A break-up fee is typically used to encourage a party to act as the initial or “stalking horse” bidder in connection with a sale under section 363 of the Bankruptcy Code. Under certain circumstances, a potential debtor may agree to pay a break-up fee to a prospective lender to entice the lender to provide the debtor with financing during its bankruptcy case. Recently, the United States Bankruptcy Court for the District of Oregon analyzed whether a lender, who ultimately did not provide any financing to the debtor, was entitled to payment of its break-up fee in a chapter 11 case. In re C&K Market, Inc., No. 13-64561-fra11 (Bankr. D. Ore. April 8, 2014).
In anticipation of filing for relief under chapter 11, the debtor, C&K Market, Inc., reached out to its existing lender, US Bank, to negotiate a debtor-in-possession financing to ensure that it had access to funds in bankruptcy. During the course of the negotiations with US Bank, C&K determined that it needed to secure an alternative source of financing (1) to gain leverage with US Bank and (2) to ensure that it had access to funds in its bankruptcy case in case US Bank decided not to provide DIP financing.
Thereafter, C&K entered into a term sheet with Sunstone Business Finance, LLC, pursuant to which Sunstone agree to provide C&K with secured DIP financing of $5 – $7.5 million, subject to bankruptcy court approval. In addition to customary and standard fees, C&K agreed to pay a break-up fee of $250,000 to Sunshine in the event the loan did not close because C&K decided to seek other financing.
Ultimately, C&K and US Bank were able to agree on the terms of DIP financing. C&K filed for bankruptcy and the bankruptcy court entered a final order approving US Bank’s DIP financing, triggering C&K’s obligation to pay the break-up fee to Sunstone.
Bankruptcy Court’s Analysis
Sunstone filed a proof of claim for $250,000 and a motion for an order allowing its claim as an administrative expense under section 503 of the Bankruptcy Code. C&K supported Sunstone’s request. The official committee of unsecured creditors, US Bank, and mezzanine lenders, however, objected to Sunstone’s claim and the administrative expense request.
In addressing Sunstone’s claim for payment of the break-up fee as an administrative expense under section 503 of the Bankruptcy Code, the court concluded that C&K and Sunstone had entered into a valid enforceable contract subject to bankruptcy court approval. Because the agreement was entered into prior to the bankruptcy filing, the break-up fee was a prepetition claim against C&K’s estate. Moreover, any benefit attributed to the arrangement with Sunstone – including providing C&K with leverage in the negotiations with the bank and assurances that it would have access to funds after filing for bankruptcy – occurred prepetition, and not post-petition, a prerequisite to allowance as an administrative expense claim. Accordingly, the court allowed Sunstone’s break-up fee as a prepetition general unsecured claim in the amount of $250,000, but denied Sunstone’s request for payment as an administrative expense.
The bankruptcy court recognized the importance of break-up fees as a tool to encourage competing offers by lenders. The court, however, concluded that it was constrained by the Bankruptcy Code’s strict requirements on administrative expenses, which Sunstone did not satisfy.
Lenders in the future should be wary of relying simply on a prepetition agreement by a potential debtor to break-up fee and consider improving their chances of payment, by obtaining a properly perfected security interest in funds set aside by the debtor to cover payment of such a fee. Such steps may nevertheless be subject to challenge and ultimately may only provide a lender with leverage to negotiate payment of a break-up fee.