Cases Involving had approved a 363 sale or a liqui- sale or - - PDF document

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J OURNAL A M E R I C A N B A N K R U P T C Y I N S T I T U T E The Essential Resource for Todays Busy Insolvency Professional Who Pays the Freight? Interplay Between Priority Claims and a Debtors Secured Lender Contributing Editor: T

SLIDE 1 44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org

JOURNAL

A M E R I C A N B A N K R U P T C Y I N S T I T U T E

The Essential Resource for Today’s Busy Insolvency Professional

Contributing Editor: Bruce S. Nathan Lowenstein Sandler PC; New York bnathan@lowenstein.com Also Written by: Bruce D. Buechler Lowenstein Sandler PC; Roseland, N.J. bbuechler@lowenstein.com

re debtors filing chapter 11

cases are utilizing § 363 of the Bankruptcy Code to obtain court approval of an expedited sale process and ultimately the sale of their busi- nesses and/or assets. All too often, the chapter 11 debtor runs a sale process that is effectively for the benefit of its secured lender. The lender typically has insuffjcient collateral to assure the full payment of its secured claim and usually agrees to provide chapter 11 fjnancing or allow the debtor to use the cash proceeds

f its collateral pursuant to a budget that

includes payment of some or all of the debtor’s chapter 11 trade payables and

ther expenses incurred during the chap-

ter 11 case, and the debtor’s and creditors’ committee professional fees. C o n s p i c u o u s l y absent from the budget are § 503(b)(9) claims, entitled to administrative pri-

rity, for the goods

that trade creditors sold to the debtor in the ordinary course

f the debtor’s busi-

ness that the debtor had received within 20 days of the bankruptcy filing. The result is an administratively insolvent bankruptcy estate with insufficient funds to fully pay all administrative-priority claims. Section 503(b)(9) claimants end up at the short end with little or no prospect for payment

f their administrative-priority claims,

while other administrative claims are either paid in full or receive more favor- able treatment. This trend may be starting to

change. In the Townsends1 chapter 11

case, pending in Delaware before Hon. Christopher S. Sontchi, the bankruptcy court initially refused to approve the debtors’ proposed chapter 11 financing arrangement with its pre-petition secured lenders because the debtors had failed to provide reasonable certainty that § 503(b)(9) administrative-priority claims would be paid through the sales

process. The lenders were offering to

fund an expedited sale process that was not expected to realize sufficient proceeds to fully pay their secured claims. The budget included the payment of trade payables and other operating expenses incurred during the case, certain pre-petition critical vendor claims, and the debtors’ and committee’s professional fees up to specified caps. However, the lenders made no provision for the payment of § 503(b)(9) administrative-priority claims. T h e T o w n s e n d s c o u r t i n i t i a l l y refused to approve the financing, even if that meant derail- ing the sale process. The court stated that the debtors’ pre-petition secured lenders could not utilize chapter 11 to sell the debtors’ business assets, com- prising the lender’s collateral, without assuring payment of all administrative expenses, including § 503(b) (9) claims. The court was particularly concerned about the prospect of administratively insolvent debtors preferring post-petition trade payables and other operating expenses, critical vendors’ pre-petition claims and estate professional fees that the lenders had approved for payment at the expense of the debtors’ § 503(b)(9) administrative claims whose prospects for payment were slim or nonexistent. The court determined that Congress, in granting § 503(b)(9) claims administrative-priority status, did not intend for these claims to be treated differ- ently than other administrative claims. In order to obtain court approval of the proposed financing and sales process, the lender reached an agreement with the creditors’ committee that ultimately resulted in full payment of § 503(b)(9) claims from the sales proceeds. However, in the Allen Family Foods Inc.2 chapter 11 case, also pending in Delaware before Hon. Kevin J. Carey,

About the Authors

Bruce Nathan and Bruce Buechler are members of Lowenstein Sandler’s Bankruptcy, Financial Reorganization and Creditors’ Rights Group. Mr. Nathan is also co-author of ABI’s Trade Creditor Remedies Manual, now available in the ABI Bookstore at bookstore.abi.

rg, and a member of ABI’s Executive

Committee.

