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The Government as Secured Creditor
"[W]hile reorganization is an important goal, this goal cannot be pursued by exterminating a secured creditor's property interest. Reorganization is not a Holy Grail to be pursued at any length." Matter of Rash, 31 F.3d 325, 330 (5th Cir. 1994).I. Define Issues And Goals At The Outset By Asking These Questions.
A. Do you have a valid, perfected security interest that is not subject to a bankruptcy avoidance power?
B. What threat is posed to collateral values or your claim by (1) the automatic stay or (2) in the case of chapter 11 or 13, from the anticipated plan?
C. Practical considerations for reorganizations. (1) Is reorganization feasible? (2) Is the debtor competent, honest and cooperative? (3) How much collateral value is lost if the debtor is liquidated?
D. Are there client policy interests besides maximizing recovery?
II. Defining The Secured Interest - Section 506.
A. Section 506(a) specifies that a secured creditor is entitled to secured status only to the extent of actual collateral value. Thus, the under -secured creditor has two claims: (1) secured to the extent of collateral value and (2) unsecured for any deficiency.
B. Section 506(b) - over -secured creditor is entitled to postpetition interest and attorney fees provided by the debt instrument even if not permitted by state law. In re Virginia Foundry Co., Inc. , 9 B.R. 493 (W.D.Va. 1981). This applies to nonconsensual as well as consensual liens. United States v. Ron Pair Enterprises, 108 S.Ct. 1464 (1988). See In re Delta Resources, Inc., 54 F.3d 722 (11th Cir. 1995) (the court reviewed the "narrow issue" of whether the creditor was entitled to receive § 506(b) interest through periodic payments during the case as adequate protection to preserve its the value of its "equity cushion." The court held that "payment of accrued postpetition interest to an oversecured creditor must await the completion of reorganization or confirmation of the bankruptcy case.").
C. Section 506(c) - secured creditor may be charged for the cost of preserving or disposing of its collateral. General standards for assessing administrative fees and cost to secured creditors are set forth in In re Korupp Associates, 30 B.R. 659 (Bankr. D.M. 1983). Liability under 506(c) is predicated on expenditures made "primarily" for the secured creditor and that "directly" benefits the secured creditor. In re Flagstaff Food Services Corp., 762 F.2d 10 (9th Cir. 1985).
D. Section 506(d) - a secured creditor's lien (in contrast to the debt) is not voided by bankruptcy discharge even if the creditor files no proof of claim unless the bankruptcy court disallows the debt on the merits pursuant to the request of a "party in interest." However, if the debt is disallowed solely because untimely filed, the lien nevertheless survives the discharge of the debt. In re Tarnow, 749 F.2d 464 (7th Cir. 1984). Is 506(d) an avoidance power in disguise? In re Folendore, 862 F.2d 1537 (11th Cir. 1989) says "yes." If the debtor requests, the debtor can avoid liens which have no value.
III. Adequate Protection - 11 U.S.C. § 361.
A. General consideration
1. Adequate protection is the Bankruptcy Code's term for the secured creditor's rights to preserve collateral values and marks the limits of the debtor's powers to continue against the secured creditor the stay under 362, to use, sale, or lease the creditor's security property under 363 or to demote the secured creditor's lien under 364.
2. The concept is derived from the Fifth Amendment's protection of property interest, according to the legislative history which cites Wright v. Union Central Life Insurance Co., 311 U.S. 273 (1940); Louisville Joint Stock Land Bank v. Radford, 295 U.S. 555 (1935). H.R. at 338-9.
3. The minimum formulation of the secured creditor's constitutional right is that the value of the collateral at the time of the filing of the petition may not be injured by the debtor or by powers derived from the Bankruptcy Code. Murphy Creditor's Rights In Bankruptcy, § 6.02. See United States v. Security Industrial Bank, 459 U.S. 70 (1982) for the most recent discussion of constitutional limitations on bankruptcy powers. See, also, In re Prime, Inc., 37 B.R. 897 (Bankr. W.D. Mo. 1984)
4. Adequate protection is equally based on policy grounds as on constitutional grounds; i.e., secured creditors are entitled to the "benefit of their bargain." H.R. At 338-9.
