On April 8, 2014, Chief Bankruptcy Judge Frank R. Alley, III for the United States Bankruptcy Court for the District of Oregon found that Sunstone Business Finance, LLC's claim against debtor C&K Market, Inc. did not constitute an administrative expense claim. The claim arose from a breakup fee for proposed DIP financing after C&K selected an alternative DIP lender.
The Court denied Sunstone's request for an administrative claim for two reasons. First, the Court found that the breakup fee did not arise from a transaction with a debtor in possession because the parties executed the DIP term sheet prepetition. Second, the Court found that Sunstone, as a potential lender, did not provide a direct and substantial benefit to the estate because the alleged benefits either occurred prepetition or were too indirect and intangible to qualify for priority treatment. If this opinion were to gain acceptance beyond this case, it could chill prepetition offers to serve as new DIP lenders, or possibly even affect the market for stalking horse bidders in a section 363 sale. In re C&K Market, Inc., No. 13-64561-fra11 (Bankr. D. Or. Apr. 8, 2014) [Dkt. No. 786].
Prior to its chapter 11 filing, C&K owned and operated approximately 60 grocery stores and pharmacies in Oregon and California. To finance its prepetition operations, C&K borrowed more than $64 million from US Bank and certain mezzanine lenders. Anticipating the need for reorganization, C&K entered into negotiations with US Bank to obtain DIP financing. Initial negotiations failed. With a bankruptcy looming, C&K turned to alternative sources of financing.
Sunstone emerged as the only party willing to offer DIP financing. Prepetition, the parties executed a term sheet that provided for, among other things, a DIP loan of $5-7.5 million at an interest rate of the prime rate plus 10% for "all outstanding obligations." C&K agreed to pay Sunstone a breakup fee of $250,000 in the event the loan did not close due to C&K finding other financing. The DIP term sheet also provided that Sunstone's commitment would remain enforceable until the Court approved a final order authorizing alternative DIP financing. C&K further agreed to support any motion filed by Sunstone for payment of the breakup fee as an administrative expense.
Subsequently, C&K and US Bank agreed to DIP financing with an interest rate well below the interest rate provided by Sunstone. C&K filed for bankruptcy on November 19, 2013 and eventually received final approval of the US Bank DIP financing, triggering Sunstone's right to receive a breakup fee under the DIP term sheet. Sunstone filed a proof of claim and motioned the Court to classify the breakup fee as an administrative expense claim. The creditors' committee, mezzanine lenders and US Bank objected to Sunstone's request on the grounds that Sunstone did not have an allowable claim, and even if it did, such claim was not entitled to administrative priority.
The Court considered two key issues. First, did Sunstone have an allowable claim? If so, was that claim entitled to administrative expense priority under section 503 of the Bankruptcy Code or was it merely a general unsecured claim. Generally, administrative claims are paid in full upon the confirmation of a bankruptcy plan, whereas general unsecured claims usually receive modest recoveries, at best.
The Court held that Sunstone had an allowable prepetition claim for the breakup fee because, among other things, the DIP term sheet was a legally enforceable contract between C&K and Sunstone. The objecting parties argued that Sunstone's claim should be denied for a number of reasons, including that the breakup fee constituted an avoidable fraudulent transfer and the DIP term sheet was vague and illusory. The Court found none of these arguments persuasive and observed that the DIP term sheet "evidenced an intent by the parties to enter into a contract" based on the terms contained therein.
Of more significance, the Court held that the breakup fee was not entitled to administrative priority. Sunstone first argued that its claim was entitled to administrative priority under section 503(b)(1)(A) of the Bankruptcy Code because the breakup fee represented "the actual, necessary costs and expense of preserving the estate." Specifically, Sunstone argued that the DIP term sheet provided a substantial benefit to the estate because it ensured C&K's "smooth and successful launching of its bankruptcy case" and "softened" lending terms ultimately provided by US Bank.
The Court disagreed. Citing to established Ninth Circuit precedent, the Court stated that a claim is entitled to administrative expense priority under section 503(b)(1)(A) of the Bankruptcy Code if it (1) arose from a transaction with the debtor in possession as opposed to the preceding entity and (2) directly and substantially benefitted the estate. The Court found that Sunstone's breakup fee did not satisfy either condition for two reasons.
First, the Court held that because the DIP term sheet "was an agreement between Sunstone and [a] prepetition non-debtor entity"; the term sheet did not arise from a "transaction with [a] debtor-in-possession." Second, the transaction did not provide a "direct and substantial" benefit to the estate. The Court found no evidence that the Sunstone term sheet caused US Bank to lend on more favorable terms, stating that there was "no evidence that providing an alternative, if costly, loan facility . . . provided more than an incidental benefit to the estate." In addition, the Court concluded that Sunstone did not provide a "direct and substantial" benefit to the estate by agreeing to hold open its offer to extend DIP financing until the Court entered a final order approving US Bank's DIP loan. Any benefit provided by Sunstone "was too indirect and intangible to qualify for priority treatment."
The Court also rejected Sunstone's argument that its claim should be entitled to administrative priority under section 503(b)(3)(D) of the Bankruptcy Code as an "actual, necessary expense" incurred "in making a substantial contribution" to C&K's bankruptcy case. The Court held that section 503(b)(3)(D) was inapplicable because the breakup fee was not an actual expense of Sunstone. Indeed, the breakup fee was "not an expense at all."
Finally, Sunstone argued that breakup fees should be allowed to encourage competing bids by lenders. The Court stated that the limitations discussed above surrounding administrative claims "reflects a Congressional policy of promoting equal distribution among creditors. Moreover, restrictions on breakup fees are just as likely to promote competition and broader negotiations and less expensive credit for borrowers, by encouraging lenders to submit proposals more likely to be accepted by debtors, other creditors, and ultimately, bankruptcy courts."
If embraced outside the District of Oregon, Judge Alley's decision casts doubt on the ability to be paid in full as an administrative creditor with respect to a breakup fee that a debtor might agree to prepetition. Thus, if the opinion were to gain acceptance beyond this case, Judge Alley's opinion could chill prepetition offers to serve as new DIP lenders, or possibly even as stalking horse bidders in a section 363 sale.
One potential way to prevent this result would be to execute final agreements surrounding DIP financing or sale terms immediately after the filing of a chapter 11 case, ensuring that the counterparty is a debtor in possession and thus that the claim is more likely to constitute an administrative claim rather than a general unsecured claim. This would solve the issue of whether the debtor in possession incurred the expense (though of course here, Sunstone would not have received the breakup fee at all, assuming US Bank would have agreed to provide the alternative funding prepetition).
It is difficult to understand why the judge did not believe the Sunstone financing benefitted the debtor's estate. In a typical case, a bidder proposing to provide DIP financing would provide value to the estate, even if (especially if) another previously reluctant bidder topped the initial proposed financing. This is similar to a stalking horse bidder that is typically entitled to a breakup fee if another bidder tops its initial bid. Such entities have clearly helped facilitate the bankruptcy and a recovery to creditors. Without full knowledge of the process in this case, it is unclear why the judge did not give this value sufficient attention. However, the ruling emphasizes the need for lenders to present evidence of the value provided by their proposed loan and potentially include a description (typically in the preamble) of such value in the loan agreement.
A potential stalking horse in a 363 sale should protect itself by ensuring that the proposed DIP lenders agree to provide a carveout from the DIP loan to pay the breakup fee. Potential lenders seeking a breakup fee would be unlikely to benefit similarly.