Golden Seahorse: Reinstatement & Default Interest

Background Facts

The facts of this case are relatively straightforward. Golden Seahorse LLC (the “Debtor”) owns and operates a 50-story Holiday Inn, which is located in downtown Manhattan near Wall Street, and it filed for chapter 11 in the U.S. Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) in November 2022. See generally In re Golden Seahorse LLC, 652 B.R. 593 (Bankr. S.D.N.Y. 2023) (click here). Like many companies, the Debtor defaulted on its loan as a result of the economic impact of the COVID-19 pandemic, and its lenders—who had a first-priority lien on the property—accelerated the loan, started charging default interest, and were on the verge of foreclosing prior to the bankruptcy filing. The 10-year loan, which had an original principal balance of $137 million, was assigned to Wilmington Trust, N.A., as trustee for various noteholders (the “Lenders”). The loan carried an annual contractual interest rate of 5.259% and a default interest rate of 10.259%.

The Debtor proposed a plan of reorganization in its bankruptcy case that aimed to reinstate the loan on its original terms (that is, without default interest) and to treat the loan as unimpaired under § 1124(2) of the Bankruptcy Code. We have discussed § 1124(2) on other occasions (see, e.g., Mallinckrodt: Analysis of 1L Make-Whole Appeal), and it generally allows for the reinstatement of debt under a plan of reorganization, notwithstanding any prior acceleration, if the plan cures any past defaults; reinstates the original maturity on the debt; compensates the creditor for any damages based on its reliance on the debt instrument; and does not otherwise alter the legal, equitable, or contractual rights of the creditor.

The Debtor’s proposal would save it approximately $20 million in default interest and fees (presumably from the event of default through emergence from bankruptcy), which the Lenders obviously wanted for themselves. The Debtor and the Lenders asked the Bankruptcy Court to decide if default interest must be paid to reinstate the debt, as this would determine the ultimate structure of the plan of reorganization.

The Bankruptcy Court agreed to answer that legal question, which is discussed below. Unlike the facts of this case, however, the law is anything but straightforward.

U.S. Bankruptcy Court Decision

On July 31, 2023, the Bankruptcy Court issued a lengthy and exhaustive 43-page decision that addressed the intersection of several very complicated and inconsistent provisions of the Bankruptcy Code. See generally In re Golden Seahorse LLC, 652 B.R. 593 (Bankr. S.D.N.Y. 2023) (click here). Not only did the Bankruptcy Court analyze those statutory provisions—namely, §§ 1123(d), 1124(2)(A), and 365(b)(2)(D) of the Bankruptcy Code—but the court also analyzed caselaw from around the country, different amendments to the Bankruptcy Code over the last 40 years, and its legislative history. The Bankruptcy Court ultimately concluded that—in order to reinstate debt under § 1124(2)(A) that was the subject of a previous monetary default—a debtor must pay default interest to the extent provided for in the loan agreement and permitted by applicable non-bankruptcy law. In other words, simply restoring the lender’s position to before the monetary default (i.e., the status quo ante) is insufficient.

Given the complexity of the law in this area, we feel it is beyond the scope of this note to delve into the intricacies of the statutory provisions, the legislative history behind those provisions, or the caselaw interpreting them. However, we distill the Bankruptcy Court’s three key holdings as follows:

Holding No. 1: Creating a General Rule and an Exception to that Rule

First, the Bankruptcy Court addressed two conflicting provisions of the Bankruptcy Code regarding what must be paid to cure a default for purposes of debt reinstatement:

The first provision is § 1123(d) of the Bankruptcy Code, which provides that “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.” Section 1123(d) therefore suggests that default interest must be paid if it is required by the applicable agreement.

The second provision is § 1124(2)(A) of the Bankruptcy Code, which provides that, for a creditor to be unimpaired under a plan of reorganization (i.e., by making the creditor whole and ineligible to vote), the plan must “cure[] 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.” On its face, § 1124(2)(A) is inconsistent with § 1123(d) because there are circumstances where a cure is not required—i.e., when § 365(b)(2) comes into play.

In order to resolve this inconsistency, the Bankruptcy Court simply held that § 1123(d) establishes a “general mandate” to comply with a loan’s cure terms, while § 1124(2)(A) serves as an exception to that mandate to the extent that the default is (1) of a kind specified in § 365(b)(2) or (2) of a kind that § 365(b)(2) expressly does not require to be cured. This begs the question: what does § 365(b)(2) say?

