DIP Lending Facility Tantamount to Impermissible Sub Rosa Plan

The epic §363 sales that were consummated in the Chrysler and General Motors bankruptcies this past summer raised objections from parties in interest[1] and concerns from the broader legal community[2] that the sale transactions were, in effect, sub rosa plans that effectively bypassed the Bankruptcy Code’s important disclosure and voting requirements. Issues related to sub rosa plans most often arise in the context of a §363 bankruptcy sale of all, or substantially all, of the assets of a financially-distressed business. However, a recent opinion from the U.S. Bankruptcy Court for the Northern District of Mississippi found that, among other problems, the chapter 11 debtor’s proposed postpetition debtor-in-possession (DIP) financing constituted an impermissible sub rosa plan. The decision highlights the need for debtors and potential DIP lenders to carefully evaluate whether financing terms may conceivably give rise to a colorable argument that a lending facility seeks to impermissibly bypass the statutory requirements pertaining to the plan confirmation process. 

Background
In In re Belk Properties LLC,[3] the court considered the chapter 11 debtor’s motion seeking authorization to enter into a post-petition financing arrangement pursuant to §§364(c)(1) and 364(d) of the Code. The debtor had commenced a commercial real estate project that was to be undertaken in three phases. Prior to the completion of the first phase, the debtor ran out of funds to complete that phase or to perform any of the preparatory architectural and consultation work in respect of the second and third phases. As of the date of the Court’s ruling, the construction lender on the project was owed more than $4.1 million, which was secured by a first deed of trust on the property. The primary contractor for the project was owed approximately $350,000, which was secured by a construction lien. There was also an unsecured claim of approximately $290,000, evidenced by a promissory note, for monies borrowed by the debtor for the initial engineering and architectural services. 

Prior to its bankruptcy filing, the debtor attempted unsuccessfully to secure additional funding from various sources to complete the project.[4] The debtor ultimately obtained the agreement of Meadowbrook Capital LLC, in its capacity as a prospective DIP lender, to lend $2 million to the debtor in order to finish the first phase, and to pay certain fees and expenses related to the project. The proposed postpetition financing came with a number of noteworthy conditions, some of which were as follows:

Prior to advancement of the funds, Meadowbrook required the entry of a final, nonappealable order from the bankruptcy court granting it a superpriority, postpetition and senior lien, priming the existing liens of the construction lender and contractor on the project;

Meadowbrook proposed to take control of the debtor’s management;

At the time of funding the DIP loan, Meadowbrook would obtain a 51 percent interest in the debtor, subject to increase upon the lender’s exercise of options to convert fees to additional equity;

Meadowbrook sought a $50,000 management fee and a $75,000 postpetition financing fee, both convertible to equity in the debtor, at Meadowbrook’s option;

Meadowbrook demanded a $25,000 break-up fee/due-diligence reimbursement, which was to be accorded superpriority administrative expense and senior lien status over the existing liens;

Meadowbrook had the authority to issue additional equity in the debtor, representing up to 90 percent thereof, with the existing principals of the debtor retaining a 10 percent equity interest;

Meadowbrook had the right to sell the development properties subject to certain “matching opportunities” available to the debtor’s principals and subject to court approval; and

Other than making regular monthly payments to the unsecured lender to prevent a default, the debtor was required to use the financing proceeds and any profits from the debtor’s operations to pay only approved budgetary expenditures.[5]

Proposed DIP Financing as a Sub Rosa Plan
The court first observed that while the present value of the overall project provided an equity cushion to the existing secured creditors, the addition of a proposed $2 million priming lien could, quite possibly, eviscerate this form of adequate protection to the pre-petition secured creditors by rendering them undersecured creditors.[6] The court then turned to the sub rosa plan implications of the proposed senior secured financing. While recognizing that the financing was not a sale of the debtor’s assets under §363(b), as was the case in In re Braniff Airways Inc.,[7] the court determined that, if the financing were approved, Meadowbrook would effectively become the debtor.[8] The proposal would permit Meadowbrook to become the chief manager of the debtor and also grant it a majority (51 percent) stake in the company “with relatively unlimited discretion” to increase its ownership stake to 90 percent. Furthermore, the lending term sheet loosely dictated the manner in which existing creditors were to be treated. The fact that the proposed funding would not be advanced until a final, non-appealable order was entered, incorporating the conditions set forth in the term sheet, made any subsequent plan of reorganization, from the court’s perspective, a fait accompli.[9] Ultimately, the court held that the proposed financing was “a clever way for the lender to gain control of the debtor’s assets without going through the processes of a §363(b) sale…[and] it achieve[d] the same effect as a sub rosa Chapter 11 plan of reorganization.”[10]

The court found even more troubling the fact that Meadowbrook, as potential DIP lender, would become the majority owner and responsible party for the debtor and, by virtue of the financing order, “would be cloaked with the rights of a debtor-in-possession as contemplated by §1107 without having been duly appointed through the procedures of §1104(a).”[11] The court noted that DIPs act as fiduciaries for all creditors of the estate, but this fiduciary capacity could not be reconciled with Meadowbrook’s status as the senior secured lender as well as a superpriority administrative expense claimant.

In view of these facts, the bankruptcy court ruled that the proposed financing had to be significantly modified to protect the bankruptcy estate’s existing creditors and the viability of the debtor. The decision also raised the possibility that any modified DIP financing proposal would need to address adequate-protection concerns of the existing secured creditors and might be weaved into a chapter 11 plan addressing the claims of other creditors.[12]

Future Implications
The terms and conditions that came with Meadowbrook’s DIP financing proposal may represent the outer limits of control that a DIP lender may seek to exert over a chapter 11 debtor’s reorganization efforts. To be sure, the Belk Properties decision presents a cautionary lesson for prospective DIP lenders seeking more than a priming lien in and against a chapter 11 debtor’s assets. Bankruptcy courts will carefully scrutinize the terms of proposed financing arrangements, and may find, as was the case in Belk Properties, that provisions authorizing a DIP lender to effectively step into the chapter 11 debtor’s shoes and dictate or allocate terms of a reorganization plan constitute an impermissible sub rosa plan.