5. The creditor is not entitled to receive his bargain in kind but in value. Id.B. Code Sanctioned Methods Of Providing Adequate Protection
1. Periodic cash payments to compensate for a decrease in collateral value.
2. Additional or replacement liens to compensate for a decrease in collateral value or
3. Other relief that grants the "indubitable equivalent" of the creditor's interest in the property.
4. Providing adequate protection is not limited as to nature or form, except that granting an administrative expense under 503(b)(1) is expressly prohibited.IV. The Automatic Stay - Section 362
A. General Consideration
1. Arises upon filing of the petition.
2. A key element of debtor protection.
3. Broad but temporary.
4. Secured creditors may not initiate or continue actions against the debtor that are based upon pre-petition claims including foreclosure proceedings. 362(a)(1).
5. Stays "any act" to obtain possession of property of the estate or of property from the estate. 362(a)(3).
6. Stays "any act" to enforce liens against property of the estate. 362(a)(4).
7. Stays "any act" to enforce liens against property of the debtor if the claim secured by the lien arose pre-petition. 362(a)(5).
8. Creditors may not "dun" the debtor. 362(a)(6).
9. The Government secured creditor has no sovereign immunity defense to stays under § 362(a). § 362(a) contains the term "entity." See 106(c).
10. Actions against nondebtors are not stayed. Teachers Ins. & Annuity Ass'n v. Butler, 802 F.2d 61 (2nd Cir. 1986); Fortier v. Dona Anna Partners, 747 F.2d 1324 (10th Cir. 1984); Williford v. Armstrong World Indus., 715 F.2d 124 (4th Cir. 1983); Wedgewood v. Fibreboard Corp., 706 F.2d 541 (5th Cir. 1983). However stay applies if non-debtor is an alter ego. In re S.I. Acquisition, Inc., 817 F.2d 1142 (5th Cir. 1987); see also A.H. Robins Co. Inc. v. Piccinin, 788 F.2d 994 (4th Cir. 1986). N.b. the special stay applicable in chapter 13. § 1301.
11. Merely giving notice of default is not a stay violation. Original Sixteen to One Mine, Inc. v. Sixteen to One Mining Corporation, 9 B.R. 636 (Bankr. D. Nev. 1981). However, notice to the debtor terminating the debtor's contract is stayed. In re Computer Communications, 824 F.2d 725 (9th Cir. 1987). See, In re Adana Mortgage Investors, Inc., 12 B.R. 989 (Bankr. N.D. Ga. 1980), vacated 687 F.2d 344 (11th Cir. 1982). (The party held in contempt was a Government agency, GNMA. The court held that GNMA's post-petition termination of debtor's contractual right to perform violated the stay. We argued unsuccessfully to the bankruptcy court that the debtor had no contractual rights in a defaulted contract and that in any event the provisions of 365 were preemptive and exhausted the debtor's power to prevent termination of executory contracts.) Contra Watts v. Pennsylvania Housing Finance Co., 876 F.2d 1090 (3d Cir. 1989) (termination of unassumable contract for loan does not violate stay). This ruling in conjunction with In re West Electronics, 852 F.2d 79 (3d Cir. 1988) (federal anti-assignment law effective to prevent assumption of procurement contract by debtor without consent) gives the United States a basis to terminate federal contract without violating the stay. Also note In re The Hub of Military Circle, 13 B.R. 288 (Bankr. E.D. Va. 1981). (The creditor/landlord was held to have violated the stay by sending the debtor a letter notifying it of a default on a lease and threatening legal action if default was not cured.)
12. The automatic stay is not applicable to post-petition claims arising out of the operation of the debtor's business by the trustee. 28 U.S.C. § 959(a); In re Investors Funding Corp., 11 C.B.C. 71 (2d Cir. 1976).
13. If foreclosure sale is completed before filing, property is out of the estate and no longer subject to the stay. In re Butchman, 2 C.B.C.2d 1974 (Bankr. S.D. N.Y. 1980). See, also, In re Glenn, 260 F.2d 1428 (6th Cir. 1985).
