In a decision issued on December 28, 2018, the Sixth Circuit Court of Appeals affirmed the Bankruptcy Court and the District Court, awarding chapter 11 debtor and creditors’ committee professionals their attorneys’ fees based upon a “carve-out” provision in the cash collateral order and ahead of the secured creditors, despite conversion of the case to chapter 7. East Coast Miner LLC v. Nixon Peabody LLP (In re Licking River Mining, LLC), Case No. 17-6310, 2018 US. App. LEXIS 36677 (6th Cir. 2018). It is likely that most chapter 11 professionals always believed that if their fees were within the carve-out amounts, they were protected in these circumstances. But, the decision serves as a good reminder to make sure that the terms of the carve-out, and related provisions in the cash collateral order, are very clear and that the order provides that the carve-out remains in place notwithstanding a subsequent conversion of the case. It is also a reassuring decision for professionals: the Court emphasized the propriety of ensuring payment to professionals even in administratively insolvent cases. 

The Licking River Mining case was originally filed as a chapter 11 so as to allow the Debtor to restructure. Certain lenders (the “Lenders”) held liens on the Debtor’s assets, including its cash. Accordingly, under section 363(c)(2) of the Bankruptcy Code, the Debtor could not use its cash without either consent of the Lenders or a court order. The Lenders consented to the use of cash collateral, and as part of the negotiations, the Final Cash Collateral Order (the “Order”) included a grant of superpriority claims and adequate protection liens for the Lenders, as well as permission to use cash collateral, which was broadly defined in the Order. 

The Court noted that attorneys and other professionals hired to assist in reorganizations usually require that any cash collateral agreement “include a provision called a ‘carve-out’ whereby the secured creditors ‘carve-out’ sums from cash collateral to ensure payment of certain fees and expenses.” Opinion, p. 3. The effect of these provisions is to “limit[] the risk to the hired professionals by giving them priority to payment from cash collateral in the event of insolvency.” Id. The Order in this case included such a provision.  

It was ultimately determined that the Debtor could not restructure, and the Lenders moved to terminate the use of cash collateral. The Bankruptcy Court then ordered amounts to be budgeted for professional fees for the professionals to complete the asset sales. While administrative insolvency was a concern, the Lenders affirmed to the Bankruptcy Court that the asset sales should be concluded prior to conversion to chapter 7. In so doing, Lenders’ counsel confirmed that the cash collateral budgets would be modified to ensure that professionals would be paid for their work on the asset sales. Id. 

Once the case was converted to chapter 7, the professionals filed their fee applications for approximately $2.5 million, and requested payment pursuant to the carve-out. The Lenders objected, arguing that the carve-out did not extend to their prepetition liens and cash collateral and instead, the sums for the carve-out could come only from postpetition liens since the case converted. The Bankruptcy Court overruled the objections, finding that both the Order and the record in the case made it plain that the carveout extended to Lenders’ prepetition liens and that the professionals could be paid from cash collateral, and the District Court affirmed. 

The Sixth Circuit began its analysis by first noting that the issue presented was a mixed question, so that the Bankruptcy Court’s interpretation of the Order should be given deference, and to the extent that the appeal involves review of the entire contract among the parties to the agreed Order, including statutory construction of provisions as applied, the review would be de novo. On the merits, the Court noted that the “crux of the Lenders’ argument is that they never intended for funds allocated to the CarveOut to come from their prepetition liens.” Id., p. 5. The Court continued:

The Lenders want to renegotiate the terms of the cash collateral order because payment of $2.5 million in professional fees substantially impacts what they will recover under their already-diminished-in-value prepetition liens. But the record is clear that they agree to hire the professionals, and they agreed for those professionals to keep working after the company became insolvent, presumably to benefit from the professionals’ work in selling the assets of the company. They may not now unilaterally renegotiate the terms of the cash collateral order to avoid paying the professionals. The reasoning of the Lenders is not supported by the terms of the cash collateral order, the Lenders’ conduct during the proceeding, or the case law. For the reasons below, their arguments are not well taken and are rejected.  

Id. Reviewing the Order, the Court focused first on the paragraph containing the carve-out, noting that it expressly said that it means professional fees “to the extent allowed at any time … “ Id. (emphasis in original). Further, nothing in the Order prevented the use of post-conversion cash to pay the professionals “and indeed, as the bankruptcy court pointed out, to fail to include the sums collected from the sale of assets in making payments under the Carve-Out would render the Carve-Out meaningless in the case of a Chapter 7 conversion where the value of the prepetition collateral has been diminished.” Id. at p. 6. Further, the Order specifically stated that the Lenders’ “claims, liens, rights, and benefits” were subject to the carve-out, which necessarily included its prepetition liens. 

Nonetheless, the Lenders argued that the carve-out simply defined payment obligations but did not provide how to fund those payments. The Court noted that this was an attempt to modify the sources they agreed would fund the carve-out in the event of conversion. Rejecting the argument, the Court recognized that “[a] carve-out provision is necessary and generally included in the parties’ negotiations to provide assurance to hired bankruptcy professionals that they will be paid if the debtor liquidates after they have incurred fees and expenses.” Id. at p. 7 (internal citation omitted). In effect, the carve-out gives a higherpriority security interest to the professionals over the secured creditors, which is also supported by the high priority given to such expenses in the Code. Id., citing 11 U.S.C. § 1129(a)(9). Without such protections, a secured creditor with a blanket lien could prevent professionals who assisted in the case from being paid. Id. Moreover, courts routinely enforce carve-out provisions in chapter 7 cases. Id. (internal citations omitted). 

The Court also noted that reviewing the Order as a whole supported enforcing the carve-out. First, the definition of “cash collateral” in the order included prepetition collateral. Second, the Order provided that the terms would survive conversion from Chapter 11 to Chapter 7. In addition, the Lenders’ conduct during the case included statements acknowledging the carve-out. 

Finally, the Court also addressed the Lenders’ argument that section 363 of the Code prohibited reallocation of priorities in Chapter 7, even though it appeared that the Lenders had abandoned that argument at oral arguments. The Court concluded that there are no provisions in section 363 or elsewhere to the effect that consent to use of cash collateral is automatically revoked upon conversion to chapter 7. It cited with approval the Bankruptcy Court’s finding that the interpret the carve-out any other way would “yield[] an illusory and absurd result.” Id. at p. 10. “As the bankruptcy court observed, under this reading ‘how could there ever be a recovery for professionals from a carve-out?’ The answer is, as the court noted, never – because the postpetition liens cannot have value if the superior prepetition liens have diminished in value. We affirm the decision of the bankruptcy court.” Id.  

Takeaway- Care should be taken to craft carve-out language that (i) covers all collateral, including prepetition, postpetition and post-conversion, (ii) subordinates the secured creditors’ liens to the professional fees awarded at any time, (iii) survive conversion of the case to chapter 7. And, if a case appears to be headed towards administrative insolvency and/or conversion, carve-out issues should be reiterated and addressed.