How Far Is Too Far Curbing Abuses in 1st-day Motion Practice

How Far Is Too Far Curbing Abuses in 1st-day Motion Practice

Journal Issue: 
Column Name: 
Journal Article: 
Most chapter 11 practitioners can rattle off a long list of "first-day" motions that a debtor may file at the outset of the case. Many types of first-day relief are viewed as customary and routine, even where the legal basis for such relief is far from clear. Recently, however, the Seventh Circuit Court of Appeals cast doubt on the ability of debtors to obtain certain types of first-day relief.1 Faced with increasingly aggressive requests by debtors—often at the behest of secured creditors who seek a stranglehold on chapter 11 cases right out of the gate—unsecured creditors can look to another recent decision, In re The Colad Group Inc., 324 B.R. 208 (Bankr. W.D.N.Y. 2005), as a way to level the playing field. Colad Group serves as a primer on first-day motion practice and contains a thoughtful discussion about the extent to which courts can and should grant extraordinary relief in the early days of a case.

In re Colad Group

In Colad Group, the debtor filed the typical bevy of first-day motions, including a motion for authority to enter into a DIP financing agreement, and sought to have them heard on extremely short notice. The proposed financing agreement provided for a roll-up of the lender's pre-petition claim, the creation of priming liens and superpriority claims for the post-petition claim, broad waivers of the debtor's rights against the lender (including surcharge and avoidance actions) and "drop dead" relief from the automatic stay in the event that the court confirmed a plan that was not acceptable to the lender.2 Moreover, the agreement called for the payment of interest at 4.5 percent over prime and substantial fees to the lender.3

The bankruptcy court approved limited aspects of the financing on an interim basis in order to provide the debtor with the needed access to capital.4 However, the court identified several defects in the financing agreement and refused to approve it on a final basis despite the support of the unsecured creditors committee. First, the court found that the fees to be charged in connection with the short-term borrowing were the equivalent of an interest rate in excess of 100 percent and concluded that the terms of the borrowing violated New York's criminal usury statute, and that the fees were designed to chill the bidding for the debtor's assets given the lender's stated intention to credit bid its secured claims at an auction.5 The court also rejected the lender's attempt to insulate itself from the equitable doctrine of marshaling. According to the court, this was an impermissible attempt to modify the rights of third parties "who have not consented and may not even have received notice of the debtor's motion."6

The Colad Group court also took aim at provisions that some chapter 11 practitioners might view as standard fare for a DIP lending agreement. For example, the court would not sanction a waiver of the right to seek to surcharge the lender under 11 U.S.C. §506(c).7 The court also refused to approve a "drop-dead" mechanism for granting relief from stay to the lender, at least with respect to parties that did not consent to that procedure (including a subsequently appointed trustee).8 Lastly, the court could not find authority in the Bankruptcy Code for limiting the time period in which avoidance actions could be asserted against the lender.9

Some Guideposts Along the Way

In Colad Group, the court spelled out four guiding principles as a prism through which to view its rulings on the various first-day motions filed by the debtor. First, the relief should be narrowly tailored to preserving the operation of the debtor's business through the transition into chapter 11.10 The justification for first-day practice is that the estate benefits from avoiding disruption in the conduct of the debtor's business and the attendant loss of value that could result. To the extent that normal operations are permitted by the Bankruptcy Code, first-day orders should be crafted to achieve those normalized operations, not for impermissible purposes such as determining the debtor's fate.

Second, first-day orders should be simple and comprehensible.11 In most cases, it is a safe bet that the debtor, its professionals and maybe others (like the bank's professionals) begin preparing first-day pleadings and the proposed orders well in advance of the filing of the case. Courts and creditors cannot reasonably be expected to read through volumes of papers and digest tremendous amounts of information overnight, and asking them to do that increases the risk of unintended or unjustified results. For example, in Colad Group, the proposed interim DIP financing order—which the debtor sought to have entered on less than three business days notice—was 26 pages long, and incorporated a 93-page loan agreement. Courts should decline to enter unnecessarily complicated or lengthy first-day orders, particularly where creditors have not had a reasonable opportunity to review them.

