Acceleration Enforceable Under State Law Following Non-Monetary Control Covenant Default Prevents Reinstatement of Loan Under Chapter 11 Plan
Chapter 11 debtors commonly use plans of reorganization to decelerate defaulted loans and reinstate the obligations according to their original terms as a means of locking in favorable terms in an unfavorable market. In order to do so, the Bankruptcy Code requires that the trustee or chapter 11 debtor-in-possession ("DIP") "cure" any defaults under the loan agreement, other than defaults related to a debtor's financial condition ("ipso facto provisions") or penalties payable due to the debtor's breach of certain non-monetary obligations.
The U.S. Bankruptcy Court for the Eastern District of New York addressed the cure obligation incident to reinstatement of a prepetition loan under a plan in In re 975 Walton Bronx LLC, 2022 WL 5265041 (Bankr. E.D.N.Y. Oct. 6, 2022). After finding that acceleration of the loan was not subject to state law equitable exceptions to enforcement, the court ruled that the DIP could not reinstate the loan without curing a default arising from a change in control of the debtor without the lender's consent.
Reinstatement of Obligations Under a Chapter 11 Plan
Confirmation of chapter 11 plans involving reinstatement of an objecting secured creditor's claim hinges on the Bankruptcy Code's definition of "impairment." Classes of claims or interests may be either "impaired" or "unimpaired" by a plan. The distinction is important because only creditors holding claims in impaired classes have the right to vote to accept or reject a plan. Under section 1126(f) of the Bankruptcy Code, unimpaired classes of creditors and shareholders are conclusively presumed to have accepted a plan.
Section 1124 defines impairment, providing as follows:
Except as provided in section 1123(a)(4) of this title [permitting the holder of a claim or interest to agree to less-favorable treatment of its claim or interest than the class], a class of claims or interests is impaired under a plan unless, with respect to each claim or interest of such class, the plan—
(1) leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest; or
(2) 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—
(A) cures any such default that occurred before or after the commencement of the case under this title, other than a default of a kind specified in section 365(b)(2) of this title or of a kind that section 365(b)(2) expressly does not require to be cured;
(B) reinstates the maturity of such claim or interest as such maturity existed before such default;
(C) compensates the holder of such claim or interest for any damages incurred as a result of any reasonable reliance by such holder on such contractual provision or such applicable law;
(D) if such claim or such interest arises from any failure to perform a non-monetary obligation, other than a default arising from failure to operate a nonresidential real property lease subject to section 365(b)(1)(A), compensates the holder of such claim or such interest (other than the debtor or an insider) for any actual pecuniary loss incurred by such holder as a result of such failure; and
(E) does not otherwise alter the legal, equitable, or contractual rights to which such claim or interest entitles the holder of such claim or interest.
11 U.S.C. § 1124 (emphasis added).
Section 365(b)(2) provides that a debtor's obligation to cure defaults under an executory contract or an unexpired lease prior to assumption does not include ipso facto clauses—provisions relating to the debtor's insolvency or financial condition, the bankruptcy filing, or the appointment of a trustee or custodian—or provisions relating to "the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform non-monetary obligations under the executory contract or unexpired lease."
Pursuant to section 365(b)(1)(A), an executory contract or unexpired lease under which the debtor has defaulted can be assumed only if the trustee or DIP cures the default, or provides adequate assurance of its prompt cure, other than with respect to "a default that is a breach of a provision relating to the satisfaction of any provision (other than a penalty rate or penalty provision) relating to a default arising from any failure to perform non-monetary obligations under an unexpired lease of real property," with certain caveats. Although the language of section 365(b)(1)(A) is confusing, even after it was supposedly clarified by Congress in 2005 (see Pub. L. No. 109–8, § 328(a)(1)(A) (2005)), it has been suggested that "the reference to non-monetary obligations and the impossibility of cure by subsequent performance means that the provision relates to continuous operation provisions and other provisions that are similar in that they involve non-monetary obligations and cannot be retroactively cured." Collier ¶ 365.06 (16th ed. 2022).
