Assumption of Executory Contracts and Curing Defaults In the Interest of Penalties

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Oct 2002

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Pursuant to §365 of the Bankruptcy Code, a trustee [or debtor-in-possession]
may assume or reject an executory contract. Assumption of an executory contract
requires the cure of any existing defaults in the manner provided in §365(b)(1).
Section 365(b)(1)'s cure provisions maintain the benefit of the bargain by
requiring compliance with a contract's terms and conditions. Compliance with certain
default provisions, however, is not as certain as one might think. In fact,
§365(b)(2) provides for several exceptions to §365(b)(1)'s cure provisions.

Section 365(b)(2)'s exceptions were drafted to defeat certain "unsavory" default
provisions as a matter of public policy. While the public policy may be clear, the
express language of §365(b)(2) is not, thereby requiring judicial interpretation.
The interpretation of the necessary cure can alter a trustee's ability to assume an
executory contract. Indeed, requiring the cure and payment of penalties and interest
under an executory contract, can make the difference in economic feasibility.

<h3>Section 365's Requirements</h3>

Section 365(b)(1) reads as follows:

<blockquote>
If there has been a default in an executory contract or unexpired lease of the
debtor, the trustee may not assume such contract or lease unless, at the time
of assumption of such contract or lease, the trustee—

<blockquote>
(A) cures, or provides adequate assurance that the trustee will
promptly cure, such default;

(B) compensates, or provides adequate assurance that the trustee will
promptly compensate, a party other than the debtor to such contract or
lease, for any actual pecuniary loss to such party resulting from such
default; and

(C) provides adequate assurance of future performance under such contract or lease.
</blockquote>
</blockquote>

However, §365's cure provisions do not require compliance with all of an executory
contract's terms and conditions. Indeed, §365(b)(2) provides several exceptions,
including the express inapplicability to a default that is a breach of a provision
relating to—

<blockquote>
<blockquote>
(D) the satisfaction of any penalty rate or provision relating to a
default arising from any failure by the debtor to perform non-monetary
obligations under the executory contract or unexpired lease. (emphasis
added).
</blockquote>
</blockquote>

While this cure exception attempts to provide relief from otherwise potentially harsh
penalty provisions, §365(b)(2)(D)'s express language creates an ambiguity as
to what exactly is excepted from cure. This ambiguity is based on the question of
whether or not Congress intended "penalty" to modify "rate," or "rate and provision."

<h3>The Ambiguity of §365</h3>

The ambiguities created by §365(b) (2)(D) and the questionable sentence
structure raise a question as to whether or not the exception is for penalty rates
and provisions for non-monetary defaults only, or whether the intent was "penalty rates
for monetary defaults, and penalty provisions for non-monetary defaults." In analyzing
this question, one must consider (1) the meaning of the phrase "penalty rate or
provision" and (2) the relation of that phrase to payment of "actual pecuniary loss"
under §365(b)(1)(B).

<h3>The Meaning of "Penalty Rates and Provisions"</h3>

The initial ambiguity created by §365(b)(2)(D) is whether the phrase "penalty
rate" stands independent of or, conversely, modifies the phrase "to perform
non-monetary obligations." If such phrase stands independent (i.e., it is an
exception applicable to non-monetary defaults only), then a trustee need not cure
penalties imposed by higher interest rates for monetary defaults.

Alternatively, if "penalty" modifies both "rate" and "provision," and both "rate"
and "provision" relate to "non-monetary defaults," then the cure exception is limited
only to penalty rates and penalty provisions for non-monetary defaults. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…,
Grant T., and Wheatly, Ralph S., "The Impact of Cure and Reinstatement on
Default Interest," 16 Am. Bankr. Inst. J. 1 (July/August 1997)</a>
("Section 365(b)(2)(D) is now clear that part of cure under [§]1124(2)
requires the payment of default interest associated with monetary defaults.").

Though contraverting case law exists, the greater weight of authority holds that
§365(b)(2)(D) creates two exceptions. Specifically, a trustee is not required
to (1) pay penalty rates (i.e., penalty interest rates) imposed for contractual
defaults, regardless of their nature, or (2) pay penalty provisions associated with
non-monetary defaults. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Claremont Acquisition Corp. Inc., 113 F.3d
1029, 1034 (9th Cir. 1997)</a>.

In Claremont, the Ninth Circuit affirmed the district court and held that
§365(b)(2)(D) excepted "the satisfaction of any penalty rate or [the
satisfaction of any penalty] provision relating to a default arising from any failure
of the debtor to perform non-monetary obligations under an executory contract or
unexpired lease." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 1034</a> (insertion and emphasis in original). As such,
the Ninth Circuit opined that "[t]he first clause addresses penalty rates that are
commonly imposed where a debtor's breach is monetary in nature. The second clause
addresses the payment of penalties under liquidated damage provisions where the debtor's
breach was non-monetary in nature." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;

The Ninth Circuit based its conclusions and holding on the limited legislative
history of §365(b)(2)(D), which "...suggests that Congress intended only
to relieve debtors of the obligation to pay penalties." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; In fact, the House
of Representatives report that was amended to add subsection (D) states: "§365(b)
is clarified to provide that when sought by a debtor, a lease can be cured at a
non-default rate (i.e., it would not need to pay penalty rates)." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; citing

H.R. REP. NO. 103-835 (1994), reprinted in 1994
U.S.C.C.A.N. at 3357.

