Dangerous Dicta for DIP Lenders The Risk of a Valid but Valueless Replacement Lien

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Jul/Aug 2002

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It is not unusual for a DIP lender to take liens in all of a debtor's assets,
including avoidance actions. A recent case decided by the U.S. Bankruptcy Court
for the Southern District of Indiana raises several questions about the ability of
the DIP lender to obtain a recovery from a security interest in debtor-in-possession
(DIP) avoidance actions.

<h3>The Facts</h3>

Mellon Bank NA, as agent for several lenders in the Qualitech Steel Corp.

bankruptcy proceeding sought to recoup some of its post-petition losses by (1)
enforcing a lien, provided by the DIP order, on Qualitech's avoidance actions and
(2) purchasing (with a credit bid) the Qualitech avoidance actions in a §363
sale. The best-case recovery on these avoidance actions was $5 million—not an
insignificant figure by itself. However, Mellon experienced a collateral burn of $30
million during the course of Qualitech's bankruptcy.

It seemed only fair, then, for Mellon to attempt to recover some of this loss
by pursuing Qualitech's avoidance actions. Fairness to one is not necessarily fairness
to another, and two avoidance action defendants challenged the bankruptcy court's
jurisdiction over Mellon's avoidance actions as well as Mellon's standing to pursue these
actions. The decision by Judge Anthony J. Metz III in In re Mellon Bank
N.A. v. Dick Corp. and In re Mellon Bank N.A. v. GE Supply Co.,
Adv. Pro. Nos. 00-296 and 00-298 (Bankr. S.D. Ind. Aug 6,
2001), may surprise you. Mellon's avoidance actions failed because, Judge Metz
ruled, the bankruptcy court lacked subject matter jurisdiction over Mellon's claim;
alternatively, Mellon lacked standing to pursue the avoidance actions.

<h3>The Decision</h3>

The bankruptcy court first analyzed whether it had jurisdiction to entertain Mellon's
avoidance actions. Sections 157(a) and 1334(b) of title 28 give district
courts jurisdiction over all civil proceedings arising under title 11, or arising in
or related to cases under title 11. Applying Seventh Circuit precedent, the
bankruptcy court found that a claim is related to a bankruptcy proceeding if it
"affects the amount of property for distribution [i.e., the debtor's estate] or the
allocation of property among creditors." (citing <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re FedPak Sys. Inc., 80
F.3d 207, 213-14 (7th Cir. 1996)</a>). However, the bankruptcy
court, again applying Seventh Circuit case law, found that related-to jurisdiction
does not continue once property leaves the estate. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Xonics Inc., 813
F.2d 127, 131 (7th Cir. 1987)</a>.

Based on these decisions, the bankruptcy court reasoned that the Qualitech avoidance
actions had already left the estate; they were sold along with substantially all of
Qualitech's assets. The avoidance actions became the stage for two creditors fighting
over non-estate property and were no longer related to Qualitech's chapter 11
proceeding. Whatever value the estate might otherwise have gained from these actions,
it had already received when the actions were pledged then sold, so the ultimate
outcome of the lawsuit could have no further conceivable impact on the administration
of the estate. Accordingly, the bankruptcy court found that subject-matter jurisdiction
lapsed.

Although the bankruptcy court need not have gone further, it continued its analysis
as though Qualitech's avoidance actions were still property of the estate, and the
bankruptcy court had subject-matter jurisdiction over the dispute. Even under these
assumptions, Mellon was left empty-handed. In the bankruptcy court's view, Mellon's
pursuit of Qualitech's avoidance actions fell prey to the constitutional requirement of
standing.

The bankruptcy court began this second analysis by ascertaining who could bring
avoidance actions. Congress ensured that a trustee had standing to bring avoidance
actions in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §§547</a> and 548, and provided the same powers to a
debtor-in-possession (<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…), 11 U.S.C. §1107(a)</a>. Federal courts broadened
the range of entities capable of bringing adversary actions by finding an implied but
qualified right for creditors' committees to bring adversary actions. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re STN
Enter. Inc., 779 F.2d 901, 904 (2d Cir. 1985)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re N.
Atlantic Millwork Corp., 155 B.R. 271, 281 (Bankr. D. Mass.
1993)</a>. More importantly for Mellon, the judiciary had crafted narrow circumstances
where a creditor could bring an adversary proceeding. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Parmetex Inc., 199
F.3d 1029, 1031 (9th Cir. 1999)</a> (creditor can bring suit where
(1) the trustee stipulated that the creditor could sue on the trustee's behalf, and
(2) the creditors have standing to bring the suit); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re P.R.T.C. Inc.,

177 F.3d 774, 781 (9th Cir. 1999)</a> (the trustee may transfer its
avoidance powers outside of a plan where (1) the creditor is pursuing interests
common to all creditors and (2) allowing the creditor to exercise those powers will
benefit the remaining creditors), and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Vogel Van & Storage Inc., 210
B.R. 27, 32 (N.D.N.Y. 1997)</a> (nothing in the Bankruptcy Code
indicates that a trustee cannot authorize a creditor to litigate an avoidance action on
the trustee's behalf). Based on this case law, the bankruptcy court found that a
creditor could bring an adversary claim. The caveat: The creditor must demonstrate that
it is pursuing interests common to all creditors.

