On July 3, 2008, the Court of Appeals for the Ninth Circuit issued its decision in General Electric Capital Corporation v. Future Media Productions, Inc., ___ F. 3d ___, ___ 2008 Daily Journal DAR 10269 (9th Cir. 2008) ruling that a secured creditor whose claim is oversecured is not barred from recovering default interest in a Chapter 11 case where the secured creditor’s claim is paid through a pre-confirmation sale of assets and not through a Chapter 11 plan.

The Ninth Circuit also ruled that the secured creditor may recover its attorneys’ fees and costs if it prevails on remand on its claim for recovery of the default interest provided for under the contractual terms of its note. The ruling reverses a bankruptcy court decision that held the oversecured creditor was not entitled to recover default interest when its debt was paid off in a Chapter 11 sale of assets under the Ninth Circuit’s precedents In re Entz-White Lumber and Supply, Inc., 850 F. 2d 1338 (9th Cir. 1988) and In re Southeast Co., 868 F. 2d 335 (9th Cir. 1989).

Legal Background and Statutory Framework
The debate over a secured creditor’s ability to recover default interest in Chapter 11 is founded on the provisions of §1123(a)(5)(G) of the Bankruptcy Code. Section 1123 addresses the contents of a plan of reorganization under Chapter 11. Section 1123(a)(5) states that a plan shall “provide adequate means for a plan’s implementation,” and then sets forth a nonexclusive list of examples of provisions pertaining to the implementation of the plan. One of the provisions set forth in §1123(a)(5)(G) includes a provision for “curing or waiving of any default.”

In the case of In re Entz-White Lumber and Supply, Inc., 850 F. 2d 1338 (9th Cir. 1988), the Ninth Circuit was asked to interpret and apply that provision in the context of the payment of a fully secured creditor whose debt had matured by its own terms and was all due and payable at the time the plan was proposed. The note in that case provided for payment of a higher rate of interest on any obligation not paid when due.

The debtor proposed a plan in which the secured creditor would be paid all principal and nondefault interest due under the note obligation and claimed that because the plan proposed to “cure” any default under the note, pursuant to §1123(a)(5)(G), no default interest was due. The secured creditor argued that the higher rate of interest was the result of the natural maturing of the note and not an acceleration by the secured creditor and thus no “cure” of a “default” was at issue.

Relying on the Second Circuit’s decision in the case of In re Taddeo, 685 F. 2d 24 (2d Cir. 1982), the Ninth Circuit explained that the concept of “curing” a default means that the parties are restored to the position they occupied under the contract prior to the default and the consequences of the default are nullified. The Ninth Circuit reasoned that by “curing” the default under the plan by paying the secured lender the amounts due under the note, the debtor was entitled to avoid all consequences of the default, including avoiding paying the post-default rate of interest on the debt. Therefore, the debtor could satisfy the fully matured debt under the Chapter 11 plan by paying the pre-default interest due.

In the case of In re Southeast Co., 868 F. 2d 335 (9th Cir. 1989), the Ninth Circuit was asked to determine whether an oversecured claim arising out of a debt in default can be cured under a plan without the debtor paying the higher default rate of interest and still be left “unimpaired” for the purposes of §1124. The Ninth Circuit ruled that based on the meaning of “cure” as explained in the Entz-White Lumber decision, the cure nullifies any default and therefore no default rate of interest is required to be paid in order to leave the oversecured creditor unimpaired.

GECC v. Future Media Productions
The issue presented in the Future Media Productions case is whether by extension of the holdings in Entz-White Lumber and Southeast Co., a debtor in Chapter 11, may satisfy an oversecured creditor’s claim without paying default interest under a note when the claim is paid outside a Chapter 11 plan in connection with a sale of the asset under Bankruptcy Code §363. In that case, the bankruptcy court authorized the debtor to sell the property securing the creditor’s debt and to pay the secured creditor’s claim at the nondefault rate of interest. The court’s decision was founded in part on reported decisions of the Bankruptcy Court for the Central District of California and the Ninth Circuit Bankruptcy Appellate Panel that had extended the holdings of Entz-White Lumber and Southeast Co. holdings to satisfaction of a secured creditor’s claim and “cure” of any default through the payment of the proceeds of a sale of property under §363 to the secured creditor outside a plan.

The Ninth Circuit in Future Media Productions held that such an extension of the Ninth Circuit’s prior holdings to sales of assets under §363 was unwarranted and improper. The Ninth Circuit held that the extension of its prior holdings was not justified because §363 contains no provision for defaults to be “cured” as part of a sale under that statute, unlike §1123, which specifically provides for a cure of defaults under a plan, or §365 pertaining to executory contracts, which provides in the statutory language for the debtor to “cure” defaults under executory contracts and unexpired leases to be assumed.

In reaching this conclusion, the Ninth Circuit specifically cited the U.S. Supreme Court’s recent decision in Travelers Sur. & Cas. Co. of America v. Pacific Gas & Electric Co., 127 S. Ct. 1199 (2007), which the Ninth Circuit interpreted as holding that “the default rate should be enforced, subject only to the substantive law governing the loan agreement, unless a provision of the Bankruptcy Code provides otherwise.” GECC v. Future Media Productions, Inc., 2008 Daily Journal DAR at p. 10270.

While the Ninth Circuit held that the default rate of interest must be paid to satisfy an oversecured creditor’s claim when the claim is paid outside a Chapter 11 plan, so long as such interest would be recoverable under the non-bankruptcy law governing the loan documents, the Ninth Circuit refused to create a bright line rule by holding that the default rate applicable in that case of two percentage points in excess of the non-default rate of interest is reasonable and enforceable as a matter of law “as an allowable default rate differential.”

The Ninth Circuit notes that the continued validity of its holdings in Entz-White Lumber and Southeast Co. may be in doubt based on amendments to the Bankruptcy Code in 1994 pursuant to which §1124 now specifically provides for payment of compensation for actual injury sustained by the claimant as a result of a default in order for the creditor to be deemed unimpaired where a default is cured under a plan.

While the court would not declare its prior precedents to be invalid in the Future Media Productions decision, the Ninth Circuit’s acknowledgment that the precedential value of those prior decisions is in doubt should be helpful to creditors in the Ninth Circuit and any other courts, which followed a rule similar to the Ninth Circuit’s regarding the payment of default interest in Chapter 11 on claims in default cured through payment under a plan or asset sale.

Lesley Anne Hawes, a partner in the Los Angeles office of McKenna Long & Aldridge, LLP, specializes in the representation of secured and unsecured creditors in bankruptcy proceedings and in the representation of federal equity receivers appointed in civil enforcement actions by federal agencies. She was one of a team of attorneys who petitioned the U.S. Supreme Court for review and ultimately prevailed in a unanimous decision by the Supreme Court in Union Bank v. Wolas, (In re ZZZZ Best). She is a regular contributor to the Monitor, and has lectured for various organizations.

She graduated Order of the Coif from University of Southern California law school. She earned her undergraduate degree from the University of Southern California, where she graduated magna cum laude with honors in Political Science.