Confusion About Section 365(b)(2)(D)

Case Law

Given the obscurity (and the latent ambiguity) of Section 365(b)(2)(D), it is somewhat surprising that very few courts have tackled its meaning. Those that have attempted an interpretation have reached contradictory conclusions.

The first court to interpret Section 365(b)(2)(D) held that subsection (b)(2)(D) does indeed eliminate the debtor's obligation to cure non-monetary defaults. See In re Claremont Acquisition Corp, Inc., 186 B.R. 977 (C.D. Cal. 1995). In Claremont, the debtor was an automobile dealer that stopped operating its dealerships 2 weeks prior to filing its bankruptcy petition. Once in bankruptcy, the debtor sought to assume and assign its dealership franchise agreements. The franchisors argued that the agreements could not be assumed unless the debtor first cured its pre-petition defaults under the agreements — in this case, its failure to operate its dealerships pre-petition. In response, the debtor argued that Section 365(b)(2)(D) eliminated its obligation to cure nonmonetary, historical defaults like its failure to operate. Not surprisingly, the franchisors argued that this Section only alleviates the debtor's burden of curing penalties arising from nonmonetary defaults. But the District Court disagreed, choosing instead to affirm both the debtor's and the bankruptcy court's interpretation of the Section:

“The plain language of the statute does not support this construction. The statute refers to a 'penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract'.” The most natural reading of this language supports the interpretation given it by the bankruptcy court – that a trustee or debtor is possession is not required to cure nonmonetary defaults in order to assume and assign executory contracts in leases. Id. at 990.

In a detailed opinion on appeal, the Ninth Circuit diverged from both lower courts, holding that the most natural reading of subsection (b)(2)(D) requires a finding that the word “penalty” modifies both “rate” and “provision.” In re Claremont Acquisition Corp., 113 F.3d 1029, 1033-35 (9th Cir. 1997). The court rested its holding on three separate grounds. First, the court pointed out that if the word “or” were eliminated from the subsection and the two separate clauses of that subsection were read standing alone, the second clause would not make sense. Instead, it would read:

“Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to a default arising from any failure by the debtor to … (D) provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.”

In the Ninth's Circuit's words, “[t]his construction is both grammatically incorrect and nonsensical.” Id. at 1034.

Second, the court considered the general structure of Section 365(b)(2). Each subdivision of that Section outlines a separate, independent exception to the rule requiring cure of defaults. The court noted that, to read subsection (b)(2)(D) as excepting both penalties and nonmonetary defaults from the debtor's cure obligations would “require[] a deviation from the general structure of the Section, as it results in a single subclause containing two completely different and unrelated exceptions.” The court refused to interpret the subsection in a way that ignored the statute's general structure.

Finally, the court reviewed the legislative history of subsection (b)(2)(D) to support its interpretation of that provision. That legislative history provides:

” [S]ection 365(b) is clarified to provide that when sought by a debtor, a lease can be cured at a nondefault rate (ie, it would not need to pay penalty rates).” In re Claremont, 113 F.3d at 1034 (citing 5 U.S. Congressional and Administrative News at 3357 (1994) (H.R. No. 103-835 (1995)). The Ninth Circuit concluded that the House Report's failure to mention an exception for nonmonetary defaults leant weight to the argument that the subsection was only meant to apply to penalties. In re Claremont, 113 F.3d at 1034.

Ultimately, the court in Claremont held that the debtor could not assume the franchise agreements at issue because its defaults under those agreements (its failure to operate its dealerships) were “historical facts” that could not be cured; and, because the court determined that section 365(b) requires a debtor to cure all defaults — both monetary and nonmonetary — the debtor's inability to cure the defaults at issue precluded assumption. Id. at 1304-35.

Subsequent courts have expressed agreement with the result in Claremont. See Three Sisters Partners, LLC (In re Shangra-La, Inc.), 167 F.3d 843, 848 n.3 (4th Cir. 1999) (noting, in dicta, that a debtor need not pay a default rate interest penalty connected to nonmonetary defaults); In re New Breed Realty Enterprises, Inc., 278 B.R. 314, 320-21 (Bankr. E.D.N.Y. 2002) (reading subsection (b)(2)(D) as applying only to penalties and therefore denying assumption of an executory contract where the debtor could not cure its nonmonetary breaches under contract); In re Ernst Home Center, Inc., 209 B.R. 955, 963 n. 6 (Bankr. W.D. Wash. 1997) (emphasizing, in dicta, that “to interpret Section 365(b)(2)(D) … to cover all damages for breach of any nonmonetary provision in a lease would read Section 365(b)(1) right out of the Bankruptcy Code.”); In re Vitanza, 1998 WL 808629 at *21 (Bankr. E.D. Pa. 1998) (noting, in dicta, that Section 365(b)(2)(d) “only relieves debtors of their obligation to pay penalties and not of their obligation to cure non-monetary defaults.”).

