonmonetary defaults.” Id. at 28.

In reaching this conclusion, Judge Bentley applied a third time-tested method of statutory interpretation: the language should be read in the way it is ordinarily understood in every day usage. If a person were trying to convey two separate carve-outs, they would most likely say something like, “Let’s excuse performance of any penalty rate, and any penalty provision relating to a non-monetary default,” or “Let’s excuse performance of any penalty rate, whether relating to monetary or non-monetary defaults, and also penalty provisions relating to non-monetary defaults.” Id. at 30. On the other hand, it would be natural for a person trying to convey a single exception to say, “Let’s excuse performance of any penalty rate or penalty provision relating to a non-monetary default,” which is essentially the language found in section 365(b)(2)(D). Id. at 29. Judge Bentley noted that this pattern of language is reflected in the interpretive canon known as the series-qualifier canon: “when a series of nouns are followed by a modifying clause, that clause modifies every noun in the series, not just the last.” Id. at 30 (citing ANTONIN SCALIA & BRYAN A GARNER, READING LAW: THE INTERPRETATION OF LEGAL TEXTS, 147 (2012)). In short, if Congress intended to create two distinct exceptions to the cure requirement in section 365(b)(2)(D), they would have drafted the statute quite differently. See id. at 31.

Conclusion and Takeaways

Having concluded that section 365(b)(2)(D) did not create a generalized exception for payment of penalties, Judge Bentley ultimately sided with the mortgage lender and rejected the debtor’s argument that it could reinstate the mortgage without paying the default rate. Left undecided was whether the default interest and fees could be challenged under New York law, as an unenforceable penalty or otherwise.

In a rising interest rate economy, we expect debtors to continue to try and reinstate low interest rate loans. Not only does reinstatement offer powerful economic benefits to a debtor, it offers a significant strategic advantage—by unimpairing the lender, the debtor effectively sidelines the lender from objecting to confirmation of the plan. As a result, expect lenders to continue to fight reinstatement by insisting on a similarly strict reading of the Bankruptcy Code as the lender in Golden Seahorse successfully argued.

¹Memorandum Decision and Order Concerning Whether Reinstatement of Accelerated Debt Under Bankruptcy Code § 1142(2) Requires Payment of Default Rate Interest (“Memorandum Decision”), In re Golden Seahorse LLC, d/b/a Holiday Inn Manhattan Financial District, Case No. 22-11582-PB (Bankr. S.D.N.Y. July 31, 2023), ECF No. 153.

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