On May 24, 2013, the US Bankruptcy Court for the Southern District of Florida held in In re National Litho, LLC that conversion from a Chapter 11 to a Chapter 7 bankruptcy proceeding does not subordinate a DIP financing lender's pre-conversion section 364(c)(1) superpriority claim to Chapter 7 administrative expenses.

On July 22, 2012, National Litho, LLC (Debtor) filed a voluntary Chapter 11 proceeding. On October 19, 2012, the Debtor filed an emergency motion seeking:

On December 4, 2012, the Court entered a final order approving the motion. By the terms of the order, the DIP loan had "priority over any and all administrative expenses, subject and subordinate to":

Two days later the Court, at the Debtor's request, converted the case to a Chapter 7 liquidation. On February 6, 2013, the DIP Lender filed a motion for allowance and payment of its priority claim. The Chapter 7 trustee and another party objected.

The key litigated issue is what effect, if any, does the conversion of a bankruptcy case from Chapter 11 to Chapter 7 have on the priority of a DIP lender's pre-conversion section 364(c)(1) superpriority administrative claim.

Under section 726(a) of the Bankruptcy Code, superpriority is given to the administrative expenses (also called burial expenses) incurred under section 503(b) after an unsuccessful Chapter 11 bankruptcy case is converted into a Chapter 7 liquidation case. This means that all of the administrative expenses of the Chapter 7 case must be paid in full before any pre-conversion administrative expenses may be paid. The purpose is to provide an incentive to encourage professionals and trustees to participate in these cases to wind up the debtor's affairs.

Under section 364(c)(1) of the Bankruptcy Code, the court may grant lenders who provide unsecured DIP financing a superpriority claim allowing them to be paid ahead of all other administrative claims. The Bankruptcy Code is unclear as to whether Chapter 7 administrative expenses have priority over this superpriority for new unsecured debt.

The Court held that, based on the plain language of the Bankruptcy Code and the DIP financing order, the DIP Lender's section 364(c)(1) superpriority claim maintained its priority over post-conversion Chapter 7 administrative expenses.

The Court rejected the Chapter 7 trustee's policy argument, advanced by the decision in In re Summit Ventures, Inc., that encouraging the complete administration of a Chapter 7 estate by giving Chapter 7 administrative expenses priority is more important than encouraging Chapter 11 financing (see 135 B.R. 478 (Bankr. D. Vt. 1991)). Instead, the Court held that because the Bankruptcy Code is unambiguous on this issue, the Court may not rely on policy arguments to vary the Bankruptcy Code's plain language.

The Court reasoned that section 726(b) of the Bankruptcy Code provides that any section 503(b) administrative claim arising in a Chapter 7 case has priority over any section 503(b) claim arising in the pre-conversion Chapter 11 case. However, nothing in section 726(b) provides that a section 503(b) claim arising in a Chapter 7 case has priority over a claim arising under section 364(c)(1) of the Bankruptcy Code. Therefore, conversion has no impact on the priority of the section 364(c)(1) claim over any section 503(b) administrative expense, whether incurred pre- or post-conversion.

The Court also examined the DIP financing order, which provided that the DIP Lender's claim had "priority over any and all administrative expenses," other than those held by the Factor and the Carve-Out. Because the DIP Lender advanced funds under this order, which did not include a carve-out for Chapter 7 administrative expenses, the conversion did not impact the priority of the pre-conversion section 364(c)(1) claim.

The Court distinguished the facts of this case from In re Sun Runner Marine, Inc., in which a court subordinated a Chapter 11 507(b) claim for "inadequate" protection to post-conversion Chapter 7 administrative expenses (see 134 B.R. 4 (9th Cir. B.A.P. 1991)). It reasoned that while section 507(b) claims are within the scope of section 726(b) of the Bankruptcy Code, the DIP Lender's claim in this case arose under section 364(c)(1), which is not within the scope of section 726(b).

This decision runs counter to the few cases that have considered this issue. Therefore the issue is still unsettled, and the outcome may depend on the jurisdiction of the case. To minimize the risk of a court subordinating its section 364(c)(1) claim, a DIP lender should consider seeking language in the DIP financing order clarifying that if the case is converted to Chapter 7, its superpriority claim maintains priority over any post-conversion Chapter 7 administrative expense claims.

For more information on DIP financing, see Practice Note, DIP Financing: Overview.

For more information on the order in which claims are paid in bankruptcy, see Practice Note, Order of Distribution in Bankruptcy.