Third, first-day orders should not modify the procedural and substantive rights created by the Code.12 Finally, a first-day order should not alter a party's nonbankruptcy, substantive rights unless such alteration is expressly authorized by the Code.13 These two principles go hand in hand and, examined out of context, they are hardly controversial. However, in the context of first-day practice, these principles are often ignored outright, or honored only in the breach, in the interests of expediency, promoting a successful organization or both.

Colad Group is not the first case where a court has curbed overreaching by a secured creditor. For example, in In re Tenney Village Co. Inc., the court refused to approve the debtor's request for authority to enter into a financing arrangement with one of its pre-bankruptcy lenders.14 The proposed loan agreement effectively provided the lender with control over the operation of the debtor's business, gave the lender relief from the automatic stay on a "drop-dead" basis in the event that a plan was confirmed over the lender's objection, and contained a waiver of all claims and defenses against the lender. The cumulative effect of these, and other provisions, was to "disarm the debtor of all weapons usable against [the lender] for the bankruptcy estate's benefit, place the debtor in bondage working for [the lender], seize control of the reins of the reorganization and steal a march on other creditors in numerous ways."15 The court concluded that the execution of the loan agreement violated the debtor's fiduciary duties to the estate, as the agreement effectively transferred control of the case and the economic value of the debtor's business and assets to one creditor, the lender.16 The court also refused to approve the bank's attempt at securing its pre-petition claims with post-petition liens and to elevate those pre-petition claims to a superpriority status under §364. As a final parting shot at the bank, the court left open the question of whether the DIP loans made by the bank on an interim basis "should be subordinated due to the bank's over-reaching."17

While the result in Tenney Village has been criticized, the case is frequently cited for the proposition that courts should not approve DIP financing agreements that are intended to, or have the effect of, perverting the chapter 11 process from a collective one to one for the exclusive benefit of the lender.18

DIP Financing: Where the Road Gets Rough

Many chapter 11 debtors need additional financing to operate their businesses after a case is filed, and a motion seeking approval of post-petition financing is often one of the most important "first-day motions." Courts have struggled to balance debtors' need for and ability to obtain financing with the fundamental premise that bankruptcy is a collective proceeding designed for the benefit of all creditors.

In In re Ames Dept. Stores Inc., the debtors sought approval of a $250 million post-petition credit facility at the outset of their chapter 11 cases.19 Although the creditors' committee approved the financing (on modified terms), the court took an opportunity to identify certain features of a post-petition financing arrangement that would not pass muster.20 In particular, the court expressed unwillingness to approve features of DIP financing arrangements that would "skew the carefully designed balance of debtor and creditor protections that Congress drew in crafting chapter 11."21 For example, the court stated its disdain for, and unwillingness to approve, default provisions triggered by a debtor's loss of exclusivity, or the appointment of a trustee or examiner.22 The court also identified a failure to provide a reasonable carve-out for estate professionals as a fatal defect, as such a failure would leave the estate and creditors unarmed and unable to protect their rights in the "adversary system contemplated by Congress in 1978 when it...recast the role of bankruptcy judges principally to one of resolving disputes."23 Provisions like these, in the court's view, gave the secured creditor an unfair amount of control over the case and provided disincentives for unsecured creditors to exercise rights granted to them by the Code.

The court also indicated its unwillingness to approve a financing where the purpose was to "benefit a creditor rather than the estate."24 Viewed in isolation, this admonition makes little sense; every DIP lender perceives a benefit to itself from an extension of credit to a debtor. Otherwise, the credit would not be made available. Ames makes it clear that a financing arrangement should not be approved where the benefits to the lender so far outweigh the benefits to the estate in general that the bankruptcy process is leveraged in favor of the lender.

