United States: A Pound of Flesh or a Reasonable Toll?

The Debtor's Perspecive on Professional fee Carve-outs as Pre-Conditions to Cash Collateral, Financing & Asset Sales in Liquidating Chapter 11 Cases

1. Introduction

From the perspective of a liquidating chapter 11 debtor, professionals' fees and the costs of DIP financing are the several pounds of flesh and the reasonable toll required for the extraordinary relief offered by the U.S. Bankruptcy Code. In almost every case, chapter 11 debtors must have financing in order to continue operating, reorganize, and/or liquidate assets. Typically, such financing will come from secured postpetition credit and the use of prepetition Lenders' cash collateral. Postpetition secured credit is often extended by the debtor's prepetition lenders or a subset thereof. Following extensive negotiations with prepetition lenders and others, chapter 11 debtors will approach the Bankruptcy Court and request authority to use cash collateral and borrow funds pursuant to §§ 363 and 364 of the Bankruptcy Code. Such financing is generally referred to as the "DIP Facility."

2. The DIP Facility

a. Overall Structure

Statutory provisions and negotiations between the debtor and its lenders usually combine to produce a DIP Facility that contains a complex web of liens, priorities, and waivers that compensate and protect the lenders for the extension of new credit and the debtor's use of collateral.

Typical provisions include: (i) a priority lien on already encumbered property in favor of postpetition lenders pursuant to § 364(d); (ii) a replacement or additional lien under § 361(2) to adequately protect prepetition secured lenders against a diminution in the value of their collateral by virtue of the lien granted under § 364(d); (iii) a lien on unencumbered property of the estate to secure postpetition credit pursuant to § 364(c)(2); and (iv) the grant of superpriority claimant status pursuant to § 364(c)(1). In addition to the liens and priority discussed above, lenders will request, and often obtain, the debtor's waiver of a number of rights, including the right to use the trustee's strong-arm powers in Chapter 5 to avoid and recover transfers made to the lenders and to invalidate the lenders' prepetition liens. Some of these more typical waivers will be discussed below.

b. Waiver of Causes of Action Against the Lenders

It is almost universally accepted that a debtor will waive its rights under Chapter 5's strong-arm powers to seek to avoid prepetition liens of and potentially preferential transfers to secured creditors who have now become postpetition lenders. These waivers are, in the words of recent expert witnesses, "more than standard" and required to "clean the slate." In re Jore Corp., 298 B.R. 703, 713 (Bankr. D. Mont. 2003).

c. Waiver of Surcharge Rights

Because the DIP Facility will provide a carve-out for the biggest administrative expenses, usually professionals' fees, lenders will assert that the costs of administration have already been provided for and - more importantly - constrained by the DIP Facility and the attendant budget. The debtor's lenders will therefore request an order prohibiting the debtor's use of § 506(c) to surcharge their collateral for the costs of the administration of the bankruptcy.¹ Many jurisdictions readily grant such relief in interim financing or cash collateral orders. See, e.g., Order Authorizing Interim Post-Petition Financing of December 9, 2002 in In re UAL Corp., et al., Case No. 02-48191, Docket No. 156 (Bankr. N.D. Ill.) (waiving the right to surcharge); Interim Order Authorizing Post-Petition Financing of May 14, 2003 in In re Magnatrax Corp., et. al., Case No. 03-11402, Docket No. 42 (Bankr. D. Del.) (ordering the debtors to seek a provision in the final order waiving surcharge).

Whether lenders will continue to be allowed to extract these waivers from debtors is in some, though slight, question. The U.S. Supreme Court ruled, in the context of seeking a surcharge under § 506(c), that none but the trustee or debtor-in-possession has the authority to bring a claim where the Bankruptcy Code uses the words "the trustee may…" See 11 U.S.C. 506(c); Hartford Underwriters Insurance Company v. Union Planters Bank, N.A., 530 U.S. 1 (2000). More precisely, the Court ruled that a party other than the trustee or the debtor-in-possession may not unilaterally seek to surcharge under § 506(c). The Supreme Court specifically declined to decide whether the trustee may assign its authority under § 506(c) and similar statutes. See id., 530 U.S. at 13 n.5. The Hartford Underwriters case and its progeny may be significant to the § 506(c) waiver issue. It could be argued that, should the Supreme Court determine § 506(c)'s grant of authority is a statutorily limited authorization rather than an assignable property right (i.e. that no one but the trustee may bring a surcharge claim under any circumstance), bankruptcy courts should not approve a waiver of such rights because under such a regime waiving the right to seek a § 506(c) surcharge would render § 506(c) a nullity.

