Lead Opinion
OPINION
OVERVIEW
The Chapter 11 debtor appeals an order granting an over-secured creditor default interest where the creditor received full payment of its principal, interest at the pre-default rate, costs and attorneys’ fees. The trial court awarded the creditor the higher interest rate because the collateral was sold pursuant to § 363 of the Bankruptcy Code rather than in the context of a plan of reorganization.
FACTUAL BACKGROUND AND PROCEEDINGS
The debtor, along with a consortium of lenders, held a second position deed of trust on certain real property located in Santa Barbara, California. The debtor, a limited partnership, and its associates, in a high risk, high interest loan exceeding 30 percent, had advanced over $850,000 to the original owner-borrowers. The property was undeveloped and could only be sold as a single lot. The original equity holders and borrowers, Frank and Lorraine Serena, defaulted and the consortium foreclosed and purchased the property at a trustee’s sale. City Commerce Bank (the “Bank”) was the holder of the first-position deed of trust, securing a note dated January 22, 1988 in the amount of $2,300,000. The Bank subsequently initiated foreclosure proceedings. To prevent loss of the property through a trustee’s sale, the debtor, on or about August 28, 1993, filed for protection under Chapter 11 of the Code. In its schedules, the debtor listed approximately $49,000 in unsecured debt and $913,690.71 in secured debt. All of the secured debt was owed to the Bank. The debtor’s enumerated assets were the real property valued at $1,530,000 and a negligible amount of personal property. On this record, and as it turned out, the bank was oversecured.
Within a month after the petition was filed, the Bank moved for relief from stay. The motion was granted subject to a 90-day moratorium in order to allow the debtor to sell the entire property to a previously-identified purchaser. The sale did not close, but to prevent foreclosure, the debtor filed a complaint for injunctive relief and a temporary restraining order. The litigation resulted in a series of preliminary injunctions which gave the debtor time to obtain approval from the California Department of Real Estate to subdivide the property into eight individual lots. As a condition of the stay of foreclosure, the debtor was required to make adequate protection payments to the Bank in the amount of $31,000 to $35,000 every six weeks. This sum was equivalent to interest at the non-default rate. Because of the Bank’s pressure for immediate liquidation,
After the sale of each lot, the Bank was also paid the net sale proceeds. The debtor ultimately sold six of the eight lots. The proceeds were sufficient to both reimburse the Bank’s costs and pay its outstanding principal plus interest at the non-default rate.
As an oversecured creditor under § 506(b), the Bank sought further interest at a default rate and attorneys’ fees of $29,500.
The court held that because the sales did not take place pursuant to a plan of reorganization, the obligation to the Bank was not “cured.” Without a legal cure, the court concluded that the Bank was entitled to attorneys’ fees and interest at the default rate. An evidentiary hearing was held on April 24, 1995, to determine the propriety of the default interest .rate and the Bank’s attorneys’ fees. The court found the interest and fees reasonable and ordered them paid. The debtor timely appealed the court’s order.
The debtor asserts that payment to the Bank constitutes a cure regardless of whether it occurs outside of, or pursuant to, a plan of reorganization. As such, the debtor claims that default interest is not owing because a cure nullifies all consequences of default, including the increased interest rate. The debtor further argues that equity demands that the court disallow the higher rate in this instance.
ISSUES
1) Whether a defaulted obligation to an oversecured creditor is cured in Chapter 11 where the creditor receives a return of principal plus interest at the pre-default rate after a sale of the collateral pursuant to § 363.
2) Whether equity requires that the pre-default rate of interest be imposed in order to allow for a distribution to the debtor.
STANDARD OF REVIEW
Whether a cure can occur pursuant to a sale under § 363 is a question of statutory interpretation and is reviewed de novo. In re Southeast Company,
DISCUSSION
Relationship of State and Federal Law
A creditor is not entitled to postpetition interest under the Bankruptcy Code unless it is oversecured. 11 U.S.C. § 506(b).
We note that, as a rule, bankruptcy courts apply state law when analyzing a debt- or’s interest in property. Butner v. United States,
A bankruptcy filing works a substantial modification of the relationship between contracting parties. A creditor who seeks enforcement of a contract interest rate in bankruptcy must show that to do so would allow for equitable distribution of estate property among creditors and would not impede the debtor’s ability to make a fresh start. Vanston,
In keeping with Vanston and Ron Pair, bankruptcy courts considering the issue generally apply the contract rate subject to rebuttal based upon equitable considerations. See, e.g., In re Terry Ltd. Partnership,
The effect of a cure of a default
The above analysis, however, does not take into account the proper course when a debtor cures the default.
