Cash Collateral The Risks of Non-consensual Use

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Sep 1999

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The filing of a chapter 11 petition automatically creates an estate consisting of all property

owned by the debtor at the time of filing.<a href="#2" name="2a">2</a> For any business, this property includes cash.

Section 363(a) of the Bankruptcy Code defines cash and cash equivalents as "cash collateral."

Often a secured creditor, such as a bank or the federal government, holds a security interest in

cash collateral.

Under §363(c)(2), the debtor is absolutely prohibited from

spending cash collateral without the consent of all parties that have an interest in the collateral,

or a court order.<a href="#3" name="3a">3</a> The basis for this prohibition is that security interests are constitutionally

protected property rights.<a href="#4" name="4a">4</a>

This rule proscribing the use of cash collateral is simple and

straightforward. Sometimes a debtor will make expenditures without the consent of the secured

creditors or the authority of the court. When this happens, the entire chapter 11 case is placed

at risk and the representative of the debtor who directed the misuse of cash collateral may face

significant financial penalties.

<h3>Implied vs. Express Consent</h3>

Typically, the chapter 11 debtor files an emergency motion

for the use of cash collateral when the petition is filed.<a href="#5" name="5a">5</a> Courts usually grant these emergency

motions and authorize debtors to make the appropriate expenditures.

Sometimes a debtor uses the cash collateral and later contends

that the secured creditor gave implied consent for expenditures, giving rise to a dispute over

whether consent was in fact given. The term "consent" suggests "an act of reason, accompanied

with deliberation."<a href="#6" name="6a">6</a> In <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Market Dev. v. Silver Wheel Freight, 823 F. 2d 362,

368-369 (1987)</a>, the Ninth Circuit ruled that consent must be expressed and that implied

consent is insufficient as a matter of law to satisfy the requirements of §363(c)(2)(A).

A contrary ruling was made in <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… of National Safe

Northeast Inc., 76 B.R. 896, 907 (Bankr. D. Conn. 1987)</a>, in which the debtor expended cash

collateral without the express consent of the secured creditor. In National Safe, the secured

creditor knew that the debtor was spending cash collateral but did not seek to prohibit its use.

The court placed the burden on the secured creditor:

[A] secured creditor on notice may not choose to ignore unauthorized use of cash

collateral until a chapter 11 case is converted and then seek to recover damages for all of

the funds so misused.

</blockquote>

The same result occurred in <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Unity Foods Inc., 75 B.R.

222 (Bankr. N.D. Ga. 1987)</a>, in which the secured creditor asserted that the debtor misused its

cash collateral. The secured creditor, who was also the principal of the debtor, sought a

replacement lien as a remedy for the purported misuse of cash collateral. The court denied the

request, noting that the debtor used the cash with the knowledge of the secured creditor and

while it was under the control of the secured creditor. The court further emphasized that the

secured creditor was the principal of the debtor. Therefore, the equities did not favor the

secured creditor. Despite the authority that a secured creditor may consent to use of cash

collateral through acts or failure to protect its interests, the penalties for misuse of cash

collateral can be severe.

<h3>Risks to the Officers of the Debtors</h3>

Courts have imposed a wide range of sanctions upon officers of

debtors who misuse cash collateral. There is case law suggesting that counsel may have an

obligation to notify the court if counsel becomes aware that the debtor is misusing cash

collateral.<a href="#7" name="7a">7</a>

The debtor's officers may face the risk of personal liability

under the tort of conversion if they misuse the cash collateral.<a href="#8" name="8a">8</a> Conversion is "the wrongful

exercise of dominion and control over another's property in denial of or inconsistent with his

rights."<a href="#9" name="9a">9</a> Under this cause of action, anyone who participates in the unauthorized use of cash

collateral may be jointly and severally liable for the conversion. Therefore, a monetary

judgment may be rendered in an adversary proceeding against a corporate officer who actively

participated in making unathorized expenditures.<a href="#10" name="10a">10</a>

Misuse of cash collateral is a serious enough offense that a

judgment against the principal for monetary damages may carry the weight of a

non-dischargeable debt. In <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Alvey, 56 B.R. 170 (Bankr. W.D. Ky. 1985)</a>, a debtor filed a

chapter 11 during which he made unauthorized expenditures out of cash collateral. After the

chapter 11 case concluded, he filed a chapter 7 petition. The secured creditor whose cash

collateral was misused filed a complaint objecting to the dischargeability of his debt on the

ground that the debt resulted from the debtor's defalcation.