Holding No. 2: Concluding that § 365(b)(2)(D) Applies to Loan Agreements

Second, the Bankruptcy Court addressed whether § 365(b)(2)(D) applies to default interest in loan agreements (like in the case of Golden Seahorse) or whether it only applies to defaults in “executory contracts or unexpired leases,” which are agreements where one party still have a performance obligation under the contract.

By way of overview, subsection (D) of § 365(b)(2) of the Bankruptcy Code is one of several exceptions to the Bankruptcy Code’s requirement that debtors must cure all defaults when assuming executory contracts and unexpired leases. In assuming such a contract or lease, § 365(b)(2)(D) does not require “the satisfaction of 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.” On its face, it appears that § 365(b)(2)(D)—which excuses any cure for a penalty rate or penalty provision—does not apply to loan agreements because the statute speaks in terms of executory contracts and unexpired leases.

However, the Bankruptcy Court held that, notwithstanding the phrase “executory contract or unexpired lease” contained in § 365(b)(2)(D), § 1124(2)(A) refers to § 365(b)(2) by explicitly using the phrase “of a kind” addressed in § 365(b)(2). According to the court, that includes “any failure to satisfy a penalty rate or penalty provision relating to a non-monetary default, regardless of the nature of the underlying contract.”

Holding No. 3: Holding that § 365(b)(2)(D) Only Applies to Nonmonetary Defaults

The Bankruptcy Court addressed the final issue, which is whether § 365(b)(2)(D) applies to penalties for both monetary and non-monetary defaults. This distinction is critical because Golden Seahorse’s default was a monetary default that resulted from nonpayment during the COVID-19 pandemic.

In conducting this analysis, the court examined § 365(b)(2)(D) in detail, including its statutory text, legislative history, and statutory purpose. The court held that § 365(b)(2)(D) is most logically and naturally interpreted as applying only to nonmonetary defaults, in part because the statute only speaks in terms of nonmonetary defaults. Accordingly, the court held that Golden Seahorse could not avoid paying the default interest on the loan.

Appeal Directly to the U.S. Court of Appeals for the Second Circuit

On September 29, 2023, the Bankruptcy Court certified its decision for direct appeal to the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) because there was no clear controlling precedent on the legal question (click here). The Second Circuit is the federal appellate court with jurisdiction over New York, Connecticut, and Vermont, and it is often regarded as one of the more influential appellate courts, particularly in commercial law. On February 20, 2024, the Second Circuit approved the request for a direct appeal (click here), which means the appeal will bypass the U.S. District Court for the Southern District of New York.

The Debtor filed its opening brief with the Second Circuit on May 7, 2024, arguing, among other things, that the three statutory provisions analyzed by the Bankruptcy Court, when read together, should not be confined solely to nonmonetary defaults. The Debtor also contends that the Bankruptcy Court’s analysis contradicts established Second Circuit precedent. The responsive brief of Wilmington Trust/the Lenders is due August 1, 2024, and we anticipate oral arguments will be held later this year or in early 2025.

Thoughts and Takeaways

We acknowledge that the case involves a small amount of outstanding debt, which may be of limited interest to some investors. However, we think this case is important to watch given its potential implications in the current interest rate environment, especially if high rates persist for the foreseeable future and chapter 11 debtors want to reinstate a significant portion of lower-coupon debt. Considering the Second Circuit’s influence and its thought leadership in Chapter 11 proceedings, any decision made in this case could have a persuasive impact on other federal courts. Indeed, if the Second Circuit paints with a broad brush, it could conceivably impact the way we think about make-wholes or default interest more generally.

That being said, the Second Circuit’s decision may ultimately be of little practical value because it only applies to monetary defaults and not to defaults related to other factors like insolvency, the financial condition of the debtor, or the commencement of a bankruptcy case, which are often the events of default that are triggered by large chapter 11 bankruptcies. A decision affirming the Bankruptcy Court might even prompt debtors to file for bankruptcy before a pre-petition monetary default in order to preserve reinstatement optionality.

We will continue to monitor this case over the next year and provide any updates, as appropriate.