One of the leading cases interpreting the concept of cure is In re Taddeo,
the power to cure must comprehend the power to “de-aceelerate.” This follows from the concept of “curing a default.” A default is an event in the debtor-creditor relationship which triggers certain consequences — here, acceleration. Curing a default commonly means taking care of the triggering event and returning to pre-de-fault conditions. The consequences are thus nullified. This is the concept of “cure” used throughout the Bankruptcy Code.
In re Taddeo,
The Taddeo court then proceeded to discuss § 365 and § 1124, and concluded that “ ‘curing a default’ in Chapter 11 means the same thing in Chapters 7 or 13: the event of default is remedied and the consequences are nullified.” Id. at 29. The Ninth Circuit cited Taddeo with approval in In re Entz-White Lumber and Supply, Inc.,
Subsequently, the issue was considered in In re 433 South Beverly Drive,
In discussing Entz-White and Southeast, the court reasoned that the central issue in each case was not whether full payment occurred pursuant to a plan, but whether the cure was sufficient to nullify the incidents of default. The court held that a “cure,” as applied in Entz-White and Southeast, arose whenever an obligation was paid in full because:
The concept of “cure” is not exclusive to Chapter 11 or plans of reorganization.... [All] references to cure involve a determination of the amount of a creditor’s claim which is allowable and ultimately payable in a bankruptcy proceeding, provided that assets prove to be sufficient. That is the same issue presented in the instant case. Absent some compelling reason to the contrary, the construction of “cure” and its application to the allowed amount of a creditor’s claim should not differ depending on whether it arises under a plan or in some other context in the Bankruptcy Code.
In re 433 South Beverly Drive,
Applying this reasoning, the court held that the debtor’s proposed § 363 sale would effect a cure. The same logic applies with greater force to the case at bar.
Post-cure interest rate
In keeping with its analysis of cure, the court in Beverly Drive declined to apply the default interest rate. The court, however, considered whether to impose a rate other than the pre-default contract rate. In resolving this issue, it followed the guidelines articulated in In re Terry Ltd. Partnership and Entz-White.
Terry interpreted Ron Pair to require a bankruptcy court to apply the contract rate in a default situation unless the equities dictated otherwise. In Entz-White, the Ninth Circuit Court of Appeals held that the same considerations governed where a default was cured, except that the applicable contract rate was the pre-default rate, not the default rate. The court further suggested that a logical reading of § 506(b) was that interest should be set at the pre-default contract rate or the market rate, whichever was higher. Id. at 1348. However, this statutory interpretation was qualified. The court explained, “[w]e continue, of course, to recognize bankruptcy courts’ ‘broad equitable discretion’ in awarding post-petition interest.” Id. at 1343 n. 9 (citing In re Anderson,
Relying on Entz-White, the Beverly Drive court concluded that the appropriate rate should be the higher of the pre-default rate or the market rate. The court reasoned that this result satisfied equity because it “ba-lanc[ed] the preservation of contract rights with the need to compensate for actual damages incurred_” Beverly Drive,
The equitable factors underlying an award of interest alluded to in Beverly Drive were more thoroughly discussed in the recent case of In re Johnson,
(1) the difference between the default and nondefault rates; (2) the reasonableness of the differential between the rates; (3) the relative distribution rights of other creditors and whether enforcement of the higher rate will do injustice to the concept of equitable distribution of the estate’s assets; and (4) the purpose of the higher interest rate. Specifically, does the default rate merely compensate the creditor for any loss resulting from the nonpayment of the principal at maturity, or is it a disguised penalty?
In re Johnson,
The applicability of the default rate was also discussed in In re DWS Investments, Inc.,
Claimants seek post-petition interest at the default rate of 25%. They claim this is the rate they use in other transactions. They, however, offer no evidence to show that this is an industry standard. Furthermore, they did not show that this rate has any relation to the market rate of interest. A default rate of interest should not be a penalty. Rather, it should be a means for compensating the creditor for any loss resulting from the nonpayment of principal at maturity. Claimants have not shown that the 25% rate has any relationship to actual or projected loss as a result of non-payment. Ron Pair supports the view that unless the statute expresses a contrary view, pre-Code law should apply.*146 Section 506(b) does not specify the contract rate in calculating interest on overse-cured claims. On the other hand, pre-Code law does empower the bankruptcy judge to balance the equities in determining the appropriate interest rate.
