A recent decision by the U.S. Supreme Court may have far-reaching implications for the way debtors-in-possession (DIPs) are financed. The case, Hartford Underwriters Insurance Co. v. Union Planters Bank (In re Hen House Interstate Inc.), (May 30, 2000), involved the effort by Hartford to recover unpaid post-petition workers' compensation insurance premiums from the debtor's lender. The lender had provided post-petition financing to the debtor in return for a lien on substantially all of the debtor's assets. Hartford's claim against the lender was based on §506(c) of the Bankruptcy Code, which provides:

The trustee may recover from property securing an allowed secured claim the...costs and expenses of preserving, or disposing of, such property...

In the Hen House case, no one disputed that Hartford's agreement to provide workers' compensation insurance was essential to the preservation of the debtor's estate and the lender's collateral. At issue, however, was whether Hartford enjoyed an independent right to pursue its claim against the lender, or whether that right belonged only to the trustee or DIP. The Supreme Court agreed to review the matter because the appellate courts that had reviewed this question were divided on the issue. Some courts had held that third-party administrative creditors could pursue a "surcharge" claim under §506(c). Others limited that right to the trustee or DIP.

Justice Scalia, the Supreme Court's champion of the "plain-meaning" doctrine, wrote the opinion for a unanimous court. The court ruled that the plain language of §506(c) reserved the right to attack a secured lender's collateral to the trustee. An administrative creditor such as Hartford has no right to pursue its administrative claim against the secured lender.

Implications for Future Bankruptcy Cases

The impact of the Hen House decision will be felt early in every chapter 11 case in which the DIP intends to seek secured post-petition financing. Traditionally, DIP lenders require, as a condition to the making of a secured post-petition loan, that the DIP waive—with the court's approval—its rights under §506(c). This decision is often routinely made by the DIP, which often has little leverage in the DIP loan negotiation. In the past, judges in Delaware and other districts where large chapter 11's are filed have allowed the DIP to make the waiver decision for itself, provided that such a decision is not binding on third parties until third parties receive notice of the decision and an opportunity to be heard by the court.

Justice Scalia's opinion makes two things clear with respect to the DIP's decision to waive its §506(c) rights: First, the DIP's decision must be made in a manner consonant with its obligation "to seek recovery under the section whenever his fiduciary duties so require." Second, the DIP's decision to waive its §506(c) rights is always binding on third parties since it is a right that belongs to the DIP alone. Plainly, the §506(c) waiver decision is now more important than ever and can be expected to be subject to a heightened level of scrutiny by judges, creditors and the U.S. Trustee. DIP lenders who continue to insist on a §506(c) waiver must be prepared for increased resistance to their traditional form of DIP financing order. Additionally, the §506(c) waiver may ultimately impose a higher cost for DIP financing in the form of increased demands for "carve-outs" by administrative creditors from the DIP lender's lien and super-priority claim. Beyond the traditional carve-outs for the DIP's professionals, the creditors' committee and its professionals, and U.S. Trustee/court fees, other constituents may seek carve-out benefits including management, utilities, landlords, critical vendors and other post-petition creditors.

Carve-out discussions do not always occur at the inception of the DIP loan. Many times they take place in connection with the implementation of the exit, especially where there appears to be a risk of administrative insolvency in a liquidating chapter 11 case. Prior to Hen House, constituencies arguing for a carve-out in connection with the implementation of a DIP lender's exit strategy had argued that absent the DIP lender's agreement to provide such carve-outs, they would pursue claims against the lender under §506(c). Although Hen House now forecloses this argument, DIP lenders in administratively insolvent cases can expect to be compelled to have these discussions if they want the benefits of liquidation under chapter 11. Underwriting decisions in high-risk situations should anticipate these costs. More often, DIP lenders are forced to assume the responsibility of administrative solvency.

Another consequence of the Hen House decision will be to increase the importance of meaningful and effective notice to creditors of the §506(c) waiver. Given the exposure the debtor's management will have to claim that the waiver constitutes a breach of fiduciary duty, management will need to take pains that all likely administrative creditors (e.g., landlords, utilities, insurers, etc.) are notified of the proposed waiver. This will create additional expense and delay. It is unlikely that §506(c) waivers will be granted as first-day orders. Accordingly, a DIP lender that requires a waiver will not get it until the final hearing on DIP financing, usually three to four weeks into the case. Ultimately, the approval of a DIP financing order with a §506(c) waiver may require the DIP lender to cut deals with those "squeaky wheels" who contest the propriety of the waiver. Those deals, if cut, inevitably will cost the debtor by lowering availability and increasing loan-monitoring costs. In practical terms, the DIP lender needs to fully understand and anticipate the expense of administration. Responsible underwriting will not allow the DIP lender to expose itself to a "black hole" of administrative expense exposure.

Recent Post-Hen House Experience

Thus far, an informal canvas of DIP lenders and their counsel suggests that not much has changed in practice as a result of Hen House. DIP lenders continue to demand and receive a §506(c) waiver from the DIP. Contrary to past practice, where such a waiver was granted as part of the first-day orders, the lender usually waits until the final DIP loan hearing to get approval. In considering whether to approve a waiver, bankruptcy courts require a showing that the DIP loan provides adequate liquidity to fund anticipated administrative expenses. The good news for DIP lenders is that when such a waiver is given by the DIP with bankruptcy-court approval and proper notice to third parties, the DIP lender should thereafter be immune from §506(c) attack throughout the course of the chapter 11. Nevertheless, DIP lenders must continue to focus on the cost of administration of a chapter 11 both at the inception and exit from the loan. A loss of such focus may lead to unexpected costs if and when the DIP lender seeks to realize upon its collateral.