DIP Financing and Liens On Avoidance Actions

In In re Simply Essentials, LLC, 2023 WL 5341506, *1 (8th Cir. Aug. 21, 2023), the Eighth Circuit held that "avoidance actions [e.g., preferences, fraudulent transfers] can be sold as property of the [Chapter 7 debtor's] estate." On a direct appeal from the bankruptcy court, the court affirmed the bankruptcy court's granting of the trustee's motions to compromise and sell property under Bankruptcy Code §363(f). A creditor had objected, arguing unsuccessfully that "avoidance actions… are not part of the bankruptcy estate …." Id. As shown below, the Eighth Circuit's holding and reasoning are consistent with the reasoning of other circuits in the asset sale context. More important, the decision has practical significance for Chapter 11 debtor in possession (DIP) lenders. U.S. Trustees and unsecured creditors regularly object to the granting of liens on avoidance actions, but Simply Essentials and other appellate rulings should now eliminate the purported legal obstacle.

Relevance

Bankruptcy judges are also often resistant when DIP lenders seek liens on avoidance actions. These estate assets are unencumbered and their proceeds would be otherwise available for unsecured creditors. Thus, local rules for Delaware and the Southern District of New York, for example, require all financing motions to identify and justify liens on estate claims "arising under sections 544, 545, 547 and 548 of the Bankruptcy Code or, in each case, the proceeds thereof." See, e.g., Del. Local Bankruptcy Rule 4001-2(a)(i)(U); Southern District of New York Bankruptcy Rule 4001-2(a)(9) (provisions must be "prominently highlighted and easily identified in the motion; failure to do so may result in such provisions being deemed denied by the court"). But mere compliance with these rules does not mean that the court will grant liens on avoidance actions. The debtor in possession and its lender must be prepared to justify the granting of such relief. As shown below, the Eighth Circuit's recent reasoning in Simply Essentials and the Seventh Circuit's analysis in Mellon Bank, N.A. v. Dick Corp., 351 F.3d 290 (7th Cir. 2003), cert. denied, 124 S. Ct. 2103 (2004) (Dick), provide DIP lenders with the legal support for obtaining liens on avoidance actions when they can show benefit to the debtor's estate.

The Seventh Circuit's Analysis

Post-petition avoidance actions (e.g., fraudulent transfers, preferences) can constitute additional collateral for a new DIP loan despite challenges by the U.S. Trustee or creditors' committee. In Dick, the Seventh Circuit upheld the secured creditors' entitlement to pursue preference actions when they had a lien on the claims. The bankruptcy court there had entered an order, affirmed earlier by the Seventh Circuit, In re Qualitech Steel Corp., 276 F.3d 245 (7th Cir. 2001), granting pre-bankruptcy secured creditors the first $30 million of preference recoveries if their collateral position deteriorated. The bankruptcy court granted this relief as a quid pro quo for the secured creditors' consenting to new DIP financing that primed their existing liens.