Chapter 6 Carve-Outs, Surcharge and Priming Liens

• Jurisdiction: United States

Chapter 6: Carve-Outs, Surcharge and Priming Liens

Stepnen v. Falanaga

The rights of secured creditors to their collateral and the proceeds arising from the disposition of their collateral in bankruptcy can be subject to both consensual and involuntary modification by the bankruptcy court. Three common issues that arise in bankruptcy cases involving allowed secured claims include consensual "carve-outs" and nonconsensual collateral "surcharges" and "priming liens." Each of the foregoing concepts can play a role at various times in a bankruptcy case, with carve-outs and priming liens often arising in the initial stages of a case and collateral surcharge occurring months or even years after a case has progressed.

A. Carve-Outs

The term "carve-out" does not appear anywhere in the Bankruptcy Code, but it nonetheless connotes definite meaning to parties-in-interest in a bankruptcy case, particularly professionals whose retention and fees in a bankruptcy case are subject to bankruptcy court approval.⁶²⁸ A "carve-out" is essentially an agreement by the secured creditor who holds a security interest in all or some of the assets of the estate to allow a portion of the proceeds to be set aside for payment to other parties-in-interest in a bankruptcy case. Generally, in the first instance, a carve-out may pay the professional fees and administrative expense claims of a case. In simplest terms, the secured creditor agrees to "carve out" a portion of its lien position proceeds to pay for administrative expenses. These administrative expenses include professional fees for the bankruptcy trustee, debtor's counsel or the unsecured creditors' committee. Additionally, carve-outs may involve the allocation of a secured creditor's collateral proceeds to the pro rata payment of general unsecured creditors that otherwise would not be entitled to any recovery from the bankruptcy estate — a concept commonly known as "gifting."⁶²⁹ The carve-out is an exception to the general rule that costs and expenses are to be borne by the debtor's estate.⁶³⁰

1. When Are Carve-Outs Necessary or Appropriate?

In theory, carve-outs are entirely voluntary by the secured creditor. In practice, however, carve-outs are most often compelled by the circumstances of the case. Regardless, a carve-out is only necessary where no other form of payment for the expenses of the bankruptcy case is available.

In chapter 11, carve-outs typically arise at the outset of the case when the debtor-in-possession seeks financing or the continued use of cash collateral to maintain business operations. In the absence of unencumbered assets, many bankruptcy courts will be reluctant to approve a financing order or the use of cash collateral to continue operations under § 364 unless a carve-out in a reasonable amount in relation to the size of the case is agreed to by the existing lender. The carve-out may ensure payment of the fees of debtor's and the committees' counsel, and possibly trustee's counsel in the event one is appointed.⁶³¹

A carve-out may also arise if the debtor seeks to sell assets subject to the secured creditor's lien under § 363 and where the secured creditor will receive a direct benefit from the sale of the collateral.⁶³² In those situations, as part of consenting to the sale under § 363, the secured creditor will often negotiate a specific dollar amount to be set aside from the anticipated sale proceeds for the payment of administrative expense claims and commonly for a dividend to unsecured creditors. A carve-out negotiated in connection with a § 363 sale that results in funds being allocated to unsecured creditors is viewed by some bankruptcy courts as an inappropriate avoidance of the plan process.⁶³³ Alternatively, a secured creditor may offer a carve-out in connection with a plan of reorganization that calls for the subsequent sale of its collateral as a means of facilitating the feasibility and implementation of the plan.

In the chapter 7 case, carve-outs often arise where there are no under-encumbered assets and the secured creditor agrees to release funds to the trustee for the payment of his expenses, as well as some dividend to unsecured creditors as an incentive to the trustee to administer the assets of the estate. However, for a carve-out to be approved in the chapter 7 context, bankruptcy courts will typically require that a "meaningful" distribution to unsecured creditors arise from the trustee's action in liquidating the fully encumbered asset.⁶³⁴

2. What Types of Fees and Expenses Are Typically Agreed to in a Carve-Out?

The types of fees and expenses that are typically agreed to in a carve-out include the administrative expenses of attorneys, accountants and other retained professionals of the estate including the debtor-in-pos-session and the unsecured creditors' committee. Often the Office of the U.S. Trustee will insist its quarterly fees and other statutory fees are included in any carve-out as well. Under certain circumstances, par-ties-in-interest or the court may require that some portion of the carve-out be set aside to cover the costs to wind down the bankruptcy estate upon its conversion to chapter 7.

As noted above, dividends to the unsecured creditor body, either in connection with a plan or as part of a § 363 sale, are also common. The concept, known as "gifting," is not accepted by all bankruptcy courts. In theory, the secured creditor is merely "giving" its property directly to another class of creditors, but this process, when accomplished in connection with a § 363 sale, results in the bypassing of the statutory priority treatment of creditor claims (i.e., secured, administrative, unsecured, equity). Administrative expense creditors who are not among the intended beneficiaries of a carve-out often object on grounds that the carved-out funds are property of the bankruptcy estate that should be applied pro rata for the benefit of all administrative claimants, according to the statutory priorities of the Bankruptcy Code.⁶³⁵

Often a secured creditor will attempt to prohibit any portion of the carve-out from being used in connection with litigation against the secured creditor by the estate professionals. While this is logical in theory, a court may not agree to approve those types of restrictions in furtherance of ensuring that the adversary system is not impacted.⁶³⁶ As discussed below, however, in connection with a carve-out, the secured creditor will typically obtain a stipulation as to the validity and priority of its liens, which will provide some protection in exchange for the carve-out.

3. What Do Secured Creditors Typically Get in Return for Carve-Out Allowances?

In exchange for providing the funds in the form of a...