Publications: Chapter 11 process provides mixed results

In this economic downturn, Chapter 11 has been used frequently to effectuate goingconcern sales of the debtor under Section 363 of the Bankruptcy Code. There are often intense negotiations among the constituencies over debtor‐in‐possession (DIP) financing terms and the outcome frequently forces a debtor to cede effective control of the case to the existing lenders early on.

Relative bargaining positions in such negotiations are shaped by the debtorʹs prepetition preparation and the likelihood that the debtor might obtain DIP financing on a priming basis over prepetition liens. To secure such financing, debtors must, among other things, provide prepetition lienholders ʺadequate protectionʺ for their lien rights. When a debtor desires to fund operations until completing a going‐concern sale in a Chapter 11, obtaining such priming financing can be critical.

Adequate protection may be provided, for example, by granting liens on unencumbered assets, by adequate protection payments or by demonstrating that an equity cushion exists. Debtors have the burden of proof on adequate protection and therefore need to be prepared for litigation if their existing lenders object.

Debtors want to obtain financing on a consensual basis, although being prepared to put third‐party priming financing in place should increase the likelihood that existing lenders will provide it consensually. When the existing lender has a reasonable equity cushion, the prepetition lender is often motivated to cooperate with the debtor in exchange for a profitable DIP financing and added protections.

In contrast, when those lenders are undersecured, they often are less motivated to provide or consent to further financing, unless they view the financings as contributing to an increased recovery on their prepetition loans. In those cases, lenders are often not inclined to support a debtorʹs budget, since they often believe increased recoveries can be realized by heavy expense reductions notwithstanding the cost to complete an asset sale or plan of reorganization. Accordingly, debtors should be prepared to litigate over the initial valuation, expected sale results and their proposed budget to demonstrate the prepetition lenders are adequately protected.

Based on cases like In re Swedeland Dev. Group, Inc., 16 F3rd 552 (3d Cir. 1994), many practitioners felt that nonconsensual priming of undersecured, prepetition lenders would be rare because allowing a priming lien would seem to automatically reduce the value of the prepetition lenderʹs collateral. If all assets are already encumbered, it was thought that providing adequate protection to a prepetition lender would generally be impossible.

However, a growing number of cases demonstrate some instances where the Chapter 11 process itself will provide the needed enhanced value to provide adequate protection. See, e.g., In re Yellowstone Mountain Club, LLC, No. 08‐61570, 2008 WL 5875547 (Bankr. D. Mont. Dec. 17, 2008) (undersecured creditor objected to a $20 million DIP financing to operate a private ski resort and the court found the prepetition lender was adequately protected because without the financing the resort would not operate). Thus, when existing lenders refuse to provide needed financing, some debtors may obtain a nonconsensual priming lien by showing that the sale process will increase the value above the initial value of the undersecured creditorʹs collateral. For example, if a debtor was operating a viable business prior to filing, but would be forced to immediately liquidate if it could not obtain the funding, a court might find that the avoidance of the loss of going‐concern value was sufficient to support the priming financing because the value realized at the 363 sale would exceed the value of the business if liquidated for lack of funding.

Although other fact patterns may support nonconsensual priming liens (e.g., if the debtor needs funding to complete a project that has modest liquidation value on petition date, but which can reasonably be expected to be completed and sold for a materially greater value for the estate) some of the clearest cases arise in the context of 363 sale efforts on facts like these when the debtor has enough time and resources to prepare for and endure a contested hearing. The debtorʹs case would always be easier to prove if the debtor has a stalking horse buyer (since the bid helps quantify the difference between the liquidation value without any financing and the results of conducting the sale under 363), but with adequate showings the mere proposal to use the proceeding to conduct a 363 sale should be sufficient if there is reasonable evidence of expected sale values and if the costs of the proceeding are likely to be less than the loss that is to be avoided by moving promptly to a 363 sale where a goingconcern values can be realized. While expected sales results must be shown, the initial important showing is the valuation of the prepetition lenderʹs collateral at the time of the filing. That valuation should be made on the basis of the creditorʹs interest in the estateʹs property, which means the value it can realize from the sale of the collateral. (A special note of caution for lenders who are considering whether to go to trial on these issues: a finding of low value at an early stage in the proceeding may adversely impact them on the determination of the amount of the secured portion of their total claim.)

As a result of the development of this line of cases, debtors considering sales under Section 363 with appropriate fact patterns need to prepare in advance of filing their bankruptcy cases to be in a position to prove that their planned process will sufficiently enhance value to qualify as adequate protection. To do so will require prepetition use of already scarce resources and the debtor will need to be comfortable he or she can get the bankruptcy court to provide a hearing date early in the case and then to identify and prepare effective witnesses to testify as to valuation and the needs and rationale for the use of the funds requested in the debtorʹs budget.