14. The stay does not extend redemption periods beyond that allowed by § 108(b). In re Glenn, 260 F.2d 1428 (6th Cir. 1985); Johnson v. First National Bank, 719 F.2d 270, 275 (8th Cir. 1983), In re Carver, 828 F.2d 463 (8th Cir. 1987) (judicial redemption period not stayed); contra In re Jenkin, 19 B.R. 205 (D. Col. 1982).
15. Forfeiture proceedings by governmental units are stayed to the extent they effect property of the estate. The governmental unit's claim against the property is converted to a nondischargeable claim against the debtor. § l02(a), 523(a)(7), and 726(a)(4). In re Ryan, 15 B.R. 514 (Bankr. M.D. Md. 1981).
16. The debtor is not insulated by the automatic stay from contempt proceedings to punish a pre-petition action even if requested by a creditor. In re Dumas, 6 C.B.C.2d 472 (B.A.P. 9th Cir. 1982).
17. Action to terminate lease of nondebtor violates stay if effect is to terminate debtor's sublease. In re 48th Street Steakhouse, 835 F.2d 427 (2nd Cir. 1987).B. Exceptions To The Automatic Stay
1. None of substance. If collateral is property of the estate, you are stayed from disposition of the property even if you are in possession. See also, § 542 and 543.
2. Commencement of a suit on behalf of HUD to foreclose a mortgage insured under the National Housing Act which covers property consisting of five or move living units is excepted from the automatic stay. This section does not permit continuation of the action. 362(b)(7).C. Duration Of The Stay
D. Enforcement Of The Stay
1. Originally violations of the stay were sanctioned by contempt actions. However, in 1984, § 362(h) was added to the code which allows damages to be awarded to "individuals" injured by "willful" violations of the stay. The Fourth Circuit determined that § 362(h) rendered grounding sanctions for violations to stay on contempt unnecessary and interpreted "individual" to include the debtor corporation. Budget Service Company v. Better Homes of Virginia, 804 F.2d 289 (4th Cir. 1986). In Hoffman v. Connecticut Dept. of Income Maintenance, 109 S.Ct. 2818 (1989) the pluarity opinion interprets 106(c) as not waiving state sovereign immunity to monetary relief. SBA v. Rinehart, 8th Cir. No. 88-5442 Oct. 6, 1989, followed plurality in Hoffman and reversed award of punitive damages for stay violation of SBA. Contempt probably is an alternative basis to sanction violations of the stay. However, exercise of contempt authority by bankruptcy judges has doubtful statutory basis. In re Sequoia Auto Brokers, 827 F.2d 1281 (9th Cir. 1987) held that bankruptcy judges lacked a statutory grant of contempt power and must treat contempt cases as if they were "non-core" matters under 28 U.S.C. § 157(c). However, the Fourth Circuit held that bankruptcy judges have civil contempt power under the Bankruptcy Rules. In re Walters, 868 F.2d 665 (4th Cir. 1989). See also R. 9020. Counsels, as well as parties, are subject to punishment which may include cost and attorneys fees. Fidelity Mortgage Investors v. Camellia Builders, 550 F.2d 47, 54 (2d Cir. 1976), cert. den., 429 U.S. 1093 (1977).
2. The court may invalidate actions taken in violation of the stay. See e.g., Zesty Foods, Inc. v. Phillips Food Corp., 536 F.2d 344 (10th Cir. 1976); In re Shepherd, 12 B.R. 151 (E.D. Pa. 1981).
