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The Differences Between Assumption and Reinstatement under the Bankruptcy Code
Although a debt agreement may be considered a contract under which both parties have ongoing obligations, section 365(c)(2) of the US Bankruptcy Code expressly prevents a debtor from treating it as an “executory contract” that a debtor may “assume” or “reject” under section 365. Instead, the debt agreement analogue to assumption is reinstatement under section 1124(2), the provision that effectively allows a debtor to “assume” a loan agreement, but only as part of a confirmed chapter 11 plan.
Assumption and reinstatement have some basic principles in common. Both require the debtor to continue to comply with all terms of the underlying agreement (including all covenants), without modification, following assumption or reinstatement. Both also require the debtor to cure any defaults under the agreement as a condition to assumption or reinstatement.
Unlike assumption, though, reinstatement does not require that the debtor demonstrate adequate assurance of future performance. Reinstatement also allows a debtor to de-accelerate a debt that has been accelerated before the chapter 11 filing. In contrast, if the non-debtor party terminated the debtor’s contract or lease prior to the commencement of a bankruptcy case, the debtor cannot revive that contract or lease through assumption under section 365.
Assumption is effectively the only method a debtor can use to retain its rights under a contract or a lease under the Bankruptcy Code. In contrast, reinstatement is not the sole means for a debtor to deal with its obligations under a debt agreement, and a chapter 11 plan may address and restructure obligations under a debt agreement without adhering strictly to the debt agreement’s terms. For example, a debtor may replace the existing loan with a new loan that modifies covenants and payment terms. If the class of lenders votes to accept the chapter 11 plan, the debtor also may take away components of the secured lenders’ collateral package. And, even if the class of lenders votes to reject the plan, the debtor may still force unsecured or secured lenders to accept modified treatment of their loans using cramdown under section 1129(b) of the Bankruptcy Code.
A New Era for Reinstatement?
Perhaps the flexible treatment afforded debt claims in a chapter 11 plan explains why reinstatement is a much less common practice than assumption. It also explains why few courts have been required to address the exact requirements for reinstatement and to understand the meaning of the references to certain sections of 365 within the reinstatement provision. The combination of a high interest rate environment and covenant-lite debt instruments, however, might lead to a new era for using reinstatement under a chapter 11 plan, at least with respect to fixed-rate debt agreements.
The SDNY Bankruptcy Court Issues a Compelling Opinion on the Treatment of Default Interest in Reinstatement
That is why the recent decision by Judge Bentley in the Golden Seahorse case is so important. Judge Bentley held that, when a debtor seeks to reinstate a debt agreement under section 1124(2) of the Bankruptcy Code, the debtor must pay, as a cure of its defaults, any default interest accrued under the terms of the debt agreement. For bankruptcy geeks, the decision is an enjoyable dissection of, and navigation through, the interlocking (and poorly drafted) provisions of sections 1124(2)(A), 365(b)(2), and 1123(d) of the Bankruptcy Code. For everyone else, especially debtors and lenders, the effective deconstruction of those sections by Judge Bentley likely means that the decision will become the definitive analysis on why a debtor is required to pay default interest provided under its debt agreement as a condition to reinstating the debt agreement.
The Reasoning Underlying the Golden Seahorse Decision
To reinstate an obligation under section 1124(2) of the Bankruptcy Code, a debtor must (among other things) cure any pre- or postpetition default other than a default “of a kind” that is “specified in section 365(b)(2)” or “that section 365(b)(2) expressly does not require to be cured.”
Under section 1123(d) to the Bankruptcy Code, “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.” Under the seemingly clear language of this section, that means that, if a debt agreement provides for the accrual and payment of default interest, then payment of default interest is required to reinstate a debt agreement under which the debtor has defaulted. Although the Golden Seahorse debtor attempted to argue otherwise, the bankruptcy court applied the clear meaning of this provision to find that, unless another exception applies, the debtor is required, as a condition to reinstatement, to pay default interest if the debt agreement provides for it.