d. Encumbering Potentially Valuable Chapter 5 Recoveries

Chapter 5 of the Bankruptcy Code provides the debtor-in-possession with potentially valuable causes of action against certain transferees of the debtor's property (referred to as "avoidance actions"). See 11 U.S.C. §§ 541-560. Such recoveries are generally free of the blanket liens of prepetition secured creditors. See 11 U.S.C. § 552 (prohibiting prepetition security interests in after-acquired property from encumbering assets acquired by the debtor or estate postpetition, with the exception of proceeds of encumbered collateral); Bruce H. White and William L. Medford, Debtor Financing and Liens on Avoidance Actions, 2004 ABI JNL. LEXIS 12 at *2-*3 (March 2004) (hereinafter "White" (stating that this rule of law is almost universal and citing In re Tek-Aids Industries, Inc., 145 B.R. 253, 256 (Bankr. N.D. Ill. 1992); In re Pearson Industries, Inc., 178 B.R. 753, 764-65 (Bankr. N.D. Ill. 1995); In re Ludford Fruit Products, Inc., 99 B.R. 18, 24-25 (Bankr. C.D. Cal. 1989); In re Integrated Testing Products Corp., 69 B.R. 901, 904- 05 (D.N.J. 1987)). Courts have limited this rule to the extent that specific property encumbered by a prepetition lien that is recovered by the trustee or debtor-in-possession, such as a fraudulent transfer, remains subject to that lien. See White at *4-*5 (citing In re Figearo, 79 B.R. 914, 917-18 (Bankr. D. Nev. 1987); Pearson Industries, 178 B.R. at 761-63); cf. John Hancock Life Ins. Co. v. Jankowski (In re Hospitality Investment Corp.), 283 B.R. 451, 455 (Bankr. E.D. Mich. 2002) ("here a secured creditor has an independent claim against a third party to recover property transferred by a debtor to the third party, that claim cannot be cut off by a trustee’s exercise of the Code’s avoiding powers to recover the property and will have priority over a trustee’s claim to the property arising out of the exercise of the avoiding powers" (emphasis in original).

It is common for lenders to request a lien on avoidance actions either as consideration for new credit or as adequate protection for the use of their collateral. Many courts will approve the grant of such a lien. See White at *5-*10; see, also, Mellon Bank N.A. v. Dick Corp. (In re Qualitech Steel Corp.), 351 F.3d 290, 292-93 (7th Cir. 2003); Gonzalez v. Nabisco Div. of Kraft Foods, Inc. (In re Furrs), 294 B.R. 763, 769-72 (Bankr. D.N.M. 2003); Ludford Fruit Products, Inc., 99 B.R. 18, 26-27 (Bankr. C.D. Cal. 1989).

The purpose of a lien on avoidance actions is to ensure that the value of such actions go to the lienholder to secure repayment of its obligations. Unsecured creditors and defendants in avoidance actions have contested the assignment and/or encumbrance of avoidance actions,² alternatively arguing that: (a) the intent and purpose of the avoidance statutes is to provide a benefit to unsecured creditors or the creditor body as a whole; (b) the language of the avoidance statutes, which usually use the phrase "he trustee may," limits the right to bring such actions to the trustee or debtor-in-possession; or (c) recoveries on avoidance actions which benefit only a handful of secured creditors does not satisfy the requirement of § 550(a), which limits recovery only where such recovery benefits the estate.