For Mellon to proceed with Qualitech's avoidance actions, Mellon had to demonstrate
that it was pursuing interests common to all of Qualitech's creditors. The bankruptcy
court looked to two statutory sections for guidance in this determination: <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
U.S.C. §1123(b)(3)(B)</a>'s allowance of a representative of the estate to
pursue claims of the estate, and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §550</a>'s provision that the trustee
may recover for the benefit of the estate an avoided transfer under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C.
§§544, 545, 547-49, 553(b)</a> or 724(a).

Finding case law interpreting §1123(b)(3)(B) as instructive, the
bankruptcy court noted that the focus of the representative of the estate analysis was
whether the appointed representative's recovery would benefit the estate. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Sweetwater, 884 F.2d 1323, 1327 (10th Cir. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re N.
Atlantic Millwork Corp., 155 B.R. at 281</a>. The benefit need not be direct;
hence, recoveries that increased the value of unsecured creditors' equity rights, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Trans World Airlines Inc., 163 B.R. 964, 973 (Bankr. D. Del.
1994)</a>, as well as the satisfaction of administrative claims with any surplus going
to unsecured creditors, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sweetwater, 884 F.2d at 1328</a>, constituted a
benefit to the estate. The bankruptcy court also drew on the reason behind allowing
avoidance actions: That similarly situated creditors should be treated alike. Allowing
one or more similarly situated creditors to pursue avoidance actions upon which recovery
would not benefit such creditors ratably ran afoul of this basic principle.

Mellon's standing was next analyzed under §550(a) of the Bankruptcy Code, which
requires that any avoidance action recovery be for the benefit of the estate. The
bankruptcy court opined that the objective of this requirement was to ensure that
avoidance actions do not nullify just obligations of a debtor while benefiting the
debtor alone. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re P.A. Bergner & Co., 140 F.3d 1111, 1118
(7th Cir. 1998)</a>. Such recoveries should be distributed through the estate in
accordance with the priorities of the Bankruptcy Code and not afford a windfall to
the rightfully obligated debtor. Avoidance action recoveries need not provide a direct
benefit to the estate, as under <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §1123(b)(3)(B)</a>, the recovery
may indirectly benefit a debtor's unsecured creditors.

In determining whether recovery of an avoidance action will benefit the estate, the
bankruptcy court discussed In re Trans World Airlines Inc.'s holding that avoidance
actions that gained the unsecured creditors notes and shares in the reorganized debtor,
but whose recovery went to pay down a secured creditor of the debtor, provided an
indirect benefit to the estate. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…;, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 973</a>. The bankruptcy court
also drew upon the Seventh Circuit's decision in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re P.A. Bergner & Co.,

140 F.3d at 1118</a>, where pre-petition bank creditors received the debtor's
avoidance actions and 100 percent of the reorganized debtor's equity in exchange for
funding $25 million for distribution to unsecured creditors. The Seventh Circuit
found that the recovery of the avoidance actions indirectly benefited the debtor's estate
by being part of the reason the pre-petition bank creditors funded $25 million for
distribution to unsecured creditors.

The bankruptcy court found Mellon's position far different from the secured creditors
in In re Trans World Airlines Inc. and In re P.A. Bergner & Co. Here,
the unsecured creditors had not received, nor would they receive, any distribution.
There was no confirmed plan or any possibility of a reorganization. Consequently, the
unsecured creditors had no stake in the debtor's success. Finally, there was no fund
created as a result of the avoidance actions for distribution to Qualitech's unsecured
creditors. The $5 million to be recovered from Qualitech's avoidance actions fell far
short of the $30 million threshold needed to ensure a distribution to Qualitech's
unsecured creditors. As such, the avoidance actions had no benefit to the estate.

Because Mellon's avoidance actions against Qualitech's creditors failed to benefit
Qualitech's estate, the bankruptcy court found that Mellon's claims did not satisfy
§550(a).

<h3>Analysis and Practice Hints</h3>

The ultimate impact of the decision is uncertain, as Mellon has appealed the
bankruptcy court's decision to the U.S. District Court for the Southern District
of Indiana, Case Nos. IP-02-C-0040-M/S and IP-02-C-0041-M/S.
Even so, the decision should give secured lenders pause as they attempt to minimize
their exposure by seeking recovery via the debtor's avoidance actions.

