Secured creditors play a large role in a distressed business situation. Unlike unsecured creditors (whom we focus on in Installment 13), a secured creditor is a party that extends credit to a debtor, and in exchange, the debtor grants the creditor an interest in one or more of its assets as security for the credit extended (the creditor then holds a lien against the subject assets as collateral for the loan). In the event the debtor defaults on its obligations to a secured creditor, the creditor can then look to the collateral to satisfy any outstanding debt (often by foreclosing).
While most people think of secured creditors as traditional bank lenders, there are numerous different types of secured creditors interested in extending credit in exchange for different types of collateral, especially in distress situations. They can be:
Secured creditors may also occupy different positions vis-à-vis other creditors based on the relative priority of their liens and the specific collateral at issue. For example, a lender that has a first position “all assets” lien on a debtor’s assets is generally considered to have first priority in all of the assets of its debtor, but may still be junior to the lien of another secured creditor who lent the debtor money to acquire equipment on a purchase money security interest (“PMSI”) basis or to the lien of certain statutory lien holders (for example, certain real or personal property tax liens).
One of the chief concerns a secured creditor has when dealing with a distressed debtor is understanding the value of collateral securing its lien, and whether its secured claim (the amount of debt it is owed) will be repaid in full from that collateral. Secured creditors may also fall into one of several categories depending on the value of the collateral securing their liens: oversecured, fully secured, or undersecured. Thus, the value of a secured creditor’s collateral influences how it is likely to view its debtor when making decisions regarding future lending, protecting its claim (and collateral) inside and outside of a bankruptcy case, and potential enforcement actions against the debtor in the event of a default. And the applicable valuation of collateral, particularly the difference between its liquidation and going concern values, will have a material impact on a secured creditor’s likelihood of recovering its losses from a defaulting debtor.
In the event that the value of a lender’s collateral exceeds the amount of its lien, the lender is considered “oversecured.” In other words, if the lender foreclosed on its lien and liquidated the collateral, the value of the collateral would be enough to (a) pay the foreclosing lender in full, and (b) leave enough cash leftover—a “cushion” or “equity cushion”—to pay claims of junior creditors or equity holders. If the value of the collateral is equivalent to the amount of the lender’s lien, the lender is “fully secured.” In both of these situations, a secured lender is in a good position, relatively speaking, because a sale of the collateral is likely to make the lender whole on its claim.
If, however, the value of the collateral is less than the amount of a lender’s lien, the lender’s perspective shifts. In a situation like this, where a lender is “undersecured,” its claim against the debtor is subject to greater risk. In the event of a sale by foreclosure or other means, the value of the lender’s collateral will not satisfy the lender’s entire claim, leaving a “deficiency claim” against the debtor for the unpaid amount of the claim. In a bankruptcy, the lender’s secured claim is bifurcated under Bankruptcy Code § 506, resulting in the lender holding two claims: a secured claim equivalent in value to the collateral securing its lien, and an unsecured claim for the remaining amount of the claim.
Below are a few key chapter 11 concepts that secured creditors (particularly senior secured lenders) should be familiar with when dealing with a distressed debtor or a debtor already in bankruptcy:
The automatic stay imposed by Bankruptcy Code § 362 generally prohibits secured creditors from taking action to recover or foreclose on their collateral during a bankruptcy case. This makes sense when considering that one of the main purposes of chapter 11 is to allow debtors the time and opportunity to propose a plan that preserves going concern value and pay creditor claims over time. Preventing secured creditors from foreclosing on their collateral therefore serves this purpose by allowing debtors a breathing spell to formulate and confirm a plan.
In certain circumstances, however, secured creditors may seek relief from the automatic stay by filing a motion with the bankruptcy court, essentially asking the court to lift the stay with respect to the relevant creditor so that it can pursue its nonbankruptcy remedies against the debtor to recover or foreclose on its collateral. Motions for stay relief are heard on a relatively expedited basis, because Bankruptcy Code § 362(e) provides that the automatic stay will terminate 30 days after a request for stay relief is made unless the court orders that the stay remain in effect.