Cases dealing with this issue, no matter their end result, tend to combine the various arguments described above. In In re Bargdill, the trustee sought to assign the right to pursue certain avoidance actions to Minster State Bank in satisfaction of its claim. 238 B.R. 711, 714-15 (Bankr. N.D. Ohio 1999). Wagner Farms and Sawmill, a potential defendant in these avoidance actions, objected to the proposed assignment on the grounds that the trustee had no authority to assign the avoidance actions. Id., 238 B.R. at 720. The court stated that § 547 actions may be brought only by a trustee, per its explicit terms, unless limiting such actions to the trustee would be contrary to public policy. Id., 238 B.R. at 721. The court went on to say that avoidance "actions are designed to accomplish two public policy goals. The first goal is to further the important bankruptcy policy of ensuring that all creditors within the same class receive the same pro-rata share of a debtor’s limited assets, and the second policy goal is to reduce the incentive of creditors to rush and dismember a financially unstable debtor by allowing a bankruptcy trustee to recoup last-minute payments made to creditors." Id. The court could "in no way conclude that such objectives are in any way hindered by limiting the Bankruptcy Code’s avoiding powers to solely the bankruptcy trustee." Id. The court went on to assert that the vast majority of relevant case law agreed with its conclusion. It cited several cases in support of this statement, including Belding-Hall Mfg. Co. v. Mercer & Ferdon Lumber Co., 175 F. 335, 339-40 (6th Cir. 1909). However only two of the cases cited were decided under the Bankruptcy Code - United Capital Corp. v. Sapolin Paints Inc. (In re Sapolin Paints Inc.), 11 B.R. 930, 937 (Bankr. E.D.N.Y. 1981) (prohibiting assignment of avoidance actions on the grounds that, inter alia, the "power to avoid a preference is one which is to be exercised in the interests of securing equality of distribution among creditors."), and In re Churchfield Management & Inv. Corp., 122 B.R. 76, 81 (Bankr. N.D. Ill. 1990).³ The other authority cited by the Bargdill court were decided under the Bankruptcy Act. See, e.g., Webster v. Barnes Banking Co., 113 F.2d 1003 (10th Cir. 1940); Grass v. Osborn, 39 F.2d 461 (9th Cir. 1930). When viewed in light of the more recent cases holding to the contrary, see Mellon Bank, Gonzalez, and Ludford Fruit, supra, one questions whether the court"s statement about the majority position is correct.⁴

With respect to the proposition that § 550 precludes recoveries for the benefit of a limited class of creditors, some courts, such as Mellon Bank, have found the § 550 element satisfied by an indirect benefit to unsecured creditors. Others have held that the element is only satisfied with a more direct benefit. See, e.g., In re Texas General Petroleum Corp. v. Evans (In re Texas General Petroleum Corp.), 58 B.R. 357, 358 (Bankr. S.D. Tex. 1986). In Mellon Bank, the Seventh Circuit Court of Appeals upheld (for the second time)⁵ a lien on avoidance actions in favor of prepetition secured lenders as adequate protection for their interest in collateral. 351 F.3d 290, 292-93 (7th Cir. 2003). In Mellon Bank, two avoidance action defendants asserted that the secured creditor-plaintiff could not stand in the shoes of the trustee by virtue of the lien that had been upheld in the earlier Qualitech decision because, among other reasons, recoveries from them would go only to secured creditors and therefore not benefit the debtor's estate as is required by § 550(a). Id., 351 F.3d at 292. After refusing to embrace the textual argument that would preclude non-trustees from bringing avoidance actions, the Seventh Circuit held that the potential benefit to the estate afforded by the use of the avoidance actions as consideration for the forbearance of prepetition secured lenders satisfied the requirements of § 550(a). Id., 351 F.3d at 292-93. The Seventh Circuit also noted that Hartford Underwriters "left undisturbed" the case law allowing for "lineal descendants" of the trustee to bring avoidance actions. Id. The Court said

Having put the prospect of preference recoveries to work for the benefit of all creditors (including the unsecured creditors) ex ante by effectively selling them to the secured creditors in exchange for forbearance--and in the process facilitating a swift sale that was beneficial all around--the bankruptcy judge did not need to use them ex post a second time, for still another benefit to the estate; there was no further benefit to be had. We established in P.A. Bergner & Co. v. Bank One, Milwaukee, N.A., 140 F.3d 1111, 1118 (7th Cir. 1998), that § 550(a) is satisfied by an indirect benefit to the estate.. The estate’s ex ante benefit is all that the statute requires.

