On August 30, 2012 the US Bankruptcy Court for the District of Delaware issued an opinion in Newhall Land & Farming Co. v. American Heritage Landscape, LP (In re LandSource Communities Development LLC) holding that prepetition mechanic's liens had priority over the lien of a debtor-in-possession (DIP) lender. The mechanics' liens had priority even though the holders of the mechanics' liens failed to file objections to the priming of their liens as required by the DIP credit agreement.

The debtors were in the business of real estate development. One of the debtors, The Newhall Land and Farming Company (Newhall) had entered into prepetition contracts with American Heritage Landscape, LP (AHL) and R&R Pipeline, Inc. (R&R). AHL and R&R held recorded mechanics' liens against property owned by Newhall. After filing for Chapter 11 relief, the debtors filed a motion to approve DIP financing, which would include a revolving credit facility secured by, among other things, priming liens on substantially all of the debtors' property. The Committee of Unsecured Creditors objected to the ambiguity in the proposed DIP financing about whether the lender was seeking to prime existing mechanics' liens and opposed the priming of those liens if that relief was being requested. Objections to the DIP financing were resolved and the bankruptcy court eventually approved the DIP financing. Before the entry of the final DIP order, AHL and R&R filed notices of perfection of their mechanic's liens under section 546(b) of the Bankruptcy Code, which permits the retroactive perfection of certain statutory liens.

The DIP credit agreement provided for permitted liens that would not be primed by the DIP financing. To deem liens as permitted liens, the DIP credit agreement required lienholders to opt out of their liens being primed by filing an objection or other responsive pleading with the bankruptcy court. Neither AHL nor R&R filed an objection. Newhall brought an adversary proceeding to seek a declaration that the mechanics' liens were primed by the DIP liens. AHL and R&R argued that their mechanics' liens remained secure, senior in priority and enforceable despite their failure to file formal objections.

The bankruptcy court granted partial summary judgment in favor of AHL and R&R, holding that their mechanics' liens had priority over the DIP lien. It ruled that although AHL and R&R did not file objections to the priming of their liens as required by the DIP credit agreement, their notices of perfection were sufficient to alert Newhall that they opposed the priming of their mechanics' liens by the DIP liens. The bankruptcy court explained that it was averse to allow the cancellation of valid liens when the lienholders had clearly asserted their rights and, therefore, it deemed the mechanics' liens to be permitted liens under the DIP credit agreement.

While the bankruptcy court ruled in favor of the holders of the mechanics' liens, it was careful to note that its decision was based on the specific circumstances in the case. It is still best practice for lienholders to make formal objections to the priming of their liens when required to preserve the priority of their liens, rather than to take the chance that a court will excuse them for failing to do so.

For more information about DIP financing, see Practice Note, DIP Financing: Overview and Timeline of DIP Financing Process.