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A recent Opinion by the Hon. Kevin J. Carey of the United States Bankruptcy Court for the District of Delaware permitted mechanic’s lien claimants to avoid being trumped by a debtor-in-possession (“DIP”) lender’s super-priority lien. The Newhall Land and Farming Company v. American Heritage Landscape, LP, C.A. Rasmussen, Inc., Granite Construction Company, and R&R Pipeline, Inc. (In re Landsource Communities Development LLC) (Adv. No. 09-51074 (KJC))(Bankr. Delaware, August 30, 2012).

The Opinion made it clear that the Court viewed itself as a gatekeeper guarding against possible overreaching by DIP lenders. The Court stated that it was “loathe to allow incineration a valid liens” based upon the failure of the mechanic’s lienholders to formally object to the DIP financing motion. The Opinion is important because it provides some practical lessons about the importance of paying close attention to DIP financing motions.

The Opinion arose in connection with an adversary proceeding filed by the debtor pursuant to section 506(a) of the Bankruptcy Code seeking a determination that the mechanic’s lien claimants did not hold valid secured claims. Section 506(a) permits a secured claim to be treated as an unsecured claim if there is no equity in the property available for the secured claim. The debtor’s primary argument was that the mechanic’s lien claimants failed to file formal objections to DIP financing motion. As a result, the debtor argued that the mechanics liens were primed by the express terms of the DIP financing agreement approved by the Court. Because the amount of the DIP lien substantially exceeded the value of the collateral, the debtor claimed that there was no value to the mechanic’s liens and that the mechanic’s lien claims could be treated as unsecured under section 506(a) of the Bankruptcy Code.

The mechanic’s lien claimants respond by pointing to the language of the DIP financing agreement which categorizes existing liens as either permitted liens or primed liens. The only difference between the two categories was that a lien would be permitted if the claimant filed an objection or “other responsive pleading” prior to the final DIP financing order. If no objection was filed, the lien would be treated as primed. As result, it appears that the debtor and the DIP lender were relying upon inaction of prior lien claimants in order to obtain the super-priority lien. The mechanic’s lien claimants noted that they had filed notices of perfection under section 546(d) of the Bankruptcy Code prior to the entry of the final DIP financing order and that the section 546(d) notices were effectively responsive pleadings to the DIP motion, even though the section 546(b) notices did not address the motion.

The Court seized upon the section 546 (b) notices of lien perfection as an indication that the mechanic’s lien claimants were not consenting to the priming effect of the DIP financing agreement. This permitted the Court to conclude that the section 546(b) notice was an "other responsive pleading” that placed the mechanic’s liens into the permitted category.

The Court noted that bankruptcy courts are frequently the final arbiter of whether DIP financing should be approved and that a bankruptcy court is perhaps the most effective negotiator against the secured lender. In other words, debtors are frequently in such need of financing to continue operations that they agree to onerous terms. The Court clearly viewed itself as a gatekeeper to protect against those onerous terms.

The lessons in this case are threefold. First, courts are frequently disinclined to permit a DIP lender to trump other secured claims in connection with DIP financing. This is particularly true in situations like the Newhall Land case where the DIP lender was effectuating a "roll up" which results in granting super-priority status to the DIP lender’s pre-petition secured claim. As a result, DIP lenders and other creditors should be cognizant that super-priority liens are generally disfavored by bankruptcy courts and could be subject to attack even after the super-priority lien is approved by the bankruptcy court.

Second, all creditors should pay close attention to the very early stages of a bankruptcy case because substantial rights may be affected. This is particularly true in connection with DIP financing, which may result in the DIP lender’s pre-petition claims being “rolled up” and secured by a super-priority DIP lien. This results in the priming and subordination of all of the other secured creditors in the case, not just mechanic’s lien claimants. In the Newhall Land case, the only thing standing in the way of the elimination of the mechanic’s liens was a sympathetic judge because the mechanic’s lien claimants failed to file formal objections to the DIP financing.

The third lesson deals with the process of obtaining a super-priority lien. Most DIP financing scenarios arise as part of the first day motions and are frequently concluded prior to the time when many creditors are up to speed in the case. As result, a court may closely scrutinize whether the notice and opportunity to be heard was sufficient and whether the creditor really had an opportunity to object to the DIP financing motion. Even without concluding that there was a defect in the procedure, the Newhall Land Court construed the language of the DIP financing agreement against the debtor and the DIP lender. A court may also be influenced by the underlying fairness of the transaction. The Newhall Land process was inherently subject to fairness attacks because the only distinction between permitted and primed liens was that attention and diligence of the creditors.

As a result, a creditor should be vigilant in the early stages of a bankruptcy proceeding. It is important that a creditor review the DIP financing motions and interim order to determine if the order provides for a super-priority lien or a “roll up” which may significantly affect the value of the creditor’s claims. A creditor should also review the DIP financing motions and interim order to determine if a formal objection is needed to preserve the creditor’s rights.