Contemporaneous with the Mellon Bank decision, the Third Circuit Court of Appeals held that non-trustees could bring avoidance actions, finding that the intent of the Bankruptcy Code provided such an alternative. See Official Committee of Unsecured Creditors v. Chinery (In re Cybergenics Corp.), 330 F.3d 548 (3d Cir. 2003). The Cybergenics court also directly addressed whether the Hartford Underwriters decision affected the ability of non-trustees to bring avoidance actions. In Cybergenics, the creditors' committee unsuccessfully petitioned the debtor-inpossession to pursue certain avoidance actions. Id., 330 F.3d at 552. After the debtor-inpossession refused, the Bankruptcy Court entered an order authorizing the creditors' committee to pursue such actions in its own right. See id. Defendants in these avoidance actions appealed to the U.S. District Court on grounds similar to those described above. The District Court overturned the Bankruptcy Court's order. See id. The Third Circuit overruled the District Court and approved the Bankruptcy Court's actions. See id. The Cybergenics court distinguished Hartford Underwriters on the grounds that Hartford Underwriters dealt with a non-trustee's "right unilaterally to circumvent the Code's remedial scheme" while the issue in Cybergenics was whether a bankruptcy court had the "equitable power to craft a remedy when the Code's envisioned scheme breaks down." Id., 330 F.3d at 552-53. The Third Circuit went on to say that "Sections 1109(b), 1103(c)(5), and 503(b)(3)(B).evince Congress's approval of derivative avoidance actions by creditors' committees." Id.

3. The DIP Facility Carve-Out

As indicated above, the DIP Facility will provide a carve-out for professionals' fees, oftentimes limiting the carve-out to the debtor's professionals. Creditors' committees will assert that such provisions allow the secured lenders too much control over the case. Case law supports the lenders' authority to limit the amounts charged against their collateral.

Courts in the Sixth Circuit have pointed out that a "carve-out" is "an agreement by a party secured by all or some of the assets of the estate to allow some portion of its lien proceeds to be paid to others, i.e., to carve-out of its lien position." In re Fortier, 299 B.R. 183, 191 n.14 (Bankr. W.D. Mich. 2003) (quoting In re White Glove, Inc., No. 98-12493 DWS, 1998 WL 731611 at *6 (Bankr. E.D. Pa. Oct. 14, 1998)). Therefore, an agreement to allocate proceeds in a particular manner and to particular administrative expense claimants should be enforceable. See, e.g., Official Unsecured Creditors' Committee v. Stern (In re SPM Mfg. Corp.), 984 F.2d 1305 (1st Cir. 1993); In re Lil' Things, Inc., 243 B.R. 278 (N.D. Tex. 2000) (enforcing the terms of a carve-out agreement). While a carve-out protects the professionals, it is generally agreed to by the secured creditor because it has concluded that an orderly administration is likely to result in the highest net recovery on its claim, even after payment of carve-out expenses.

Because a carve-out is a charge against collateral, the proposed secured lender should have the right to determine who will benefit from the carve-out. See, e.g., Unsecured Creditors' Committee v. Jones Truck Lines, Inc. (In re Jones Truck Lines, Inc.), 156 B.R. 608, 611 (W.D. Ark. 1992) ("Although the bank and the company have clear interests, it is hard to see what the unsecured creditor's interest is in the use of the bank's cash collateral."); see also Nuclear Imaging Systems, Inc., 270 B.R. 365 (Bankr. E.D. Pa. 2001) (allowing secured creditor to designate certain administrative claimants in carve-out); In re American Resources Management. Corp., 51 B.R. 713 (Bankr. D. Utah 1985) (permitting payment of debtor.s professionals in full, while committee professionals received pro rata payment). But cf. In re Coventry Commons Assoc., 149 B.R. 109, 113-15 (Bankr. E.D. Mich. 1992) (allowing the debtor, provided it demonstrated adequate protection, to use cash collateral to pay professionals' fees despite objection by secured lender).