Claremont's lower-court ruling was adopted, prior to the Ninth Circuit's
affirmation, in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re GP Express Airlines Inc., 200 B.R. 222 (Bankr.
D. Neb. 1996)</a>. In GP Express, the court agreed with Claremont, finding
that "a debtor is not required to cure or satisfy any penalty rate obligation, and

a debtor is not required to cure any defaults in non-monetary obligations. The
statutory term 'rate' refers to interest rate...." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 233-34</a> (emphasis
added); see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Western Pacific Airlines Inc., 219 B.R. 298,
304 (Bankr. D. Colo. 1998)</a> (where the court held that a trustee is
excused from curing any defaults that occur due to a penalty rate or that arise from
a debtor's failure to perform nonmonetary obligations.)

Pursuant to this line of case law, a trustee is not required to pay penalty rates
imposed for the failure to make timely payments in order to cure a default under an
executory contract. However, such decisions compound the ambiguity as to what
constitutes a "penalty" and how a "penalty" relates to the obligation to pay "actual
pecuniary loss[es]" under §365(b)(1)(B).

<h3>"Penalty Rates" and "Actual Pecuniary Loss"</h3>

Neither the Bankruptcy Code nor applicable case law defines "penalty," nor whether
it implies something punitive in nature, or alternatively, merely anything beyond the
non-default interest rate. Although case law is limited, one case indicates that
"penalty rate" means a rate that is more punitive in nature, not a rate that is
merely higher than the standard contract rate.

Specifically, the court in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Phoenix Business Park Limited Partnership, 257
B.R. 517 (Bankr. D. Ariz. 2001)</a>, stated:

<blockquote>
Thus, if a default interest rate is a "penalty rate," then it does not need
to be paid as part of a §1124(2) cure. Here, the court has little
difficulty concluding that a default rate of 24 percent—against a contract rate
of 10.75 percent—as well monthly late charges...should be construed as
"penalty rate[s]" within the meaning of this statute.
</blockquote>

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 521</a> (emphasis added).

Based on the Phoenix Business Park holding, a "default rate" is acceptable as long
as it is not found by a court to be a "penalty rate." Whether or not a court will
find and conclude that the default rate is a penalty rate is a case-by-case
determination. Nonetheless, it is not a wholesale rejection of all default interest
rates.

However, the payment of interest as a pecuniary loss is not dependent on the
parties' agreement. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Health Science Products Inc., 191 B.R. 895,
910 n.18 (Bankr. N.D. Ala. 1995)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Jim Walter
Resources Inc., 126 B.R. 895, 898 (Bankr. M.D. Fla. 1991)</a>

("Clearly, interest is an actual pecuniary loss flowing directly from the admitted
default of the debtor.").

In fact, "[o]ne of the purposes of §365 is to permit the debtor to continue
in a beneficial contract, provided, however, that the other party to the contract
is made whole at the time of the debtor's assumption of said contract." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re J.W.
Mays Inc., 30 B.R. 769, 772 (Bankr. S.D.N.Y. 1983)</a>.
Therefore, "to make the [creditor]...whole pursuant to §365 of the Code, the
debtor assuming the lease is required to make payment of interest on the
pre-petition...installments." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Eagle Bus Manufacturing
Inc., 148 B.R. 481, 482 (Bankr. S.D. Tex. 1992)</a> (where the
court found that "the primary way to compensate a creditor for its loss of use of
money is interest. Simple logic, therefore, would dictate that interest should be
included as Part [sic] of a [creditor's] actual pecuniary loss."). Therefore, the
penalty rate exception to §365's cure provisions does not result in excepting the
payment of interest. Instead, the exception applies to penalty interest, and interest
that is not a penalty remains due as part of a cure. Despite courts' allowance for
interest as a pecuniary loss that must be cured, §365(b)(1)(B) "does not
provide an independent right of recovery of attorney's fees and expenses." <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Ryan's Subs Inc., 165 B.R. 465, 468 (Bankr. W.D. Mo. 1994)</a>.
Instead, reimbursement of attorneys' fees and expenses must be provided for in the
underlying contract. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Mid American Oil Inc., 255 B.R. 839,
841 (Bankr. M.D. Tenn. 2000)</a>.

Regardless, the exception provided in §365(b)(2)(D) does not excuse any and
all types of default provisions. Instead, §365(b)(2)(D) excepts penalty
provisions as public policy supports the non-payment of harsh, penalizing provisions.

<h3>Conclusion</h3>

While the express language and sentence structure of §365(b)(2)(D) is unclear
in structure, the judicial interpretation thereof certainly clarifies its meaning.
Simply stated, Congress intended to except harsh penalty provisions from the cure
requirements of §365(b)(2)(D).

While not all default provisions are excepted, practitioners are advised to take
§365(b)(2)(D) and the case law interpreting it into consideration when drafting
the default provisions of contracts and leases. Indeed, the case law demonstrates that
a non-debtor party to a contract may get "penalty rates and provisions," as long as
they do not look like "penalty rates and provisions." As demonstrated by
§365(b)(2)(D) itself, so much of interpretation is in the words, grammar and
punctuation.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Tuesday, October 1, 2002 - 12:00

Bankruptcy Rule

2002