Id. at 849.
Here, the debtor has paid the oversecured creditor its entire principal, together with a variable rate of pre-default interest (including adequate protection payments during the pendency of the sales), costs and attorneys’ fees. As indicated above, a variable rate has some relationship to market rate. If the default rate is not to be a penalty, but a means by which to compensate the Bank for its actual losses, the Bank should provide specifies as to such loss.
The court below found the default rate of interest, an additional 7 percent, to be reasonable. This finding was based on the testimony relating to reasonableness provided by the Bank’s expert, who testified:
Q: So that element of risk, though, didn’t play a large role in your consideration of this loan and this default rate?
A: Correct.
Q: Did I understand you correctly to testify that the default rate in this ease reflects the bank’s costs?
A: Correct.
Q: In what way?
A: The bank has a lot of costs. It has very direct costs. When the loan defaults, it loses its interest income. Its expenses increase. It becomes a problem loan, a non-accrual loan. It must.be monitored more frequently. There — the collection costs rise dramatically. There’s the administrative costs associated with that: mail, telephones, meetings, officer time, report preparations.
There are indirect costs. The indirect costs are as some function — some amount of money has to be provided for in loan loss reserve. So there’s bad debt expense of some amount.
There are also costs of increased capitalization for the bank, meaning it’s a problem asset. They must have a higher capital cushion to account for problem assets in total.
Q: But it is your testimony that the seven percent default rate of interest in this case accurately reflects that incremental cost to the bank caused by the default on this particular loan.
A: It’s as close as I know how to get.
Q: Is there any other factor that forms the bank’s motivation for imposing default rates of interest on loans like this?
A: Yes. They want to encourage the borrower to resolve the issue. They want to eliminate a defaulted assets [sic] from their books as rapidly as possible.
Q: So it’s fair to say, isn’t it, that perhaps there are two components of a default rate of interest. One is to recoup costs caused by the default. Another is to coerce the debtor into making payments.
A: “Coerce” is a strong word, but they certainly want to encourage the debtor to resolve the issue, make payments, repay the loan, yes.
Cross-examination of Mr. Parker, lender’s witness, Transcript of Hearing, April 24, 1995, at 25:14-27:4.
Thus, the Bank’s expert, while asserting that the Bank has suffered damages, failed to quantify them or to demonstrate the extent to which they remain uncompensated. Further, the Bank’s expert states that, independent of loss, coerced compliance is a factor. Implicit in this consideration is the notion of penalty. Assuming losses were sustained, the Bank provides no evidence as to the compensatory effect of a rate above the contract rate to make it whole. The Bank argues instead that, since the trial court found the default rate reasonable, the debtor has no choice but to pay it. In any event, it is not possible to perceive from the testimony of the Bank’s expert, without quantification, that the figure of $260,000 represents a conscionable or reasonable charge simply for delay in payment where it had already received full payment of interest at the contract variable rate.
In the context of this case, consideration of whether a given default rate is within the range of a generally acceptable level of inter
Future changes to the law
In its ruling below, the trial court relied, in part, upon recent changes made to the Code pursuant to the Bankruptcy Reform Act of 1994 (the “Act”). . The court noted that § 305(a) of the Act provides that the contract and nonbankruptcy law dictate the amount necessary to effect a cure under a plan. Although the legislative history makes clear that the amendment was designed to restrict rather than expand creditors’ rights, the trial court reasoned that the new language served to overrule Entz-White.
Whether the changes restricted or enlarged the rights of secured creditors, however, they are inapplicable here because they were enacted after the case was filed and should not be applied retroactively.