To obtain relief from the automatic stay, secured creditors must show that (1) cause exists; or (2) that there is no equity in the relevant property and that the property is not necessary for the debtor to effectively reorganize.
Where a secured creditor asserts that “cause,” exists to lift the automatic stay, there are no enumerated factors for what constitutes cause other than a lack of adequate protection (a concept we discuss below). In practice, this essentially means that, if the bankruptcy court finds that the creditor is entitled to adequate protection but the debtor can’t or won’t provide it, the stay will be lifted.
In the event a creditor asserts that there is no equity in the relevant property (i.e., the secured creditor is undersecured), and that the property is not necessary for the debtor to reorganize (i.e., the debtor either doesn’t need the property or has no hope of reorganization even if it keeps it), there are competing burdens of proof that must be met. Creditors bear the burden of proof with respect to the issue of equity in the property; and debtors bear the burden of proof with respect to whether the property is necessary for an effective reorganization.
Finally, in the case of a single asset real estate (SARE) chapter 11 bankruptcy, specialized stay relief provisions are triggered under Bankruptcy Code § 362(d)(3). Essentially, if a creditor seeks stay relief in a SARE case, the stay may be lifted 90 days after the petition date (or 30 days after the court determines that the case fits the definition of a SARE case, if later) unless the debtor first (1) files a reorganization plan likely to be confirmed; or (2) makes monthly payments of interest to the secured creditor(s) holding an interest in the real estate before this deadline passes.
Since a chapter 11 debtor generally remains in possession of its assets and operates its business in the ordinary course, it generally has the right to continue using the assets that it pledged as collateral to secure some or all of its obligations to creditors, even if the debtor defaulted on its obligations prepetition. For example, a debtor that operates a movie theater may have pledged the theater seating it uses in its auditoriums as collateral for a business loan. Upon filing chapter 11, Bankruptcy Code § 363(c)(1) permits the debtor to continue using the seating in its day-to-day operations.
In the case of a lender that holds a lien against a debtor’s cash (i.e., its “cash collateral”), which includes cash and cash equivalents and extends to the proceeds of other collateral (accounts receivable, rents, inventory, etc.), some restrictions apply. Before a debtor can use cash collateral, Bankruptcy Code § 363(c)(2) requires that it must obtain either (a) the consent of the lender holding a lien against the cash; or (b) a court order allowing it to do so. A chapter 11 debtor typically needs immediate access to cash, resulting in the need for the debtor to prepare and submit a first day motion requesting authority to use cash collateral, which we discuss in Installment 15.
In the event that a debtor’s request to use cash collateral is contested by its lender, the lender bears the burden of proving that it does in fact hold a valid security interest in the debtor’s cash, at which time the burden shifts to the debtor to show that it can provide the lender with adequate protection for the lender’s security interest.
For a debtor to use, sell, or lease a secured creditor’s collateral in chapter 11, it must provide the creditor with adequate protection. In other words, in order to use the collateral, the debtor must preserve the value of the secured creditor’s interest in its collateral. Bankruptcy Code § 361 describes the concept of “adequate protection” for a secured creditor’s lien during a bankruptcy case. Adequate protection may take many forms, including (a) periodic cash payments to the lender; (b) postpetition interest payments to the lender; or (c) granting the lender replacement or additional liens on assets that were previously unencumbered, among others. One reason this is important is because a debtor’s failure to provide adequate protection to a lender can be a basis for the lender being granted relief from the automatic stay under Bankruptcy Code, as we discuss above.
The form of adequate protection varies from case to case depending on a number of factors, including risk to the lender; available unencumbered assets; and the debtor’s ability to make postpetition payments to the lender on account of its interest, among others.
Where the collateral being used is tangible and generates cash proceeds (e.g., rents generated from the operation of a shopping center), a lender holding a lien against the subject collateral is often considered adequately protected where the debtor uses the proceeds of the collateral (the rent collected) to preserve it (the building and its improvements).
