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A Lesson in DIP Financing Due Diligence

May/June 2018

The Bankruptcy Code contains an array of provisions designed to encourage lenders to provide debtor-in-possession ("DIP") financing in chapter 11 cases, including authorization of "superpriority" administrative expense claims and "priming" liens designed to ensure that DIP loans are repaid. However, as illustrated by a ruling recently handed down by the U.S. Court of Appeals for the Seventh Circuit, these provisions do not relieve a DIP lender from its obligation to perform customary due diligence regarding the terms of the loan, including the extent and value of the collateral securing it. In Banco Panamericano, Inc. v. City of Peoria, 880 F.3d 329 (7th Cir. 2018), the Seventh Circuit held that a DIP lender with a superpriority claim secured by a "blanket lien" on all of the debtor lessee’s assets did not have a "better claim" to property which automatically reverted to the lessor upon termination of a lease.

"All Asset Liens" and DIP Financing

Under the Uniform Commercial Code (the "UCC"), in order for a security interest to attach to a debtor’s property, the financing statement granting the security interest must clearly describe the property. See UCC § 9-203(B). However, section 9-504(2) of the UCC provides that a financing statement sufficiently identifies the collateral if the financing statement states that the security interest covers "all assets." If properly perfected, such a "blanket lien" will have priority over subsequent liens and security interests, with certain exceptions, including purchase money security interests, certain mechanic’s and tax liens, and pari passu or priming liens securing DIP financing in a bankruptcy case.

The Bankruptcy Code provides that a bankruptcy trustee or DIP may obtain unsecured credit or financing in the ordinary course of business and that the resulting claims will be treated as administrative expenses. See 11 U.S.C. § 364(a). In addition, the bankruptcy court may authorize the trustee to obtain non-ordinary course unsecured credit or financing with administrative expense priority. If such unsecured financing is unavailable, the court, after notice and a hearing, may authorize the trustee or DIP to obtain: (i) unsecured financing with "superpriority" over other administrative expenses; or (ii) financing secured by a lien on unencumbered assets, a junior lien on already encumbered assets, a lien on already encumbered assets equal in priority to existing liens, or a "priming" lien on already encumbered assets, so long as the existing lien holder is provided with "adequate protection." See 11 U.S.C. § 364(c) and (d).

Panamericano

In November 1995, the City of Peoria, Illinois, signed a lease with Resource Technology Corporation ("RTC"). RTC agreed to lease land in and beneath the city’s public landfill to build and operate a gas conversion system. This system captured methane gas from beneath the landfill’s surface and transported the gas through an interconnect made up of three miles of wires, pipes, and utility poles. RTC then converted the gas into electricity and sold it to the local electric utility company.

Under the lease, RTC had the exclusive right to construct, operate, and maintain the conversion system and interconnect at its own expense. In exchange, RTC paid Peoria a 6 percent royalty on its electricity sales to the local utility company.

Peoria had the right to terminate the lease if RTC abandoned the gas conversion system. The lease provided that, within 30 days of termination, Peoria could notify RTC of any structures, equipment, and below-ground installations the city wished to retain, at no cost. Post-termination, Peoria also had the option to purchase any equipment that RTC wished to sell at a mutually agreed upon price. Finally, the lease provided that "[t]itle to and ownership of any of RTC’s property which is not removed within ninety (90) days after termination passes to Peoria." RTC and Peoria initially agreed to a 10-year lease term.

In 1999, creditors filed an involuntary chapter 7 case against RTC in the Northern District of Illinois. After the bankruptcy court converted the case to chapter 11, the court authorized RTC to obtain DIP financing from Banco Panamericano ("BP"). The financing order provided that BP’s claims would have superpriority administrative expense priority under section 364(c)(1) of the Bankruptcy Code and that the loans would be secured "by liens and security interests in essentially all of RTC’s assets." The loan agreement defined BP’s collateral to include "all of the assets of the Debtor . . . including, but not limited to . . . landfill gas rights and collection facilities leases . . . and all of the Debtor’s residual right in the underlying leased property."

RTC defaulted on its postpetition loan in 2004, and the bankruptcy court lifted the automatic stay to permit BP to proceed against its collateral. However, the stay relief order excluded certain assets from being deemed collateral, namely, the "electric generation equipment and contracts to sell electricity relating to the Debtor’s facilities located in . . . Peoria, Illinois."