That left the bankruptcy court to grapple with the effect of the incorporation of the exceptions provided in section 365(b)(2) into the reinstatement requirements. In other words, what did Congress mean when it referred to a default “of a kind specified in section 365(b)(2)” or “of a kind that section 365(b)(2) expressly does not require to be cured”?
Section 365(b)(2) is best known for its invalidation of “ipso facto” clauses as a condition of assumption of an ongoing contract or lease. In other words, to assume a contract or lease, the debtor is not required to cure a contractual default that relates to the debtor’s financial condition, bankruptcy filing, or appointment of a prepetition custodian. That principle is well-accepted and, by virtue of section 1124(2), allows a debtor to reinstate a loan agreement notwithstanding the occurrence of any ipso facto defaults.
Section 365(b)(2) has another exception, though — under subsection (D), a debtor need not cure a default under a provision relating to “the satisfaction of any penalty rate or penalty provision relating to a default arising from the failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.” The bankruptcy court rejected the debtor’s strained interpretation that “of a kind” was meant to refer only to contracts and leases that are subject to section 365 of the Bankruptcy Code. Section 1124(2) does not deal with such contracts and leases (that is the purpose of section 365), and such an interpretation also would nullify the exception for defaults under ipso facto provisions. In effect, such an interpretation would make reference to section 365(b)(2) in section 1124(2) meaningless.
The more difficult question, though, is how to interpret the language of section 365(b)(2)(D) — “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.” Does the subsection only excuse cure when the default is the failure to perform a nonmonetary obligation (in which case, the debtor need not satisfy a penalty rate or penalty provision associated with the failure to perform a nonmonetary obligation)? Or, does the exception excuse both (1) payment of any penalty rate (which would include default interest) regardless of the type of default, and (2) satisfaction of any “penalty provision” if the default arises from the debtor’s failure to perform a nonmonetary obligation?
This was a trickier issue for the bankruptcy court. The bankruptcy court analyzed the language of the statute (applying the “series-qualifier canon” and also reviewing subsection (D) in the context of the other subsections of section 365(b)(2)), the legislative history (rejecting the debtor’s arguments that the legislative history supported excusing payment of penalty rates for any kind of default), and the policy arguments against requiring payment of default interest as a condition of reinstating a loan agreement.
In the end, the bankruptcy court concluded that the language of section 365(d)(2)(D) is only intended to apply to nonmonetary defaults. Judge Bentley concluded that such interpretation was consistent with the prohibition against ipso facto defaults in the other subsections of section 365(d)(2), which seek to excuse the cure of noncurable defaults. Nonmonetary defaults, similarly, are the types of defaults that are noncurable — the debtor cannot turn the clock back — and excusing the cure of nonmonetary defaults is consistent with the overall purpose of section 365(d)(2).
Based on this analysis, the bankruptcy court concluded that section 365(b)(2)(D) only creates a cure exception for nonmonetary defaults; therefore, a debtor cannot use such section to excuse payment of default interest as a condition of reinstatement of a loan agreement.
Interestingly, Golden Seahorse did not address how, if at all, a separate reinstatement requirement contained in section 1124(2) would affect its analysis — the requirement in subsection (D) that the debtor provide compensation for any “actual pecuniary loss” incurred by the non-debtor party as a result of the debtor’s failure to perform a nonmonetary obligation. Arguably, this subsection reinforces the result in Golden Seahorse — because a debtor is not required to (and cannot) cure only nonmonetary defaults, it at least must compensate a party for any actual losses it incurred as a result of such defaults.
Interpreting the effect of that provision, however, is for the next case. Given the thoroughness of Judge Bentley’s reasoning, Golden Seahorse sets a high bar for challenging the requirement to pay default interest as a condition to reinstatement of a loan agreement under a chapter 11 plan.