Similarly, in the case that the lender is oversecured and an equity cushion exists—meaning the value of the collateral substantially exceeds the amount of the secured debt—often by itself constitutes adequate protection for the lender.
One common means of providing adequate protection to a lender whose primary collateral is a debtor’s accounts receivable (“A/R”) is to grant the lender “replacement liens” on the debtor’s postpetition receivables. This is because Bankruptcy Code § 552 operates to cut off any liens secured by A/R as of the petition date. Thus, a debtor can grant replacement liens on its postpetition A/R to the lender, and so long as the debtor generates A/R postpetition at the same or better rate as it did prepetition, the lender will be adequately protected.
Once adequate protection is established, the analysis does not end there. Because the value of a lender’s collateral may be subject to ongoing fluctuations in value during the course of a chapter 11 case, parties must be aware of how to address decreases (diminutions) in the collateral’s value.
Collateral may decrease in value during a chapter 11 case for any number of reasons. Real estate and securities market values may fluctuate, equipment used in the debtor’s business will diminish in value due to wear and tear, or uncollected A/R may age to a point where its value must be decreased or discounted as uncollectible.
These risks are very real for secured creditors in chapter 11. Lenders must therefore be vigilant in monitoring their collateral postpetition. With the automatic stay in effect preventing a lender from foreclosing on its collateral without first obtaining relief from the stay from the bankruptcy court, the first and often best means of protecting against diminution in collateral value is through adequate protection. If a lender believes its collateral is decreasing in value, it is the lender’s responsibility (other than with respect to cash collateral described above) to seek adequate protection or stay relief before a court will scrutinize the issue.
In the event of a valuation fight between parties in a chapter 11 case, it may become necessary for the lender and debtor both to engage valuation experts capable of providing testimony in support of each party’s asserted position.
Beyond the basic concepts discussed in this installment, secured creditors may be faced with additional challenges and related considerations within a chapter 11 case that will influence their strategy in the case.
The concepts of recharacterization and equitable subordination are not frequently applied in chapter 11, but are important to beware of and understand so as to avoid them, because they can be devastating to a secured lender when they do apply.
Recharacterization allows bankruptcy courts to characterize a transaction according to its economic substance as opposed to its form. The archetypal example is a recharacterization of debt to equity (meaning that a secured lender’s claim is sent to the bottom of the priority stack if a loan is recharacterized as an equity investment). Courts considering recharacterization challenges weigh a number of factors when deciding whether to recharacterize debt as equity, including whether: (a) the lender is also an equity participant in the debtor; (b) the lender obtained control of the debtor in exchange for its “loan”; (c) the debtor could obtain outside investment; (d) the lender received additional equity in exchange for its “loan”; (e) the “loan” bore a fixed maturity date; (f) the debtor had adequate capital at the time of the transaction; and (g) the transaction was documented as a loan.
Recharacterization is rare, especially if a transaction is arms-length (i.e., the lender is not a shareholder of the debtor or a debtor affiliate), and where this is the case, the risk of recharacterization to a secured lender is very low. But the concept of equitable subordination may come into play even in the case of arms-length dealings between a debtor and lender.
Under the doctrine of equitable subordination, Bankruptcy Code § 510(c) allows bankruptcy courts to (a) subordinate any claim to any other claims; and (b) transfer a secured lender’s lien to the debtor’s bankruptcy estate for the benefit of all creditors, or both. Equitable subordination is most likely to be argued in the case of a lender that acted inequitably prepetition, and common examples where equitable subordination applies involve lenders who exercised undue influence or control over the debtor and its business, or engaged in fraud.
The twin threats of recharacterization and equitable subordination present real risk to lenders in chapter 11. And though they are rarely applicable, they may be raised by various parties as a means of exercising leverage in negotiations with the lender within the case. Thus, by understanding these concepts ahead of time, lenders can mitigate the risks associated with them to best protect their interests postpetition.
