No Authorization? No Problem. Court Finds that Unauthorized Loan Is Entitled to Priority Status

Contributed by Blaire Cahn
In In re Reilly, the United States Bankruptcy Court for the Western District of New York considered whether a postpetition loan that has not been authorized by the bankruptcy court is entitled to treatment as an administrative expense under section 503(b)(1) of the Bankruptcy Code.  The court found that, although section 364(b) of the Bankruptcy Code provides “a guaranteed pathway to priority,” it is not the only basis upon which a postpetition loan may be accorded priority status.  
Several months after commencing a bankruptcy case, the debtor borrowed $25,000 from his brother without seeking approval from the bankruptcy court.  He used these funds to satisfy adequate protection, domestic support, and income tax obligations.  The debtor later repaid his brother $10,000, again without seeking court authorization.  Upon learning of these events, counsel to the debtor filed a motion seeking approval of the loan pursuant to section 364(b) of the Bankruptcy Code and its partial repayment on a nunc pro tunc basis.  The United States Trustee objected to the motion, arguing that section 364(b) only permits approval of a financing transaction outside of the ordinary course of business “after notice and a hearing.”
The court first considered the appropriateness of nunc pro tunc relief.  Pursuant to section 364(b), “[t]he court, after notice and a hearing, may authorize the trustee to obtain unsecured credit or to incur unsecured debt … allowable under section 503(b)(1) of this title as an administrative expense.”  Bankruptcy Rule 4001(c) provides that a court may commence a final hearing on a motion for authority to obtain credit no earlier than 14 days after service of the motion, except in certain circumstances where it is necessary to avoid immediate and irreparable harm to the estate.  The court found that the Bankruptcy Code and the Bankruptcy Rules contemplate prior authorization of a loan to a debtor outside of the ordinary course of business and do not make any allowance for nunc pro tunc approval.
The court next examined whether it could nevertheless accord priority status to an unauthorized postpetition loan.  The court determined although section 364(b) provides a “safe haven wherein a prospective lender receives assurance of an administrative priority,” it does not preclude a lender from otherwise establishing an entitlement to priority under section 503(b)(1).  The court relied on a decision from the United States Court of Appeals for the Second Circuit under the Bankruptcy Act.  In Standard Capital Corporation v. Saper, the Second Circuit found that a lender is not foreclosed from seeking a determination that advances should be treated as administrative expenses, even where such advances were not authorized by the court.  In a subsequent appeal in the same case, the Second Circuit noted that “a priority claim should only be allowed if the judge ‘is confident that he would have authorized it if a timely application had been made,’ and … if ‘he is reasonably persuaded that the creditors have not been harmed by a continuation of the business made possible by the loan.’”
Applying this rule to the case at hand, the bankruptcy court held that it likely would have authorized the debtor’s loan from his brother.  The proceeds were used to repay secured and priority creditors and allowed the debtor to continue to generate income needed to repay other prepetition creditors.  Because the court found that it had no authority to authorize the loan retroactively, it treated the debtor’s motion as an application to allow the loan as an administrative expense under 503(b)(1).  Finding that the loan represented an actual and necessary cost of preserving the estate, the court allowed the administrative expense.
Although this case certainly should not stop debtors from seeking authorization for postpetition loans under section 364, it is interesting to note that careless lenders may have another avenue for obtaining priority status.
Blaire Cahn is an Associate at Weil Gotshal & Manges, LLP in New York.