While the lender in Tenney Village may have crossed the line, the lenders did not cross the line in Official Committee of New World Pasta Co. v. New World Pasta Co. (In re New World Pasta Co.).25 In that case, the unsecured creditors' committee challenged a term in the DIP loan agreement that prohibited the debtors from proposing a plan that was not previously approved by the lenders.26 On appeal, the district court upheld the bankruptcy court's approval of the challenged provision. The court began by rejecting the committee's characterization of the provision as a "lock-up." Whereas a "lock-up" agreement involves an agreement that a creditor will vote for a plan, the challenged provision simply made the debtor's filing of a plan that was not approved by the lender a default under the loan agreement. The court distinguished cases where creditors had signed agreements binding them to vote for a particular plan.27

The court also rejected the argument that the provision violated §§1129(b) and 1126 of the Code.28 As to §1129(b), the court noted that the debtors were not precluded from attempting to cram a plan down over the lenders' objection (which the court, citing In re Tenney Village, suggested would have been impermissible).29 Instead, the debtors could not run their business with the lenders' cash collateral, or with the proceeds of the DIP facility, if the plan was not acceptable to the lenders. In other words, the debtors retained the option to find alternative sources of working capital and to wage a contested confirmation battle with the lenders. The court similarly rejected the committee's argument that the provision gave the lenders the right to vote on a plan even if the lenders were not impaired and therefore not entitled to vote under §1126(f).30 The provision did not implicate right or ability of the secured lenders to vote on the plan and therefore did not
violate §1126(f).

A recent case from the Northern District of New York illustrates how a court will examine the particular provisions of a proposed financing, and how approval is not an "all or nothing" proposition.31 In Mid-State Raceway, the debtors sought approval, under §364, of three loans. Each of the loans was proposed in connection with an offer to acquire a controlling position in the debtors under a confirmed plan. The proceeds of the first loan would have been used for immediate working capital, including payroll and other operating expenses. The other loans were contingent on the passage of certain legislation affecting the debtors' business, and the lender had the right convert the loans to equity in the reorganized debtors under the contemplated plan. As part of the financing, the lender had the right to appoint a CEO, subject to the approval of the court and a regulatory agency with jurisdiction over the debtors' business, to appoint additional members of the debtors' boards, and to control the day-to-day management of the debtors' business.

The court approved certain aspects of the financing over the objection of the debtors' primary secured creditor. In particular, the court viewed the management rights sought by the lender as "a reasonable quid pro quo, giving [the lender] some measure of control over his investment by getting involved in the management of the debtors."32 The court declined to approve the other portions of the financing as it considered them "beyond the scope of §364 and, therefore, void."33 Although the court did rely on the cases prohibiting sub rosa plans, there was a clear concern that §364 should not be used to circumvent the plan-confirmation process and to deny creditors all of the rights that attend that process.

Conclusion

Courts will continue to struggle to determine how far is too far in terms of first-day relief, particularly in relation to post-petition financing. Giving too much latitude to debtors and secured creditors could tilt the Code's careful balancing of rights; giving them too little latitude could frustrate the rehabilitative purposes of chapter 11 and could lead to more liquidations and lower recoveries for creditors. Although Colad Group does not identify the line with precision, it does provide a useful guide on the sometimes bumpy road to first-day relief.


Footnotes

1 See In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004) (affirming district court's reversal of first-day order authorizing critical-vendor payments); In re UAL Corp., 412 F.3d 775 (7th Cir. 2005) (reversing bankruptcy court's order enjoining claims trading to preserve net operating loss carryforwards). Return to article

2 See 324 B.R. at 217-25. "Roll-up" refers to the practice of paying pre-petition claims with the proceeds of post-petition financing, thereby transmogrifying a pre-petition claim into a post-petition claim. "Cross-collateralization," another common technique of DIP lenders, refers to the practice of securing pre-petition claims with post-petition liens (including liens that reach beyond the extent permitted by 11 U.S.C. §552). See Official Committee of Unsecured Creditors v. New World Pasta Co. (In re New World Pasta Co.), 322 B.R. 560, 569 n.4 (Bankr. M.D. Pa. 2005). The "roll-up" technique helps avoid the legal deficiencies that some courts have identified with respect to cross-collateralization. See In re Saybrook Mfg. Co. Inc., 963 F.2d 1490 (11th Cir. 1992). Return to article

