• To Cure the Incurable Default: Another Look at Claremont and BankVest
  • May 9, 2004 | Authors: Francis J. Lawall; Bonnie MacDougal Kistler
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • Last week, the Bankruptcy Update column reported on a recent decision of the U.S. Court of Appeals for the First Circuit in Eagle Insurance Co. v. BankVest Capital Corp.(In re BankVest Capital Corp.), 360 F.3d 291 (1st Cir. 2004), along with the conflicting decision of In re Claremont Acquisition Corp., 113 F.3d 1029 (9th Cir. 1997).

    The Ninth Circuit in Claremont held that non-monetary defaults are not excepted from the cure requirements of 11 U.S.C. §365, and since by definition non-monetary defaults cannot be "cured," the contract cannot be assumed. The First Circuit in BankVest rejected that ruling and held that non-monetary defaults are indeed excused by §365, so that a debtor may assume the contract without taking any action to address its non-monetary default. A petition for certiorari has now been filed with the Supreme Court in the BankVest case based on this conflict between the First and Ninth Circuits.

    Both courts begin at the same point-with the premise that non-monetary defaults are historical events that cannot be cured. Where they diverge is on the consequence of such incurability. The Ninth Circuit took the "strict constructionist" approach and enforced the non-monetary default provisions to deny the debtor the benefit of its contract. The First Circuit took the "practical implications and overarching rehabilitative policy" approach to allow the debtor to ignore the burdens of its default.

    But the paramount imperative of §365 is that the burdens and benefits of a contract must go together. Is there a way to treat non-monetary defaults that strikes a better balance between the burdens and the benefits? Perhaps, if the starting premise is re-examined.

    Consider a typical non-monetary default. Butch, owner of Butch's Burgers, Inc., is so strapped for cash that he can't meet his payroll or get meat deliveries, so he hangs a "Gone Fishing" sign on his door and hurries off to see his lawyer. A week later, he files Chapter 11. Butch's principal asset is his franchise agreement with the Juicy Burger Company, which authorizes him to market and sell hamburgers under the "Juicy" name. Butch eventually reopens his restaurant, and after business picks up, he files a motion to assume his franchise agreement under §365(a) of the Bankruptcy Code. He proposes to cure his payment defaults to Juicy in full in cash and to provide assurance of future performance through a letter of credit. But Juicy objects that there is another pre-petition default Butch has overlooked in his cure proposal: his failure to operate for seven consecutive days, which is an event of default under the franchise agreement.

    Since there is no way to undo this historical fact, Juicy argues that it is an incurable default that bars contract assumption. Butch insists that he cannot reorganize without the franchise; Juicy maintains that its brand name has been tarnished by all the days of darkness.

    In Claremont, the debtor was an automobile dealer that was similarly in non-monetary default for failure to operate for seven consecutive days. The issue was whether that default was excused under §365(b)(2)(D), which provides: "(2) Paragraph (1) of this subsection [requiring a cure] does not apply to a default that is a breach of a provision relating to- (D) 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."

    The debtor argued that the word "or" in subsection (D) creates two distinct and independent exceptions to the cure requirement: (1) penalty rates; and (2) any non-monetary obligations. The franchisor, on the other hand, argued that the word "penalty" modifies both "rate" and "provision," so that subsection (D) does nothing more than excuse penalties from the cure requirement.

    The Ninth Circuit agreed with the franchisor. Adopting a strict "plain language" approach to statutory construction, the court found it to be "both grammatically incorrect and nonsensical" to read two independent exceptions into subsection (D).

    Instead, it deduced from the structure of §365(b)(2), as well as the limited legislative history, that Congress intended subsection (D) to address a single issue: the payment of penalties. It concluded that subsection (D) provides an exception from the cure requirement for satisfaction of "penalty rates" and "penalty provisions relating to nonmonetary defaults," but did not create a catch-all exception for all non-monetary obligations. The court held that the historical default could not be cured and thus the franchise agreement could not be assumed.

    Since Claremont, lower courts have done their best to limit its perceived draconian impact.

    The First Circuit in BankVest chose to reject Claremont entirely. Finding the textual approach and the legislative history unhelpful, it decided to focus on the practical considerations of bankruptcy policy. To prevent a debtor from assuming a contract based on historical events that it cannot remedy undermines Congress's basic purpose in §365: to promote the successful rehabilitation of the business.

    Imposing an obligation to cure non-monetary defaults would allow the counter-party to effectively "bankruptcy-proof" its contract by building in stringent performance or quality requirements that a financially distressed party could never meet. Such non-monetary defaults would be akin to ipso facto provisions that are expressly excepted from the cure obligation by §365(b)(2)(A)-(C). For the same policy reasons, the First Circuit concluded that the debtor need not cure the non-monetary defaults before assuming the equipment leases.

    A comparison of the Claremont and BankVest decisions reveals that the Ninth Circuit probably has the better of the statutory construction argument. If non-monetary defaults were meant to be a separate and independent cure exception, the following reading of subsection (D) would result: "(2) Paragraph (1) of this subsection [requiring a cure] does not apply to a default that is a breach of a provision relating 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."

    Not only is this reading "non-grammatical and nonsensical," as the Claremont court pronounced it, but it strains credulity to imagine that Congress sneaked a whole new category of excused defaults into subsection (D) when it could have simply added a subsection (E) if that was its intent. Moreover, if subsection (D) actually exempted all non-monetary defaults from the cure requirement, subsections (A) through (C) would be superfluous.

    Logically the Ninth Circuit construction of the statute should prevail. But the First Circuit clearly has the better of the policy argument, since the very idea of an incurable default is an anathema to the purposes of the Bankruptcy Code.

    But that brings us full-circle to the starting premise of both circuit court decisions: the assumption that a non-monetary/historical default is incurable. The Ninth Circuit accepted this notion without question; the First Circuit recognized that some courts and commentators dispute the inherent incurability of non-monetary defaults, but nonetheless chose to follow the view that non-monetary defaults cannot be cured.

    The presupposition is that "cure" means dollar-for-dollar payment-obviously impossible where there is no dollar-for-dollar equivalent-but nowhere does the Code define the term that way. Indeed, the Code doesn't define "cure" at all. The same word appears in §§1123(a)(5)(G) and 1322(b)(3) (providing for the curing of any default in chapter 11 and chapter 13 plans, respectively), and courts construing those provisions have held that non-monetary, historical defaults can be cured, for example, by compensating the non-debtor party for any loss occasioned by the default.

    Unless and until the Supreme Court grants certiorari in BankVest, bankruptcy courts should consider charting the following course between the conflicting circuits: follow the Ninth Circuit's view that non-monetary defaults are not excused by §365(b)(2)(D), but also heed the First Circuit's view that a non-monetary default cannot stand as an insurmountable barrier to contract assumption. Courts could then attempt to fashion a cure for the default that measures the injury to the non-debtor party and compensates it in cash or in kind or some combination of the two.

    Not all non-monetary defaults would necessarily lend themselves to such an approach, but under the right circumstances, the court could devise a cure that truly addresses the harm caused by the default, yet at the same time, affords the debtor a realistic opportunity to assume the contract.

    In the case of Butch's Burgers, the injury to the "Juicy" brand might be cured, for example, by a cash payment combined with more stringent operational requirements in the future. The benefits and burdens of the contract have remained together: Butch must make amends for his default, but he will live to sell "Juicy" burgers another day.