In the past, a chapter 11 debtor's counsel might have opted to take advantage of a sale of assets under §363 of the Bankruptcy Code to avoid the delays and uncertainties of the plan confirmation process. On June 16, 2008, the U.S. Supreme Court in Florida Dept. of Revenue v. Piccadilly Cafeterias Inc. held that if a chapter 11 debtor wanted to sell property free of transfer taxes, it had to sell its assets under a confirmed plan and not merely in a §363 sale in contemplation of a plan. ___U.S.___, 128 S.Ct. 2326 (2008). Recently, the Ninth Circuit Court of Appeals has eliminated another potential benefit of using a §363 sale prior to a plan of reorganization in General Elec. Capital Corp. v. Future Media Productions Inc., ___F.3d___, 2008 WL 2610459 (9th Cir. July 3, 2008).
In Future Media,GECC had lent the debtor $10.5 million along with a $5 million revolving line of credit, secured by substantially all of the debtor's assets. The loan carried a pre-default interest rate of Index Rate plus 1.5 percent per annum and a default rate of an additional 2 percent per annum. The loan went into default pre-petition and commenced bearing interest at the default rate (it had not matured). The debtor filed for chapter 11 protection and sought to enter into a cash-collateral agreement with GECC. The creditors' committee objected to continued payment of the default interest rate to GECC. There was no dispute that GECC was oversecured by the proceeds of the sale of its collateral. To stop the default interest rate from accruing pending the bankruptcy court's determination of whether GECC was entitled to receive the default rate and attorneys' fees and costs, the parties agreed that the debtor could pay GECC in full, including the accrued default rate interest from the sale proceeds, subject to the bankruptcy court's later determination of the issue. The bankruptcy court subsequently ruled that GECC was only entitled to receive its pre-default rate of interest on its claim and was not entitled to attorneys' fees or costs from the sale proceeds. The court based its decision on the Ninth Circuit's decision in In re Entz-White Lumber and Supply Inc., 850 F.2d 1338 (9th Cir. 1988). GECC appealed.
The Ninth Circuit's holding in Entz-White is very controversial. In that case, the debtor proposed a plan of reorganization that treated an oversecured creditor's claim on a naturally matured loan as not "impaired" for voting purposes under §1124(2)(A). The debtor proposed in its plan to pay the debt of its secured creditor in full with pre-default interest even though the debtor was in default for its failure to pay the loan when it matured. The Ninth Circuit ruled that §1124(2)(B) does not limit the "cure" to only accelerated loans; rather, the section applies to all defaulted debts including matured ones. 850 F.2d at 1341-43.
A number of courts have called the Entz-White holding into question due to the 1994 amendments to the Code that added §1123(d) and deleted §1124(3). See, e.g., In the Matter of the Southland Corp., 160 F.3d 1054, 1059 n.6 (5th Cir. 1998) (doubting Entz-White holding, though explaining 1994 amendments were inapplicable because debtor filed petition in 1990). But see In re Phoenix Business Park Ltd Partnership, 257 B.R. 517, 520-22 (Bankr. N.D. Ariz. 2001) (asserting there was no congressional intent to overrule Entz-White;because default rate was penal, amended sections could not have changed result). Other courts have concluded that the Ninth Circuit's analysis of §1124(2) in Entz-White is just wrong and that a cure of a default and reinstatement of pre-default interest only can occur on a debt that has been accelerated due to a default, but not once it matured. In re Route One West Windsor Ltd Partnership, 225 B.R. 76, 83-86 (Bankr. D. N.J. 1998); In re Ace-Texas Inc., 217 B.R. 719, 726 (Bankr. D. Del. 1998); In re 139-141 Owners Corp., 313 B.R. 364, 368-69 (S.D.N.Y. 2004) (especially where debtor was solvent); In re K & J Properties Inc., 338 B.R. 450, 461 (Bankr. D. Colo. 2005) (no default to cure when the loan matured); and In re Sweet, 369 B.R. 644, 650-51 (Bankr. D. Colo. 2007) (reading Phoenix Business to modify Entz-White to only apply where default rate is penal; when it is not penal, default rate can be charged to a matured loan under §1124).
Nevertheless, Entz-White remained good law in the Ninth Circuit. Indeed, in In re Casa Blanca Project Lenders, 196 B.R. 140, 146 (9th Cir. B.A.P. 1996), the Bankruptcy Appellate Panel (BAP) interpreted Entz-White to apply to a cure under a sale of an asset under §363. In that case, the proceeds of the sale of the collateral of the secured creditor were sufficient to pay the full debt plus default interest. The bankruptcy judge ruled that the secured creditor was entitled to the default rate of 25 percent because the sale was not pursuant to a plan of reorganization. The debtor appealed, and the BAP found that the concept of "cure" in bankruptcy was not limited to a plan and that the default rate was not reasonable, but was penal. Further, the BAP noted that while the Code had been amended in 1994, the BAP did not have to reach those issues because this case predated the amendments.
On appeal of the bankruptcy court's holding in Future Media,the Ninth Circuit found that GECC was entitled to default interest on its debt. The circuit panel found that Entz-White did not apply to a sale outside of a plan of reorganization. Judge Trott, writing for the court, concluded that the reasoning in Casa Blanca was unpersuasive because §363 does not even mention or implicate the "cure" process. The circuit court remanded the matter to the bankruptcy court to determine what rate should properly be used. Additionally, it directed the bankruptcy court to apply the rule that there is "a presumption of allowability for the contracted for default rate 'provided that the rate is not unenforceable under applicable nonbankruptcy law.'" 2008 WL 2610459 at *4 (quoting 4 Collier on Bankruptcy, ¶506.04[2][b][ii] (15th ed. 1996)). Further, in rejecting GECC's request that the case not be remanded for a determination of whether the default rate of an additional 2 percent is reasonable, the Ninth Circuit refused to establish any "bright-line rule" of what is a reasonable default rate.
Although Future Media did not overrule Entz-White, debtor's counsel can no longer use Entz-White as the basis to "cure" a pre-petition default and to deprive a secured creditor of default interest when its collateral is sold outside of a plan. Interestingly, had the debtor in Future Media confirmed a plan with the very same sale, no one would have questioned that GECC would have been denied its default rate of interest (amounting to an additional $164,995) on its defaulted, but not naturally matured, loan under §1124(2) of the Code. Now, prior to proceeding with a §363 sale in a chapter 11 case, the debtor and its creditors' committee need to first consider whether the benefits of a sale under a plan outweigh the delays and uncertainties attendant to plan confirmation.