Section 522s Hidden Threat to Secured Creditors There Goes Your Equity Cushion

Journal Issue

May 2006

Column Name

Practice & Procedure

Citation

ABI Journal, Vol. XXV, No. 4, p. 28, May 2006

Bankruptcy Code

522

Topic Tags

Practice and Procedure

Uniform Commercial Code/Article 9

Journal HTML Content

Last month's Practice & Procedure column discussed the application of 11
U.S.C. §552(a)'s automatic severance of after-acquired property interests,
as well as §552(b)'s proceeds exception thereto. The proceeds exception,
as detailed last month, increased in potency due to Revised UCC Article 9. Revised
Article 9, after all, creates an automatically attaching and perfecting security
interest in proceeds of encumbered collateral. See UCC §§9.102(64),
9.203(f), and 9.315(a)(2) (2005). Thus, a perfected security interest in pre-petition
property, without more, results in the proceeds thereof surviving §552(a)'s
automatic severance and remaining cash collateral subject to 11 U.S.C. §363's
restrictions.
While secured creditors embrace §552 (b)'s proceeds exception, many are
unaware of §552(b)'s hidden danger: the "equity" exception. In
addition, depending on one's interpretation, a debtor might effectuate a surcharge
without the prerequisites and standards for an 11 U.S.C. §506 surcharge.
5 King, Lawrence P., et. al., Collier on Bankruptcy, §552.02[4][c]
(15th ed. Rev. 2005). Furthermore, §552(b)'s equity exception has the potential
to work, for all practical purposes, a partial avoidance of an oversecured creditor's
property interests, thereby diminishing an otherwise healthy equity cushion.
Though often ignored, this provision can alter the course of a bankruptcy case
in more ways than one.

Section 552, the Proceeds Exception and the Equity Exception 
Pursuant to §552(a), "property 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." 11 U.S.C. §552(a). Section 552(b), however, provides an
exception to §552(a) for proceeds, products, offspring or profits of encumbered
pre-petition property, except to any extent that the court, after notice and
hearing and based on the equities of the case, orders otherwise. 11 U.S.C. §552(b)(1).
Further excepted are rents 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 any extent that the court, after notice
and hearing and based on the equities of the case, orders otherwise. 11 U.S.C.
§552(b)(2).
Despite the broad proceeds exception(s), §552(b) does not provide an all-encompassing
security interest preservation. Instead, one must first consider whether the
property arising post-petition truly constitutes proceeds of encumbered pre-petition
property, as well as whether §552(b)'s equity exception applies.
When Proceeds Are Not "Proceeds"
Proceeds of encumbered pre-petition property do not necessarily include the
entire amount received from the disposition thereof. Instead, the disposition
of encumbered pre-petition property may yield both proceeds and additional property
that does not constitute proceeds for §522(b) purposes. See, e.g.,
In re Cafeteria Operators LP, 299 B.R. 400 (Bankr. N.D. Texas 2003).
In Cafeteria Operators, for example, the court held that revenue generated
by the debtor's labor, in preparing food for human consumption, was not necessarily
subject to a pre-petition security interest in the raw food inventory. Cafeteria
Operators, 299 B.R. at 408-09. The court reasoned that "restaurant
customers are paying some premium to have the food prepared prior to consumption
and served to them." Id. at 409.

Therefore, only that portion of the revenues attributable to the raw food inventory
constituted proceeds and the secured creditor's cash collateral. Id.
The court did not, however, find that all revenue received from food sales was
unencumbered, only that portion that was attributable to food preparation (i.e.,
the debtor's labor). Id. The court in Cafeteria Operators further
found, though noting that such additional findings were not necessary, that
even if all of the debtor's revenue from the sale of prepared food, which would
include revenue generated from human labor, constituted proceeds, the equities
of the case would require the court to limit the extent of the pre-petition
security interest's post-petition continuation so as to prevent the secured
creditor from receiving a windfall via the debtor's labor. Id. at 409-10.
Such a windfall would occur when the proceeds were of significantly higher value
than the raw food inventory, for which the increase in value was directly attributable
to the debtor's labor. Id.
Though many cite Cafeteria Operators for support in applying the equities
exception, Cafeteria Operators first and foremost defines, irrespective
of the equities, proceeds under §552(b). Other courts have defined proceeds
to exclude proceeds from post-petition accounts receivables and proceeds from
proceeds that accrue post-petition. See, e.g, In re Skagit
Pacific Corp., 316 B.R. 330, 336 (9th Cir. BAP 2004) (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)).

