Restructuring

“Break-up fees,” a common deal-protection construct, both inside and outside of chapter 11, are designed to compensate an initial bidder or prospective lender for the time and money invested in formulating and documenting a transaction and establishing a “floor” for potential terms.  In recent years, however, courts have been critical of break-up fees and other bidding protections on the basis that such protections are unnecessary to safeguard lenders and may discourage debtors from exploring higher and better offers for the benefit of the estate and creditors.  So-called “stalking horse bidders” and break-up fees took yet another hit, in a recent decision, In re C & K Market, Inc., by the United States Bankruptcy Court for the District of Oregon, which ruled that a break-up fee for a prospective debtor-in-possession (DIP) financing lender was a prepetition claim not entitled to administrative expense priority.
Background
In C & K Market, anticipating a need for reorganization, the debtor, which owned and operated grocery stores and pharmacies in the Pacific Northwest, commenced negotiations with its senior lender, U.S. Bank, on a potential DIP financing package.  As a matter of prudence, as well as to gain leverage in its negotiations with U.S. Bank, the debtor approached several other lenders for alternative DIP financing proposals.  The only alternative lender, however, willing to respond quickly enough was Sunstone Business Finance, LLC.
The debtor and Sunstone quickly agreed on a proposal for DIP financing, and a term sheet (and later a DIP credit agreement) was executed shortly thereafter.  The term sheet provided for a DIP loan in the range of $5 to $7 million. Additionally, it provided for a $250,000 break-up fee, payable to Sunstone in the event the loan facility was not closed due to the debtor’s election to seek other financing.  The term sheet provided that Sunstone’s commitment would remain enforceable until a final order approving other financing was approved by the bankruptcy court.  At that point, the break-up fee would become due and the debtor was required to support a motion for treatment of the break-up fee as an administrative expense.
At the same time, negotiations between the debtor and U.S. Bank were progressing.  The debtor’s management revealed to U.S. Bank that it had signed a term sheet with an alternative lender (Sunstone), but did not reveal the terms of the competing loan.  Eventually, the debtor and U.S. Bank agreed to a DIP financing package on substantially better terms than those offered by Sunstone and, shortly thereafter, the debtor commenced its chapter 11 case.
After a final order approving U.S. Bank’s DIP loan was entered, Sunstone filed a proof of claim for the amount of the break-up fee and a motion to allow the $250,000 claim as an administrative expense under section 503(b) of the Bankruptcy Code.  Consistent with the term sheet, the debtor supported Sunstone’s motion.  The creditors’ committee, U.S. Bank and certain of the debtor’s other lenders, however, objected, both to the administrative treatment and the claim itself.
Section 503(b)(1)(A) of the Bankruptcy Code provides for the allowance, as administrative expenses, of the “actual, necessary costs and expenses of preserving the estate.”  Similarly, section 503(b)(3)(D) awards administrative expense priority to the actual and necessary expenses incurred by a creditor in making a “substantial contribution” to the case.
Analysis
Allowance of the Claim
The bankruptcy court agreed with the debtor and Sunstone, determining that the break-up fee constituted a valid prepetition claim against the estate.  In doing so, the court found that the term sheet evidenced an intent by the parties to enter into a contract and provided the basic terms of the agreement.  Even though the amount of the DIP loan was described as a range in the term sheet, the court found that it was clear that the parties intended for a more formal agreement to follow to fill in the gaps, and the DIP credit agreement clarified the amount of the proposed facility.  As the term sheet represented an enforceable contract, subject to a condition subsequent that the bankruptcy court either approve the Sunstone DIP facility or enter an order approving a DIP facility from another lender, the court determined that the break-up fee constituted a valid claim.
Administrative Expense Treatment
With respect to the treatment of the break-up fee as an administrative expense, however, the court sided with the objecting parties.  Although Sunstone argued that its prepetition actions provided substantial benefits to the estate, including the “smooth and successful” launching of the bankruptcy case, and the benefits derived from “softened” lending terms eventually provided by U.S. Bank, the court noted that these alleged beneficial effects occurred prepetition, as did the execution of the term sheet itself.  As a result, and in accordance with the test articulated by the Ninth Circuit in Microsoft Corp. v. DAK Indus., Inc. (In re DAK Indus., Inc.), the claim arising from the prepetition term sheet did not qualify for administrative expense treatment under section 503(b)(1).  Even if the claim had arisen postpetition, however, the evidence presented to the court showed that, although U.S. Bank generally knew that the debtor had an agreement with another lender, it did not know any of the details of the term sheet, and U.S. Bank was not influenced by Sunstone in its negotiations with the debtor.  As a result, the court determined that the Sunstone DIP term sheet did not provide a “direct and substantial” benefit to the estate.
The court further noted that, as the breakup fee was a fee and not an expense, it did not qualify for administrative expense treatment under section 503(b)(3)(D).  The court concluded its opinion by stating that the policy of allowing break-up fees to encourage competing bids among DIP lenders necessarily took a back seat to the Congressional policy of promoting equal distribution among creditors.  The court further noted that “restrictions on break-up fees are just as likely to promote competition and broader negotiations, and less expensive credit for debtors, by encouraging lenders to submit proposals more likely to be accepted by debtors, other creditors, and ultimately, bankruptcy courts.”
Conclusion
The concluding statements by the C & K court should serve notice to potential lenders that courts will continue to carefully scrutinize break-up fees and other bidding protections.  Lenders should be wary of relying simply on prepetition agreements to secure break-up fees and may want to consider additional steps and protective measures to improve their prospects for collection.