In East Coast Miner LLC v. Nixon Peabody LLP (In re Licking River Mining LLC),[1] the Sixth Circuit Court of Appeals recently upheld a bankruptcy court determination (affirmed by the district court) that a carve-out for professionals’ fees in a cash-collateral order was enforceable notwithstanding the conversion of the case from chapter 11 to chapter 7. The decision was based on the express language of the order and prior representations of the lenders’ counsel to the bankruptcy court, as well as what the court considered normal and necessary practice.
The case stemmed from the involuntary bankruptcy of U.S. Coal Corp. and its subsidiaries, including Licking River Mining. The appellants were four lenders to the debtor who held liens on essentially all the debtor’s assets. The lenders had agreed to a cash-collateral order containing a “carve-out” that provided for all allowed fees of estate professionals approved by the bankruptcy court to be paid ahead of the lenders in the event of a conversion to chapter 7. The professionals had been retained to see the debtor’s assets.
After it later became clear that restructuring was no longer an option, the lenders informed the bankruptcy court of their continued support for the debtor’s pursuit of asset sales and affirmed that cash-collateral budgets would be modified to provide for payment of the fees of the professionals working on these sales. Ten days later, the case was converted to chapter 7. Following conversion, the appellees, attorneys and other estate professionals (collectively, the “Professionals”) submitted fee applications seeking compensation totaling $2.5 million, and sought to have those fees be paid pursuant to the carve-out, a result that would substantially reduce the collateral available to the secured lenders.
The lenders objected to the payment on the theory that, after conversion, the carve-out funds could not come from the proceeds of pre-petition liens. The objection was overruled by the bankruptcy court, which found that the cash-collateral order and the record made it clear that the carve-out extended to the lenders’ pre-petition liens. This decision was affirmed by the district court.
The Sixth Circuit stated that the “crux of the Lender’s argument is that they never intended for funds allocated to the Carve-Out to come from their prepetition liens.”[2] The court noted that this was essentially a contract dispute and that since cash-collateral orders are typically treated according to general contract principles, a court should look at the entire document as part of an integrated whole. The court found that there was nothing in the language of the order that indicated that cash collateral could not be used for purposes of the carve-out post-conversion, and that excluding funds derived from the sale of assets would render the carve-out meaningless.
The court noted that the definition of cash collateral in the order specially mentioned pre-petition collateral and that the order explicitly provided that the terms would survive a conversion from chapter 11 to chapter 7. Additionally, the court found persuasive that the record indicated that the lenders had represented to the bankruptcy court on at least two occasions that they intended to fund the carveout with their pre-petition liens, including at the hearing 10 days before conversion when they specifically consented to contractual payment of the professionals. The court also noted that carve-outs are often used and are enforced even where a case is converted to chapter 7.
The court rejected the lenders’ argument that under 11 U.S.C. § 363(b) and (c), assets cannot be reallocated from secured creditors to unsecured creditors. The court ruled that the Bankruptcy Code “does not govern the rights of creditors to transfer or receive nonestate property”or to agree among themselves to disposition of amounts ultimately recoverable, and thus did not prevent the Lenders from entering into an agreement to allow their collateral to be used to pay estate professionals.[3] The court echoed the sentiment of the bankruptcy court that the practical effect of the lenders’ argument was that an agreed-upon carve-out would be virtually meaningless and ineffective in providing recovery of a professional fee.
This case is a welcome court of appeals decision reinforcing the validity and enforceability of carve-out provisions in DIP financing/cash-collateral orders to provide for the funding of estate professional fees where the lender agreed to the inclusion of such a carve-out. It also serves as a reminder that counsel for lenders and estate professionals alike should carefully review the language of carve-out provisions to ensure that such provisions properly protect their client’s rights and reflect their expectations for the case.