Last in Line I

Who Pays the Freight? Interplay Between Priority Claims and a Debtor’s Secured Lender

Bruce S. Nathan 1 In re Townsends Inc., Case No. 10-14092 (CSS) (Bankr. D. Del.). 2 In re Allen Family Foods Inc., Case No. 11-11764 (KJC) (Bankr. D. Del.). Bruce D. Buechler

SLIDE 2 44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org the court approved a quick sale of assets that primarily benefitted the debtors’ pre-petition secured lenders and did not assure full payment of § 503(b)(9) priority claims by the debtors at risk of administrative insolvency. Therefore, it is less than fully clear whether other courts will follow the approach adopted by the court in Townsends and NEC Holdings,3 another case pending in Delaware.

Cases Involving Administratively Insolvent Debtors Conducting a Sale

r Liquidation

There has been a great deal of debate over whether a debtor can fjle a chapter 11 case and utilize § 363(b) of the Bankruptcy Code to conduct a sale

r liquidation process that primarily

benefjts its pre-petition secured lender where there is no realistic possibility

f confirming a chapter 11 plan and

the estate is administratively insolvent. The Townsends court focused on this scenario because certain post-petition trade payables and the § 503(b)(9) administrative-priority claims were at risk of nonpayment through the proposed sale process. In In re Encore Healthcare, the court refused to approve a debtor’s motion establishing procedures for the sale of substantially all of its assets.4 The court determined that the sale, pursuant to § 363, lacked a valid business justifjcation.5 The debtor’s assets consisted of a single piece of real estate, office and medical equipment, and fixtures that were leased pre-petition to a tenant that

perated a skilled nursing facility.6 The

debtor sought to sell its assets to a third party and use the sales proceeds to pay the costs of the sale and partially pay the secured lender’s claim.7 The debtor then intended to immediately convert its case to a chapter 7 case following court approval of the sale.8 The Encore Healthcare court sua sponte questioned the propriety of a § 363 sale that the debtor was propos- ing solely for the benefjt of the debt-

r’s secured lender, and ultimately

denied approval of the sale.9 While

ther courts had approved § 363 sales

as “an important step in furtherance

f a reorganization proceeding,” in

Encore Healthcare, the sale did not contemplate preserving an operating business and the jobs of any employ- ees.10 The court also contrasted this case with other cases where the courts had approved a § 363 sale or a liquidation process.11 One case provided for payment of administrative claims and a fund for payment to unsecured creditors,12 while in another case, the debtor realized proceeds in excess of the amount of the secured claim.13 In United States Trustee v. GPA Technical Consultants Inc. (In re GPA Technical Consultants Inc.), shortly after its chapter 11 filing, the debtor had ceased its business operations and conducted an orderly liquidation of its assets subject to its lender’s security interest and proposed a liquidating plan to complete this process.14 The U.S. Trustee moved to convert or dismiss the debtor’s chapter 11 case because it was unlikely that unsecured creditors would realize any recovery and only the secured creditor and debtor’s counsel would benefjt.15 The debtor and secured lender opposed the motion, arguing that the secured lender had funded all of the debtor’s payroll and other operating expenses and subordinated its secured claim to payment of the debtor’s attor- neys’ fees.16 The debtor was also funding its post-petition operating losses through the proceeds of the sale of its assets.17 The court denied conversion or dis- missal of the case.18 The court stated that when considering the best interests

f creditors and the estate, “the inter-

ests of the secured creditor are legiti- mate interests to be taken into account in deciding whether to convert or dismiss a chapter 11 case.”19 The court also noted that the debtor’s unsecured creditors were not being harmed because they were out of the money, regardless

f whether the case remained in chapter

11, was converted to a chapter 7 case or was dismissed.20 These cases were decided prior to the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), which significantly expanded trade creditor rights by add- ing § 503(b)(9)’s administrative-priority claim in favor of sellers of goods. Courts must now consider the appropriateness

f an administratively insolvent debtor’s

sale or liquidation of assets that does not provide for full payment of administrative claims, including § 503(b)(9) administrative-priority claims.

