Automatic Severance of After-Acquired Property Interests under 522

Journal Issue

Apr 2006

Column Name

Practice & Procedure

Citation

ABI Journal, Vol. XXV, No. 3, p. 36, April 2006

Bankruptcy Code

361

363

552

Topic Tags

Practice and Procedure

Uniform Commercial Code/Article 9

Journal HTML Content

It is common in today's commercial financing environment to find grants of security
interests in property that the debtor has yet to own (i.e., "after-acquired
property"). After-acquired property interests are a valid means of attaching
a security interest to future property of the debtor, irrespective of whether
such property exists or even whether the debtor intends to acquire additional
property. U.C.C. §9.204(a) (2005).
Due to the common grants of such security interests, some are confused by a
debtor's offer of replacement liens in exchange for the use of cash collateral.
Indeed, many a practitioner has heard the expression, "but I already have
a replacement lien because of the after-acquired property clause." Such
expressions evidence a lack of understanding of 11 U.S.C. §552(a), and
its effect on after-acquired property interests.
While non-practitioners fail to understand §552(a)'s extent and effect,
there is a similar lack of understanding by some bankruptcy practitioners as
to the extent and effect of Revised Article 9's definition of "proceeds."
"Proceeds," post-Revised Article 9, are now automatically included
in a security interest on collateral, which alters the former analysis of §552(a)'s
effect on "after-acquired property."1 Understanding §552(a) and
Revised Article 9's automatic "proceeds" security interest, as well
as the applicable exceptions, is key in addressing cash-collateral issues.
Section 552's After-Acquired Property Interest Severance

Section 552(a) cuts off liens on property acquired by the debtor after the
commencement of a bankruptcy case, and reads:
<blockquote>
"[P]roperty acquired by the estate or by the debtor 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." 
</blockquote>
11 U.S.C. §552(a). The severance of security interests in after-acquired
property is subject to express exceptions, which are discussed below and in
next month's column. 11 U.S.C. §552(b). Irrespective of the stated exceptions,
Congress enacted §552(a) and its automatic severance of after-acquired
property interests in recognition of the separation between pre-petition and
post-petition property and in furtherance of the fresh-start concept. See
5 King, Lawrence P., et al, Collier on Bankruptcy, §552.01[1]
(15th ed. Rev. 2005). A debtor's fresh start often requires the use of property
acquired post-petition free and clear of pre-bankruptcy liens.
By severing pre-petition liens on property acquired post-petition, §552(a)
essentially takes a snapshot of the debtor's property as of the petition date
and the security interests attached thereto. With certain exceptions set forth
below, property existing prior to that snapshot remains unaffected, whereas
property acquired after that snapshot is free and clear of any pre-petition
security interest that would otherwise attach, even those that include a security
interest in after-acquired property. 11 U.S.C. §552(a); T-H New Orleans
Ltd. P'ship. v. Financial Security Assurance Inc. (In re T-H New Orleans
Ltd. Pship.), 10 F.3d 1099, 1104 (5th Cir. 1993), cert. denied, 511 U.S.
1083, 114 S.Ct. 1833, 128 L.Ed.2d 461 (1994).

The severance of pre-petition security interests from after-acquired property
is important in the first days of a bankruptcy case. During those first days,
debtors routinely seek the use of cash collateral pursuant to the terms of 11
U.S.C. §363. It is, in part, §363's prohibitions that necessitate
§552's after-acquired property severance. And it is often at the "first-day"
hearing that the after-acquired security interest and §552 come together.
Cash Collateral Issues Related to After-Acquired Property 
Pursuant to 11 U.S.C. §363, a debtor may not use, sell or lease property
of the estate that is encumbered by a pre-petition security interest without
obtaining either consent of the secured party or court authorization. 11 U.S.C.
§363(c)(2). Consent or court authorization, however, is not necessary if
the property to be used, sold or leased is unencumbered, (i.e., no pre-petition
security interest covering the specific property). Id. Due to §552's
automatic severance of pre-petition security interests on after-acquired property,
often the only unencumbered property is after-acquired property.
After-acquired property, however, is usually acquired with property of the
estate existing prior to the petition date. For example, a debtor acquires inventory
after the petition date with, at least initially, cash acquired prior to the
petition date.
The use of encumbered pre-petition property to acquire post-petition property
that, pursuant to §552(a), is unencumbered necessitates the grant of a
replacement lien. See, e.g., In re Cafeteria Operators LP,
299 B.R. 400, 410 (Bankr. N.D. Tex. 2003). The use of pre-petition collateral
necessitates a replacement lien because allowing a debtor to use encumbered
property to create unencumbered property harms the property interests of the
secured party. See, e.g., Id; Arkison v. Frontier Asset
Management LLC (In re Skagit Pacific Corp.), 316 B.R. 330, 336, fn.
5 (9th Cir. BAP 2004) (citing Williamette Production Credit Assn.
v. Lovelady, 21 B.R. 182, 184-85 (Bankr. D. Ore. 1982)).

