Advanced Distressed Debt Concepts: Contesting Priming Liens in DIP Financing

Each month, we hope to feature a number of posts from some of our guest writers that we discussed about in the beginning of the year.  Last month I introduced readers to George Mesires, partner in the Finance and Restructuring Practice at Ungaretti & Harris LLP, who will be contributing articles focused on bankruptcy concepts for the blog.  Enjoy!

Contesting Priming Liens in DIP Financing
Within any chapter 11 business bankruptcy, a secured creditor runs the risk of having its interest primed in favor of a lender who provides the debtor additional operating capital during the pendency of the bankruptcy proceedings through debtor-in-possession (“DIP”) financing under § 364 of the Bankruptcy Code.  Such risk is not easy to quantify, is highly fact-specific, and may depend on, among other things, whether the creditor sought to be primed is oversecured or undersecured.  A recent case in the Bankruptcy Court for the Northern District of Illinois is illustrative of the circumstances under which a priming lien will be granted, and provides insight into the Court’s analysis for those secured lenders who would like a deeper understanding of this issue.  The case is notable for the detail the Court provides in its analysis of when a priming lien under § 364(d) is appropriate.  Fullsome court decisions have been few and far between in recent years as most DIP financing arrangements are consensual.

In In re Olde Prairie Block Owner, LLC, 448 B.R. 482 (Bankr. N.D. Ill. 2011), the Debtor owned “two parcels of choice real estate” located adjacent to McCormick Place in Chicago (one of North America’s leading convention centers), where the Debtor intended to develop a hotel complex to serve those visiting McCormick Place.  At an evidentiary hearing on the prepetition secured creditor’s lift stay motion, the Court found the value of the Debtor’s property to be approximately $81 million, based on evidence offered by the Debtor’s expert witness.  Because the prepetition lender was unwilling to advance any additional funds, the Debtor sought DIP financing that included a priming lien over the prepetition lender’s $48 million mortgage on the parcel.  Thus, the prepetition secured lender was oversecured by over $30 million.

Judge Schmetterer issued a thoughtful decision that set forth the analytical framework for considering priming DIP loans.  A debtor can obtain credit secured by a senior or equal lien on encumbered estate property with court approval and after notice and a hearing only if: (1) the debtor is unable to obtain credit otherwise and (2) the interest of the creditor to be primed is adequately protected.  11 U.S.C. § 364(d).  Generally, “adequate protection” requires that a secured lender receive compensation or something of value during the pendency of the bankruptcy case to protect it against the diminution or erosion in value through depreciation, dissipation, or any other cause, including the dollar value of the priming DIP loan.  Adequate protection can take many forms, including, but not limited to, periodic cash payments, postpetition security interests (replacement liens), liens in unencumbered property, or an “equity cushion” (the amount by which the secured lender is oversecured).

Under § 364 of the Bankruptcy Code, there is no requirement that the debtor explain or justify its proposed use of funds.  However, as the Court explained, if the Debtor’s borrowing request was granted, the funds would become property of the bankruptcy estate and therefore subject to the usage limitations set forth in § 363 of the Bankruptcy Code.  Under § 363, a debtor may use or sell estate property outside the ordinary course of business only after notice and a hearing, and after the debtor demonstrates an “articulated business justification” for the use of the funds.

In Olde Prairie, the Debtor demonstrated that it was not able to obtain credit under less onerous terms than those offered by the DIP lender.  Next, the Debtor was able to demonstrate that the existing senior lender’s interest was adequately protected by virtue of the large equity cushion (approximately 38% of value) to protect the senior lender from any potential diminution in value during the pendency of the case.  However, the Court noted that a large equity cushion is not a “debtor's piggy bank and the uses contemplated for the new loan must have serious likelihood of benefitting the property and advancing the purposes of reorganization. A priming lien without such a showing would impose an unwarranted burden on the secured creditor if reorganization fails.”  The Court further noted that because the valuation was based on expert opinion, which is not a substitute for testing the market to obtain actual sales or funding, “allowing a priming lien should be considered with caution to avoid transferring the entrepreneurial risk of failure by Debtor's investors and principals onto the secured creditor…Given the inherent uncertainty of determining valuation through methods commonly used by experts in appraising real estate, some restraint in allowing priming liens to fund particular expenses is warranted.”