The court ruled that the debt was not discharged except to the

extent that any expenditures preserved the secured creditor's collateral. The court stated that

"the unauthorized use of cash collateral by a chapter 11 debtor creates a prima facie case of

breach of fiduciary duty in a non-dischargeability complaint in a later chapter 7

proceeding."<a href="#11" name="11a">11</a>

A simpler approach is to require the debtor's principal to

repay the secured creditor. In <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Etch-Art Inc., 48 B.R. 143 (Bankr. D. R.I. 1985)</a>, a

chapter 11 debtor spent cash collateral in violation of §363(c) and a court order. The secured

creditor sought to find the debtor and its principal in contempt. Although the court denied the

request for contempt, it ruled that the debtor's principal must compensate the secured

creditor for the amount of the loss.

The court stated its view plainly:

[W]e know that some cookies are missing from the jar, and that Nancy Ronci should be

ordered to put some back, but we don't know how many.<a href="#12" name="12a">12</a>

</blockquote>

Sanctions for contempt of court remain a viable remedy for

the unauthorized use of cash collateral. In <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Spring Plaza Associates L.P., 188 B.R. 50

(Bankr. M.D. Fla. 1995)</a>, the debtor made payments that were not authorized by a cash

collateral order. The secured creditor asked the court to find the debtor in contempt of court.

The court granted the motion, but allowed the debtor the opportunity to purge itself of contempt

by remitting to the secured creditor the amount of the unauthorized payments.

Sometimes the remedy for contempt of court is more

punishing. <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Williams, 191 B.R. 497 (Bankr. M.D. Ga. 1996)</a>, illustrates the breadth of

possible sanctions. In Williams, creditors filed a motion to find the debtors in contempt for

violating a cash collateral order. The court found that the debtors violated a cash collateral order

by withdrawing segregated funds and continuing to use cash collateral without authority. As a

remedy, the court ordered the debtors to repay the misappropriated funds, account for the

decline in inventory, pay $2,500 in punitive damages to each creditor, and reimburse the

creditors for their attorneys' fees.<a href="#13" name="13a">13</a> What makes this remedy remarkable is that the court

specifically noted that there was "no indication that debtors diverted any significant amount of

movants' collateral to their own use."<a href="#14" name="14a">14</a>

<h3>Risks to the Continuation or Success of the Case</h3>

There is no specific provision in the Bankruptcy Code that

provides a remedy to be imposed against the chapter 11 debtor for the misuse of cash

collateral.<a href="#15" name="15a">15</a> However, courts have cited various sections of the Bankruptcy Code to craft

remedies for the misuse of cash collateral.

Section 1112(b) provides that the court may dismiss or

convert a chapter 11 case for cause. This section permits the court to consider a wide range of

factors, including an inability to effectuate a plan, an unreasonable delay or an absence of a

reasonable likelihood of rehabilitation when there is also a diminution of the estate.<a href="#16" name="16a">16</a> When the

debtor has made unauthorized expenditures out of cash collateral, a traditional remedy is the

dismissal of the case, as in <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Alvey, 56 B.R. 170 (Bankr. W.D. Ky. 1985)</a>.

A debtor's violation of a cash collateral order may also bring

about the "effective termination" of the chapter 11 case, if the court denies future access to

cash collateral. <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Oxford Royal Mushroom Products Inc., 19 B.R. 974 (Bankr. E.D. Pa.

1982)</a> illuminates the dangers associated with defying cash collateral orders.

In Oxford Royal, a chapter 11 debtor and secured creditor

stipulated to an order under which the debtor was permitted to use cash collateral. The order

authorized the court to terminate the future use of cash collateral if the debtor failed to comply

with the order. After the debtor breached the terms, the secured creditor obtained an order

terminating the use of cash collateral. The debtor subsequently sought court authority to use

cash collateral. The court denied the motion with the following reasoning:

We conclude that the proper interpretation of that clause is that the debtor is precluded

from using the cash collateral under any circumstances. It does not mean that the debtor

has simply lost the ability to use the cash collateral with the consent of the bank, as

provided by §363(c)(2)(A), but it also means that the debtor has likewise lost the right

to seek authority from the court for the use of cash collateral pursuant to

§363(c)(2)(B).<a href="#17" name="17a">17</a>

</blockquote>

Without the ability to use cash collateral, it would be unlikely that the debtor could function.

Thus, the case would effectively be terminated.

Bankruptcy courts are often reluctant to terminate a chapter

11 case even if the debtor has misused cash collateral. Nonetheless, the debtor should consider

the response that the unauthorized use of cash collateral may invoke from the court and the

creditors. Pursuant to §1107(a), a debtor-in-possession (DIP) is vested with most of the

powers and duties of a trustee. A debtor that acts with indifference to the special treatment

afforded to cash collateral undercuts the trust reposed in it and the credibility of its

management. The likely result is that its future actions will be viewed with great scrutiny and

suspicion. This does not bode well for a successful chapter 11 case.

