When a $5.2 million loan was neither disclosed to nor approved by the bankruptcy court, what sort of a claim does a lender receive when the loan enabled the chapter 11 debtor to turn a multi-million-dollar profit in flipping real property? Secured, pari passu unsecured, subordinated, none?
Fortunately for the lender, Chief Bankruptcy Judge Wendy L. Hagenau of Atlanta did not treat the loan as a contribution of equity, which would have resulted in no recovery. However, she subordinated the unauthorized loan to other unsecured claims, which meant that the lender recovered no interest and lost only $500,000.
District Judge Richard W. Story affirmed Judge Hagenau on September 30 in a testament to the discretionary power given to a bankruptcy judge in deciding how to treat an unauthorized loan that benefitted the estate, with the benefit of hindsight. He said that the lender, an insider, “knowingly ignored the rules and should not be rewarded with a priority claim to the detriment of true creditors.”
Given what Judge Hagenau identified as inequitable conduct, the lender likely would not have emerged so well if unsecured creditors were not being paid in full.
The Loan
Judge Hagenau authorized the chapter 11 debtor to sell developed real property for $7.2 million. At the time, the property had negative cash flow. The deal gave the debtor an option to repurchase the property by a specified date for about $9.3 million.
The debtor was unsuccessful in locating a traditional or even a “hard money” lender to finance the repurchase. So, the debtor took down two loans, neither of which was disclosed to or approved by the bankruptcy court.
One lender granted a $4.1 million loan secured by a recorded mortgage on the property.
For the remainder of the purchase price, the debtor borrowed some $5.2 million from a commonly owed affiliate that qualified as an insider. The loan carried 12% interest and was to mature in four months. The debtor signed a mortgage to secure the $5.2 million loan, but it was never recorded.
Judge Hagenau learned about the loan when another creditor mentioned the transaction in court papers in a separate litigated matter. She dragged everyone into court to explain and appointed a chapter 11 trustee in the short term.
The trustee later sold the property for almost $12.8 million. She approved the sale to the lender that made the $4.1 million loan and allowed that lender to credit bid the $4.1 million. The sale threw off a net of almost $8.5 million before dealing with the $5.2 million loan.
The $5.2 million lender filed a motion in substance asking Judge Hagenau to approve the loan nunc pro tunc. She gave the lender a claim subordinated to unsecured claims. As a result, the $5.2 million lender recovered no interest and lost only $500,000 of principal because other unsecured claims amounted to only $2.6 million.
Subordination of the claim allowed other unsecured creditors to recover in full. Had the $5.2 million loan been given priority or even pari passu status with unsecured creditors, other unsecured creditors would have been affected negatively and significantly.
Judge Hagenau’s decision rested in part on her sense of the underlying purpose of the $5.2 million loan. Judging by the short, four-month maturity, she suspected that the $5.2 million lender intended to foreclose and strip the value away from the debtor.
By the way, the lender with the unauthorized $4.1 million loan did not escape unscathed. The lender sought payment of about $600,000 in interest. Ultimately, Judge Hagenau approved a settlement where the $4.1 million lender gave up one-third of its interest claim.
The $5.2 million lender appealed but was rebuffed altogether by District Judge Story.
Broad Discretion Upheld in Ruling on an Unauthorized Loan
Judge Story denied the request for administrative status, saying there was a lack of compliance with Section 364. As a matter of noncompliance with the statute, the loan was not made in the ordinary course of business and was not approved by the court.
Likewise, the lender was not entitled to a claim under Section 503(b)(3)(D) for a substantial contribution, again for noncompliance with the statute. Although an affiliate of the debtor, the $5.2 million lender was neither a creditor nor an equity holder.
Having failed under the statute, the lender wanted Judge Hagenau to use equitable powers and grant administrative status. Judge Story held that Judge Hagenau had not abused her discretion in declining to rely on equity to elevate the loan.
The lender failed in arguing that Judge Hagenau should have approved the loan nunc pro tunc. She believed that nunc pro tunc relief was not available after Roman Catholic Archdiocese of San Juan, Puerto Rico v. Acevedo Feliciano, 140 S. Ct. 696 (2020). To read ABI’s report, click here.
Judge Hagenau also believed she had no authority under Section 105(a) to raise the status of a loan when there was no compliance with the statute.
Considering the equities, Judge Story held that Judge Hagenau acted “squarely within [her] discretion” by making the $5.2 million loan subordinate to other unsecured claims. More specifically, he said that “the equities do not weigh in favor of elevating the [$5.2 million] claim above the claims of other creditors.”
Finally, Judge Story gave the lender no slack for having consulted with an attorney before making the loan. He upheld Judge Hagenau’s exercise of discretion by refusing to give the lender any deference for “reliance on legal counsel other than the known bankruptcy counsel,” who knew nothing about the loan until she read about it in a court order.
In short, Judge Story found no abuse of discretion and affirmed Judge Hagenau.
When a $5.2 million loan was neither disclosed to nor approved by the bankruptcy court, what sort of a claim does a lender receive when the loan enabled the chapter 11 debtor to turn a multi-million-dollar profit in flipping real property? Secured, pari passu unsecured, subordinated, none?
Fortunately for the lender, Chief Bankruptcy Judge Wendy L. Hagenau of Atlanta did not treat the loan as a contribution of equity, which would have resulted in no recovery. However, she subordinated the unauthorized loan to other unsecured claims, which meant that the lender recovered no interest and lost only $500,000.
District Judge Richard W. Story affirmed Judge Hagenau on September 30 in a testament to the discretionary power given to a bankruptcy judge in deciding how to treat an unauthorized loan that benefitted the estate, with the benefit of hindsight. He said that the lender, an insider, “knowingly ignored the rules and should not be rewarded with a priority claim to the detriment of true creditors.”
Given what Judge Hagenau identified as inequitable conduct, the lender likely would not have emerged so well if unsecured creditors were not being paid in full.