In Jones Truck Line, supra, the creditors' committee objected to the final cash collateral order because, among other things, it did not provide a carve-out for the committee's professionals. 156 B.R. at 614. The committee attempted to argue, despite the court's notation that the Bankruptcy Code did not require such a carve-out, that the committee's professionals. "constitutional right" to fees should be recognized because of the committee's necessary role as "watchdogs over the bankruptcy process." Id. The Bankruptcy Court disagreed with the committee and determined that such a carve-out requirement for its counsel would "jeopardize the bank’s role in advancing the cash collateral" needed to liquidate the debtor. Id. The District Court agreed with the Bankruptcy Court and upheld its order. Id.

Indeed, courts have enforced previously agreed-to carve-outs against an undersecured creditor even where the creditor later objected to such enforcement. See, e.g., In re Cenargo Int'l, PLC, 294 B.R. 571, 601-03 (Bankr. S.D.N.Y. 2003). In Cenargo, undersecured noteholders stipulated to a $300,000 carve-out from their collateral for the benefit of the debtors' professionals. Id., 294 B.R. at 580-81. The carve-out was agreed to be "determined without regard to fees and expenses which may be allowed on an interim basis or any prepetition retainer paid to the Debtors’ counsel in connection with or related to the chapter 11 cases," thereby rendering the $300,000 insurance for, in the court's words, "burial expenses." Id. Later, after the U.S. Bankruptcy Court surrendered jurisdiction over the debtors to English insolvency administrators, the undersecured noteholders objected to the payment of the debtors' professionals fees, arguing that the $300,000 carve-out had been intended as an aggregate, instead of conditional, provision and that debtors' counsel provided them with no value. Id., 294 B.R. at 575. The court, calling the noteholders' interpretation of the carve-out language "overly narrow," held the noteholders to their agreement and enforced the carve-out, despite the disputed benefit provided to the noteholders by debtors' counsel. Id., 294 B.R. at 602.

4. Conclusion

The modern trend with respect to each of the issues addressed above is to provide more flexibility to debtors-in-possession and their constituents. This trend is demonstrated by the more recent cases cited supra. More courts are beginning to allow parties other than the debtorin- possession or trustee to bring surcharge actions (thus clearing the way for secured lenders to require waiver of such rights by the debtor-in-possession) and avoidance actions (enabling lenders to take liens on Chapter 5 recoveries and assume only the natural risk of recovery associated with such actions). Courts also appear more willing to enforce carve-outs, which furthers the overall viability of the bankruptcy process by providing comfort to professionals.

Some observers have referred to the consideration for DIP Facilities as giving "the store...away to the lender.2 In re Jore, 298 B.R. at 713. While this may be an overstatement, the need for financing places debtors in a weak position with respect to lenders' requirements for postpetition credit. Because of this inherent quality of the Chapter 11 regime, creditors' committees need to be mindful of their responsibility to prevent overreaching by secured lenders in the early stages of the case when financing orders are negotiated and entered.

Jerald I. Ancel, Marlene Reich, and Jeffrey J. Graham, Dangerous Dicta for DIP Lenders: The Risk of a Valid but Valueless Replacement Lien, 2002 ABI JNL. LEXIS 111 (July 2002).

Scott E. Cohen, Rolling the Dice with Unsecured Creditors' Money: Creditors' Committee Fails to Protect Proceeds of Avoidance Actions, Bankruptcy Bulletin of Weil, Gotshal & Manges LLP, Vol. 9 No. 3 (March 2002).

James S. Cole, The Carve Out from Liens and Priorities Guarantee Payment of Professional Fees in Chapter 11, 1993 Det. C. L. Rev. 1499 (1993).

G. Ray Warner, Selected DIP Loan Issues: Hot Topics, presented at the ABI Winter Leadership Conference (December 2002).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.