The Facts of Townsends

On Dec. 19, 2010, Townsends

Inc. and four affiliates (the debtors)

filed their chapter 11 cases. Founded in 1891, the debtors were a third-gen- eration, family-owned poultry company headquartered in Georgetown,

Del. Immediately after their fjling, the

debtors filed a motion seeking court approval of a debtor-in-possession (DIP) financing facility provided by the debtors’ pre-petition secured lend-

ers. The financing motion outlined a

series of milestones requiring a quick sale of substantially all of the debtors’

assets. The secured debt (including the

proposed DIP fjnancing) was more than twice the amount of the $43 million stalking-horse bid offered for the debt-

rs’ assets, leaving administrative and

priority claims that were excluded from the DIP budget and unsecured creditors with no hope of a recovery. Immediately after appointment, the creditors’ committee entered into nego- tiations with the debtors and lenders

ver the proposed fjnancing facility and

the related proposed sale of the debtors’

assets. The committee concluded that the

debtors’ estates were administratively insolvent because the debtors’ budget did not provide for the payment of all administrative claims, including § 503(b) (9) administrative-priority claims. Following unsuccessful negotia- tions with the lenders, the committee

bjected to the DIP financing. The

committee argued that the expedited sale process supported by the fjnancing was solely for the benefit of the debtors’ pre-petition secured lenders and would leave their estates administratively insolvent with no means

f paying all administrative claims,

including nonbudgeted post-petition

perating expenses and § 503(b)(9)

administrative-priority claims. 3 In re NEC Holdings Corp., Case No. 10-11890 (PJW) (Bankr. D. Del.). 4 312 B.R. 52 (Bankr. E.D. Pa. 2004). See also In re Duro Industries, No. 02-16131, 2004 Bankr. LEXIS 1235, at *16 (Bankr. D. Mass. Aug. 26, 2004) (liquidation of assets in bankruptcy not appropriate where unsecured creditors will not receive recovery); In re Golf LLC, 322 B.R. 874, 878 (Bankr. D. Neb. 2004) (no reason to approve 363 sale where only secured creditor will benefjt); In re Fremont Battery Co., 73 B.R. 277, 279-80 (Bankr. N.D. Ohio 1987) (sale not appropriate where proceeds would only benefjt secured creditor and would result in insuffjcient assets for plan to be proposed); In re Au Natural Rest. Inc., 63 B.R. 575, 581 (Bankr. S.D.N.Y. 1986) (expedited sale not appropriate where there was no valid business justifjcation and distributions to unsecured creditors were unlikely). 5 Encore Healthcare, 321 B.R. at 57-58. 6 Id. at 53-54. 7 Id. at 54. 8 Id. 9 Id. at 57-58. 10 Id. at 57. 11 Id. 12 In re Medical Software Solutions, 286 B.R. 431 (Bankr. D. Utah 2002). 13 In re Channel One Communications Inc., 117 B.R. 493 (Bankr. E.D. Mo. 1990). 14 106 B.R. 139, 140 (Bankr. S.D. Ohio 1989). 15 GPA Technical, 106 B.R. at 140. 16 Id. 17 Id. 18 Id. See also In re Western Pac. Airlines Inc., 218 B.R. 590, 597 (Bankr.

D. Colo. 1998) (motion to convert chapter 11 case to chapter 7 denied

even though chapter 11 case was solely for benefjt of secured DIP lender). 19 GPA Technical, 106 B.R. at 142.

SLIDE 3

Townsends Court’s Refusal to Approve Chapter 11 Financing

The Townsends court initially refused to grant the debtors’ motion for approval of DIP fjnancing to implement their sale process because of the failure to make any provision for the full payment of § 503(b)(9) administrative-pri-

rity claims. The court was unwilling to

approve a process that primarily benefjtted the debtors’ secured lenders where there was a real potential of administrative insolvency. The court was particularly concerned about the debtors preferring one group of administrative claims, including post-petition trade payables and other operating expenses and professional fees, whose claims were to be paid pursuant to the budget the lenders had approved, over another group of administrative claims, the § 503(b)(9) administrative-priority claims that were not included in the bud-