The Court found that most of the expenses the Debtor sought to fund with the DIP loan would likely advance the value of the bankruptcy estate and further the Debtor’s reorganization. The Debtor anticipated using the funds to lobby for certain tax benefits, which would increase the overall value of the parcel and encourage outside investment.  The Debtor was also using the funds to further its hotel development plans.  The Court thus found that the Debtor had shown under § 363 that it had articulated a “serious . . . business justification for most of the proposed uses of the requested loan, regardless of whether they are inside or outside the ordinary course of business, and that those uses are in the best interest of the estate.”

The outcome might have been different in the Olde Prairie case had the prepetition secured lender been undersecured (that is, if the value of the collateral was less than the secured lender’s claim). Indeed, there is ample authority that holds that an undersecured creditor cannot be primed when the value of the prepetition secured lender’s collateral will decrease during the bankruptcy case and the debtor cannot provide any adequate protection for such decrease.  See, e.g., In re Swedeland Dev. Group, Inc., 16 F.3d 552 (3d Cir. 1994) (denying DIP financing on priming basis where debtor sought postpetition financing to fund construction of residential units on a partially finished real estate development, the prospects of which were inherently risky); In re Fontainebleau Las Vegas Holdings, LLC, 434 B.R. 716 (Bankr. S.D. Fla. 2010)(denying postpetition priming loan where debtors sought postpetition financing to complete development of a hotel and casino that was only 70% complete and was not operating or generating any cash); In re YL West 87th Holdings LLC, 423 B.R. 421 (Bankr. S.D.N.Y. 2010 )(denying postpetition financing where debtor owned an unfinished real estate development project and its prospects for success were highly speculative).

In addition, an undersecured prepetition lender who holds a blanket lien on a debtor’s assets typically argues that it cannot be adequately protected for the diminution in value of its collateral caused by the priming loan because the debtor has no unencumbered assets to pledge as security for such decrease in value during the pendency of the bankruptcy case.  See e.g., In re Swedeland, 16 F.3d 552, 567 (3d Cir 1994)(“[t]he law does not support the proposition that a creditor ... undersecured by many millions of dollars, may be adequately protected when a superpriority lien is created without provision of additional collateral by the debtor.”).

After considering these cases, can a secured lender draw a bright line and conclude that a debtor can prime an oversecured lender but not prime an undersecured lender?  Not exactly; for there are circumstances where a debtor may provide an undersecured prepetition lender with adequate protection by preserving and maximizing the value of its collateral during the bankruptcy case.  See e.g., In re Hubbard Power & Light, 202 B.R. 680 (Bankr. E.D.N.Y. 1996)(holding that the secured creditor was adequately protected where a first priority priming lien “would enable the [d]ebtor to commence operating and as an operating business, all of the [d]ebtor’s assets would increase in value [and] [a]lthough it [was] not clear what that value would be, it certainly would be of a greater value than the value of the [d]ebtor’s property in its [non-operational] state”); see also In re 495 Cent. Park Ave. Corp., 136 B.R. 626 (Bankr S.D.N.Y. 1992) (holding that a prepetition secured creditor was adequately protected because “the value of the debtor’s property [would] increase as a result of the renovations funded by the proposed financing”)(“Although appraisers for both sides disagree as to what the value of the building would be following the infusion of approximately $600,000.00, there is no question that the property would be improved by the proposed renovations and that an increase will result.  In effect, a substitution occurs in that the money spent for improvements will be transferred into value.  This value will serve as adequate protection for Hancock’s secured claim.”); In re Yellowstone Mountain Club, LLC., No. 08-61570, 2008 WL 5875547 (Bankr. D. Mont. Dec. 17, 2008)(holding that secured creditors were adequately protected because, among other things, without the proposed financing, the debtor’s business would “go dark” to the detriment of all creditors and the DIP financing would, therefore, “preserve the value of their collateral and in fact enhance it in an amount that exceeds the amount of the DIP Loan by multiples.”).  Thus, in situations where a secured lender is undersecured, it may still be primed if the debtor can demonstrate that the value of the secured lender’s collateral will be preserved or enhanced through the DIP financing.

Because DIP financing is often the lifeblood of a debtor during a chapter 11 bankruptcy case, participants are well-advised to be familiar with the circumstances when a priming lien may be granted and when it may not.

George is a monthly contributor to the Distressed Debt Investing blog and practices restructuring and bankruptcy law at Ungaretti & Harris LLP.  George can be reached at grmesires [at] uhlaw.com.


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About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.