Debtor Financing and Liens on Avoidance Actions

Journal Issue

Mar 2004

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In seeking "adequate protection" for a debtor's use of cash collateral, a pre-petition secured creditor typically prefers
replacement liens over other forms of adequate protection. After all, obtaining a property interest creates a new set of
rights for the recipient. Unsecured creditors, on the other hand, would prefer that the court not grant replacement
liens, as granting replacement liens may reduce the availability of unencumbered assets.

While maintaining unencumbered assets for possible distribution to unsecured creditors is important, a pre-petition
security interest is a property right entitled to protection. In addition, replacement liens are sometimes the only
form of adequate protection available. Moreover, when seeking post-petition financing, granting liens on otherwise
unencumbered assets may provide the only incentive for a prospective post-petition lender to advance funds to a
debtor.

However, when the proposed replacement liens extend to avoidance actions, the reaction of unsecured creditors may
change from objection to infuriation. The mere suggestion of granting a lender, whether pre or post, a lien on
avoidance actions will drive an unsecured creditors' committee into an objecting frenzy as they seek to protect their
constituent's interests. Despite the typical insistence by an unsecured creditors' committee that granting liens on
avoidance actions is an abomination of the Bankruptcy Code, courts are split on the issue. Recent caselaw addresses
the rights of secured creditors as part of the bankruptcy estate, thereby opening the door for replacement liens on
avoidance actions.

<h3>Pre-petition Liens on Avoidance Actions</h3>

An initial issue that often arises when considering the grant of a security interest on avoidance actions is whether a
pre-petition lender's blanket lien extends to avoidance actions. Most, if not all, of the courts addressing the issue
have held that a blanket pre-petition lien does not extend to avoidance actions because such actions only exist upon
the commencement of a bankruptcy case. See In re Tek-Aids Industries Inc., 145 B.R. 253, 256 (Bankr. N.D. Ill.
1992); In re Pearson Industries Inc., 178 B.R. 753, 764-65 (Bankr. N.D. Ill. 1995); In re Ludford Fruit
Productions Inc., 99 B.R. 18, 24-25 (Bankr. C.D. Ca. 1989); In re Integrated Testing Products Corp., 69 B.R.
901, 904-05 (D. N.J. 1987). These courts based their decisions on the language of 11 U.S.C. §552(a), which
provides that "property acquired by the estate after the commencement of the case is not subject to any lien resulting
from any security agreement entered into by the debtor before the commencement of the case." See Tek-Aids, 145
B.R. at 256; Pearson Industries, 178 B.R. at 764; Ludford Fruit Productions, 99 B.R. at 24-25; Integrated
Testing, 69 B.R. at 903. While creditors have argued that §552(b) preserves their interests in after-acquired
proceeds, such an interest only extends to proceeds of collateral upon which a lien existed prior to the petition date.

See 11 U.S.C. §552(b); see, also, Tek-Aids, 145 B.R. at 256; Ludford Fruit Productions, 99 B.R. at 24-25;
Integrated Testing, 69 B.R. at 903.

However, courts have distinguished liens that exist on specific property from blanket liens when analyzing the
attachment thereof to the proceeds of avoidance actions, particularly fraudulent transfer actions. See In re Figearo,
79 B.R. 914, 917-18 (Bankr. D. Nev. 1987); Pearson Industries, 178 B.R. at 761-63. In both Figearo and

Pearson Industries, the court held that where a trustee recovers specific property, or the value thereof, which
property was secured by a pre-petition lien, the pre-petition security interest may attach to the proceeds of the
avoidance action. See Figearo, 79 B.R. at 918; Pearson Industries, 178 B.R. at 761-63. After all, but for the
fraudulent transfer, the secured creditor's lien would have existed and survived the debtor's bankruptcy case. See Id.
The distinguishing factor is the ability to trace a lien to specific property that existed prior to the petition date.
Nonetheless, analyzing the propriety of replacement liens on avoidance actions is a different matter.

<h3>Post-petition Liens on Avoidance Actions</h3>

Although avoidance actions may not exist prior to the petition date, thus negotiating the attachment of a
pre-petition lender's security interest thereto, they most certainly exist post-petition. Nonetheless, certain courts
refuse to grant a lien on avoidance actions, whether for adequate protection or to secure debtor-in-possession
(DIP)financing, because "neither a trustee in bankruptcy, nor a debtor-in-possession, can assign, sell or otherwise
transfer the right to maintain a suit to avoid a preference." See In re Texas General Petroleum Corp. v. Evans (In re
Texas General Petroleum Corp.), 58 B.R. 357, 358 (Bankr. S.D. Tex. 1986). In fact, even where contracts
negotiated at arm's-length explicitly provide for the assignment of an avoidance action in exchange for valuable
consideration, certain courts have simply refused to give any effect to such an assignment. See United Capital
Corp. v. Sapolin Paints Inc. (In re Sapolin Paints Inc.), 11 B.R. 930, 937 (Bankr. E.D.N.Y. 1981).

