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Dealing With Distress For Fun & Profit – Installment #9 – Secured Creditors & Chapter 11

A written tour of business bankruptcy and its alternatives

Dealing with Distress for Fun and ProfitOur prior installment discussed some of the basic things a secured creditor needs to know about Chapter 11. The automatic stay was one of them.  But, since we like to keep these things short (on the presumption that others also have short attention spans) we didn’t say all we want to say on the topic (in fact, this installment won’t satiate us either and we will continue to explain other aspects of the automatic stay in future installments). For now, we continue our prior installment’s focus on the automatic stay from the perspective of the secured creditor.

The General Rule – Actions are Stayed

The automatic stay imposed by Bankruptcy Code §362, generally prohibits any action by a secured creditor to recover or foreclose on its collateral during a bankruptcy case. This makes some sense since one of the main purposes behind chapter 11 is to allow the debtor to formulate a plan so it can try to preserve going-concern value.  If secured creditors could generally foreclose on their collateral, there wouldn’t be much chance for a company to emerge from bankruptcy as a going concern.

Stay Relief

Bankruptcy Code §362(d) provides a few avenues for relief- ways a party can get “stay relief”- which can be pursued by filing a “motion for relief from the automatic stay.” Such a motion is a contested matter, pursuant to Bankruptcy Rule 9014. Bankruptcy Code §362(e)provides for prompt consideration by the court of stay relief motions, because the stay will terminate 30 days after the request for relief, absent a court ordering that the stay remain in effect. While many such motions are resolved within the 30 period, it is not always the case.

  • Cause, Including Lack of Adequate Protection

    The first ground for relief from the stay is “cause, including lack of adequate protection.” What this essentially means is that if the court finds that a creditor is entitled to adequate protection but the debtor can’t (or won’t) provide it, then the creditor is entitled to stay relief. Despite the use of the word “including,” the statute fails to enumerate any additional bases that constitute “cause.” Other bases are found to exist by courts on a case-by-case basis. Courts generally tend to balance the harm imposed on the secured creditor by continuing the stay, against the benefit of the stay to the debtor, with a presumption in favor of the debtor.

  • No Equity + Not Necessary

    The second ground for relief from the stay is satisfied if (1) there is no equity in the property (the secured debt exceeds the property value), and (2) the property is “not necessary to an effective reorganization (the debtor can reorganize without the property or cannot reorganize at all).” The secured creditor has the burden of proof on the “no equity in the property” issue. The debtor has the burden of proof on the “necessary for an effective reorganization” issue.

  • SARE Cases

    The third ground for relief from the stay applies only to single-asset real estate cases set forth in §362(d)(3) and the definition of single asset real estate in §101(51B).

  • Fraud

    The final stay relief provision applies to real estate whose ownership has been transferred or has been subject to another bankruptcy case as a part of a fraudulent scheme. It allows for in rem stay relief to be recorded and provide up to two years’ worth of relief from stay for acts against the property in a future bankruptcy case.

Interest (and/or Other Payments) During the Case?

Secured creditors ordinarily do not receive principal payments during the case—even if they are due under the terms of the loan. However, if a creditor is oversecured (the collateral value after deducting any senior liens exceeds the debt), the secured creditor will be entitled under §506(b) to at least the accrual of post-petition interest (and reasonable fees, if specified in the loan) to the extent it is oversecured.  Keep in mind that the question of interest is different than the issue of receiving “adequate assurance payments.”

Recharacterization and Equitable Subordination

Lenders should be aware of the term “recharacterization” and “equitable subordination.” Although they are not often applied, they are worth mentioning because (1) a little planning can go a long way, and (2) in the relatively rare circumstances that these doctrines are applied, the consequences can be disastrous for the lender. “Recharacterization,” allows a bankruptcy court to characterize a transaction in accordance with its economic substance rather than its form, such as the recharacterizing debt as equity. Factors that courts use to determine whether to recharacterize debt as equity include whether: (1) the “lender” was also a stockholder, (2) the “lender” obtained control of the borrower in exchange for the “loan,” (3) the corporation could obtain outside funding, (4) the “lender” received additional equity in exchange for the investment, (5) there was a fixed maturity date for the “loan,” (6) the debtor had adequate capital at the time of the “loan,” and (7) the transaction was documented as a loan.

Recharacterization is a remote risk, particularly if the transaction was an arms-length one, i.e., the lender is not a shareholder or affiliated entity, then A secured lender should watch for “equitable subordination,” especially when the lender is held to have acted inequitably, to the detriment of other creditors. Bankruptcy Code § 510(c) allows the court to subordinate any claim to any other claim(s), and/or to transfer a secured lender’s lien to the estate (where it will benefit all creditors rather than just the secured creditor). A common fact pattern involves a lender who exercised an unreasonable level of control over the debtor and its business. Sometimes there is a fine line between a secured lender trying to assure that a debtor is maximizing the prospects that it will repay the lender’s loan and exercising “undue control.”

Can the Debtor Sell a Secured Creditor’s Collateral During the Case?

