Fifth Circuit Reconciles Lenders’ “Adequate Protection” Requirement with Code’s Fallback Superpriority Administrative Claim

The Fifth Circuit Court of Appeals, on October 19, 2010 corrected a bankruptcy court’s calculation of a secured lender group’s superpriority administrative claim more than two years after consummation of the debtors’ chapter 11 reorganization plan. [1] In doing so, the court reconciled the rationale for giving secured lenders “adequate protection” with the “fallback” superpriority administrative claim of § 507(b) of the Bankruptcy Code. [2]

Facts
Pacific Lumber Co. (Palco) and five affiliated entities, including the wholly-owned Scotia Pacific Co. (Scopac), filed chapter 11 petitions on Jan. 28, 2007. The debtors grew, harvested and processed redwood timber. Scopac was a special purpose entity with 200,000 acres of redwood timber. [3]

The debtors’ primary creditors included a bank, owed $36 million; noteholders, owed $714 million; and a private-equity fund (the “fund”), owed $160 million. The noteholders had a lien on substantially all of Scopac’s assets, subject to the bank’s senior lien. [4]

Noteholders’ Replacement Liens and Superpriority Administrative-Expense Claim
The bankruptcy court entered orders allowing the debtors to use the noteholders’ and bank’s cash collateral during the reorganization case. In exchange, as “adequate protection,” the court granted the noteholders and bank a replacement lien on assets not already subject to the existing liens. The cash collateral orders contained this specific language:

[A] first priority, perfected replacement lien and security interest in all the property of Scopac of the same type as the Prepetition Collateral in which [bank] and the [noteholders] do not have a lien…and in the Cash Collateral of Scopac, to the extent of the post-petition diminution of its interests in the Pre-petition Collateral and the Cash Collateral. [5]

According to the court, “the orders were perfectly clear that the proceeds and product of the Prepetition Collateral constitute cash collateral.” [6] Finally, the court also gave the noteholders and bank a fallback superpriority administrative-expense claim to the “extent of the post-petition diminution of their interests,” pursuant to § 507(b). [7]

Bankruptcy Court Rulings
The bankruptcy court eventually terminated the debtors’ exclusive period for filing a chapter 11 reorganization plan, enabling the fund to propose a plan (the “fund plan”) that would give it the equity of the reorganized companies. The noteholders objected to this plan, arguing that, among other things, it artificially devalued their secured claim. Arguing separately, they asserted a superpriority administrative-expense claim pursuant to § 507(b) for the “substantial post-petition decline” in the value of their collateral reflected in the fund plan. [8]

After hearing “extensive valuation testimony,” the court found that the value of Scopac’s timber, its primary asset, was worth “not more than $510 million,” but delayed entry of a confirmation order to consider the noteholders’ superpriority administrative-expense claim under § 507(b). [9] Thus, the noteholders had an unsecured deficiency claim of more than $200 million. [10]
The bankruptcy court held further hearings, focusing on the noteholders’ § 507(b) claim. Undisputed testimony showed that the noteholders’ collateral at the beginning of the reorganization case included $48.7 million in non-timber assets owned by Scopac. [11] Despite additional testimony showing that the Scopac estate generated an additional $29.7 million in proceeds from the sale of timber during the reorganization, the bankruptcy court failed to recognize proceeds as the noteholders’ cash collateral and did not account for this amount in determining the amount of the noteholders’§ 507(b) claim. [12]

The bankruptcy court deducted the bank’s superior claim of $36.2 million and another $8.9 million that Scopac had paid to the noteholders’ professionals to arrive at the following calculation of the noteholders’ remaining interest in the Scopac non-timber collateral:

Moreover, the court reasoned, the timberland collateral had not declined in value during the reorganization. The noteholders thus held a secured claim of $513.6 million: $510 million based on their lien against the timber assets and a net $3.6 million lien on Scopac’s non-timber assets. The fund agreed to modify its reorganization plan to provide for payment of this amount. In denying the noteholders an administrative-expense claim based on § 507(b), the bankruptcy court reasoned that the noteholders were entitled to no more than a $513.6 million secured claim, after confirming the fund plan on July 8, 2008. [13]

The noteholders filed separate appeals from the § 507(b) order (the “§ 507(b) appeal”) and the confirmation order (the “confirmation appeal”). Although the bankruptcy court denied the noteholders’ request for a stay of confirmation pending appeal, the Fifth Circuit entertained a direct appeal of the confirmation order without a stay. [14]

Pacific Lumber I (Confirmation Appeal)
The Fifth Circuit largely affirmed the bankruptcy court’s confirmation order on Sept. 29, 2009. [15] It noted, however, that the bankruptcy court “may have made a mathematical error and deprived the Noteholders of [a] post-petition administrative priority claim,” remanding the case “for a determination of the value of this administrative priority claim and the extent to which effective relief is available.” [16]

