Debtors Can't Have Their Cake and Eat it Too: SDNY Bankruptcy Judge Rules that Hotel Must Pay Default Interest As Condition to Reinstating Loan
By Robert J. Malatak and Eloy A. Peral
The Bankruptcy Code permits a chapter 11 debtor-borrower pursuant to a plan of reorganization to “de-accelerate” and retain a loan notwithstanding the debtor’s default. To accomplish this, the debtor must cure the default, reinstate the loan’s maturity, compensate the lender for certain losses, and not otherwise alter the lender’s legal rights. As the Federal Reserve has steadily increased interest rates since March 2022, borrowers have sought to use reinstatement to lock in long-term debt bearing below market rates. The increasing prevalence of plans that reinstate loans has magnified a critical question which has received scant attention; that is, as part of a cure and reinstatement is a debtor required to pay default interest? On July 31, 2023, Bankruptcy Judge Phillip Bentley for the Southern District of New York in the case of In re Golden Seahorse LLC, d/b/a Holiday Inn Manhattan Financial District concluded that to reinstate a loan a debtor must indeed pay default interest and other fees triggered by a monetary default to the extent required by the loan agreement and state law.
Golden Seahorse (the “Debtor”) owns a 50-story hotel in Manhattan under the Holiday Inn Flag. The property is subject to a $137 million, 10-year mortgage bearing 5.259% interest. Due to the Debtor’s monetary default, the lenders accelerated the loan and charged default interest at 5% above the non-default rate.
The Debtor filed a chapter 11 petition before the lenders could install a receiver. The lenders filed secured claims totally approximately $179 million, including almost $18 million in default interest plus more than $2 million in fees.
The Debtor filed a plan of reorganization that would reinstate the loan and treat the lenders’ claims as unimpaired under § 1124(2), but without paying the $20 million in default interest and fees arising from the default. The parties agreed to have Judge Bentley rule on the default interest issue prior to the plan solicitation process.
While Judge Bentley’s holding is straightforward, the analysis that led to his decision is far from simple. Due to the surprising thinness of relevant case law, Judge Bentley had to engage in a meticulous, sprawling analysis of the pertinent Code provisions and their legislative history in his 40-page opinion. The questions posed by Judge Bentley and his legal conclusions are set forth below rather than a comprehensive summary of his analysis.
- Should the court apply the plain terms of § 1123(d), which provides that the amount necessary to cure a default pursuant to a plan “shall be determined in accordance with the underlying agreement and applicable nonbankruptcy law.” That is, should the court treat § 1123(d) as an absolute mandate to limit cure amounts only in accordance with the underlying agreement or applicable state law or is the mandate circumscribed by other Code provisions, such as by the carve-out to cure amounts in § 365(b)(2)(D) (discussed below)?
- Section 365(b)(2)(D) carves-out from the amounts necessary to cure a default under an executory contract or unexpired lease “any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.” Section 365(b)(2)(D) is made applicable to chapter 11 plans by § 1124(2)(A). Does that mean that § 365(b)(2)(D), which conflicts with § 1123(d), applies to loan agreements in addition to executory contracts and unexpired leases?
- Section 365(b)(2)(D) is ambiguous and courts and commentators disagree on its proper interpretation. Should the statute be read to only excuse the payment of penalty rates (e.g., default interest) and penalty provisions relating to breaches of nonmonetary obligations, as the lenders contended? Or does it excuse the payment of (i) penalty rates (e.g., default interest) relating to both monetary and non-monetary defaults and (ii) penalty provisions relating to non-monetary defaults, as the Debtor contended?
The court answered the first two questions in the Debtor’s favor and the final question in the lenders’ favor. First, the court concluded that the “carve-out created by § 1124(2)’s incorporation of § 365(b)(2)(D) must be treated as an exception to § 1123(d)’s otherwise absolute mandate.” As to the second question, it concluded that § 1124(2)(A), which incorporates by reference the carve-out in § 365(b)(2)(D), applies to loan agreements. The court dedicated the most space to grappling with the third and final question. After an exhaustive review of the legislative history and a searching analysis of § 365(b)(2)(D)’s text, it concluded that § 365(b)(2)(D) “creates a single cure exception, excusing penalty rates and provisions triggered by nonmonetary defaults. It does not also create an exception for penalty rates that arise from monetary defaults.” As such, the court ruled that the Debtor could not reinstate the loan without paying default interest and fees as required by its loan agreement and New York law.
While the Golden Seahorse decision is a resounding win for lenders, it does not end the conversation about default interest and reinstatement. Judge Bentley’s first-of-its-kind opinion is well-reasoned and compelling, but it conflicts with other authorities, including decisions from the 9th Circuit with respect to the third question posed by Judge Bentley. As shown by the judge’s near exclusive reliance on statutory analysis and historical context, other courts could very well adopt a contrary view. Moreover, debtors can still challenge default interest on state law grounds when seeking to reinstate a loan. Lastly, the Debtor may appeal Judge Bentley’s decision.
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 In re Golden Seahorse LLC, No. 22-11582 (PB), 2023 WL 4936196, __B.R.__ (Bankr. S.D.N.Y. July 31, 2023) (available at https://www.nysb.uscourts.gov/sites/default/files/opinions/314390_154_opinion.pdf).
 All statutory references herein are to the Bankruptcy Code.
 Golden Seahorse, at 5.
 Id. at 28.
 Id. at 28-29, note 18.