Chapter 39 Enforcing Security Interests in Bankruptcy

Part VII Enforcing an Article 9 Security Interest

Chapter 39 Enforcing Security Interests in Bankruptcy

A. Generally

We are concerned with bankruptcy because it is important to put secured credit into a broader context that includes debt collection outside bankruptcy and also those rules that govern collection in bankruptcy. Without the broader context, one would have a rather distorted view of debt collection law generally and Article 9 in particular. Some "messy" detail regarding the federal bankruptcy law, the Bankruptcy Reform Act (BRA) or "Code" is unavoidable. However, our concern is with the implications of bankruptcy for secured creditors.

As has often been noted, bankruptcy is the "acid test" of whether you have done your job as an attorney for a secured creditor. There are several types of bankruptcy proceedings, including Chapter 7 (liquidation), Chapter 11 (reorganization) and Chapter 13 (individual rehabilitation).

In a Chapter 7 a trustee gathers all the property of the estate and distributes it to secured claims, priority unsecured claims and unsecured claims, with the amount available for the latter two types of claims being adjusted downward for any allowable exemptions. Chapter 11 and Chapter 13 bankruptcy are "pay out" bankruptcies in which a debtor attempts to pay off some of the debts according to a plan.

To a large extent, we will limit our treatment to Chapter 7 (Liquidation) bankruptcies because they are easier to understand and best illustrate the theoretical objectives of bankruptcy, namely, to achieve an equitable distribution of a debtor's assets and enable the debtor to make a "fresh start" through the device of a discharge.

As was seen in Chapter 30 (Secured Party Versus Trustee in Bankruptcy), the equitable distribution goal is undermined by the fact that enforceable secured claims must be paid dollar-for-dollar before any other claims are be paid (and, hence, trustees, who represent unsecured creditors, are in an adversarial relationship with secured parties).

We also noted in Chapter 30 (Secured Party Versus Trustee in Bankruptcy) that a discharge does not apply to secured claims and is of concern only as to deficiencies (which are unsecured). You would benefit from reading B & S (cited in Chapter 3), Ch. 6.

We saw in Chapter 9 (The Specifics of Enforceability -- After-Acquired Property, Proceeds and Future Advances) that, under BRA 552(b), a security interest that is fully enforceable under Article 9 may be unenforceable as to property, other than proceeds, that is acquired after bankruptcy is filed. A review of that section as discussed in Chapters 9 (The Specifics of Enforceability -- After-Acquired Property, Proceeds and Future Advances) and 30 (Secured Party Versus Trustee in Bankruptcy) is in order.

In Chapters 26 (Secured Party Versus Lien Creditor) and 30 (Secured Party Versus Trustee in Bankruptcy), we examined BRA § 544(a) and its impact on unperfected security interests, BRA § 547, under which even perfected security interests may be vulnerable as avoidable preferences, and also BRA § 522(f)(1)(B), a provision that empowers a debtor to avoid certain non-possessory, non-purchase money security interests that impair exemptions.

Here we will focus our attention on two other matters affecting Article 9 security interests. The first is the automatic stay under BRA § 362. The second is the distribution scheme (the claims settlement process) in bankruptcy and the proposition that secured claims fare better in bankruptcy than do unsecured claims.

B. The Automatic Stay

We considered the automatic stay in Chapter 26 (Secured Party Versus Lien Creditor) and Chapter 30 (Secured Party Versus Trustee in Bankruptcy) as it affects the ability of a secured party to perfect after bankruptcy has been filed. BRA § 362(a) sets forth the actions that are barred and BRA § 362(b) contains the exceptions. BRA §§ 362(a)(4) and (a)(5) prohibit any act to create, perfect, or enforce any lien against property of the estate and any such action against property of the debtor to the extent that the lien secures a claim that arose before bankruptcy was filed.

The automatic stay, in fact, bars essentially all activity by which a creditor seeks to improve its position to collect a debt from property of the bankruptcy estate or the debtor's property after bankruptcy has been filed, unless there is an exception to the stay.

BRA § 362(b)(3) contains the exception to the stay that allows perfection after bankruptcy is filed in certain cases that we examined in Chapter 26 (Secured Party Versus Lien Creditor) and Chapter 30 (Secured Party Versus Trustee in Bankruptcy).

Under BRA § 362(a) the stay automatically goes into effect immediately upon the filing of a petition in bankruptcy ("the commencement of a case"). The stay is important to Article 9 secured parties because it bars them from enforcing even a perfected security interest until the stay is terminated under BRA § 362(c) or is lifted under BRA § 362(d). It is important to debtors because it allows them to continue in possession of collateral, and under certain conditions, including especially providing adequate protection of a security interest in the collateral, to use or even sell the collateral. See BRA § 363.