Despite this reluctance, other courts have noted that granting a lien on avoidance action recoveries is not the same as
an absolute assignment of the avoidance action itself. See, e.g., In re Furrs, 294 B.R. 763, 768-70 (Bankr. D.
N.M. 2003); see, also, Ludford Fruit Productions Inc., 99 B.R. at 24-25 (where the court held that the lender
received a lien on, inter alia, post-petition general intangibles, which includes proceeds from avoidance actions as
such actions are general intangibles). Thus, while a secured creditor may have no standing to bring an avoidance
action, it can enforce a properly granted security interest against the recoveries of such avoidance actions. See Furrs,
294 B.R. at 768-70.

Most recently, certain courts have allowed the lineal assignment of avoidance actions to creditors and paved the way
for granting replacement liens thereon. See, e.g., Mellon Bank N.A. v. Dick Corp. (In re Qualitech Steel Corp.), 351
F.3d 290 (7th Cir. 2003) (where the court declined to dismiss a preference action brought by a bank group agent
based on the court's previous grant of replacement liens on avoidance actions); In re Housecraft Industries USA
Inc., 310 F.3d 64 (2d Cir. 2002) (where the court held that where a debtor consents, and/or relief is obtained from
the court, a committee may bring avoidance actions). While providing support for entities other than the
debtor/trustee to bring avoidance actions, the true import of these cases is the recognition that a secured creditor is a
part of the bankruptcy estate. See, e.g., Mellon Bank, 351 F.3d at 293-94. And even where the proceeds from
avoidance actions benefit only, or primarily, the secured creditor, a benefit to the bankruptcy estate still exists as
required for recovery by 11 U.S.C. §550(a). See Id.; see, also, Furrs, 294 B.R. at 772-74.

For example, in Mellon Bank, the court granted pre-petition secured creditors a replacement lien on avoidance
actions because, as of the petition date, the pre-petition lenders were unsecured and post-petition financing was
necessary to conduct an orderly liquidation. The proceeds of the liquidation, however, were insufficient to satisfy
the post-petition financing, let alone the pre-petition secured debt.

Although dismissed by the bankruptcy court that granted the replacement liens, and despite this decision being
affirmed by the district court, the Seventh Circuit held that a bankruptcy estate includes all creditors, whether
secured or unsecured, and what happens to recovered funds is dependent on statutory and contractual entitlements.
Mellon Bank, 351 F.3d at 293. Indeed, if the pre-petition secured creditors could not recover from avoidance
actions, then those secured creditors would have a large unsecured deficiency claim. Id. Under the preference
defendant's logic, then the estate would benefit by virtue of a benefit to unsecured creditors, the largest of whom
would be the aforementioned pre-petition secured creditors. Id. Thus, such a rule makes no difference, nor does it
affect the rights of preference defendants. Id. at 293-94. Therefore, the fact that the beneficiary of an avoidance action
is a secured creditor should not entitle an avoidance defendant to retain an otherwise avoidable transfer. Id. at 294.

The Seventh Circuit's ruling in Mellon Bank must be taken in context, as its opinion did not address the propriety
of granting replacement liens on avoidance actions and/or the proceeds thereof. Nor did Mellon Bank address the
diminution of value of collateral of an undersecured creditor. Such issues were addressed, albeit non-substantively,
in its predecessor, In re Qualitech Steel Corp., 276 F.3d 245 (7th Cir. 2001).

In Qualitech, the Seventh Circuit based its holding on the failure to preserve error at the lower court level, as
opposed to the substantive issues. See Qualitech, 276 F.3d at 247-48. As such, neither Mellon Bank nor Qualitech

provide binding precedent on the issues of the propriety of granting replacement liens on avoidance actions or on
the proper measure of diminution of value. Thus, reliance on Mellon Bank and Qualitech must be kept in context.

Nonetheless, courts are recognizing the practical implications of secured creditor rights and the policy considerations
behind avoidance actions. Avoidance actions provide more than a means of recovery; they also provide a deterrence
for those who would strong-arm payment in anticipation of bankruptcy.

<h3>Conclusion</h3>

Allowing a debtor to grant a lien on avoidance actions, whether replacement or otherwise, will allow many
bankruptcy estates to continue operations, thereby satisfying the Bankruptcy Code's underlying purpose: to give a
debtor the chance at a fresh start. Thus, post-petition lenders are encouraged to lend more than the value of hard
assets, and courts may protect the interests of undersecured creditors while allowing the use of cash collateral and/or
by approving post-petition financing.

While some will argue that replacement liens are only granted to the extent that the debtor's use of the lender's
collateral resulted in a diminution thereof, that is a valuation argument that is beyond the scope of this article (but
perhaps next month's).

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Monday, March 1, 2004 - 12:00

Bankruptcy Rule

2004