Adequate Protection for Secured Creditors: The Interest Accrual Myth

I cannot recall how many attorneys, young and old, creditor counsel or debtors I have heard stand up in open court and state with conviction that a debtor must provide “adequate protection” under 11 U.S.C. § 361 for the interest accrual on the lender’s secured debt claim or stated another way, the failure to do so means the equity cushion will be eroded by the accruing interest and adequate protection must be provided for this “erosion by interest accrual.” This proposition then usually translates into the argument that a debtor must keep the interest accrual current as part of the requirements of adequate protection under § 363 to use cash collateral or to prevent relief from stay under § 362, to which I respectfully reply “you’re wrong.”

While keeping interest current is one form of adequate protection, and in certain small business and single-asset real estate cases is actually required by the Bankruptcy Code under certain circumstances, [1] it is an inaccurate and often misleading statement to insist that the lender’s interest accrual must be kept current or it is somehow a measure of the diminution in the adequate protection offered if it is not. Let’s start with a basic refresher on adequate protection for a secured lender’s claim.

Adequate Protection Is Required Only for the Secured Claim Existing as of Petition Date
Adequate protection under § 361 only protects a creditor’s interest in a debtor’s property:

[s]ection 361 addresses only a decrease in value of the entity’s interest in the property. Therefore, if the equity cushion has been eroded by the accumulation of post petition interest rather than a decrease in value of the collateral, the creditor should not be entitled to adequate protection. The creditor’s interest in the collateral is actually increasing by the accumulation of interest. It seems settled that under Timbers of Inwood Forest, interest accrues only up to the value of the creditor’s interest in the collateral under section 506(a); interest itself should not trigger a right to adequate protection payments even if the interest accrual consumes the entire equity in the property.” [2]

This analysis from Collier is the logical conclusion from the bifurcation in § 506 between a secured claim and an unsecured claim and the rights an over secured creditor has pursuant to 11 U.S.C. § 506(b). If adequate protection required installment payments accrued post-petition interest, an oversecured creditor would remain forever oversecured and would potentially receive interest payments in excess of the equity cushion, contrary to the limitation in § 506(b) that post-petition interest accrues “only to the extent” of the equity cushion. Thus, unpaid interest accrual is not entitled to be paid and does not cause a ‘diminution’ in the value of the collateral.

Adequate Protection Does Not Include Preservation of Secured Creditor’s Equity Cushion.
Equity cushion is adequate protection. It is generally recognized that an equity cushion of 20 percent or more in collateral generally will be sufficient to adequately protect a lender’s claim. See, e.g., In re Steffens, [3] which held that an equity cushion of 24 percent is sufficient adequate protection to deny relief from stay. When this equity cushion begins to erode away due to the accrual of a lender’s interest, attorneys fees and costs, many lenders panic and insist that the debtor must maintain the equity cushion by keeping the interest accrual, fees and costs current or face relief from stay or the prohibition against the use of cash collateral. These arguments are simply misplaced.

 Two circuit courts of appeal have addressed whether a secured creditor is entitled to adequate protection for interest accruing on its debt in order to preserve an equity cushion In re Delta Resources, Inc. [4] and Matter of T-H New Orleans Ltd. Partnership. [5] Both squarely held that an oversecured creditor is not entitled to payment of accruing interest in order to maintain its equity cushion.

The Delta Resources court explained that the Supreme Court’s decision in United Sav. Ass'n of Texas v. Timbers of Inwood Forest Assocs. Ltd. [6]ineluctably led to this conclusion, following the logic outlined in 3 Collier on Bankruptcy § 361.03[2] (Lawrence King, 15th ed. 2008). “Thus, to the extent that the bankruptcy court's order does violence to the teachings of Timbers by ordering the payment of interest pending confirmation as opposed to ordering interest to accrue, it was error.” [7] Ultimately, the Delta Resources courtexpressly held that “an oversecured creditor’s interest in property [that] must be adequately protected encompasses the decline in the value of the collateral only, rather than perpetuating the ratio of the collateral to the debt.” [8]Similarly, the In re Richards courtrelied on the reasoning in Delta Resources and stated:

A decline in the amount of an equity cushion is not equivalent to denial of adequate protection of a secured claim. Statements made in Timbers of Inwood Forest do not suggest that an oversecured creditor is entitled to adequate protection of the entire equity cushion. A secured creditor's rights are confined to those specified in § 506. Id. Section 506(b) grants the oversecured creditor a claim for post-filing interest and legal fees to the extent of the collateral cushion. [9]

Thus, a debtor is not required to protect an equity cushion in property in which a lender has an interest.
 A practical example of this doctrine can be seen in the Colorado case of In re Rocky Mountain Instrument Co., in which Hon. Howard R. Tallman considered a secured lender’s request for adequate-protection payments to preserve an equity cushion in the lender’s collateral.  In that case, the lender had a “thin” equity cushion of $269,712.59. Nevertheless, the court rejected the lender’s request for adequate protection payments to preserve the equity cushion:

Unlike an undersecured creditor, an oversecured creditor, like the Bank, is entitled to receive post-petition interest on its secured claim. 11 U.S.C. § 506(b). But the oversecured creditor’s entitlement to receive post-petition interest on its claim is not an entitlement to receive something over and above the value of its collateral. As the interest accrues, it becomes a part of the debt that is secured by the collateral but only so long as the total of the debt remains less than the value of collateral. [10]

Applying that reasoning, the court concluded that the “[b]ank is not entitled to adequate protection in the form of periodic interest payments to maintain its equity cushion at its present level.” [11]

Section 363 Limits When a Debtor Can Use Cash Collateral, Not How It Is Used
Many lenders insist that §§ 363 and 361 somehow give them the right to veto the debtor’s expenditures and restrict when, for example, the estate may hire professionals and pay them using “cash collateral.” Many of these restrictions on the use of cash collateral are understandably negotiated into stipulations and stipulated orders by the parties. However, in a contested situation, these arguments for restrictions on the use of cash collateral only carry weight where adequate protection does not exist. If adequate protection exists, § 363 does not permit restrictions on the use of cash collateral to those that the lender chooses or that only benefit the lender’s interest. For example in In Re PROALERT LLC [12], the court refused to exclude categories of expenses from a contested cash collateral order. Indeed, as the court went on the say, professional fees do not have to be shown to benefit the lender in any way to be payable from cash collateral, as long as the lender’s interest in cash collateral remains adequately protected. [13] Cash collateral may be used for the “general benefit of the estate and need not be devoted exclusively to the protection of the creditor or the collateral.” [14]

Conclusion
Next time you are in court and you hear the argument made that the equity cushion must be preserved and the interest accrual must be kept current, keep in mind that those broad generalities do not apply where adequate protection exists for the lender’s interest in the collateral as of the filing date. Broad generalities rarely apply in bankruptcy matters and this is a good example of where they frequently do not.