By reinstating an obligation and curing defaults under section 1124(2), a plan effectively can "roll back the clock to the time before the default existed." MW Post Portfolio Fund Ltd. v. Norwest Bank Minn., N.A. (In re Onco Inv. Co.), 316 B.R. 163, 167 (Bankr. D. Del. 2004); see also 11 U.S.C. § 1123(a)(5)(G) (providing that a plan shall provide adequate means for its implementation, such as "curing or waiving of any default"). However, this does not mean that reinstatement relieves the debtor of the obligation to pay postpetition interest at the default rate specified in a loan agreement or applicable non-bankruptcy law. See In re New Investments, Inc., 840 F.3d 1137 (9th Cir. 2016); In re Sagamore Partners, Ltd., 620 Fed. App'x. 864 (11th Cir. 2015); In re Moshe, 567 B.R. 438 (Bankr. E.D.N.Y. 2017).
For a chapter 11 debtor, reinstatement of a loan may be the preferable strategy if the loan bears an interest rate lower than the prevailing market rate and is otherwise subject to terms (including covenants) that are favorable to the debtor. Reinstatement may also allow the debtor to lock in a loan under favorable terms until post-reorganization financing becomes more available or attractive.
975 Walton Bronx LLC (the "debtor") owned a mixed-use building with retail and residential units in the Bronx, New York. The property secured a mortgage loan in the amount of $22.5 million from Investors Bank ("IB"). The 2015 loan agreement contained a change-in-control restriction (the "control covenant") limiting ownership of the debtor to its sole managing member, 15-21 Crooke LLC ("Crooke"), until the loan was repaid. Crooke's sole managing member was Benzion Kohn ("Kohn").
The loan agreement provided, however, that IB could consent to a change in the legal or equitable ownership of the debtor and assumption of the mortgage provided that, among other things: (i) no event of default under the loan agreement had occurred and remained uncured at the time of the loan assumption; (ii) the proposed transferee had delivered an assumption agreement to IB with specified terms; and (iii) IB had received a "transfer processing fee" equal to 1% of the outstanding principal amount of the loan plus any costs and expenses incurred by IB in connection with the transfer.
Events of default under the loan agreement included any change in ownership of the building or the equity ownership of the debtor without IB's prior written consent.
In January 2018, Crooke transferred 49.99% of its ownership interest in the debtor to the J Partners Group ("J Partners") without IB's consent. Thereafter, J Partners managed the property. The debtor further defaulted on the loan in April 2020 by, among other things, failing to make debt service payments and failing to provide financial information required by the loan agreement to IB. IB delivered notice of the defaults and its intention to accelerate the loan in August 2020.
In October 2020, IB assigned the loan to Walton Improvement Group LLC ("Walton"). In February 2021, Walton commenced an action in state court to foreclose on the property. Its complaint listed the payment defaults but omitted the control covenant default.
The foreclosure action was stayed when the debtor filed for chapter 11 protection in the Eastern District of New York on February 25, 2021. Walton filed a proof of secured claim in the case for approximately $24 million.
The debtor's chapter 11 plan proposed to reinstate the loan according to its original terms (with one exception) and to cure all prepetition payment defaults with interest at the default contract rate (approximately $1.6 million). Walton objected to confirmation of the plan, arguing that the loan could not be cured and reinstated due to the control covenant default.
During the plan confirmation hearing, the bankruptcy court ruled that Walton did not waive the default arising from breach of the control covenant and was not estopped from enforcing it. In addition, this non-monetary default was incurable without Walton's consent, which Walton was authorized to withhold retrospectively for any reason or no reason at all. Notwithstanding the default, however, the court held that the loan would be unimpaired, and thus susceptible to reinstatement, if the debtor could show that acceleration was inappropriate due to the existence of certain equitable factors under New York law, as outlined in In re 53 Stanhope LLC, 625 B.R. 573 (Bankr. S.D.N.Y. 2021). It accordingly ordered the parties to brief this issue.
The Bankruptcy Court's Ruling
After briefing and a trial, the bankruptcy court held that the debtor could not reinstate the loan under its chapter 11 plan without curing the non-monetary control‑covenant default, which required Walton's consent.
Initially, U.S. Bankruptcy Judge Jil Mazer-Marino explained that, under New York law, a mortgagee is entitled to enforce an acceleration clause in a mortgage absent some element of fraud, exploitative overreaching, or unconscionable conduct. 975 Walton, 2022 WL 5265041, at *4 (citing Fifty States Mgmt. Corp. v. Pioneer Auto Parks, Inc., 46 N.Y.2d 573, 575 (N.Y. 1979); Graf v. Hope Bldg. Corp., 254 N.Y. 1 (N.Y. 1930)). Even so, she noted, "'equity will often intervene to prevent a substantial forfeiture occasioned by a trivial or technical breach'" or "'to prevent unconscionable overreaching where a good faith mistake has been promptly cured and there is no prejudice to the non-defaulting party.'" Id. at *5 (quoting Fifty States, 46 N.Y.2d at 576-77).