Indeed, in Skagit Pacific, a debtor collected pre-petition balances
on outstanding pre-petition accounts and used such proceeds in operations to
create new accounts receivables. In subsequently analyzing the extent of the
pre-petition security interests' continuation, the court held that proceeds
from the pre-petition accounts receivables remained collateral, but when converted
into proceeds from post-petition accounts receivables, without the benefit of
a 11 U.S.C. §361 replacement lien, §552(a) acted to sever the pre-petition
security interest. Skagit Pacific, 316 B.R. at 336. Clearly, Skagit
Pacific demonstrates the necessity and importance of replacement liens,
irrespective of Revised Article 9.
Nonetheless, even where proceeds from the disposition of collateral are undoubtedly
proceeds, such property interests are not necessarily beyond attack. Indeed,
another avenue of attack lurks in plain sight: an exception to the proceeds
exception based on the "equities" of the case. See 11 U.S.C.
§552(b).
The Equity Exception
Just as every rule has its exception, both subsections of §552(b) include
their own exception, as both end with the same phrase: "except to any extent
that the court, after notice and hearing and based on the equities of the case,
orders otherwise." 11 U.S.C. §552(b)(1) and (b)(2). As stated, the
last phrase of each subsection provides an express exception to the proceeds
exception of §552(a)'s automatic severance of after-acquired property interests.
The language of this express exception authorizes a court to order that property,
which would otherwise constitute proceeds under §552(b) and therefore remain
subject to an encumbered pre-petition security interest, is not subject to the
pre-petition security interest.
Section 552(b)'s equity exception is typically applied in reorganizations,
as opposed to liquidations, to prevent oversecured creditors from receiving
a windfall by realizing upon property that arose or increased in value post-petition,
the value of which would otherwise further the debtor's reorganization. Stanziale
v. Finova Capital Corp. (In re Tower Air Inc.), 397 F.3d 191, 205
(3d Cir. 2005). The debtor's reorganization should benefit from the debtor's
efforts and/or use of other assets of the estate that result in the appreciation
of collateral, as allowing the secured creditor to receive the benefit of such
efforts and/or from the use of unencumbered assets would result in a windfall
to which the secured creditor is not entitled. Id. (citing In re Bennett
Funding Group Inc., 255 B.R. 616, 634 (N.D.N.Y. 2000)).

Though a seemingly harsh result, a quick study of unencumbered vs. encumbered
assets, and the beneficiaries of each, clarifies matters. Specifically, and
generally speaking, unencumbered assets of the bankruptcy estate benefit unsecured
creditors, whereas secured creditors have their encumbered assets for satisfaction
of their claims. Where a secured creditor is undersecured, the undersecured
portion is lumped with all other unsecured creditors who must seek satisfaction
of their claims from unencumbered assets of the estate.
Thus, if proceeds from the disposition of encumbered property increased in
value from the use of unencumbered assets, then the secured creditor has benefited
to the detriment of unsecured creditors from property that should benefit unsecured
creditors. On the other hand, where no unencumbered assets, or efforts from
the debtor, were used to enhance the value of collateral, the value of which
increased despite the debtor's use of the creditor's cash collateral, no such
windfall exists and the "equities" would not support an erosion of
collateral. See, e.g., In re Muma Services Inc., 322 B.R.
541, 559 (Bankr. D. Del. 2005); In re The Bennett Funding Group Inc.,
255 B.R. 616, 634 (N.D.N.Y. 2000).
Similarly, where a debtor's conduct damaged a secured creditor's collateral
and expended funds recovered from insurance to repair that collateral, such
expenditures do not equate to a windfall. In re Tower Air Inc., 397 F.3d
191, 205 (3d Cir. 2005). Instead, a creditor in such a situation is merely recovering
what it is due as a secured creditor with a valid proceeds security interest
in insurance proceeds. Id.

Accordingly, the "equities" of the case require an analysis of the
facts and circumstances of each case. For example, where a bankruptcy estate
puts significant effort into disposing encumbered property, or man hours are
used to finish incomplete inventory that increase the amounts realized from
such disposition, the equities of the case may require the court to apportion
the proceeds. See In re Patio & Porch Systems Inc., 194 B.R. 569,
575 (Bankr. D. Md. 1996); see, also, In re First Nat'l. Bank v. Willis
(In re Jones), 908 F.2d 859 (11th Cir. 1990) (holding that a secured
creditor's interest in a debtor's life insurance policy did not extend to increase
in cash surrender value attributable to post-petition premium payments).
Thus, although §552(b) authorizes a court to hold that a portion of an
otherwise automatically attached and perfected security interest is free and
clear of such security interest, §552(b)'s equity exception is not tantamount
to an avoidance of the entire security interest. Instead, courts should consider
what portion, if any, of the secured creditor's property interests in proceeds
should be unencumbered and held by the debtor free and clear based on the equities
of the case. In other words, what portion should benefit the bankruptcy estate
as a whole, instead of benefiting the secured creditor only, despite the secured
creditor's property interests.
Conclusion
To some, §552(b)'s equity exception to the proceeds exception of §552(a)
resembles a surcharge and/or an avoidance of liens. Though not couched in such
terms, it has the same practical effect: creating unencumbered assets from otherwise
validly encumbered assets.
The difference, however, is that §552(b)'s equity exception is a limitation
on what constitutes proceeds under §552(b), being, in turn, an exception
to §552(a)'s automatic severance of after-acquired property interests.
Thus, applying §552(b)'s equity exception does not require the constitutional
due process safeguards that an avoidance action requires as it does not alter
property interests, but redefines and limits property interests.

While case law attempts to differentiate between circumstances that define
proceeds from those that require an examination of the equities, they certainly
share common grounds. Nonetheless, where the proper facts and circumstances
exist, a close look at §552's entire text may reveal a lifeline for an
otherwise overwhelmed debtor.

Journal Authors

Bruce H. White

William L. Medford

Journal Date

Monday, May 1, 2006 - 12:00

Bankruptcy Rule

2006

none