Thus, and assuming the lack of a sufficient equity cushion or other mitigating
circumstances, the secured creditor is entitled to adequate protection, which
often comes in the form of a replacement lien. The replacement lien results
in the encumbrance of the after-acquired property, thereby putting the secured
party in the same position as with the pre-petition property and preventing
the diminution in value of the secured party's property interests. Thus, when
a debtor that uses pre-petition cash, for which a valid security interest exists,
to purchase inventory after the petition date, the secured party gets a lien,
via the grant of a replacement lien in a cash collateral order, in that newly
acquired inventory.2
On the other hand, if the debtor seeks to use after-acquired property, (i.e.,
property unencumbered by pre-petition security interests pursuant to §552(a)),
the debtor need not grant replacement liens or any other form of adequate protection,
as there is no property interest to protect. See, e.g., Cafeteria
Operators, 299 B.R. at 403. Because after-acquired property is not subject
to §363's consent or court-authorization requirements, the determination
of whether property constitutes after-acquired property is critical. Unfortunately,
identifying what property constitutes after-acquired property is not as simple
as it first appears.
After-Acquired or Not After-Acquired: That Is the Question 
After-acquired property is not necessarily all property that comes into the
debtor's possession post-petition. For example, a debtor's refund right under
a retainer agreement is a general intangible that arose pre-petition and, therefore,
remains subject to any pre-petition security interest encompassing general intangibles.
See In re Serve Convenience Stores Inc., 299 B.R. 126, 132-33 (Bankr.
M.D.N.C. 2003). On the other hand, a chapter 12 debtor's interest in federal
disaster relief funds is after-acquired property, despite any pre-petition lien
on crops, if the federal program providing the disaster relief funds does not
exist on the petition date. In re Stallings, 290 B.R. 777, 782-84 (Bankr.
D. Idaho 2003); Burgess v. Sikes (In re Burgess), No. 04-30189,
2006 WL 205043, *8-10 (5th Cir. Jan. 27, 2006).