Despite this authority, a number of bankruptcy courts construe subsection (b)(2)(D) as relieving debtors of their obligation to cure nonmonetary defaults in their entirety. The leading case espousing this interpretation is In the Matter of GP Express Airlines, Inc., 200 B.R. 222, 233-34 (Bankr. D. Neb. 1996), a case that pre-dates the Ninth Circuit's ruling in Claremont. In GP Express Airlines, the debtor-airline moved to assume its executory contracts with Continental Airlines. Continental objected on the ground that the debtor's failure to cure nonmonetary, pre-petition defaults (eg, its failure to meet performance standards relating to the completion of flights, the timely arrival of flights and the use of standardized accounting services) under the contracts precluded assumption. Continental further argued that the nonmonetary defaults were inherently incurable because they were defaults relating to performance standards which the debtor had failed to achieve. In response, the debtor relied on Section 365(b)(2)(D), arguing that this Section relieved its burden of curing nonmonetary, performance related defaults. The Bankruptcy Court agreed with the debtor and cited the lower court's ruling in Claremont in support of its decision:

The sole reported decision directly construing amended section 365(b)(2)(D) concludes that a debtor in possession is not required to cure nonmonetary defaults. My reading of amended section 365(b)(2)(D) is consistent with Claremont … Continental's reading of the amended section (D) results in illogical requirements: A “penalty rate” would be enforceable and would have to be cured on a monetary obligation but not on a nonmonetary obligation. If penalties are not favored, they should not be required to be cured in either case. Further, under Continental's interpretation, debtors would have to cure nonmonetary defaults, which is often impossible, but would be relieved of the obligation to cure “penalty rates,” which appears to provide illusory relief. Id. at 233-34 (internal citations omitted).

Even after the Ninth Circuit's contrary opinion in Claremont 1 year later, other courts have continued to cite the GP Express Airlines decision for the proposition that debtors need not cure nonmonetary defaults. See, e.g., In re Walden Ridge Development, LLC, 292 B.R. 58 (Bankr. D. N.J. 2003) (criticizing the Ninth Circuit's holding in Claremont); In re BankVest Capital Corp., 270 B.R. 541, 543-44 (Bankr. D. Mass. 2001) (adopting the reasoning of GP Express Airlines), aff'd 290 B.R. 443 (1st Cir. B.A.P. 2003); In re Western Pacific Airlines, Inc., 219 B.R. 298, 304 (Bankr. D. Colo. 1998) (noting, in dicta, agreement with the GP Express interpretation of Section 365(b)(2)(D)), rev'd on other grounds, 219 B.R. 305 (D. Colo. 1998).

Most notably, the First Circuit Bankruptcy Appellate Panel refused to follow Claremont, reasoning that “[i]n practice, if debtors had to cure nonmonetary defaults, many leases could not be assumed because the cure would be impossible to accomplish,” BankVest Capital Corp., 290 B.R. at 447, which is precisely what the Claremont court found Congress intended.

Conclusion

Next month's conclusion of this article discusses “incurable” nonmonetary defaults in depth.

It is generally understood that bankruptcy law requires debtors to cure all contractual defaults before assuming any executory contract because debtors would receive a windfall without such requirement: They could assume (and compel performance on) contracts that they had breached without paying any resulting damages claim. If such a result were permitted under the Code, failing companies would have even less incentive to continue performing on contracts pre-petition because they could presumably seek to assume those contracts in bankruptcy without penalty. For this reason, Bankruptcy Code ' 365(b)(1) expressly provides that a debtor may only assume an executory contract if the debtor first:

• cures, or provides adequate assurance that it will promptly cure any defaults under the contract;
• compensates, or provides adequate assurance that it will promptly compensate, a party for any actual pecuniary loss resulting from such default; and
• provides adequate assurance of future performance under the contract. 11 U.S.C. ' (b)(1).