E. Obtaining Relief From The Automatic Stay
1. File a motion rather than a complaint. R. 4001 and R. 9014.
2. Standards for obtaining relief - 362(d)
a. For actions against property, subsection (2) of 362(d) is specific. For relief sought under that section the court "shall" grant relief if the debtor has no equity and the property is not necessary "to an effective reorganization." Thus, in a chapter 7 case the absence of equity requires the court to dissolve the stay because a reorganization is not being attempted. In re Preuss, 15 B.R. 896 (Bankr. 9th Cir. 1981); In re Hart, 5 B.R. 524 (Bankr. N.D. Ga. 1980). However, in case of reorganization, in addition to showing lack of equity, the secured party must also show that the property is not necessary to the reorganization effort. This section does not apply literally, and relief will be granted if a successful reorganization is not reasonably possible within a reasonable period of time. United Sav. Ass'n v. Timbers of Inwood Forest, 108 S.Ct. 626, 632 (1988) (Dictum suggest that 362(d)(2) is creditor's protection from "inordinate and extortionate delay" by debtor.).
b. Subsection (l) of 362(d) is the section of general applicability. The general standard is "cause, including lack of adequate protection."
(i) Do not ignore "cause" - any good reason can serve as a basis for relief from the stay. For example, lapse of insurance or failure to maintain the collateral could constitute cause. An agreement to lift stay in event of default by debtor is enforceable. Sellerville Sav. & Loan Ass'n v. Kelly, No. 82-4987 May 20, 1983 (E.D. Pa.)
(ii) Refer to discussion regarding adequate protection for the showing required for relief under that standard.
(iii) In applying adequate protection to a secured creditor, periodic cash payments to compensate for depreciation during the stay have been allowed. In reWheeler, 12 B.R. 908 (Bankr. D. Mass. l981). The secured party's payment of taxes and insurance on the collateral post-petition is a form of "loss" to the creditor even where the collateral's value is not decreasing. In re Riviera Inn, 7 B.R. 725 (Bank. D. Conn. 1980).
(iv) The Supreme Court ended the long running debate over an undersecured creditor's right to demand compensation from the debtor for its "lost opportunities" caused by the imposition of the automatic stay. United Savings Association v. Timbers of Inwood Forrest, 108 S. Ct. 626 (1988) held that secured creditor's right to adequate protection does not include the right to be compensated for the delay in foreclosure that bankruptcy stay caused. Accordingly, cases such as In re American Mariner Industries, Inc. 734 F.2d 426 (9th Cir. 1984) and Grundy National Bank v. Tandem Mining, 754 F.2d 1436 (4th Cir. 1985) are overuled.
(v) Most courts have held that "equity cushion," that is the difference between the outstanding debt and the value of the collateral, may constitute adequate protection. See e.g., In re Hutton-Johnson Co., Inc., 6 B.R. 855 (Bankr. S.D. N.Y. 1981). In re Pleasant Valley, Inc., 6 B.R. 13 (Bankr. D. Nev. 1980); In re San Clemente Estates, 5 B.R. 607 (Bankr. S.D. Ca. 1980); but see In re Alyucan Interstate Corp., 12 B.R. 803 (Bankr. D. Utah 1981).
c. If adequate protection is provided and later proves to be inadequate, the secured creditor is granted a "super priority" over all other expenses of administration. § 507(b)
3. Time limitations.
a. In the case of an action regarding property, the court must hold a preliminary hearing and make at least a preliminary disposition within 30 days after a party seeks relief from the stay. § 362(e).
b. The court must continue the stay after a preliminary hearing if he finds a "reasonable likelihood" that the party opposing relief will prevail. See In re Castle Ranch ofRamona, Inc., 3 B.R. 45 (Bankr. S.D. Ca. 1980). Section 363(e) requires the final hearing to be "commenced" within 30 days from the preliminary hearing. However, no deadline for the completion of the hearing or for court decision is provided. This gap is filled by the new Bankruptcy Rules. The stay expires 30 days after the final hearing is commenced unless the court sooner denies the request for relief. Rule 4001(b). Most bankruptcy court decisions hold that it can "reimpose" stay if lapses, e.g., In re Kleinsasser, 12 B.R. 452 (Bankr. D. S.D. 1981) where a creditor was enjoined despite the expiration of the automatic stay. But see, In re River Hills Apartments Fund, 813 F.2d 702 (5th Cir. 1987) (stay lifted automatically and TRO denied for failure to post a bond).