Next, the bankruptcy court reasoned that, under New York law, a court exercising its equitable powers can prevent the enforcement of a mortgage acceleration clause triggered by a non-monetary default. In Stanhope, Judge Mazer-Marino explained, the bankruptcy court acknowledged that acceleration clauses are strictly enforced under New York law upon a monetary default, but noted that, in deciding whether to enforce an acceleration clause triggered by a non-monetary default, New York courts consider whether the mortgagee suffered actual damages as a result of the default, whether the default impaired the lender's security, whether the default makes future payment of principal and interest less likely, and whether the default was inadvertent or insignificant. Id. at *6 (citing Stanhope, 625 B.R. at 584).
Judge Mazer-Marino concluded that, under either the Stanhope standard or the Fifty States standard, Walton was within its rights to accelerate the mortgage loan based on the debtor's default under the control covenant. In so ruling, the bankruptcy court rejected the debtor's argument that Walton purchased the loan for the sole purpose of foreclosing on the property and therefore engaged in the kind of "fraudulent, exploitative, overreaching, or unconscionable conduct" described in Fifty States. Even if it were aware of the control-covenant default when it bought the loan, Judge Mazer-Marino wrote, Walton's acquisition of the debt to accelerate the loan and foreclose was "a legitimate exercise of a mortgage assignee's rights." Id. at *7.
The bankruptcy court also rejected the debtor's argument that IB engaged in inequitable conduct by failing to grant the debtor a forbearance. According to Judge Mazer-Marino, IB was not obligated to offer a forbearance or to negotiate a sale of the loan to the debtor, and the debtor admitted that, at the time it was seeking a forbearance, it had defaulted on the control covenant and its payment obligations.
Addressing the Stanhope standard, the bankruptcy court found, among other things, that: (i) Walton suffered actual damages due to the control-covenant default because J Partners failed to pay debt service, real estate taxes, and water bills with respect to the property, evidencing "J Partners' lack of care or dubious business judgment," and failed to escrow certain fire insurance proceeds; (ii) the control-covenant default made the future payment of principal and interest on the loan less likely because the debtor paid insider loans that "more closely resemble[d] contributions to equity as opposed to short-term loans," instead of servicing the mortgage debt, and Walton was prejudiced because, unlike Kohn, neither J Partners nor its investors had executed a "bad-boy" guarantee of the debt to deter them from approving actions detrimental to the mortgagee; and (iii) the debtor intentionally defaulted on the control covenant and J Partners made a business decision to purchase its 49.9% interest even though it knew that it would violate the covenant.
"The equitable principles articulated in Graf and Stanhope," Judge Mazer-Marino wrote, "have no application here." The bankruptcy court accordingly ruled that the debtor's chapter 11 plan could not be confirmed to the extent that it provided for reinstatement of the Walton loan without curing the change-in-control covenant default.
The bankruptcy court's examination in 975 Walton of equitable limitations under New York law on the ability of a lender to enforce its acceleration and foreclosure rights is instructive, but arguably unnecessary given the context.
Section 1124(2) expressly states that, to reinstate an obligation, any and every default must be cured "other than a default of a kind specified in section 365(b)(2) of this title or of a kind that section 365(b)(2) expressly does not require to be cured." Section 365(b)(2), in turn, excuses from cure only obligations relating to breaches of ipso facto provisions or to the payment of penalties incurred due to the debtor's failure to perform non-monetary obligations under an executory contract or unexpired lease.
Neither section 1124(2) nor section 365(b)(2) includes an exception to the requirement to cure defaults—non-monetary or otherwise—that are technical, minor, or caused by a lender's inequitable conduct. To be sure, section 1124(2)(d) does relieve the trustee or DIP from compensating a lessor for pecuniary losses arising from the breach of non-monetary obligations under a nonresidential real property lease subject to section 365(b)(1)(A), but that provision has no relevance to the facts in 975 Walton. None of these section 1124(2) exceptions excuses cure of defaults, monetary or non-monetary, under a loan agreement that is to be reinstated in a chapter 11 plan.
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our “Contact Us” form, which can be found on our website at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.