Sixth Circuit Enforces a ‘Carveout’ for Professionals after Conversion to Chapter 7

The Sixth Circuit nixed a plethora of arguments advanced by secured lenders aiming to nullify a cash collateral carveout to which the lender had agreed on several occasions before conversion to chapter 7.

In his December 28 opinion, Circuit Judge Gilbert S. Merritt, Jr. explained that the appeal was an effort by the lenders “to renegotiate the terms of the cash collateral order because payment of the $2.5 million in professional fees substantially impacts what they will recover under their already-diminished-in-value prepetition liens.”

In a final cash collateral order in the chapter 11 case, the lenders agreed to a carveout allowing the use of some of their cash collateral to pay fees earned by counsel for the debtor and the official creditors’ committee. When it became clear that confirming a plan was impossible, the lenders filed a conversion motion but agreed to the selling of assets in chapter 11. They also confirmed that cash collateral budgets would be modified to ensure payment to professionals working on the sales.

After conversion to chapter 7, counsel for the debtor and the committee filed fee applications seeking payment from the $2.5 million carveout. Over the lenders’ objection, Chief Bankruptcy Judge Tracey N. Wise of Ashland, Ky., allowed the fees and directed payment from the lenders’ cash collateral. The lenders appealed to the district court and lost.

Ruling on the lenders’ second appeal to the Sixth Circuit, Judge Merritt upheld the lower courts, describing the cash collateral order as containing a typically comprehensive cash collateral carveout for professionals to remain binding in chapter 7 by its terms.

On appeal, the lenders argued that conversion to chapter 7 meant that the carveout could only be paid from post-petition, adequate-protection collateral, not from prepetition collateral. Judge Merritt said that the “plain language” of the cash collateral order allowed payment of counsel fees from prepetition collateral. Were it otherwise, he said, requiring payment only from post-petition, adequate-protection collateral “would render the carveout meaningless in the case of a chapter 7 conversion . . . .”

Ruling that the cash collateral order itself allowed payment of the fees, Judge Merritt said the lenders “may not now unilaterally renegotiate the terms of the cash collateral order to avoid paying the professionals.” Citing case law, he said that “courts routinely enforce carveout provisions in chapter 7 cases.”

Next, Judge Merritt addressed the lenders’ arguments based on Section 363(b) and (c). He interpreted the lenders as contending that the authority to use cash collateral terminated automatically when the debtor ceased operating. According to the lenders, they were entitled to “new” adequate protection before the professionals could be paid.

The lenders premised their argument on the idea that the funds carved out from the collateral became estate property on conversion, to be distributed in the order of priorities, with secured lenders coming ahead of professionals.

Judge Merritt said the “theory goes beyond anything appearing expressly or by implication in the Code.” The Code, he said, only governs distributions of estate property.

In substance, Judge Merritt said the cash collateral order was an agreement by the lenders to pay professionals from their own property, not from estate property. “Nothing in the Code,” he said, “prohibits the lenders from agreeing to use their collateral to pay the professionals.”