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Priming Liens in Bankruptcy: "Don't Throw Me Under the Bus!"

10.24.2008

Chapter 11 bankruptcy filings are on the rise nationwide. In North Carolina, bankruptcy courts have seen a surge in real estate development and construction industry filings. The increased number of filings, combined with lenders' attempts to limit their outstanding exposure in the areas of construction and acquisition and development loans, has led to an increased number of debtors filing motions seeking to prime the liens of their pre-petition lenders in order to secure post-petition debtor-in-possession ("DIP") financing under § 364(d) of the Bankruptcy Code.

Under § 364(d), after notice and hearing, the court may authorize a debtor to obtain credit or incur debt secured by a senior or equal lien on property of the estate that is already subject to a lien if the debtor shows two things: (1) the debtor is unable to obtain such credit otherwise and (2) the interests of the current lien holder will be adequately protected should the proposed senior or equal lien be granted. The debtor, not the creditor, has the burden of proof on the issue of adequate protection.

A debtor's ability to obtain a priming lien usually hinges on the second requirement of § 364(d). The "most important question" in determining whether a creditor is adequately protected "is whether the interest of the secured creditor whose lien is to be primed is being unjustifiably jeopardized." In re Mosello, 195 B.R. 277, 289 (Bankr. S.D.N.Y. 1996). The proposed adequate protection must be sufficient to give the creditor the value of its prebankruptcy bargain.

Typically, courts find that a creditor is adequately protected in one of three ways. First, when the debtor's DIP loan is used to pay down the pre-petition lender's outstanding debt; second, when the debtor agrees or is ordered to make monthly payments to the lender; and third, when the court finds that the lender is protected by the existence of an equity cushion.

In a recent opinion in the Eastern District of North Carolina, the Bankruptcy Court granted a debtor's motion seeking to prime SunTrust's lien with DIP financing in excess of $2,000,000.00 after finding that the pre-petition lender was adequately protected. The court determined that the lender was adequately protected in all three ways. First, it was proposed that the lender would receive a $633,598.96 reduction in its total debt by advancement of the DIP funds; second, the debtor was ordered to make a monthly adequate protection payment in the amount of $12,000.00; and third, the court found an eleven (11) percent equity cushion. See In re Den-Mark Construction, Inc., No. 08-02764-8-RDD (E.D.N.C. Aug. 6, 2008). SunTrust has since appealed this order.

In Den-Mark, and in many other cases where the ability of a debtor to obtain DIP financing hinges on a priming lien, valuation of the property in question is critical to a determination of whether the pre-petition lender is adequately protected. It is critical that any secured lender facing the prospect of a priming lien in bankruptcy have at least one recent, thorough and non-biased professional appraisal of the property in question to offer at the hearing. A judge making the decision of whether to grant a priming lien will have to determine the fair market value of the property at issue. Such a determination directly influences whether an adequate protection payment will be required and whether an equity cushion is found to exist.

The problem for pre-petition creditors is that in the past courts have granted priming liens both when there was substantial equity in the property and when there was no equity in the property. When substantial equity exists, the rationale is that the property value ultimately should support paying both the pre-petition lender and the DIP lender in full. When there is no equity, the rationale is that the pre-petition lender would not have been paid in full even absent a priming lien, and junior lienholders have no prospect of payment without the infusion of funds from a DIP lender. As one court put it, any proposal by a debtor, whether offering adequate protection or not, "should provide the pre-petition secured creditor with the same level of protection it would have if there had not been post-petition superpriority financing." In re Swedeland Development Group, Inc., 16 F.3d 552, 564 (3rd Cir. 1994).

As debtors continue to file post-petition financing motions in bankruptcy, lenders can protect their interests by being prepared to present evidence showing the judge how much adequate protection is necessary to avoid irreparable harm to the lender. After all, "Congress did not contemplate that a secured creditor could find its position eroded…". In re Windsor Hotel, LLC, 295 B.R. 307, 314 (Bankr. C.D. Ill. 2003). If the lender is not prepared with appraisals that are accurate in the current market, the judge will have only the debtor's evidence to consider when determining what constitutes adequate protection. These days more than ever, a little prebankruptcy planning might keep you from being thrown under the bus.

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