In a recent decision in In re Packaging Systems, LLC, the Bankruptcy Court for the District of New Jersey ruled that a lender that held a “super-priority” administrative expense claim under section 364(c)(1) of the Bankruptcy Code was still entitled to its super-priority status even after the debtor’s case converted to chapter 7.  The decision may provide comfort to lenders and consequently make it easier for debtors to obtain debtor-in-possession financing.

First, some background is necessary. Section 364(c)(1) of the Bankruptcy Code encourages lenders to extend credit to debtors-in-possession by affording such lenders a “super-priority” claim. A super-priority claim has “priority over any or all administrative expenses of the kind specified in section 503(b)” of the Bankruptcy Code, which includes claims that are for the “actual, necessary costs and expenses of preserving the estate.” As a result, section 364(c)(1) greatly improves the chances that the lender will be repaid monies lent to the debtor-in-possession, and is an important tool for debtors seeking to obtain financing during the reorganization process. Separately, section 726(b) of the Bankruptcy Code provides that when a case is converted from chapter 11 to chapter 7, administrative claims under section 503(b) that are incurred for the administration of the chapter 7 estate take priority over section 503(b) claims that were incurred during the chapter 11 case.  By making sure that the chapter 7 trustee is compensated first, section 726(b) is meant to encourage the efficient liquidation and wind-down of the chapter 7 estate.

When it filed its chapter 11 case in 2012, Packaging Systems sought authority to assume a factoring and security agreement with Harborcove Financial, LLC, pursuant to which Harborcove held a first-priority security interest in all of Packaging Systems’ assets. Apparently unable to obtain credit otherwise, Packaging Systems also sought permission to enter into a post-petition factoring agreement with Harborcove and to provide a super-priority administrative claim to Harborcove pursuant to section 364(c)(1). The court allowed Packaging Systems to assume the agreement, subject to certain amendments, and granted Harborcove a section 364(c)(1) administrative expense claim with priority “over any and all administrative expenses incurred and priority claims arising in this case.” Recoveries received in chapter 5 avoidance actions (i.e., fraudulent and preferential transfer claims) were excluded from Harborcove’s administrative expense claim. In addition, Harborcove’s claim was subject to carve-outs for quarterly fees paid to the U.S. Trustee and for the fees incurred by Packaging Systems’ counsel.

With its funding from Harborcove, Packaging Systems remained in chapter 11 for a year before converting to chapter 7 upon motion brought by the United States Trustee. The chapter 7 trustee pursued six preferential and fraudulent transfer claims, ultimately recovering approximately $90,000 for the estate. Nevertheless, the chapter 7 administrative expenses exceeded the amount in the estate, and as a result, the chapter 7 trustee proposed to pay only the chapter 7 administrative expenses in the Final Report, citing section 726(b).  In contrast, the chapter 11 administrative expenses would not be paid at all.

Harborcove objected to the Final Report, arguing that its super-priority administrative expense claim, granted before conversion to chapter 7, should be paid before any chapter 7 administrative expenses were paid.

The case law analyzing the interplay between sections 364(c)(1) and 726(b) is split. Some courts, such as the Ninth Circuit Bankruptcy Appellate Panel, have concluded that the statutory language is ambiguous and have relied on policy arguments that favor payment of chapter 7 administrative expenses over chapter 11 administrative expenses. Other courts, such as the Bankruptcy Courts for the Southern District of Florida and for the Northern District of Illinois, have concluded that because section 726(b) does not expressly reference section 364(c)(1), but only section 503(b), section 364(c)(1) claims retain their super-priority status and must be paid before post-conversion administrative expense claims, notwithstanding section 726(b).

The Packaging Systems court, acknowledging the policy cited by some courts, concluded that the statutory language was clear and held that super-priority claims arising under section 364(c)(1) retain their super-priority status notwithstanding a subsequent conversion to chapter 7.  Therefore, the court continued, a “Chapter 7 trustee must take into account the existence of a pre-conversion super-priority claimant” such as Harborcove’s super-priority claim. Interestingly, the court held that Harborcove was not without fault, in that it had failed to put the chapter 7 trustee on notice of its administrative expense claim.  The court noted that Harborcove would not receive anything if the chapter 7 trustee had not pursued the preferential and fraudulent transfer claims.  Accordingly, the court exercised its equitable powers to order that the trustee was entitled to payment of the costs and expenses incurred in the avoidance actions.

Although Packaging Systems is focused on post-conversion issues, it is likely to have the greatest impact on the early stages of chapter 11 cases, when debtor-in-possession financing is being negotiated. At this point in the case, debtors may have less leverage, and lenders may be less willing to negotiate, if lenders believe that their interests will not be protected through a conversion to chapter 7. Lenders may be even less willing to part with protections such as section 506(c) waivers if they believe that they can lose their super-priority status if the case converts. Instead, lenders may insist on additional measures, such as additional security, to protect themselves in the event of a conversion.  The court’s decision in Packaging Systems may alleviate these concerns and may encourage debtor-in-possession financing.