get. Further, the committee demonstrat-

ed that the original budget did not even provide for payment of all post-petition trade payables through the proposed closing of the asset sale.21 Interestingly, Judge Sontchi was also the judge dealing with the proposed chapter 11 fjnancing in NEC Holdings, also pending in Delaware and also involving a debtor facing the risk of administrative insolvency. NEC (former- ly known as National Envelope Corp.) similarly moved for court approval of a DIP financing arrangement provided by NEC’s pre-petition secured lender to facilitate an expedited sale process that primarily benefjtted the lender. The NEC court also refused to approve the fjnancing unless the lender was willing to “pay the freight, and the freight is...certainly an administratively solvent estate.”22 The court was concerned about the dim prospects for the full payment of all administrative claims, including § 503(b)(9) administrative claims. The Townsends court originally denied the financing and then strongly urged the parties to make modifjcations to the financing order and return it to the court several days later. The court stated that it would either convert or dismiss the case unless the parties reached a resolution.23 The parties negotiated a final financing order that authorized the debtors to establish an escrow to be funded from the sales proceeds to pay § 503(b) (9) claims based on a slid- ing scale of the amount realized from the sale, and fully pay all post-petition administrative claims that the debtors had incurred. Following the court’s approval of the financing facility, the debtors conducted a very successful auction that netted suffjcient proceeds to fully pay all of the debtors’ post-petition administrative claims and § 503(b)(9) administrative-priority claims.

A Different Approach in Allen Family Foods

In the Allen Family Foods case, also involving a poultry company on the brink of administrative insolvency, Judge Carey approved a quick sale process that primarily benefjtted the debt-

rs’ pre-petition secured lender. While

“troubled”24 by the prospect of the debtors’ administrative insolvency and the probability of insufficient funds to fully pay all § 503(b)(9) administrative- priority claims, the court nevertheless approved the sale without any assurance

f the full payment of these claims. The

court concluded that enough pain had been infmicted on the lender based on its agreement to fund the payment of post- petition trade payables and other operating expenses, the pre-petition claims of critical vendors (which included some of the § 503(b)(9) administrative-priority claims), and the debtors’ and the committee’s professional fees.25 The court noted that the creditors asserting § 503(b)(9) administrative-priority claims made no “ongoing contribution to the chapter 11 case,” in contrast to the other administrative claimants to be paid under the lender-approved budget who were providing goods and services to the debtors during the chapter 11 case.26 The Allen Family Foods court also concluded that the dis- parate treatment of administrative claims did not warrant denying approval of the sale and would have only been at issue if there were a pending chapter 11 plan where all administrative claims must be paid in full.27

Conclusion

The approach that Judge Sontchi adopted in Townsends and NEC Holdings appears to signify a willingness to ques- tion older decisions. This approach provides creditors with § 503(b)(9) administrative-priority claims and creditors’ committees with additional leverage and a counterweight to the leverage secured lenders have at the outset of certain chapter 11 cases. Debtors and their lenders should expect to see this argu- ment raised in quick-sale cases where administrative insolvency is a real possibility, and these rulings should also compel debtors and secured lenders to more carefully analyze the debtor’s exposure to § 503(b) (9) claims prior to the commencement of a bankruptcy case. However, as Judge Carey made clear in Allen Family Foods, it is unclear whether

ther courts are prepared to follow Judge

Sontchi’s approach. n Reprinted with permission from the ABI Journal, Vol. XXX, No. 9, November 2011. The American Bankruptcy Institute is a multi-disciplinary, nonpartisan organization devoted to bankruptcy issues. ABI has more than 13,000 members, representing all facets of the insolvency fjeld. For more information, visit ABI World at www. abiworld.org. 44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org 20 Id. 21 See Townsends, Jan. 21, 2011, Hearing Transcript (“Townsends Transcript”) at page 23:14-24 (Dkt. No. 338). 22 See NEC, July 13, 2010, Hearing Transcript, at page 100:14-20 (Dkt.

No. 224).

23 Townsends Transcript at page 25:8-11. 24 See Allen Family Foods, July 27, 2011, Hearing Transcript (“Allen Foods Transcript”) at page 44:23 (Dkt. No. 225). 25 Allen Foods Transcript at pages 44:23-25 and 45:1-4. 26 Allen Foods Transcript at page 27:10-11. 27 Allen Foods Transcript at pages 40:7-25 and 41:1-10. The Allen Family Foods court might have also been reassured by the possible existence

f unencumbered assets with suffjcient value to fully pay all § 503(b)(9)

administrative claims and the lack of any waiver of § 506(c) claims in the fjnancing order.

SLIDE 4 44 Canal Center Plaza, Suite 400 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abiworld.org