Actions that violate the automatic stay typically are treated as being ineffective. See, e.g., In re Custer, 50 UCC Rep. Serv. 2d 608 (Bkcy ND Iowa 2003) (in which the court held that an attempt to perfect a security interest after bankruptcy had been filed and that was not within the exception to the stay in BRA § 362(b)(3) was void). Moreover, a creditor who violates the stay can be held in contempt or have to pay attorney's fees and could be liable for damages under BRA § 362(h). See, e.g., In re Moffett, 288 B.R. 721 (Bkcy E.D. Va. 2002), affirmed, 356 F.3d 518 (4th Cir. 2004); In re Rozier, 283 BR 810 (Bkcy M.D. Ga. 2002).

Recall that creditors learn about a bankruptcy through notice from the court or independently, but there may be some time lag between the filing, which is when the stay goes into effect, and the time a creditor learns about the bankruptcy. However, the stay operates whether or not a creditor knows about the bankruptcy. A creditor who acts out of ignorance of the bankruptcy is less likely to suffer sanctions than one who intentionally chooses not to obey the stay.

The stay prohibits any action to foreclose a security interest in property of the estate that has not been completed as of the time a bankruptcy is filed. When a debtor files bankruptcy most of the debtor's property becomes property of the estate. BRA § 541(a)(1) broadly defines property of the estate to include all property in which the debtor has a legal or equitable interest on the date of bankruptcy, subject to certain exclusions set out in the remainder of BRA § 541.

In United States v. Whiting Pools, Inc., 462 U.S. 198 (1983), the Supreme Court held that the IRS could be forced to turn over to the estate property of the debtor that had been seized to satisfy a federal tax lien before the debtor filed a Chapter 11 bankruptcy but which had not been disposed of at the time the bankruptcy petition was filed.

In so holding, the Court compared the federal tax lien scheme to that provided for in the enforcement provisions of Article 9 and concluded that until the property had been disposed of the IRS had only a lien and the debtor had a sufficient interest in the property to make it property of the bankruptcy estate subject to the turnover provisions of the bankruptcy statute.

Although the Supreme Court in Whiting Pools did not refer to a right of redemption as such, it has been held that until the debtors right to redeem under new Article 9 section 9-623 has been foreclosed by a disposition (or acceptance in satisfaction of the debt) collateral seized by an Article 9 secured party is property of the bankruptcy estate subject to the automatic stay. In re Moffett, 288 B.R. 721 (Bkcy E.D. Va. 2002), affirmed, 356 F.3d 518 (4th Cir. 2004), is an apt example.

In Moffett the court distinguished the right to possession from an ownership interest and concluded that only the former was lost when collateral is repossessed and the right to redeem under new section 9-623 continues until the collateral has been disposed of. In so holding, the court rejected an argument that new section 9-619 transfers ownership of a vehicle to a secured party upon repossession.

According to the court, new section 9-619 is intended only to facilitate a disposition of a vehicle subject to a certificate of title law imposing as a condition of an effective transfer of the vehicle that a change of ownership be reflected in the motor vehicle records and that new section 9-619(c) makes clear that a transfer of record pursuant to new section 9-619 is not of itself a disposition and does not relieve the secured party of its obligations under Article 9.

The court further refused to read the Virginia certificate of title statute to transfer title by operation of law at the time a vehicle is repossessed because to so interpret the certificate of title law would be to nullify new section 9-623 and the right to redemption that it creates. Id. See also, In re Sanders, 291 B.R. 97 (Bkcy E.D. MI 2003).

Consequently, the prevailing view is that a secured party who has repossessed but has not yet disposed of collateral at the time a petition in bankruptcy is filed is barred by the automatic stay from proceeding to dispose of the collateral and may be forced to turn the collateral over to the bankruptcy estate.

Decisions to the contrary tend to have turned on a conclusion that ownership of collateral is transferred when the collateral is repossessed as a matter of non-UCC law, in particular, certificate of title statutes. See In re Menashe, 301 B.R. 757 (Bkcy S.D. Fla. 2003) (concluding that the UCC is silent as to the effect of a repossession on ownership and interpreting the Florida certificate of title statute to mean that the debtor is divested of ownership when a vehicle is repossessed); In re Rozier, 283 B.R. 810 (Bkcy M.D. Ga. 2002) (in which the court refused to follow cases interpreting Florida and Alabama law to effect a transfer of ownership at the time of a repossession because the applicable Georgia law did not do so).