Despite this well-understood and widely applied Code provision, the Bankruptcy Reform Act of 1994 modified Section 365 in such a way as to potentially eliminate the long-standing obligation to cure certain defaults in connection with the assumption of executory contracts. Specifically, Section 365(b)(2)(D) now provides that:

The requirements of Section 365(b)(1) do not apply to a default that is a breach of a provision relating to the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease. 11 U.S.C. ' 365(b)(2)(D) (emphasis added).

Courts disagree as to the interpretation of this provision. Some read it in the conjunctive, as excusing the debtor's obligation to cure any penalty rate or penalty provision arising from a nonmonetary default. Others read it in the disjunctive, as excusing the debtor's obligation to cure either penalty rates or contractual provisions relating to nonmonetary defaults. If this latter interpretation is adopted, then Section 365(b)(2)(D) carves out a significant (and, from the debtor's perspective, extremely favorable) exception to Section 365's requirements for contract assumption — that is, it alleviates the debtor's burden of curing nonmonetary defaults when, for example, the time for performance under the contract has passed.

Case Law

Given the obscurity (and the latent ambiguity) of Section 365(b)(2)(D), it is somewhat surprising that very few courts have tackled its meaning. Those that have attempted an interpretation have reached contradictory conclusions.

The first court to interpret Section 365(b)(2)(D) held that subsection (b)(2)(D) does indeed eliminate the debtor's obligation to cure non-monetary defaults. See In re Claremont Acquisition Corp, Inc., 186 B.R. 977 (C.D. Cal. 1995). In Claremont, the debtor was an automobile dealer that stopped operating its dealerships 2 weeks prior to filing its bankruptcy petition. Once in bankruptcy, the debtor sought to assume and assign its dealership franchise agreements. The franchisors argued that the agreements could not be assumed unless the debtor first cured its pre-petition defaults under the agreements — in this case, its failure to operate its dealerships pre-petition. In response, the debtor argued that Section 365(b)(2)(D) eliminated its obligation to cure nonmonetary, historical defaults like its failure to operate. Not surprisingly, the franchisors argued that this Section only alleviates the debtor's burden of curing penalties arising from nonmonetary defaults. But the District Court disagreed, choosing instead to affirm both the debtor's and the bankruptcy court's interpretation of the Section:

“The plain language of the statute does not support this construction. The statute refers to a 'penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract'.” The most natural reading of this language supports the interpretation given it by the bankruptcy court – that a trustee or debtor is possession is not required to cure nonmonetary defaults in order to assume and assign executory contracts in leases. Id. at 990.

In a detailed opinion on appeal, the Ninth Circuit diverged from both lower courts, holding that the most natural reading of subsection (b)(2)(D) requires a finding that the word “penalty” modifies both “rate” and “provision.” In re Claremont Acquisition Corp., 113 F.3d 1029, 1033-35 (9th Cir. 1997). The court rested its holding on three separate grounds. First, the court pointed out that if the word “or” were eliminated from the subsection and the two separate clauses of that subsection were read standing alone, the second clause would not make sense. Instead, it would read:

“Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to a default arising from any failure by the debtor to … (D) provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.”

In the Ninth's Circuit's words, “[t]his construction is both grammatically incorrect and nonsensical.” Id. at 1034.

Second, the court considered the general structure of Section 365(b)(2). Each subdivision of that Section outlines a separate, independent exception to the rule requiring cure of defaults. The court noted that, to read subsection (b)(2)(D) as excepting both penalties and nonmonetary defaults from the debtor's cure obligations would “require[] a deviation from the general structure of the Section, as it results in a single subclause containing two completely different and unrelated exceptions.” The court refused to interpret the subsection in a way that ignored the statute's general structure.

Finally, the court reviewed the legislative history of subsection (b)(2)(D) to support its interpretation of that provision. That legislative history provides:

” [S]ection 365(b) is clarified to provide that when sought by a debtor, a lease can be cured at a nondefault rate (ie, it would not need to pay penalty rates).” In re Claremont, 113 F.3d at 1034 (citing 5 U.S. Congressional and Administrative News at 3357 (1994) (H.R. No. 103-835 (1995)). The Ninth Circuit concluded that the House Report's failure to mention an exception for nonmonetary defaults leant weight to the argument that the subsection was only meant to apply to penalties. In re Claremont, 113 F.3d at 1034.

