In an effort to subordinate the unsecured creditor’s setoff rights,¹ debtor in possession (DIP) lenders often seek to prime setoff rights in orders approving DIP financing (DIP orders). While in appropriate circumstances § 364(d) of the Code authorizes the priming of existing liens, a right of setoff, unlike a lien, is not directly affected by § 364(d) despite contrary arguments from secured creditors. However, bankruptcy courts have not taken a uniform stance on the ability to prime setoff rights.

Statutory Background

Several Code sections are implicated when a DIP lender attempts to prime a creditor’s setoff right, including §§ 364(d), 553(a) and 506(a). Section 364(d) permits a DIP lender to prime existing liens as follows: The Court, after notice and a hearing, may authorize the obtaining of credit or the incurring of debt secured by a senior or equal lien on property of the estate that is subject to a lien only if—

(A) the trustee is unable to obtain such credit otherwise; and
(B) there is adequate protection of the interest of the holder of the lien on the property of the estate on which such senior or equal lien is proposed to be granted.²

In turn, § 553(a) preserves a creditor’s common law right to setoff under the following terms:³

Except as otherwise provided in this section and in sections 362 and 363 of this title, this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case.⁴

By its terms, then, § 553 may be affected by only two Code sections. Section 362 governs the automatic stay, and as such, “operates as a stay, applicable to all entities—of the setoff of any debt owing to the debtor that arose before the commencement of the case under this title.”⁵ Section 363 governs the use, sale or lease of estate property, granting the debtor or trustee the right to do so even if the property is subject to the right of setoff.⁶ Finally, in recognition of and in conjunction with the setoff right preserved in § 553, § 506(a) provides that a setoff right be treated as a secured claim as follows:

An allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under section 553 of this title, is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor’s interest or the amount so subject to setoff is less than the amount of such allowed claim.⁷

Analysis

Notwithstanding the express language of § 553 prohibiting the Bankruptcy Code (other than §§ 362 and 363) from affecting setoff rights, DIP orders occasionally include express language subordinating setoff rights pursuant to § 364(d),⁸ or authorizing a general priming lien pursuant to § 364(d) “upon all tangible and intangible property of the Debtors’ estates that are encumbered” and often include additional protective language that the priming liens are senior to all other liens, security interests or claims.⁹ Even where the DIP order’s priming language does not expressly seek to prime or subordinate rights of setoff, DIP lenders often argue that a DIP order’s § 364(d) priming lien has primed a creditor’s setoff rights.¹⁰

DIP lenders seeking to prime setoff rights point to the broad equitable powers of a bankruptcy court pursuant to § 105 and the adequate-assurance requirement of § 364(d) for su