The message to practitioners is that they must examine applicable non-UCC law, especially certificate of title statutes, to determine whether such law could counter the general view that the right of redemption under new section 9-623 is sufficient to bring repossessed property into the bankruptcy estate and subject it to the automatic stay. However, even where non-UCC law is susceptible to such an interpretation, the argument that such an interpretation would nullify new section 9-623 and that new section 9-619 cuts against such an interpretation may well be persuasive. See Moffett, supra; In re Estis, 311 B.R. 592 (Bkcy D. Kan. 2004).

For completeness, it should be noted that Whiting Pools, supra, involved a Chapter 11 reorganization proceeding and the Supreme Court declined to indicate whether its reasoning would also apply to a Chapter 7 liquidation or Chapter 13 rehabilitation proceeding. However, the cases just discussed, holding that the right of redemption is sufficient to bring repossessed property into the bankruptcy estate and to trigger the automatic stay and turn over, involved Chapter 13 proceedings. It also should be noted that the duration of the stay and turn over orders are conditioned on adequate protection as discussed below.

Secured parties may seek relief from the stay by filing a "lift stay" motion. Relief must be granted under BRA § 362(d)(2) when the debtor has no equity in the collateral and the collateral is not needed for an effective organization. Where reorganization of a business is not possible or has little chance for success a court may well conclude that collateral that is the target of a lift stay motion is not necessary to an effective reorganization.

Relief from the stay also may be granted under BRA § 362(d)(1) "for cause." Most for cause motions assert a lack of adequate protection of the secured party's security interest.

Adequate protection is not defined in the Code. BRA § 361 indicates that periodic payments, substitute liens and providing a secured party the "indubitable equivalent" of the secured party's interest in the collateral all may provide adequate protection. Debtors who file bankruptcy generally do not have a sufficient cash flow situation to make periodic payments and substitute liens have the effect of denying to other creditors payment out of property that otherwise would be available. "Indubitable equivalent" has no meaning in the abstract and basically is whatever a court says it is in a particular case.

In practice, the most important decision in a "for cause" lift stay proceeding is whether there is a lack of adequate protection. The U.S. Supreme Court, in United Savings Ass'n v. Timbers of Inwood Forest Associates, 484 U.S. 365 (1988), made it clear that it is only the value of the collateral that must be adequately protected. Therefore, a secured party may lack adequate protection because the collateral is being used or sold or the value of the collateral is otherwise deteriorating, but the fact that a secured party is not able to foreclose and is losing the opportunity to reinvest the value of collateral, as it would outside bankruptcy, does not result in a lack of adequate protection.

It is important to be aware that interest accruing after bankruptcy is filed is not an allowable claim, i.e., post-filing interest generally is not recoverable in bankruptcy. However, under BRA § 506(b) interest and attorney's fees may be recoverable by an oversecured creditor. Whether excess security must be adequately protected is a question the answer to which is not entirely clear.

Courts often look at whether there is an “equity cushion,” meaning whether the collateral is worth more than the debt and whether the value of the collateral is deteriorating in such a way that the debt will become undersecured or even unsecured.

It is useful to contrast two situations. First, if a debtor is using equipment in the debtor's business there will be some amount of depreciation. If there is no equity cushion sufficient to protect against the deteriorating value of the equipment then the debtor may be required to provide adequate protection, for example, by making periodic payments. Second, if a creditor has a mortgage on real estate then because real estate generally appreciates rather than depreciating in value, there is less chance that a court would find a lack of adequate protection.

Many adequate protection battles are fought as to cash collateral. Cash collateral is defined in BRA § 363(a) to mean collateral that is in the form of cash or cash equivalents, including deposit accounts. Cash collateral includes cash proceeds from collateral.

Recall from Chapter 9 (The Specifics of Enforceability -- After-Acquired Property, Proceeds and Future Advances) that new Article 9 defines proceeds in new section 9-102(a)(64) to include income from collateral that is not disposed of. It was noted in Chapter 9 that there is a question whether bankruptcy courts will give to proceeds, as used in the bankruptcy act, the expansive meaning given to the concept in new Article 9.

However, there may be an issue only as to BRA § 552(b) limiting the enforceability of security interests in collateral acquired after a bankruptcy is filed to proceeds. The reason is that BRA § 363(a) expressly includes within the meaning of cash collateral not only cash and cash equivalents, but also "proceeds, products, offspring, rents or profits and certain charges arising in connection with hotel and motel lodgings. Consequently, cash proceeds are cash collateral but so also are products, offspring, rents or profits of collateral generally.

The meaning of cash collateral is important because, under BRA § 363(c)(2), a debtor may use cash collateral only if the debtor gets the secured party's consent or a court order based on a finding that the secured party's interest in the cash collateral is adequately protected.

