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Creditors’ Committees in Chapter 11 May Be Under Attack

The Delaware Bankruptcy Court has ruled that professional fees are not limited to the amount of the “carve-out” approved as part of a post-petition financing order.

In In re Molycorp, Judge Sontchi ruled that counsel fees, which are otherwise approved by the court, must be paid to confirm a plan of reorganization—even if the approved fees exceed the “carve-out” amount.

Why This Ruling Changes Carve-Outs and Financing Agreements

While the court’s reasoning is sound—it is, after all, grounded in the Bankruptcy Code’s well-established priorities scheme and plan confirmation requirements—the ruling will undoubtedly change how post-petition lenders negotiate financing agreements.

If you are a trade creditor, you should be worried.

How It All Happened

The facts of the case are straightforward. Molycorp, Inc. and its affiliates (the “Debtors”) filed chapter 11 in June 2015. Oaktree Capital Management, L.P. (“Oaktree”), agreed to provide a secured loan to fund the Debtors’ operations during the chapter 11 case.

A provision in the Bankruptcy Court’s final order authorizing the financing arrangement allowed the official committee of unsecured creditors (the “Committee”) to use up to $250,000 of Oaktree’s collateral to investigate causes of action that the Debtors potentially could assert against third parties. Oaktree agreed that this $250,000 carve-out would cover attorneys’ fees to be paid prior to confirmation of a reorganization plan.

The Committee’s investigation uncovered claims against certain of the Debtors’ directors and officers. After obtaining the Bankruptcy Court’s approval, the Committee commenced an adversary proceeding against these directors and officers, which was later settled. The settlement ultimately enabled the Debtors to propose a consensual plan of reorganization.

Committee counsel filed an application requesting approval of fees and expenses incurred during the case, including fees and expenses for its investigation of the Debtors’ causes of action, totaling approximately $8.7 million.

Oaktree Objected

Oaktree objected to the application, arguing that the fees were excessive, unreasonable, and violated the terms of the financing order because the fees for the investigation exceeded $250,000. Oaktree also argued that the financing order did not authorize payments for fees associated with commencing litigation.

Committee counsel replied to the objections, asserting that the carve-out did not impose a cap on professional fees, but instead served the purpose of ensuring that at least some portion of a lender’s collateral is available to pay those fees, once approved by the Bankruptcy Court.

Committee counsel also argued that a carve-out is irrelevant in an administratively solvent case where a plan of reorganization has been confirmed, because such amounts, once approved by the Bankruptcy Court, are administrative expenses that must be paid dollar-for-dollar by operation of various provisions of the Bankruptcy Code (e.g., 11 U.S.C. §§ 503, 507 and 1129(a)(9)).

The Bankruptcy Court ruled that the financing order did not impose an “absolute cap” on the fees incurred by the Committee’s counsel.

It concluded that, because administrative claims can only be paid from unencumbered assets, and cannot be given priority over existing claims having priority, the carve-out would be counsel’s only source of payment if the Debtors’ case had become administratively insolvent.

Explanations and Interpretations

But, in this case, the Debtors were not administratively insolvent; they were able to obtain confirmation of a plan of reorganization and were therefore bound by the requirements of § 1129 of the Bankruptcy Code. Full payment of all approved administrative expense claims (such as Committee counsel’s fees) is one of those requirements.

The Bankruptcy Court also held that the carve-out provision in the financing order did not act as a waiver of the right to full payment of allowed professional fees. Importantly, the Bankruptcy Court indicated that its ruling would likely be different if the Debtors were unable to confirm a plan.

While the ruling contains no new interpretations of existing law (and should not come as surprise to anyone), it does highlight the importance of carve-outs in chapter 11.

Financing orders are negotiated at the beginning of a chapter 11 case, when, in most instances, parties do not know if the debtor will be administratively solvent at the end of the case.

Studies show that approximately 50% of chapter 11 cases are converted to chapter 7 or are dismissed. In other words, about half of all chapter 11 cases result in a confirmed plan. Professionals representing debtors and committees, therefore, tend to negotiate “worst-case” carve-outs to ensure a minimum amount of compensation if the case becomes administratively insolvent or converts to chapter 7.

Lenders’ professionals, on the other hand, usually view carve-outs as limitations on compensation, regardless of the outcome of the case. In most cases, this divergence of views is immaterial or any disputes are settled before a court is forced to intervene.

Other Fallout from the Molycrop Ruling

The ruling in Molycorp will undoubtedly change how lenders’ professionals approach carve-outs. Lenders’ professionals will likely draft carve-out provisions expressly providing for an “absolute cap” on compensation, or seeking a waiver of estate professionals’ rights to assert administrative expense claims, in exchange for their clients’ agreeing to provide a carve-out.

Estate professionals, particularly those representing committees, must also change how they approach carve-outs. A committee’s effectiveness is defined by how active or passive its actions are in a chapter 11 case. Small-dollar carve-outs will restrict committee actions and reduce their role, while simultaneously giving lenders (and other constituencies) greater license to pursue their agendas.

Committee professionals must brace for a sea-change in carve-out negotiations, and remain vigilant to protect the interests of trade creditors in chapter 11.

About Michael A. Brandess

Michael A. Brandess, a partner in his firm’s Bankruptcy, Reorganization and Creditors’ Rights practice group, is consistently recognized for his dedicated and zealous representation of his clients, finding the most efficient and creative solutions, securing his clientele the most value for their claims.  Michael’s practice focuses on the representation of asset purchasers in complex bankruptcy…

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Michael A. Brandess

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