While DIP Lenders rightfully negotiate for super-priority administrative expenses which trump post conversion chapter 7 administrative expenses, these provisions are not uniformly enforced.
DIP Lenders should require the inclusion of specific language providing that section 364(c)(1) super-priority claims have priority over chapter 7 administrative expense claims, including those to be incurred by a chapter 7 trustee above the agreed upon “burial expenses.”
Lenders who provide post-petition financing (also known as debtor-in-possession financing) and who grant debtors authority to use their cash collateral, routinely require that the U.S. bankruptcy court’s approval orders grant them super-priority administrative expenses status. This includes priority over all such expenses to be incurred should the case be converted to a chapter 7 case, subject to an agreed upon carve-out for a chapter 7 trustee costs and expenses, i.e. “burial expenses.” As a provision approved by the bankruptcy court, lenders hope and assume that it will be respected when challenged by the chapter 7 trustee. But, does it? A review of the case law on the issue by the In re Packaging Systems, LLC court teaches us that the answer is maybe.1
The bankruptcy code provisions at issue, sections 364(c)(1) and 726(b), do not directly address one another. Section 364(c)(1) authorizes the court to grant the lender an administrative expense claim with priority over all administrative expenses specified in section 503(b) and 507(b) of the bankruptcy code (which include the administrative expenses of a chapter 7 trustee). Section 726(b), in turn, provides that in a case converted to chapter 7, the administrative expenses incurred post conversion have priority of those incurred pre conversion.
In the Packaging Systems case, the Debtor and Harborcove Financial, LLC were parties to a factoring and security agreement. After the Debtor filed for chapter 11, the court approved the assumption by the Debtor of its agreement with Harborcove. The order approving the assumption granted Harborcove a super-priority administrative expense claim under section 364(c)(1). Without specifically mentioning possible post conversion expenses, the order provided Harborcove with priority “over any and all administrative expenses incurred and priority claims arising in this case…” A year after entry of the order, the case was converted to chapter 7 and a chapter 7 trustee was appointed. The trustee eventually recovered funds through avoidance actions, and sought to distribute the funds recovered to post conversion chapter 7 administrative expense claimants instead of Harborcove, asserting that chapter 7 administrative expense claims take priority over Harborcove’s 364(c)(1) claim. Harborcove objected, arguing that all post conversion chapter 7 administrative expense claims are subordinated to its super-priority 364(c)(1) claim.
Surveying the case law on the subject shows a split among the courts. Some courts hold that section 364(c)(1) gets priority because it specifically addresses “all administrative expenses,” while section 726(b) fails to address section 364(c)(1). Another court reached the same result but held that section 364(c)(1) claims are not administrative expense claims but an entirely separate class of claims with priority over administrative expense claims. Other courts disagree and hold that the plain meaning of the bankruptcy code is clear, and section 726(b) provides priority for post conversion claims to pre conversion claims.
The Packaging Systems court sided with the courts that give priority to super-priority administrative expenses approved under section 364(c)(1). The court found the language of the two provisions to be clear, and held that a chapter 7 trustee must take account of the existence of pre conversion administrative expense claims in determining how to administer the case. Translation: chapter 7 trustees should not incur significant costs and expenses without first determining whether there are sufficient assets to compensate them for the work they are about to do.
But, there is twist. Recall that the assets recovered by the chapter 7 trustee resulted from avoidance actions brought by the trustee. However, the order approving the assumption of the factoring agreement carved-out avoidance actions from the collateral securing Harborcove’s claims. And without the trustee’s pursuit of avoidance actions, Harborcove would have been entitled to nothing. In the court’s view, Harborcove is entitled to a super-priority claim, but not to a windfall. Resorting to equity, the court allowed the trustee to recover costs and expenses incurred only in the pursuit of the avoidance actions.
The takeaway is that while DIP Lenders rightfully negotiate for super-priority administrative expenses which trump post conversion chapter 7 administrative expenses, these provisions are not uniformly enforced. Nonetheless, it is recommended to require the inclusion of specific language providing that section 364(c)(1) super-priority claims have priority over chapter 7 administrative expense claims, including those to be incurred by a chapter 7 trustee above the agreed upon “burial expenses.”
Finally, an issue that was unaddressed by Packaging Systems, is whether a chapter 7 trustee is bound by orders that were entered before, and have direct effect on his or her appointment. We leave this issue for another day.