Even if the bankruptcy court does not dismiss the case or

terminate the use of cash collateral, the debtor remains vulnerable at the confirmation stage of

the case. Section 1112(a)(2) provides that to satisfy the requirements for plan confirmation

the proponent must comply with the applicable provisions of chapter 11. In <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… v. United States, 45 B.R. 836 (S.D. Ga. 1984)</a>, this requirement was invoked to deny plan confirmation

on the grounds that the debtor had "spent cash proceeds from the sale of collateral without the

court's permission." The import of this decision should not be understated: If a debtor violates a

cash collateral order, its entire effort in chapter 11 may be futile.

<h3>Conclusion</h3>

A DIP is a fiduciary whose responsibilities include ensuring

that cash collateral is not used without the consent of the secured creditor or a court order. The

officers of the debtor should not assume that the requirements governing cash collateral are

mere technicalities without force and effect. The officer of a debtor that misuses cash collateral,

for whatever purpose, is subject to personal liability. This liability may result in the

imposition of punitive damages or the entry of an order to refund an amount equal to the cash

collateral expended.

The potential consequences to the chapter 11 debtor and the

chapter 11 case are equally severe. Misuse of cash collateral may cause the dismissal or

effective termination of the case. At the end of the case, the debtor may find that confirmation is

denied.

Given the serious consequences of misusing cash collateral,

the best approach is to ensure that cash collateral is spent only with express authority

incorporated in an order of the court.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> The author is Senior Attorney Advisor for the U.S. Trustee Program. The views expressed in this article are those of the author and do not necessarily represent the views of, and

should not be attributed to, the U.S. Department of Justice or the U.S. Trustee Program. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §541(a)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Archer, 34 B.R. 28, 30 (Bankr. N.D. Tex. 1983)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re George Ruggiere Chrysler-Plymouth, 727 F.2d 1017, 1019 (11th Cir. 1984)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> See FED.R.BANKR.P. 4001(b)(2). <a href="#5a">Return to article</a>

<a name="6">6</a> Black's Law Dictionary, 276 (5th ed. 1979). <a href="#6a">Return to article</a>

<a name="7">7</a> See <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Rivers, 167 B.R. 288 (Bankr. N.D. Ga. 1994)</a> (If a debtor-in-possession is incompetent, it should be apparent that reorganization is unlikely, if not impossible, and it is

the duty of a court-appointed professional to bring that fact to the attention of the U.S. Trustee and the court) (citation omitted); See, also, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… Properties No. Two v. Big

Hill Inv. Co., 93 B.R. 357, 361 (N.D. Tex. 1988)</a> (District court ruled that sanctions could be imposed against counsel and principal in part because of misuse of cash collateral,

but remanded the case for new computation and allocation of sanctions between parties). <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… of Koran Enterprises Inc., 61 B.R. 321, 326-327 (Bankr. W.D. Mo. 1986)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… National Bank v. Komatsu Zenoah America Inc., 991 F. 2d 273, 274 (5th Cir. 1993)</a> (citation omitted). <a href="#9a">Return to article</a>

<a name="10">10</a> See Koran Enterprises at 327; see, also, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Fay Associates Ltd. Partnership, 225 B.R. 1,7 (Bankr. D. D.C. 1998)</a> (Remedies for misuse of cash collateral include personal

liability). <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Alvey, 56 B.R. at 173-174</a>. See, also, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Weber, 99 B.R. 1001, 1019-1020 (Bankr. D. Utah 1989)</a> (Debtor's discharge denied, in part, because he had violated terms of

cash collateral order); See, also, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Aerosmith Denton Corp., 36 B.R. 116, 119 (Bankr. N.D. Tex. 1983)</a> (Proper sanctions can be imposed against those responsible for use of

cash collateral). <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Etch-Art Inc., 48 B.R. at 147</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Williams, 191 B.R. at 503</a>. <a href="#13a">Return to article</a>

<a name="14">14</a> Id. See, also, <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Williams, 61 B.R. 567, 575 (Bankr. N.D. Tex. 1986)</a> (Debtor liable for sanctions for unauthorized use of cash collateral). <a href="#14a">Return to article</a>

<a name="15">15</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Kleather, 208 B.R. 406, 416 (Bankr. S.D. Ohio 1997)</a>. Section 413 of H.R. 833 (the Bankruptcy Reform Act of 1999) states that the "unauthorized use of cash collateral

harmful to one or more creditors" is grounds for conversion or dismissal of the case. See proposed <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §1112(b)(3)(D)</a>. <a href="#15a">Return to article</a>

<a name="16">16</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re C-TC 9th Avenue Partnership, 113 F.3d 1304, 1311, n. 5 (2nd Cir. 1997)</a>. <a href="#16a">Return to article</a>

<a name="17">17</a> <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… re Oxford Royal Mushroom Products Inc., 19 B.R. at 975</a>. <a href="#17a">Return to article</a>

Journal Authors

Dean Wyman

Journal Date

Wednesday, September 1, 1999 - 12:00