In In re Crescent Oil Company, et al., Case No. 09-20258, pending in the U.S. Bankruptcy Court for the District of Kansas, the court entered an order approving a gifting carve-out that could provide a road map for some undersecured lenders in their dealings with unsecured creditors’ committees.
In Crescent Oil,the secured lender entered into a stipulation with the Official Unsecured Creditors’ Committee (the committee) that provided that the committee would accept a certain sum and receive a percentage of the proceeds from the sale of the debtors’ assets. In return, the committee would completely release the secured lender from any further liabilities or potential avoidance actions (the stipulation). In Crescent Oil, the secured lender provided debtor-in-possession (DIP) financing. The DIP order provided that all parties in interest had a specified period of time to object to the secured lender’s claims and the perfection of its security interests and/or raise any avoidance action claims. Only the committee preserved this objection deadline by getting the secured lender to continue the objection date as it related to the committee. This extension as to the committee occurred several times. Ultimately, the committee came to an agreement with the secured lender as to the certain sum and percentage of sale proceeds that would be acceptable to it in connection with settling with the secured lender. This settlement was for the benefit of the unsecured creditors only, and no funds were allocated to any other class of claimants. The resolution reached by the secured lender and the committee was approved by the court.
In advocating for the resolution, both the secured lender and the committee argued that the right of a secured creditor under the Bankruptcy Code to agree to such a carve-out as proposed by the stipulation was clearly articulated by the Ninth Circuit Court of Appeals in In re Debbie Reynolds Hotel & Casino Inc., 255 F.3d 1061 (9th Cir. 2001). In In re Debbie Reynolds, a secured creditor “entered into an agreement allowing the [chapter 11] debtor’s counsel to collect a $50,000 surcharge from its secured property.” Id. at 1064. The agreement also provided that no other creditor could seek a surcharge under §506(c) of the Bankruptcy Code. Id. at 1061. The agreement was challenged by a creditor who had loaned money to the debtor postpetition and had received a “super-priority” claim under §364(c) of the Code. Id. The objecting creditor argued that the $50,000 was estate property that should be distributed according to the priorities established in the Bankruptcy Code. Id. at 1064. The Ninth Circuit ruled against the objecting creditor, stating that “[w]e agree with Appellants and hold that a §506(c) surcharge is not an administrative claim, but an assessment against a secured party’s collateral. As such, it does not come out of the debtor’s estate, but rather comes directly from the secured party’s recovery. Consequently, §506(c) expenses do not fall within the priority scheme of the Bankruptcy Code at all.” Id. at 1066.
Other courts have held similarly. The Tenth Circuit Bankruptcy Appellate Panel adopted the reasoning found in In re Debbie Reynolds when it upheld a debtor’s agreement with a postpetition financier to waive any right to claim a surcharge against assets securing the postpetition financing. See In re Inteliquest Media Corp., 326 B.R. 825 (10th Cir. B.A.P. 2005). In re Inteliquest quoted In re Debbie Reynolds at length, with the panel declaring: “[A] surcharge under 11 U.S.C. §506(c) is not an administrative expense. It is an assessment against a secured party’s collateral as reimbursement for a particular benefit to such a secured creditor.” Id. at 832. Delaware bankruptcy courts have also recently approved carve-outs for the exclusive benefit of unsecured creditors. See In re World Heath Alternatives Inc., 344 B.R. 291 (Bankr. D. Del. 2006), and In re TSIC Inc., 393 B.R. 71 (Bankr. D. Del. 2008).
In Crescent Oil, the secured lender argued that, as in In re Debbie Reynolds and In re Inteliquest, the proceeds from a secured party’s collateral were not property of the estate and could be utilized by the secured party as it saw fit. The secured lender further argued that the Bankruptcy Code permitted a secured lender to elect to part with a specified portion of the collateral proceeds, to which it may be entitled in order to avoid the cost, delay and uncertainty of further litigation. The committee also supported the resolution previously outlined, stating that it was in the unsecured creditors’ best interest to have the certainty the settlement provided.
The Crescent Oil carve-out will not be a possibility in every case and may be disfavored in some jurisdictions. In In re On-Site Sourcing Inc., 412 B.R. 817 (Bankr. E.D. Va. 2009), the court flatly rejected a proposed sale that would have set aside proceeds for the unsecured creditors. The On-Site court flatly rejected the characterization of the carve-out as being an allocation of the secured creditor’s property. “[T]he proceeds from the sale of property of the estate are property of the estate. Bankruptcy Code §541. This is not changed by the fact that the property sold is subject to an encumbrance. That just means that the proceeds are also subject to an encumbrance. The proceeds nonetheless remain property of the estate.” In order to gain approval of the asset sale, the debtor had to eliminate the unsecured creditor carve-out.
The On-Site opinion notwithstanding, it appears that gifting carve-outs are at least a possibility in most jurisdictions. When a situation like Crescent Oil presents itself, a secured lender should give thought to using a portion of its proceeds to settle with the committee. Such a resolution brings certainty of the outcome to both the secured lender and the committee, as well as allows both parties to avoid the substantial costs of litigation. It also has the effect of forging an alliance between the debtor and the unsecured creditors.