3 See 324 B.R. at 220. Return to article

4 See 324 B.R. at 219-20. Return to article

5 See Id. at 220-23. Return to article

6 See Id. at 224. Return to article

7 See Id. at 224. In light of the uncertainty regarding the ability of individual creditors to invoke the rights granted by §506(c) (see Hartford Underwriters Ins. Co. v. Union Planters Bank, 530 U.S. 1, 11 n.5, 120 S.Ct. 1942, 1950 n. 5, 174 L.Ed.2d 1 (2000)), a debtor's grant of a § 506(c) waiver may be particularly burdensome for unsecured creditors. Return to article

8 See 324 B.R. at 224. Return to article

9 See Id. at 225 ("However, §546(a) is a statute, not a rule. Consequently, this court lacks authority to approve the shorter time limits that [the lender] would impose"). Return to article

10 See 324 B.R. at 213. Return to article

11 See Id. Return to article

12 See Id. at 213-14. Return to article

13 See Id. at 214. Return to article

14 104 B.R. 562 (Bankr. D. N.H. 1989). Return to article

15 Id. at 568. Return to article

16 See Id. at 569. Return to article

17 See Id. at 571. Return to article

18 See, e.g., In re Defender Drug Stores Inc., 145 B.R. 312 (9th Cir. BAP 1992); In re Plabell Rubber Prods. Inc., 137 B.R. 897 (Bankr. N.D. Ohio 1992). Return to article

19 See 115 B.R. 34, 35-36 (Bankr. S.D.N.Y. 1990). Return to article

20 Many of the statements in Ames are dicta in light of the modifications to the financing agreement made by the lender and the debtors. See 115 B.R. at 41. Nonetheless, the court's opinion is useful in sketching out the boundaries of what is acceptable and what is unacceptable in terms of a post-petition financing. Return to article

21 See 115 B.R. at 38. Return to article

22 See Id. Return to article

23 115 B.R. at 40. Return to article

24 115 B.R. at 39. Return to article

25 322 B.R. 560 (Bankr. M.D. Pa. 2005). Return to article

26 322 B.R. at 565. The loan agreement also limited the use of loan proceeds to investigate the validity of claims against lenders, and precluded the use of any of the loan proceeds, or the lenders' collateral, to prosecute claims against the lenders. The court declined to address this issue on appeal, as the committee's request for leave to assert the estate's causes of action against the lenders had not been decided, and therefore the issue was not ripe for determination. See 322 B.R. at 566. Return to article

27 See 322 B.R. at 568 (distinguishing In re Stations Holding Co., 2004 WL 1857116 (Bankr. D. Del. 2004), and In re NII Holdings Inc., 288 B.R. 356 (Bankr. D. Del. 2002)). Return to article

28 The committee also argued that the debtors had, in effect, transferred their exclusivity rights under §1121 to the lenders. The court declined to reach that issue, however, because the debtors' exclusivity period had expired. See 322 B.R. at 569. Return to article

29 See 322 B.R. at 570 (noting that the challenged provision "does not preclude the debtors from cramming down the senior secured pre-petition lenders...and consequently does not violate §1129(b) of the Code"). Return to article

30 Section 1126(f) provides that a class of unimpaired claims or interest is conclusively presumed to have accepted a plan and that there is no requirement of soliciting votes from the holders of claims or interest in that class. See 11 U.S.C. §1126(f). Return to article

31 See In re Mid-State Raceway Inc., 323 B.R. 40 (Bankr. N.D.N.Y. 2005). Return to article

32 See 323 B.R. at 62 (citing In re Western Pac. Airlines Inc., 223 B.R. 567, 574 (Bankr. D. Colo. 1997)). Return to article

33 See Id. Return to article

Journal Date: 
Tuesday, November 1, 2005