Pacific Lumber II (§ 507(b) Appeal)
The noteholders had also appealed from the § 507(b) order to the district court, arguing that the bankruptcy court had undervalued their administrative-priority claim. The district court dismissed this appeal on Feb. 6, 2010, ruling that the “[§] 507(b) Order [was] an integral part of the Confirmation Order.” [17] Because the confirmation appeal was pending in the Fifth Circuit, the district court believed that it lacked jurisdiction to consider the § 507(b) appeal separately. [18]

Nonetheless, the Fifth Circuit reversed the district court’s dismissal, holding that the § 507(b) appeal challenged the “bankruptcy court’s ruling on the diminution in value of the secured claim after the petition date and the status of sales proceeds of collateral before confirmation. These are independent factual inquiries, unrelated to confirmation,” and their consideration “could not have had the effect of interfering with [the confirmation appeal] or circumventing it.” [19]

Moreover, the court refused to dismiss the appeal as equitably moot, holding that “so long as there is the possibility of ‘fractional recovery,’ the Noteholders need not suffer the mootness of their claims.” [20] “Equitable mootness should…not be a shield for sharp or unauthorized practices. Applying equitable mootness too broadly to disfavor appeals challenging the treatment of secured debt carries a price. It…destabilizes the credit market for financially troubled companies.” [21]

Adequate Protection and § 507(b)’s “Fallback” Administrative-Priority Claim
The Fifth Circuit “has explained that adequate protection of a secured creditor’s collateral and its fallback administrative-priority claim are tradeoffs for the automatic stay that prevents foreclosure on debtors’ assets: the debtor receives ‘breathing room’ to reorganize, while the present value of a creditor's interests is protected throughout the reorganization.” [22]

“Adequate protection,” as explained by the court, “is a term of art in bankruptcy practice…; in short, it is a payment, replacement lien or other relief sufficient to protect the [secured] creditor against diminution in the value of its collateral during the bankruptcy.” [23] Under §§ 362, 363 and 364 of the Code, a secured lender is entitled to be “adequately protected” from any erosion in the value of its collateral during the bankruptcy. [24] Section 361 provides a nonexhaustive list of potential forms of adequate protection: (1) lump-sum or periodic cash payments, (2) replacement liens or (3) “such other relief,” resulting in the secured lender’s receiving the “indubitable equivalent” of its “interest in such property.”

Adequate protection may prove inadequate. Indeed, a bankruptcy court will typically determine the appropriate form of adequate protection well before confirmation, without the benefit of knowing how much the collateral will actually depreciate during the bankruptcy.

Section 507(b) thus

[allows an administrative-expense claim to be paid out as part of a reorganization plan] under § 503(b) where adequate protection payments prove insufficient to compensate a secured creditor for the diminution in the value of its collateral. “It is an attempt to codify a statutory fail-safe system in recognition of the ultimate reality that protection previously determined the ‘indubitable equivalent’…may later prove inadequate.” [25]

In such instances, § 507(b) provides a superpriority administrative expense as a “fallback” to compensate for the difference between the projected and actual diminution of the collateral’s value. For example, a bankruptcy court may determine that a secured lender, with an underlying claim of $600,000, is adequately protected on Jan. 1, 2011, when the projected value of the collateral over a four-month period is as follows:

 

Nonetheless, by plan confirmation on April 1, 2011, the lender’s collateral may have actually depreciated at a faster rate, as shown below:

The projected decline in the value of the collateral over the course of four months was approximately $219,000, but the collateral depreciated by more than $464,000 to a value of approximately $535,000 on April 1, 2011, thus giving lender, owed $600,000, a § 507(b) superpriority administrative claim (unsecured) of $65,000.

Bankruptcy Court’s Failure to Include Timber Sale Proceeds
The amount of any secured lender’s § 507(b) administrative claim turns on the value of its collateral. In Pacific Lumber, the bankruptcy court had granted the noteholders a replacement lien, subject only to the bank’s superior lien, in any “proceeds and product” generated by the collateral, plus a “superpriority administrative claim to the extent” of any diminution of this interest during the bankruptcy, [26] but the bankruptcy court failed to recognize the noteholders’ lien on the $29.7 million of collateral sale proceeds received by the estate during the reorganization case.

Indeed, “[t]he cash collateral orders protected the Noteholders in two ways. [First,] they protected against a diminution in the value of the $48.7 million cash collateral that existed at the date of filing.” [27] Second, they “specifically granted a continuing lien in the proceeds of the prepetition collateral, i.e., the $29.7 million [of] generated proceeds from timber sales during the reorganization.” [28] If these liens proved inadequate, the noteholders also had a § 507(b) claim. According to the Fifth Circuit, the bankruptcy court erred because it “entirely omitted the second component [the $29.7 million of asset sale proceeds] from its calculations and failed to credit those proceeds to the Noteholders' § 507(b) claim.” [29] Thus, the Fifth Circuit calculated the correct amount owed to the noteholders as follows:

The court remanded the appeal with orders to enter judgment for the Noteholders on their $29.7 million administrative-priority claim. [30] Indeed, Pacific Lumber II is consistent with other appellate rulings protecting secured lenders’ claims from lower courts’ undervaluations or from their failure to protect collateral. [31]