Chapter 11 debtors are authorized to continue doing business in the ordinary course without seeking court approval of such transactions, which includes sales of assets encumbered by secured debt. A debtor that has pledged its inventory as collateral for a loan, therefore, is not required to seek court approval of the sales it makes to customers as part of its regular operations. But sales outside the ordinary course of business do require court approval. In the case of asset sales outside the ordinary course, such as a sale of the debtor’s business as a going concern, the debtor is likely to seek to do so free and clear of any liens on the assets being sold (often as an incentive to or by requirement of buyers). Debtors may do so under Bankruptcy Code § 363, so long as they satisfy at least one of the criteria set forth in § 363(f). In that case, the secured creditor’s lien will attach to the proceeds of the sale, and those proceeds will be used to pay off the lien. Additionally, when a secured creditor’s collateral is sold, except under unusual circumstances, the creditor will have the right to credit bid at the auction or sale.
A key concept for secured lenders is that of providing credit to a debtor on a postpetition basis, which we discuss in Installment 15. Bankruptcy Code § 364 affords special protections to creditors providing a debtor with postpetition “DIP financing,” and should be considered carefully not only by a senior secured lender, but also by junior lienholders and unsecured creditors whose rights are likely to be affected if the bankruptcy court approves such financing.
The goal of a reorganization under chapter 11 is to propose and confirm a plan, which may be done consensually, or by cramming the plan down over the objection of a secured creditors under Bankruptcy Code § 1129(b)(2)(A).1 A cram down over a secured party’s objection can take place when another group of similarly situated creditors (a class) votes to accept the plan. A class is deemed to have accepted a plan if the holders of claims in the class equaling at least two thirds (2/3) in amount and more than one half (1/2) in number (that actually voted in said class) vote to accept the plan. Essentially, this means that a debtor can propose a plan that modifies the terms of its secured obligations in one of three ways. First, the debtor’s plan can propose granting a secured creditor a note secured by its existing collateral, plus a market interest rate. Second, the debtor can propose to sell the creditor’s collateral and grant the creditor a lien against the proceeds of the sale (and the creditor will be able to credit bid at that sale). Finally, the debtor can propose providing a secured creditor with the “indubitable equivalent,” of its claims. While this term is not well defined in all contexts, the most commonly accepted means of satisfying the indubitable equivalent standard is by proposing that the debtor convey the lender’s collateral to it in satisfaction of the lender’s claim.
Additionally, if a secured creditor is undersecured, it can elect to have its claim treated as “fully secured” under Bankruptcy Code § 1111(b). When a secured creditor makes an “1111(b) election,” the plan must propose paying the full amount owed to the secured creditor , including, for example, all principal and interest due under its loan documents; in addition, if such payments are made over time, the present value of the payments must equal at lease the value of the collateral at the time the plan is approved.
A complete understanding of chapter 11 and secured debt from the perspective of a secured creditor is more than we can pack into this single installment. Lenders’ attorneys spend years mastering these concepts, and we hope that by touching on some of the most important ones here, it will be easier to understand the big picture in the context of this series.
The authors are corporate restructuring and insolvency attorneys with Much Shelist, P.C. and Levenfeld Pearlstein, LLP. Read more about in their bios below.
Understanding all this stuff in the context of bankruptcy is important, but not every distressed company winds up in bankruptcy. So, you also need to understand how it works outside of bankruptcy. Read Installment 15 for the rest of the story.
To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive custom PowerPoint about the topic):
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Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer” by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
Rob is a principal at Much Shelist and has more than three decades of experience counseling financial institutions and debtors in all areas of creditors’ rights, bankruptcy, and financing matters. He brings a wealth of experience to clients in need of representation in bankruptcy proceedings, commercial foreclosures, bankruptcy litigation, out-of-court workouts, and the acquisition and…
Jack is a corporate and restructuring partner in the Chicago office of Sugar Felsenthal Grais & Helsinger LLP. Jack’s practice covers a range of healthy and distressed business engagements. He is widely recognized for his excellent work as a restructuring attorney including recognition by various organizations for his strategic thinking and tactical expertise, including SuperLawyers…
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