Ultimately, the court in Claremont held that the debtor could not assume the franchise agreements at issue because its defaults under those agreements (its failure to operate its dealerships) were “historical facts” that could not be cured; and, because the court determined that section 365(b) requires a debtor to cure all defaults — both monetary and nonmonetary — the debtor's inability to cure the defaults at issue precluded assumption. Id. at 1304-35.

Subsequent courts have expressed agreement with the result in Claremont. See Three Sisters Partners, LLC (In re Shangra-La, Inc.), 167 F.3d 843, 848 n.3 (4th Cir. 1999) (noting, in dicta, that a debtor need not pay a default rate interest penalty connected to nonmonetary defaults); In re New Breed Realty Enterprises, Inc., 278 B.R. 314, 320-21 (Bankr. E.D.N.Y. 2002) (reading subsection (b)(2)(D) as applying only to penalties and therefore denying assumption of an executory contract where the debtor could not cure its nonmonetary breaches under contract); In re Ernst Home Center, Inc., 209 B.R. 955, 963 n. 6 (Bankr. W.D. Wash. 1997) (emphasizing, in dicta, that “to interpret Section 365(b)(2)(D) … to cover all damages for breach of any nonmonetary provision in a lease would read Section 365(b)(1) right out of the Bankruptcy Code.”); In re Vitanza, 1998 WL 808629 at *21 (Bankr. E.D. Pa. 1998) (noting, in dicta, that Section 365(b)(2)(d) “only relieves debtors of their obligation to pay penalties and not of their obligation to cure non-monetary defaults.”).

Despite this authority, a number of bankruptcy courts construe subsection (b)(2)(D) as relieving debtors of their obligation to cure nonmonetary defaults in their entirety. The leading case espousing this interpretation is In the Matter of GP Express Airlines, Inc., 200 B.R. 222, 233-34 (Bankr. D. Neb. 1996), a case that pre-dates the Ninth Circuit's ruling in Claremont. In GP Express Airlines, the debtor-airline moved to assume its executory contracts with Continental Airlines. Continental objected on the ground that the debtor's failure to cure nonmonetary, pre-petition defaults (eg, its failure to meet performance standards relating to the completion of flights, the timely arrival of flights and the use of standardized accounting services) under the contracts precluded assumption. Continental further argued that the nonmonetary defaults were inherently incurable because they were defaults relating to performance standards which the debtor had failed to achieve. In response, the debtor relied on Section 365(b)(2)(D), arguing that this Section relieved its burden of curing nonmonetary, performance related defaults. The Bankruptcy Court agreed with the debtor and cited the lower court's ruling in Claremont in support of its decision:

The sole reported decision directly construing amended section 365(b)(2)(D) concludes that a debtor in possession is not required to cure nonmonetary defaults. My reading of amended section 365(b)(2)(D) is consistent with Claremont … Continental's reading of the amended section (D) results in illogical requirements: A “penalty rate” would be enforceable and would have to be cured on a monetary obligation but not on a nonmonetary obligation. If penalties are not favored, they should not be required to be cured in either case. Further, under Continental's interpretation, debtors would have to cure nonmonetary defaults, which is often impossible, but would be relieved of the obligation to cure “penalty rates,” which appears to provide illusory relief. Id. at 233-34 (internal citations omitted).

Even after the Ninth Circuit's contrary opinion in Claremont 1 year later, other courts have continued to cite the GP Express Airlines decision for the proposition that debtors need not cure nonmonetary defaults. See, e.g., In re Walden Ridge Development, LLC, 292 B.R. 58 (Bankr. D. N.J. 2003) (criticizing the Ninth Circuit's holding in Claremont); In re BankVest Capital Corp., 270 B.R. 541, 543-44 (Bankr. D. Mass. 2001) (adopting the reasoning of GP Express Airlines), aff'd 290 B.R. 443 (1st Cir. B.A.P. 2003); In re Western Pacific Airlines, Inc., 219 B.R. 298, 304 (Bankr. D. Colo. 1998) (noting, in dicta, agreement with the GP Express interpretation of Section 365(b)(2)(D)), rev'd on other grounds, 219 B.R. 305 (D. Colo. 1998).

Most notably, the First Circuit Bankruptcy Appellate Panel refused to follow Claremont, reasoning that “[i]n practice, if debtors had to cure nonmonetary defaults, many leases could not be assumed because the cure would be impossible to accomplish,” BankVest Capital Corp., 290 B.R. at 447, which is precisely what the Claremont court found Congress intended.

Conclusion

Next month's conclusion of this article discusses “incurable” nonmonetary defaults in depth.