Oversecured Creditor Entitled to Default Interest if Collateral Sold Under Section 363(b)

An oversecured creditor’s right to interest, fees, and related charges as part of its allowed secured claim in a bankruptcy case is well established in U.S. bankruptcy law. Less clear, however, is whether that entitlement encompasses interest at the default rate specified in the underlying contract between the creditor and the debtor. The answer to that question can be a thorny issue in chapter 11 cases because the Bankruptcy Code provides that a chapter 11 plan may cure and reinstate most defaulted obligations, and courts disagree as to whether the power to cure defaults nullifies all consequences of default, including the obligation to pay default interest. The Ninth Circuit Court of Appeals recently had an opportunity to examine the interplay between these seemingly incongruous provisions of the Bankruptcy Code. In General Elec. Capital Corp. v. Future Media Productions, Inc., the court reversed a bankruptcy court order disallowing default interest and costs as part of the claim of a secured creditor whose collateral was sold by the debtor outside of a chapter 11 plan, ruling that the court erred by applying the Bankruptcy Code’s plan confirmation provisions in a situation where cure and reinstatement of the secured creditor’s debt was neither contemplated nor possible.

Allowance of Default Interest as Component of Allowed Secured Claim

Debts and other obligations, secured or otherwise, are generally classified as “claims” in the Bankruptcy Code. This means that a secured obligation may give rise to both a secured claim, to the extent that the value of any property securing it is equal to or greater than the face amount of the underlying debt, and an unsecured claim, to the extent of any deficiency in the collateral value. In accordance with section 506(a) of the Bankruptcy Code, the value of the debtor’s interest in assets securing a debt determines whether the debt gives rise to an allowed secured claim, an allowed unsecured claim, or both.

If a creditor turns out to be “oversecured” because its collateral value exceeds the face amount of the underlying debt, section 506(b) provides that it may recover interest and related costs as part of its allowed secured claim:

To the extent that an allowed secured claim is secured by property the value of which, after any recovery under subsection (c) of this section, is greater than the amount of such claim, there shall be allowed to the holder of such claim, interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement or State statute under which such claim arose.

Although the provision clearly expressly refers to “interest on such claim . . . provided for under the agreement or State statute,” it does not specify whether any distinction should be made between ordinary and default rate interest. Most courts, consistent with the Supreme Court’s 1989 ruling in United States v. Ron Pair Enterprises, Inc., have allowed (or at least recognized a presumption of allowability for) default interest provided in a contract as part of a secured creditor’s claim, provided the rate is not unenforceable under applicable nonbankruptcy law. As discussed below, however, some courts have concluded otherwise if the debtor proposes to “cure” the obligation as part of its chapter 11 plan.

Cure of Defaulted Obligations Under a Chapter 11 Plan

As a general rule, contract law does not give a party in breach or default of a contract the right to rectify, or “cure,” its breach or default absent the express agreement of the parties. The Bankruptcy Code changes this rule under certain circumstances. Section 1123(a)(5)(G) states that a proposed chapter 11 plan shall “provide adequate means for the plan’s implementation, such as . . . curing or waiving of any default.” As it applies to claims (as distinguished from executory contracts and unexpired leases), the cure concept also appears in the statute’s provision regarding the concept of “impairment.” Specifically, section 1124(2) provides that a class of claims is “impaired” under a plan (and therefore entitled to vote to accept or reject it) unless the plan, “notwithstanding any contractual provision or applicable law that entitles the holder of such claim or interest to demand or receive accelerated payment of such claim or interest after the occurrence of a default,” (i) cures any such default, (ii) reinstates the maturity of the claim, and (iii) compensates the claimant for any damages incurred in reasonably relying on such contractual provision or such applicable law.

Some courts, following the approach articulated in the Ninth Circuit’s 1988 ruling In re Entz-White Lumber & Supply, Inc., have held that, because curing a default nullifies its consequences, a debtor curing a default as part of its chapter 11 plan need pay interest on the outstanding obligation only at the pre-default rate specified in the governing contract. This approach, however, represented the minority view even before 1994, when Congress added section 1123(d) to the Bankruptcy Code to prevent mortgagees from realizing a windfall at the expense of unsecured creditors by forcing debtor-homeowners who wished to cure defaults to pay the bulk of their income to satisfy the secured creditor’s claims for mortgage arrears and related charges. Section 1123(d) (which closely tracks a similar provision in chapter 13) provides that:

Notwithstanding subsection (a) of this section and sections 506(b), 1129(a)(7), and 1129(b) of this title, if it is proposed in a plan to cure a default the amount necessary to cure the default shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.

On its face, the provision would appear to overrule the Entz-White approach. Even so, some courts have ruled even after the enactment of section 1123(d) that a debtor need pay only pre-default interest to cure and render a defaulted obligation unimpaired under a chapter 11 plan in accordance with section 1124(2). The Ninth Circuit recently had an opportunity to revisit the continued vitality of its approach on this issue in Future Media.