You may explore the basics of the automatic stay and relief from the stay in the next four problems.

Problem 39.1 (interactive)

We have considered the example of Jane purchasing a Toyota from Dream Machine, Inc. (DM) on credit secured by an enforceable interest in the Toyota and what DM may do outside of bankruptcy if Jane defaults. Suppose that just after Jane defaulted and after DM has began efforts to recover the Toyota from Jane, Jane filed a Chapter 7 bankruptcy.

(a) If DM continues with efforts to repossess the Toyota, has it violated the automatic stay? Are sanctions likely to be imposed?

(b) Suppose DM had already repossessed the Toyota at the time Jane filed bankruptcy but DM had not yet disposed of the Toyota (or completed an acceptance of it) as the date of bankruptcy. Could DM go ahead with a disposition (or acceptance) after bankruptcy?

Problem 39.2 (interactive)

Donna Debtor operates a plumbing parts shop. Western Bank has a security interest n Donna's inventory of pluming parts and equipment, existing and later-acquired. Donna has filed a Chapter 11 bankruptcy. The collateral in which Western has an enforceable security interest is worth no more than $200,000 and the debt owing is $205,000. Donna closed the plumbing parts shop two weeks before bankruptcy and has no plans to reopen the shop. Western has moved for relief from the stay.

Should the motion be granted?

Problem 39.3 (interactive)

Assume the facts of Problem 39.2. Assume further, however, that Donna Debtor's business has been in continuous operation and Donna filed bankruptcy because of a legal dispute with a supplier that interrupted Donna's cash flow. Donna expects the legal dispute to be resolved soon and that the business will begin to show a profit within a few months and the facts tend to support the Debtor's expectations. Western Bank has a security interest in a delivery truck worth about $20,000. Western is owed $15,000 on the loan. Western has moved for relief from the stay as to the truck.

(a) Should relief be granted under BRA § 362(d)(2)?

(b) Should relief be granted under BRA § 362(d)(1)?

(c) If Western Bank was owed $20,000 and the truck was worth only $20,000, would Western have a better chance for getting relief from the stay?

Problem 39.4 (interactive)

Donald Debtor manufactures and sells automobile parts. Lisa Lender lends to Donald and perfects a security interest in Donald's existing and after-acquired inventory of widgets. Donald defaults on the loan and files bankruptcy seeking to reorganize its business. Donald has a bank account at Central Bank in which Donald has deposited only proceeds from the sale of widgets.

Is Lisa's security interest enforceable in bankruptcy?

May Donald draw checks on the bank account without Lisa's consent?

C. The Claims Distribution Process

We earlier examined the basic scheme for distribution of assets in a Chapter 7 liquidation proceeding. We noted that an enforceable secured claim must be paid dollar for dollar and that a claim is secured under BRA § 506(a) to the extent of the value of the collateral up to the amount of the secured debt.

Unsecured creditors, by contrast, get a pro rata share of what assets are left after secured claims and priority unsecured claims (such as administrative claims, including attorney's fees incurred for the benefit of the estate), are satisfied.

The percentage of an unsecured claim that will be paid is captured in the following formula:

(Total assets - secured claims [-exemptions for individuals] - priority unsecured claims)

divided by

Total of unsecured claims.

In Article 9 terms, that portion of a debt that exceeds the value of collateral is a deficiency and a deficiency is an unsecured claim. If a creditor is undersecured, i.e., there is a deficiency, the creditor is both a secured claimholder and an unsecured claimholder.

The unsecured portion affects the numerator of the equation in that the reduced amount of the secured debt leaves more in the numerator. However, the unsecured claim must be added to the denominator. An undersecured creditor takes dollar for dollar on the secured portion of its debt and gets the same percentage of the unsecured claim as do other unsecured creditors.

You may explore the bankruptcy distribution scheme in the next problem.

Problem 39.5 (interactive)

On the date of bankruptcy Delia Debtor has assets worth $100,000. Included in these assets is a widget worth $10,000 that is subject to a timely perfected security interest held by Southwestern Bank to secure a debt of $10,000. There are no applicable exemptions. The priority unsecured claims total $10,000. The total of general unsecured claims is $100,000.

(a) How much will Southwestern Bank take out of the bankruptcy?

(b) How much would an unsecured creditor with a $10,000 unsecured claim take out of bankruptcy?

(c) How much would Southwestern Bank take out of the bankruptcy if the widget in which it has a security interest is worth only $5,000. In answering this question, assume that despite the change in facts the total value of the assets continues to be $100,000.

CASE COMMENTARY

In re Yates, 332 B.R. 1 (10th Cir. BAP 2005)