In addition, §552(b) provides two exceptions to the severance of the pre-petition
lien. First are proceeds, products, offspring or profits of encumbered pre-petition
property, except to the extent based on the equities of the case the courts
orders otherwise. 11 U.S.C. §552(b)(1). Second is the extent such after-acquired
property constitutes rents of such property or the fees, charges, accounts or
other payments for the use or occupancy of rooms and other public facilities
in hotels, motels or other lodging properties, except to the extent based on
the equities of the case the courts orders otherwise. 11 U.S.C. §552(b)(2).
In contrast to §552(a)'s automatic severance of after-acquired property
interests, §552(b) "balances the Code's interest in freeing the debtor
of pre-petition obligations with a secured creditor's right to maintain a bargained-for
interest in certain items of collateral. It provides a narrow exception to the
general rule of §552(a)." In re Bering Trader Inc., 944 F.2d
500, 502 (9th Cir. 1991). Section 552(b) balances those interests by excluding
proceeds of encumbered property, albeit after-acquired, from §552(a)'s
provisions.
For example, where a secured party has a pre-petition lien on inventory, the
cash proceeds from the sale of the inventory are not affected by §552(a).
This "proceeds" exception has become increasingly relevant due to
Revised Article 9.
Revised Article 9 changed the definition and application of "proceeds."
"Proceeds" means the following property: (a) whatever is acquired
upon the sale, lease, license, exchange or other disposition of collateral;
(b) whatever is collected on, or distributed on account of, collateral; (c)
rights arising out of collateral; (d) to the extent of the value of collateral,
claims arising out of the loss, nonconformity or interference with the use of,
defects or infringement of rights in, or damage to, the collateral or (d) to
the extent of the value of collateral and to the extent payable to the debtor
or the secured party, insurance payable by reason of the loss or nonconformity
of, defects or infringement of rights in, or damage to, the collateral. UCC
§9.102(64) (2005). In addition to an expanded definition, a security interest
in properly attaches to any identifiable proceeds of collateral. UCC §9.315
(a)(2) (2005).
Thus, due to the amendments to Article 9 of the UCC, "proceeds" now
automatically extends to after-acquired property that is derived from the original
collateral, even if there is no disposition of the original collateral.3
In addition, a security interest in property extends to proceeds even in the
absence of any language in the security agreement. Id.
Therefore, irrespective of §552(a)'s language, a pre-petition security
interest in property creates a valid and continuing lien on the proceeds of
such property, such as cash from the sale of inventory. As such, what would
otherwise constitute after-acquired property remains subject to the pre-petition
security interest, thereby requiring consent or court authorization to use.
T-H New Orleans, 10 F.3d at 1104.
However, and as will be further discussed in next month's column, §552(b)
does not exempt proceeds from post-petition accounts receivables, nor proceeds
from proceeds that accrue post-petition. See, e.g., Skagit
Pacific, 316 B.R. at 336 (citing In re HRC Joint Venture, 175 B.R.
948, 953 (Bankr. S.D. Ohio 1994); In re Texas Tri-Collar Inc., 29 B.R.
724, 726-27 (Bankr. W.D. La. 1983); In re Cross Baking Co., 818 F.2d
1027, 1032 (1st Cir. 1987)). For example, in Skagit Pacific, where a
debtor collected pre-petition balances on outstanding pre-petition accounts
and used such proceeds in operations to create new accounts receivables, the
court held that the proceeds from the pre-petition accounts receivables remained
collateral, but when converted into proceeds from post-petition accounts receivables,
the pre-petition security interest was severed. Skagit Pacific, 316 B.R.
at 336; see, also, Cafeteria Operators, 299 B.R. at 410.

Skagit and Cafeteria Operators, which will be discussed next
time, are good examples of what will likely be a long line of cases analyzing
and determining the post-petition effect and extent of Revised Article 9's "proceeds"
definition and automatic attachment. As a new wave of bankruptcies approaches
and new cash collateral fights are brought, the issues addressed in Skagit
and Cafeteria Operators will undoubtedly be prevalent.
Conclusion
 Section 552(a)'s after-acquired security interest severance and the amendments
to Article 9 of the UCC are inter-connected such that practitioners must understand
their provisions and exceptions both alone and together. Looking at §552(a)
in a vacuum creates a false simplicity, usually leading to an incorrect analysis.
However, the assumption that Revised Article 9's definition of proceeds and
automatic attachment of the lien extends a pre-petition security interest indefinitely
is also faulty. Courts have and will create exceptions, just as Congress created
§552(b)'s exception for proceeds. To complicate matters, Congress created
a dangerous and stealthy exception, hidden in the last phrase of subsection
(b). As will be discussed in next month's practice and procedure column, the
above review is just the beginning.
<hr>
Footnotes

1 See Warner, G. Ray, "Perfection in Proceeds under Revised Article
9," 20, 1 Am. Bankr. Inst. J. 16 (Feb. 2001); Warner, G. Ray, "Proceeds
in Bankruptcy Under Revised Article 9," 20, 2 Am. Bankr. Inst. J. 22 (March
2001). 
2 11 U.S.C. §361 contemplates the grant of adequate protection such as
a replacement lien only to the extent that the debtor's use of the cash collateral
deceases the value of the secured party's property interests, a concept that
is beyond the scope of this article. 
3 See U.C.C. §§9.102(64), 9.203(f), 9.315 (2005); see,
also, Warner, G. Ray, "Proceeds in Bankruptcy under Revised Article
9," 20, 1 Am. Bankr. Inst. J. 22 (March 2001).

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Saturday, April 1, 2006 - 12:00

Bankruptcy Rule

2006

none