Future Media

Multimedia accessory manufacturer Future Media Productions, Inc. (“Future Media”), entered into a loan agreement in 2004 with General Electric Capital Corporation (“GECC”). Under the agreement, GECC provided the company with a term loan in the amount of $10.5 million and a revolving line of credit in the amount of $5 million. The loan bore pre-default interest at an index rate plus 1.5 percent per annum, with default interest to accrue at an additional 2 percent per annum. The loan agreement also obligated Future Media to pay attorneys’ fees and costs incurred by GECC in enforcing its rights under the contract.

Future Media defaulted on the loan in March 2005, after which default interest commenced to accrue. Concluding that an orderly liquidation of its assets was the best option, Future Media filed for chapter 11 protection on February 16, 2006, in California. The bankruptcy court later approved an agreement with GECC (which was oversecured) permitting the company to use GECC’s cash collateral, but reserved for later determination any final decision on whether the allowed amount of its secured claim would include interest at the default rate and related costs. Shortly afterward, the debtor was authorized to sell substantially all of its assets in a sale conducted under section 363(b) of the Bankruptcy Code. The court ultimately ruled that GECC was entitled to interest at the pre-default rate only and that it was not entitled to attorneys’ fees or costs. In doing so, it relied on Entz-White as authority for limiting GECC’s claim. GECC appealed directly to the Ninth Circuit Court of Appeals.

The Ninth Circuit’s Ruling

The Ninth Circuit reversed. Citing the Supreme Court’s 2007 ruling in Travelers Cas. & Sur. Co. of Amer. v. Pac. Gas & Elec. Co. for the proposition that creditor entitlements in bankruptcy arise from underlying substantive laws creating the debtor’s obligations, the court of appeals reasoned that a default rate of interest should be enforced “subject only to the substantive law governing the loan agreement, unless a provision of the Bankruptcy Code provides otherwise.” In this case, the Ninth Circuit concluded that neither applicable state law nor the Bankruptcy Code prohibited GECC from receiving default interest as part of its allowed secured claim.

The court of appeals declined to decide whether Entz-White was overruled by section 1123(d). Even so, it faulted the bankruptcy court’s reliance on the ruling. Entz-White, the Ninth Circuit emphasized, involved cure of a defaulted obligation under section 1124(2) to render the claim unimpaired for purposes of voting on a chapter 11 plan, rather than a section 363(b) sale of collateral and payment of a secured creditor’s claim from the proceeds. It rejected as uncompelling other court rulings that have transposed principles applied in connection with section 1124(2) to circumstances involving the sale of a secured creditor’s collateral under section 363(b), concluding that nothing in the statute precludes payment of default interest as part of the creditor’s allowed secured claim:

Because the Bankruptcy Code does not provide a “qualifying or contrary provision” to the underlying substantive law here, the bankruptcy court’s extension of Entz-White to the loan agreement’s default rate was error. Consistent with the Supreme Court’s holding in Travelers, we hold that the parties’ arms length bargain, governed by New York law, controls.

Analysis

The reasoning of Future Media confines the default-rate interest debate to situations involving cure under section 1124(2). Still, the ruling does little to resolve a thorny issue in bankruptcy jurisprudence that has persisted for nearly 15 years. Moreover, reconciling an approach that awards default interest (and related costs) to an oversecured creditor, unless the debtor is proceeding toward confirmation of a chapter 11 plan that proposes to cure the secured obligation, is no easy matter, particularly when it would appear to contradict the express language of section 1123(d). Many courts confronted with the incongruity of Entz-White with section 1123(d) have chosen to side-step the issue or to fashion creative rationales, tenable or otherwise, for retaining a legal approach that is undoubtedly popular with debtors intent upon avoiding the contractual consequences of default in a bankruptcy case. For example, in In re Sweet, a Colorado bankruptcy court concluded that section 1123(d) does not abrogate the Entz-White line of cases because the provision does not apply in all circumstances, such as the one before it, where no right to cure existed under either the underlying promissory note or applicable state law absent initiation of foreclosure proceedings. Future Media continues in that vein.

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General Elec. Capital Corp. v. Future Media Productions, Inc., 536 F.3d 969 (9th Cir. 2008).

Great W. Bank & Trust v. Entz-White Lumber & Supply, Inc. (In re Entz-White Lumber & Supply, Inc.), 850 F.2d 1338 (9th Cir. 1988).

United States v. Ron Pair Enterprises, Inc., 489 U.S. 235 (1989).

In re Sweet, 369 B.R. 644 (Bankr. D. Col. 2007).

Travelers Cas. & Sur. Co. of Amer. v. Pac. Gas & Elec. Co., 127 S. Ct. 1199 (2007).

In re Zamani, 390 B.R. 680 (Bankr. N.D. Cal. 2008).