On April 8, 2014, the US Bankruptcy Court for the District of Oregon, in In re C&K Market, Inc., held that a prospective DIP financing lender was entitled to an unsecured claim for a break-up fee negotiated with the potential debtor prepetition, that was payable if the debtor chose an alternate financing arrangement with another lender (No. 13-64561, (Bankr. D. Or. Apr. 8, 2014)).

C&K Market, Inc. (C&K) was a regional grocery store operator which, as of the petition date, was indebted to US Bank for $33,809,109 and to mezzanine lenders for $30,600,798. In 2013, C&K anticipated the need to reorganize and started negotiating a DIP financing with US Bank to be put in place before C&K filed for Chapter 11 protection. However, C&K determined that it needed to develop an alternative source of DIP financing to:

On October 25, 2013, C&K signed a term sheet (Term Sheet) with Sunstone Business Finance, LLC (Sunstone), which stated, among other things, that:

These terms were later finalized in an executed DIP credit agreement (Sunstone DIP Agreement), which clarified that, among other things, the DIP facility would be "up to $7,000,000."

On November 18, 2013, C&K agreed on a DIP financing package with US Bank. On November 19, 2013, C&K filed its Chapter 11 petition and moved for approval of US Bank's DIP financing, which included considerably better loan terms than offered by Sunstone. On December 27, 2013, the Court entered a final order approving US Bank's DIP financing, which triggered C&K's obligation to pay the break-up fee to Sunstone.

Sunstone filed a proof of claim for the $250,000 break-up fee and a motion for an order allowing its claim as an administrative expense under section 503(b) of the Bankruptcy Code. Administrative expense claims must be paid in full in cash on the effective date of the plan of reorganization.

While C&K supported Sunstone's motion, the creditors' committee, US Bank and the mezzanine lenders (collectively, Objectors) objected both to the administrative treatment of the claim and the claim itself. The Objectors argued that the proof of claim should be denied because:

The Court allowed Sunstone's break-up fee as a prepetition unsecured claim, but denied its motion for administrative expense treatment under section 503(b).

Turning first to the validity of the claim itself, the Court examined the Term Sheet and easily dismissed the Objectors' arguments. Addressing the first argument, the Court noted that, while the break-up fee was relatively high, it was negotiated by the parties and the evidence indicated that Sunstone would not have agreed to provide DIP financing without the break-up fee. Further, Sunstone's willingness to lend on short notice served as consideration for the break-up fee.

Addressing the second argument, the Court stated that because no evidence was presented about what a reasonable break-up fee should be in these circumstances, it could not determine whether the $250,000 fee constituted reasonably equivalent value for the services provided by Sunstone (a prerequisite for protecting a transfer from avoidance as a fraudulent transfer under section 548 of the Bankruptcy Code), and declined to disallow the break-up fee on that basis.

As to the third and fourth arguments, the Court found that the Term Sheet provided sufficient certainty of the DIP facility amount to be enforceable and that the agreement was not vague or illusory. The Term Sheet evidenced the parties' intent to be bound and, while the Term Sheet did not contain a specific amount, it did specify a range along with the basic terms of the agreement, including events of default and remedies. In fact, the Sunstone DIP Agreement filled in the gaps left by the Term Sheet and provided that the DIP facility was "up to $7,000,000" which, the Court held, provided the requisite certainty.

Turning to the issue of administrative priority, the Court declined to give Sunstone's claim administrative expense priority treatment. Under section 503(b)(1)(A) of the Bankruptcy Code, a claimant must show that the debt:

The Court explained that the alleged benefits that Sunstone provided to C&K, including assurances that C&K would have access to funds after filing for bankruptcy and leverage in its negotiations with US Bank, actually accrued to C&K prepetition and did not benefit C&K as the DIP after it filed for bankruptcy.

Sunstone also argued that by holding its offer to lend open until the Court entered a final order approving US Bank's DIP financing, it provided consideration to C&K as the DIP. However, providing alternate financing on terms less favorable than the DIP facility offered by US Bank, the Court held, was at most an incidental benefit to the estate. This was not the type of direct and substantial benefit necessary to transform a contingent prepetition claim into an administrative expense claim.

Finally, Sunstone argued that its claim for the break-up fee should be treated as an administrative expense under section 503(b)(3) of the Bankruptcy Code because it made a "substantial contribution" to the case. However, the Court held that the break-up fee was not an actual expense of Sunstone, nor any expense at all. Sunstone's actual expenditures were paid by C&K prepetition as required by the Term Sheet, which provided for payment of $5,000 to cover its out-of-pocket expenses.

This case illustrates that break-up fees can be used in the DIP financing context, as they are in section 363 sales where they are used to provide deal protection for stalking horse bidders (see Practice Note, Buying Assets in a Section 363 Bankruptcy Sale: Overview: Deal Protections). However, break-up fees awarded in section 363 sales, which occur during the bankruptcy case, are typically granted administrative expense claim status because they confer a postpetition benefit to the debtor. In contrast, because DIP financing is often negotiated before the debtor files for bankruptcy, the benefits derived from break-up fees in this context occur prepetition and therefore cannot be treated as administrative expenses. A stalking horse DIP lender can maximize payment on its break-up fee by obtaining a properly perfected security interest in the funds allocated by the debtor to pay the fee. However, the creditors' committee and other interested parties may challenge this action, so ultimately this may only give the lender leverage in negotiating payment of the break-up fee.

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