A debtor may sell assets in the ordinary course of business without court approval. For example, a retail debtor may sell inventory without the need for court approval. If the sale is outside the ordinary-course-of-business, however, court approval is necessary. Typically, the sale of encumbered assets will result in the lien following the asset. Debtors, however, often want to sell assets “free and clear” of liens by satisfying one of the five criteria set forth in §363(f). The most common of these criteria are when the secured creditor consents or where the asset would sell for a higher price than the amount of debt encumbering it. In these situations, a lien will attach to the proceeds of the sale (which is then used to pay off the lien). If a secured creditor’s collateral is sold, the creditor has the right to “credit bid” (i.e., offset its claim against its bid, rather than paying out cash) at the sale, pursuant to §363(k). What Happens Upon

Conversion to Chapter 7?

The primary job of a chapter 7 trustee is to distribute assets (if any) to unsecured creditors. Thus, if a secured creditor’s collateral is worth more than the liens encumbering it plus the costs of sale, a chapter 7 trustee is likely to sell the collateral, pay the costs of sale and the liens, take his commission (subject to court approval), and distribute the remainder to other creditors. If the collateral is worth less than the liens encumbering it (plus the costs of a sale) then the trustee is likely to abandon the collateral (or consent to relief from the stay so that a lienholder can foreclose).

Post-petition Financing and the Secured Creditor

Many debtors will need new post-petition financing (“DIP lending”) in order to be able to operate during bankruptcy. Bankruptcy Code §364provides a series of inducements to incent a post-petition lender, who otherwise might not be inclined to lend money to a bankrupt company. The debtor may pledge unencumbered assets to the DIP lender to secure the post-petition loan. This will typically not be of particular concern to the pre-petition secured creditor. But often there are not unencumbered assets, or at least not sufficient unencumbered assets to make the DIP lender comfortable. In these situations, the court may grant to the DIP lender a lien on already encumbered assets—a pre-petition lender’s collateral. This lien may be subordinate to existing liens on such collateral, on an equal priority with existing liens (i.e. “pari passu” with existing liens), or even senior in priority to existing liens (a so-called “priming lien”).

Case law makes it particularly difficult to get permission to do a priming lien over the objection of a pre-petition secured creditor, since it typically imposes significant risk on the pre-petition lender. A pre-petition secured lender may consent to a pari passu lien where such a lender realizes that the debtor needs new financing to operate but does not want to put in new money itself. Sometimes the pre-petition secured lender will also be the DIP lender. The existing lender is a natural candidate, since it has an incentive to protect its pre-petition investment. In that case, the lender may “prime” its pre-petition loan with a new post-petition loan, which is less controversial than a new lender obtaining a priming loan.

The Secured Creditor and the Plan

In many cases where a plan is confirmed the secured creditor, debtor, and possibly unsecured creditors make a deal, which is reflected in the terms of the plan. If no deal is made, the debtor may resort to one of the three “cramdown” options of the Bankruptcy Code described in §1129(b)(2)(A), which allow a debtor who has the support of at least one impaired class of creditors (i.e., creditors whose rights are modified by the plan) to modify the terms of a secured obligation—even if the secured creditor objects. First, the debtor can give the secured creditor a note secured by its existing collateral, with a principal amount equal to the value of the collateral plus market interest rate. For example, if the creditor is owed $1.8 million but has collateral with a value of $1.3 million, the debtor must give the creditor a $1.3 million note with a “market” interest rate based on, among other things, the length of the term involved. Generally, the longer the term, the higher the risk, and the higher the interest rate.

An undersecured creditor may choose to make the “fully-secured” election under §1111(b), which triggers the application of the additional requirement that the face value of total payments of principal and interest over the life of the plan must, at least, equal the total amount of the secured creditor’s debt. The second option is that the debtor can sell the creditor’s collateral, giving the creditor a lien on the sale proceeds. The creditor has a credit bid right in any such sale. The third option is referred to as providing the lender the “indubitable equivalent.”  Most often, it is invoked when a debtor wants to convey a secured creditor’s collateral to the secured creditor in satisfaction of the secured debt. In real estate cases, this is sometimes referred to as “dirt for debt”. Sometimes, when the creditor is oversecured, the debtor, if its case is both clear and compelling, will seek to convey only a part of the collateral, arguing that only part of the collateral is necessary to satisfy the whole debt.

Conclusion for this Installment

We know we packed a lot into this one.  At the same time, the irony is, we left a lot out to make this readable.  Trust us; we will spend the next few installments coming at this stuff from slightly different angles.  By the time we are through, you will have a good understanding of this topic.

To read other installments in this series, click here.

For a great discussion on insolvency, we recommend this webinar and this webinar. You can also learn about federal equity receiverships here, and get advice on what to do when your business is struggling here.

About George Kuney

Prior to joining the faculty in 2000, Professor Kuney was a partner in the San Diego office of Allen Matkins Leck Gamble & Mallory LLP where he concentrated his practice on insolvency and reorganization matters nationwide.  Before that he received his legal training with the Howard, Rice and Morrison & Foerster firms in his hometown…

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George Kuney

About Jonathan Friedland

Jonathan Friedland is a partner with Sugar Felsenthal Grais & Helsinger, LLP. Although based in Chicago, he is licensed to practice in Arizona, Illinois, New Jersey, and New York. He views his job very simply: to make clients money whenever possible and to protect their interests at every turn. Jonathan holds the highest possible rating…

Read Full Bio »   •   View all articles by Jonathan »

Jonathan Friedland
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