We note further that while the sales at issue were not made in consummation of a plan, they took place in the context of a Chapter 11 case. The record shows, however, that the debtor filed a plan at the time of the hearing below. The plan provides for the sale of the two remaining lots and partial payment of a claim filed by the debtor’s equity partner. The Bank urges us to disregard this plan because it provides for payment to an equity partner. While no confirmation issue is before us, because it may have some bearing on the equitable aspects of this matter, we note that a plan may provide for equity holders as well as creditors. Thus, a plan can appropriately provide for payment to equity holders per se as long as the debtor adheres to the absolute priority rule. 11 U.S.C. § 1129(b)(2)(B); In re Johnston,
The amount owing for default interest could be modified and “crammed down” under a plan as allowed under §§ 1124 and 1129. See, e.g., In re L & J Anaheim Associates,
CONCLUSION
As a general rule, the contract rate will apply unless equitable considerations dictate otherwise, see, e.g., Terry Ltd. Partnership,
Here, the court considered whether the default interest rate was “unconscionable.” To that end, it heard testimony from the Bank’s expert regarding whether the rate was reasonable and within industry norms. The standard applied by the bankruptcy court did not give sufficient weight to the various equitable considerations. It also failed to consider the Bank’s potential and actual damages, losses, and risk incurred as a result of the default.
The record here does not support a finding that the default rate was intended to or in fact did compensate the Bank for its losses. Thus, based on this limited record, the default interest awarded to the Bank appears to be a penalty or an unreasonable charge. Accordingly, the decision awarding default interest shall be reversed and remanded to the bankruptcy court for further consideration of the purpose of the Bank’s default interest rate and whether it actually compensated the Bank for losses incurred as a result of the debtor’s default.
REVERSED and REMANDED.
. Unless otherwise stated, all references to "sections” and "rules” refer to the U.S. Bankruptcy Code, 11U.S.C. § 101 etseq.
. Although the debtor initially objected to the Bank's attorneys' fees, it did not preserve the issue on appeal.
. Section 506(b) provides, in pertinent part, that an oversecured creditor is entitled to "interest on such claim, and any reasonable fees, costs, or charges provided for under the agreement under
. "[T]he Supreme Court has held that contractual and other legally-established rights may sometimes conflict with equitable principles of distribution under the bankruptcy laws.” In re Hollstrom,
. A cure of "a default commonly means taking care of the triggering event and returning to pre-default conditions.” In re Entz-White Lumber & Supply, Inc.,
. Chapter 11 permits a plan of liquidation as an alternative to reorganization. Thus, § 1123(b)(4) states that a plan may "provide for the sale of all or substantially all of the property of the estate, and the distribution of the proceeds of such sale among holders of claims or interests.” There is no apparent reason why the equitable consequences should differ for a secured creditor or the debtor whether the liquidation is performed under § 363 or under § 1123. We also note that § 1123(b)(4) provides for distribution of proceeds to "holders of claims or interests.”
. "This provision will be applicable prospectively only, i.e., it will be applicable to all future contracts. ...” H.R. 103-834, 103d Cong., 2d Sess. § 39, 140 Cong.Rec. 10770 (1994), reprinted in 1994 U.S.C.C.A.N. 3340, 3364.
. The amended version of § 1123 provides: “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 non-bankruptcy law.” 11 U.S.C. § 1123(d). As the legislative history explains, the amendment "will limit the secured creditor to the benefit of the initial bargain with no court contrived windfall. It is the Committee's intention that a cure pursuant to a plan should operate to put the debtor in the same position as if the default had never occurred.” H.R. 103-834, 103d Cong., 2d Sess. § 39, 140 Cong.Rec. 10770 (1994), reprinted in 1994 U.S.C.C.A.N. 3340, 3364.
.Section 1124 provides in relevant part:
[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.
11 U.S.C. § 1124.
Section 1129 requires in relevant part that:
If a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan....
11 U.S.C. § 1129(a)(10).
Concurrence Opinion
concurring:
I generally concur in the judgment of the Panel and specifically endorse its analysis of the equitable factors that govern an award of default interest. I write separately, however, to address the broader implications of the Panel’s discussion of “cure.” First, I disagree with the majority’s conclusion that the concept of “cure” should apply to a lien-free sale. Additionally, the authorities relied upon by the majority in reaching that conclusion would prohibit any award of default interest in a sale setting.