A secured lender might have avoided Mellon's plight by ensuring that the debtor's
avoidance actions are not included in a sale of assets. If these actions are part
of an asset sale, the avoidance actions will pass out of the estate and therefore
out of the bankruptcy court's jurisdiction. One possible method of avoiding such a
transfer is to condition DIP financing on avoidance actions not being sold during the
course of the debtor's bankruptcy. Another tactic to ensure that a bankruptcy court
will retain subject-matter jurisdiction over avoidance actions may be to condition the
secured lender's DIP financing on receiving the right to avoidance action proceeds.

See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Tenn. Wheel & Rubber Co., 64 B.R. 721 (Bankr. M.D. Tenn.
1986)</a>. This would make the transfer of such actions unlikely.

More troubling to secured lenders is the bankruptcy court's dicta regarding the
benefit to the estate requirement found in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… U.S.C. §§550(a)</a> and
1123(b)(3)(B). At first blush, a secured creditor's best bet for overcoming
this requirement would be to create a fund for disbursement to unsecured creditors.
However, a secured lender must be wary of creating funds that are speculative, as
one court found that a disbursement funded by an unsecured, non-guaranteed note of
$125,000, payable in the future, did not provide a benefit to the estate.
<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re N. Atlantic Millwork Co., 155 B.R. at 283-84</a>.

Furthermore, it may not be feasible for the secured lender to create such a fund,
since the secured creditor will likely have taken a substantial loss on its dealings
with the debtor. A compromise may be possible by the secured lender agreeing to split
any recovery on the debtor's avoidance actions with the estate, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kroh Bros.
Dev. Co., 100 B.R. 487, 498 (Bankr. W.D. Mo. 1989)</a>, or
placing any avoidance action proceeds in a fund where any recoveries obtained in excess
of the creditor's claim are distributed to unsecured creditors. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sweetwater,

884 F.2d 1323, 1327 (10th Cir. 1989)</a>. These scenarios avoid any
further cash infusion by the secured lender while providing a benefit to the estate.
Even so, the promise of excess funds must be plausible. After all, Mellon promised
disbursement of excess funds to the estate, but there was absolutely no chance of
obtaining a recovery in excess of its indebtedness.

If a confirmed plan, either of reorganization or liquidation, is present, the
secured lender faces fewer obstacles in recovery of avoidances proceeds as the universe
of potential benefits, both direct and indirect, increases dramatically. This is due
in part to judicial willingness to equate a recovery by the debtor with the
enhancement of a creditor's equity interest in the reorganized debtor. See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Trans World Airlines Inc., 163 B.R. at 973</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re N. Atlantic Millwork
Co., 155 B.R. at 282</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Amarex Inc., 96 B.R. 330,
334-35 (W.D. Okla. 1989)</a>; see, also, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Acequia Inc., 34
F.3d 800, 811 (9th Cir. 1994)</a>. Courts have also found a benefit
to the estate where an avoidance action recovery would make reorganization more likely
or enhance the debtor's likelihood of fulfilling post-confirmation obligations. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re
Acequia Inc., 34 F.3d at 811-12</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re N. Atlantic Millwork Co.,

155 B.R. at 282</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Churchfield Mgmt. & Inv. Corp., 122 B.R.
76, 82 (Bankr. E.D. Ill. 1990)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Tenn. Wheel & Rubber
Co., 64 B.R. at 725</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Kennedy Inn Assoc., 221 B.R. 704,
715 (Bankr. S.D.N.Y. 1998)</a>; but, see <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. First Am. Bank,

39 F.3d 898, 905 (8th Cir. 1994)</a>.

Mellon's position reflects the most difficult scenario for a secured lender to provide
a benefit to the estate—a liquidating debtor without a plan or hope for distribution.
Short of creating a fund for unsecured creditors, what can a secured lender do to
provide a benefit to a debtor's unsecured creditors? Provided that a debtor's assets
do not fall far short of its secured indebtedness, or alternatively that recovery from
the debtor's avoidance actions may potentially satisfy the debtor's secured obligations,
a court may find a benefit to the estate where a recovery on avoidance actions, to
be split 50/50 between the creditor and the estate, is the sole potential source
of distribution for unsecured creditors. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re P.R.T.C. Inc., 177 B.R.
at 783</a>. A secured creditor may also attempt to use the debtor's precarious
financial situation to its benefit, as one court found, in dicta, a benefit to the
estate where a creditor waived substantial (and unsecured) claims against the estate
and thereby saved a limited-resource estate the expense of defending such claims. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
re Maxwell Newspapers Inc., 189 B.R. 282, 287-88 (Bankr.
S.D.N.Y. 1995)</a>.

<h3>Conclusion</h3>

Avoidance actions and the proceeds thereof are an attractive asset of the debtor.
However, a secured lender must take care that this beauty is not merely skin deep.
Without a benefit to the estate, a secured lender's acquisition of these rights may
not add any additional collateral for the secured lender and only provide headaches for
its counsel.

Journal Authors

Jeffrey J. Graham

Jerald I. Ancel

Marlene Reich

Journal Date

Monday, July 1, 2002 - 12:00

Bankruptcy Rule

2002