4. Scope of the hearing.
a. Courts have generally rejected debtors' assertions of substantive counterclaims in response to a complaint for relief from the stay. See e.g., In re Roloff, 598 F.2d 783 (3rd Cir. 1979); In re Groundhog Mountain Corp., 1 B.C.D. 923 (Bankr. S.D.N.Y. 1975).
b. The filing of a complaint for relief from stay by the United States does not constitute a waiver of sovereign immunity for purposes of counterclaims. See § l06(a) which required the United States to assert a claim. Cf. In re Racing Wheels, Inc., 6 B.C.D. 719 (Bankr. M.D. Fla. 1980) where the request to modify the stay is found to be a procedural necessity and not a "claim" within the meaning of Fed. R. Civ. P. 12(b) and 13.
5. Burdens of Proof.
a. The trustee has the burden of proof on all issues except the debtor's equity in collateral. § 362(g).
b. As a practical matter, however, the secured creditor may be forced to carry the burden, where pertinent, of showing that reorganization is impossible, especially at the outset of a bankruptcy proceeding when the bankruptcy court is likely to be sympathetic to efforts to rehabilitate. See, Murphy, Creditors Rights In Bankruptcy, § 6.16.
F. Tactical Considerations Regarding The Automatic Stay
1. Play it straight with regard proving collateral values. Even though a low collateral evaluation will aid in litigation regarding relief from the stay, establishing too low a value may redound against the secured creditor in approaching a plan of reorganization where the secured creditor benefits from a high evaluation for the collateral. In re Zellner, 3 B.C.D. 2d 42 (Bankr. N.D. Ill. 1980).
2. The aggressive creditor is rewarded. That is, if a super priority is available under § 507(b) if adequate protection is proves inadequate, but the creditor must have requested adequate protection to be eligible.
3. Be aware of the continuing risks that the estate or another creditor can be boosted ahead of your secured position. E.g. § 364 or § 506(c).
4. Accounts receivable and inventory collateral are usually perishable and require prompt action to protect their values. The floating lien stops floating as of the filing of the petition. § 552. Also for any accounts or inventory created during the 90 days before bankruptcy a preference problem is likely to have arisen. § 547. If you want the debtor to operate and to maintain your secured position in the receivables and inventory post-petition, you must execute and perfect a new security agreement with court permission and with notice to all affected creditors. In re Prime, Inc., 15 B.R. 216 (Bankr. W.D. Mo. 1981).
5. When the collateral consists of rents, a request for interim relief should include sequestration of rents if state law requires. See Butner v. United States, 440 U.S. 48 (1979). However, Eighth Circuit holds that HUD's perfected security interest in rents is enforceable in bankruptcy despite contrary state law requirements. United States v. Landmark Park & Associates, 795 F.2d 683 (8th Cir. 1986).
6. Note the relationship between stays under § 362 and the debtors right to use collateral under 363. A stay without power to use is of little benefit to the trustee.
7. Get deals in writing.
8. Have deals approved by the bankruptcy court.
9. Notice other creditors if they are affected by the transaction.V. Use, Sale Or Lease Of Collateral - 363
A. General Considerations
1. Use of collateral not in the ordinary course of business is permissible only after notice and hearing. If the business is not authorized to operate, all use is considered not in the ordinary course. 11 U.S.C. § 363(b).
2. For use in the ordinary course, no prior court order is needed unless the collateral constitutes "cash collateral." 363(c).
3. U.C.C. § 9-306(4) will normally determine the scope of "cash collateral" where the collateral constitutes "proceeds" unless the Bankruptcy Code is applicable. E.g.,In re Aerosmith Denton Corp., 36 B.R. 116 (N.D. Tx. 1983)
4. If "cash collateral" within the meaning of § 363(a)court approval after prior notice and hearing is required unless the entity with an interest in cash collateral consents. 363(c)(2). In reK. L. Smith Enterprises, Ltd ., 2 B.R. 280 (Bankr. D. Colo. 1980). Query - What remedy does the affected creditor have if the debtor uses cash collateral without consent or court permission? One solution is to request the court to confer a replacement lien, super priority to the creditor under 507(b) or, at least, an administrative priority under 503(a). In re Aerosmith Denton Corp., 36 B.R. 116 (Bankr. N.D. Tx. 1983); In re Prime, Inc., 37 B.R. 897 (Bankr. W.D. Mo. l981). Another is to seek contempt sanctions against the debtor (and his attorney where appropriate). But see ContinentalMarine Corp., 35 B.R. 990 (Bankr. E.D. Mo. 1984)
5. Keep in mind that where notice has been given and no party has demanded a hearing, a hearing may be dispensed with. § 102(1). 6. The court is admonished to schedule the hearing in accordance with the "needs" of the debtor and that the court shall "act promptly" on a request to use cash collateral. 363(c)(3).B. The Creditor's Protection Is The Right To Demand Adequate Protection.