Sections 1123(a)(5) and 1124(2) of the Bankruptcy Code expressly recognize the right to “cure” a default through a Chapter 11 plan of reorganization. The two leading cases decided by the Ninth Circuit Court of Appeals which discuss “cure” are both firmly rooted in the plan confirmation process. See In re Entz-White Lumber & Supply, Inc.,
Courts in other circuits have not extended the discussion of “cure” in Entz-White and Southeast to the lien-free sale setting. Rather, these courts simply determined the amount of the creditor’s allowable claim under section 506(b), including equitable entitlement to default interest, in order to distribute the proceeds from the sale of the creditor’s collateral. The issue of “cure” never even surfaces in these decisions. See, e.g., In re Terry Limited Partnership,
In the Ninth Circuit, the few reported decisions that have considered whether a default can be “cured” in connection with a lien-free sale reach different results. Courts have expressly stated that Entz-White and Southeast are inapplicable to sales pursuant to section 363. In re Boardwalk Partners,
On the other hand, In re 433 South Beverly Drive,
These conflicting authorities do not satisfactorily resolve the issue of whether the Southeast and Entz-White holdings should apply to lien-free sales. However, on balance, I believe the concept of “cure” should not be applied in a section 363 lien-free sale context. First, the plain meaning of the statute should control. United States v. Ron Pair Enterprises, Inc.,
Another reason favoring a more conservative approach is that the consequences of a “cure” through a confirmed plan, as opposed to a lien-free sale, may differ. Although payment in full of a secured claim can occur in either setting, the distinction can be important and was implicitly recognized in The creditor in Entz-White claimed that the proposed Chapter 11 plan could not “cure” the default because its loan had fully matured prior to bankruptcy. It relied on In re Seidel,
But when a debt has already matured — as in Seidel’s case — ‘cure’ as defined by these courts cannot aid the debtor, since reinstatement of the original terms of the debt will merely make the debt immediately due and payable.
The facts in this appeal illustrate the potential problems with treating payment through a sale of the creditor’s collateral as the equivalent of a “cure” under a plan. Here, as in Entz-White, the loan matured by its terms prior to the Debtor’s bankruptcy. Although the Bank obtained relief from the automatic stay early in the Chapter 11 case, the effective date of the relief was delayed approximately ninety days to permit the Debtor to complete a pending bulk sale of the project. When this sale fell through, the Debtor obtained permission from the California Department of Real Estate to sell the property in individual lots. It also obtained a series of preliminary injunctions from the bankruptcy court, contingent on payment of current interest to the Bank, delaying the Bank’s foreclosure until the individual parcels of property could be sold.
This chronology of events must be contrasted to an immediate and complete repayment of the Bank’s entire claim upon plan confirmation. In fact, these piecemeal sales of the Bank’s collateral and reduction of its indebtedness over time would not have constituted a “cure” for purposes of Entz-White. The Ninth Circuit Court of Appeals was explicit that a naturally matured loan would need to be paid immediately upon confirmation to obtain the benefits of a “cure.” Thus,
The majority equates the pay-off of a loan as part of a section 363 sale to a “cure” pursuant to a confirmed plan. The consequence of this approach, however, is that the Bank would not be entitled to default interest. While Entz-White recognized the bankruptcy court’s discretion to determine an appropriate interest rate, it concluded that:
[The debtor] is entitled to avoid all consequences of the default — including higher post-default interest rates.... It is clear that the power to cure under the Bankruptcy Code authorizes a plan to nullify all consequences of default, including avoidance of default penalties such as higher interest.
The decision regarding whether the concept of “cure” applies to a lien-free sale is directly tied to the question of whether the Bank is even entitled to receive default interest. Implicit in that concept, as interpreted by the Ninth Circuit Court of Appeals in Entz-White, is a prohibition against default interest. On the other hand, if the more limited approach I urge is followed, the Bank may still be able to collect default interest under section 506(b). On remand, the bankruptcy court should consider the fact that the Bank has now been fully repaid, thus receiving the equivalent of a “cure” of its defaulted loan obligation. That factor alone, however, should not preclude the allowance of default interest.
I agree with the result reached by the majority, which requires the bankruptcy court to examine and consider various equitable factors before allowing default interest. My disagreement extends only to the Court’s application of the Entz-White and Southeast holdings to lien-free sales, which would preclude any award of default interest.
. At least one court has allowed default interest because the plan failed to pay off a matured loan on confirmation. In re Tri-Growth Centre City, Ltd.,
. The Debtor has now proposed a plan that provides for full payment of the Bank’s claim. The bankruptcy court correctly determined, however, that filing a plan after the sales had been completed and the Bank was already paid did not warrant treatment under Entz-White. To the extent the Bank's default had been cured, it was cured outside of a plan. Transcript of Hearing, February 21, 1995, pp. 10-12.