The court converted RTC’s chapter 11 case to a chapter 7 case in September 2005. The chapter 7 trustee operated the company for approximately one year before beginning to liquidate RTC’s assets. During this time, RTC continued to operate its Peoria gas conversion program, and the bankruptcy court authorized RTC to extend its lease with Peoria. However, methane gas collection soon dwindled, and gas conversion stopped completely.

Peoria sent a formal termination letter in February 2008, citing RTC’s failure to cure certain breaches of the 1995 lease. Additionally, Peoria notified RTC that, according to the terms of the 1995 lease, the city elected to keep all of RTC’s "structures" and "below-grade installations and/or improvements." Peoria asked RTC to remove any equipment that it wished to retain from the gas conversion site as soon as possible. Thereafter, Peoria began operating the system itself.

BP sued Peoria in February 2013 in federal district court, alleging that the city unjustly enriched itself "by benefiting from the structures and installations that it retained after termination of the RTC lease." The bank claimed that its superpriority lien against all of RTC’s assets gave it a "better claim" than Peoria had to the structures and installations. Both the bank and the city filed cross-motions for summary judgment.

In Illinois, a plaintiff claiming unjust enrichment must "allege that the defendant has unjustly retained a benefit to the plaintiff’s detriment, and that the defendant’s retention of the benefit violates the fundamental principles of justice, equity, and good conscience." HPI Health Care Servs., Inc. v. Mt. Vernon Hospital, Inc., 131 Ill. 2d 145, 160 (1989). In cases where a plaintiff is seeking recovery of a benefit that was transferred to the defendant by a third party, the defendant’s retention of the benefit is unjust when:

(1) the benefit should have been given to the plaintiff, but the third party mistakenly gave it to the defendant instead . . . (2) the defendant procured the benefit from the third party through some type of wrongful conduct . . . , or (3) the plaintiff for some other reason had a better claim to the benefit than the defendant.

Id. (emphasis added).

BP argued that the "other reason" it had a "better claim to the benefit" than Peoria was that BP had a superpriority claim against and a first priority lien on all of RTC’s assets, which should supersede any claim the city had on the basis of its lease with RTC.

The district court ruled against BP, holding that Peoria had the "better claim" on the basis of the terms of the lease. BP appealed to the Seventh Circuit.

The Seventh Circuit’s Ruling

A three-judge panel of the Seventh Circuit affirmed. The Seventh Circuit panel reasoned that the 1995 lease addressed three types of property—"equipment," "structures," and "below-grade installations and/or improvements"—but gave RTC post-termination rights only in the equipment. Once the lease was terminated, the court explained, RTC "retained a property interest in the equipment at the gas collection project" because the lease stated that RTC had the option of either removing its equipment or selling it to Peoria. However, the lease did not provide RTC with any post-termination rights in the "structures" or "below-grade installations and/or improvements"—only post-termination duties (including the duty to restore the premises and to remove any structures that Peoria chose not to retain).

According to the Seventh Circuit panel, Peoria possessed the "better claim" because the plain language of the lease made it clear that the property automatically passed to Peoria 90 days after the termination of the lease. Because RTC never possessed any additional post-termination rights in the "structures" or "below-grade installations and/or improvements," the court reasoned, it was impossible for BP to possess "greater rights to the property than originally held by RTC," even with a superpriority claim and first priority lien in bankruptcy. Therefore, the Seventh Circuit panel held that the "bank’s security interest could not reach the structures and installations at Peoria’s landfill."

Outlook

Panamericano is a cautionary tale for DIP lenders. First, it highlights the risks of collection following a failed chapter 11 case. BP evidently sued Peoria because, after RTC’s bankruptcy case was converted to a chapter 7 liquidation, the estate lacked assets sufficient to repay the DIP financing.

Second, the case illustrates the importance of careful due diligence in assessing the collateral for a DIP loan. Simply put, if the debtor does not own some of the assets used in its business (either at the outset of the DIP loan or due to divestiture pursuant to the terms of a valid contract), superpriority claims or first priority blanket liens granted in connection with DIP financing will not bring such assets into the universe of the lender’s collateral.

This article was prepared with the assistance of Meredith Collier.

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