1. At "any time" a secured party may request a hearing where the court must "prohibit or condition" any proposed use of the collateral by the trustee as needed to provide adequate protection to the secured creditor's interest. § 363(e).
2. The standards for adequate protection are the same as discussed above. E.g., "Equity cushion" held to be adequate protection for use of cash collateral. In re Walker-Anderson, 1 C.B.C. 2d 831 (Bankr. C.D. Cal. l980); Worcester County Nat'l Bankv. Xinde Int'l Inc., 13 B.R. 212 (D. Mass. 1981).
3. The trustee has the "burden of proof on the issue of adequate protection." § 363(e).
4. A secured creditor seeking adequate protection under 363(e) would normally seek relief from the stay under 362(d) in addition. The usual creditor would not be content merely with prohibiting use of the collateral but also would desire to foreclose his interest where adequate protection cannot be provided. Also, procedural advantages are gained. At least where property is concerned, requests for relief under 362(d) must be expedited whereas determinations of "adequate protection" under 363 do not have the same advantage.
5. Use of secured creditor's collateral under 363 must be consistent with relief granted under 362. § 363(d).C. Sales Of Collateral By The Trustee Free And Clear Of Liens - 363(f)
1. By withholding consent the secured creditor can prohibit sale unless the proposed sale price exceeds the value of the lien or where the interest is in "bona fide dispute."
2. A sale free and clear of liens will result in the lien attaching to the proceeds.
3. On a sale free and clear of liens the creditor can bid the amount of his allowed claim as an offset against the purchase price. 363(k).
4. A debtor in chapter 11 may not use 363 to sell substantially all its assets in the absence of a confirmed plan. In re White Motor Credit Corp., 4 C.B.C.2d (Bankr. N.D. Ohio 1980; see also, In reBraniff Airways, Inc., F.2d (5th Cir. March 7, 1983); but see In re WHET, Inc., 4 C.B.C.2d 1131 (Bankr. D. Mass. 1981) and In re Boogaart of Fla., 5 C.B.C.2d 1441 (Bankr. S.D. Fla. 1981).VI. Secured Creditor's Lien May Be Demoted By The Provision For Obtaining Credit In § 364
A. The Interest Of A Senior Lien May Be Demoted Or Diluted By The Court Only Where Adequate Protection Is Provided The Demoted Lienor. 364(d)
B. Even Then The Court Must Find That The Credit Sought Is Not Available Pursuant To The Other Provisions In 364.
1. Subsection (a) of 364 permits the debtor to incur unsecured debt in the ordinary course without court permission which debt is an automatic first priority administrative expense.
2. Unsecured debt out of the ordinary course requires court permission. 364(b)
3. If unsecured credit is not available, the court can authorize loans secured by (a) a super priority administrative expense, (b) a lien on unencumbered property, or (c) a junior lien. 364(c)
4. If lien demotion is threatened, request a hearing where adequate protection must be provided. 364(d)(2)VII. Post-Petition Effect Of Security Interest - § 552
A. Property acquired by the estate post-petition is not subject to liens created by a pre-petition security agreement.
B. The "proceeds" of property subject to security interest pre-petition remain encumbered post-petition unless the court orders otherwise based upon the "equities." § 552(b). See also, U.C.C. 9-306(4).
C. Thus, a secured creditor is entitled to adequate protection of his proceeds.