We’ve all seen it, right? Loan documents where a borrower grants a blanket security interest in nearly all of its assets to a lender, including assets that it may acquire in the future? These “after-acquired” security interests in real and personal property are all too familiar to most secured lenders — especially when lending to a sophisticated business with fluctuating assets. Security interests in a borrower’s future assets are intended to provide extra protection to the lender and are enforceable in most contexts. After-acquired clauses, however, are not guaranteed to give a secured lender a “leg up” once a bankruptcy is filed.
Security Interests in After-Acquired Property
The “general rule” actually provides just the opposite. Section 552(a) of the Bankruptcy Code provides that “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.” [1] In other words, once a borrower files bankruptcy, any post-petition property acquired by the debtor will not be subject to the lien of the pre-petition lender — even if the pre-petition loan documents include an “after-acquired” clause. As with any bankruptcy statute, there are exceptions to the rule that are well worth knowing.
First, under § 552(b)(1), if a lender’s pre-petition security agreement attaches a security interest to the debtor’s pre-petition property, then that security interest will also attach to post-petition proceeds, products, rents or profits of the collateral, so long as it is provided for in the security instrument. [2] The second exception was added in 1994. It provides that a pre-petition security interest in the debtor’s pre-petition property and rents generated therefrom will extend to post-petition rents from the property, as long as the security agreement provides for it. [3] Of course, both of these sections are subject to the powers of the trustee and to the equitable authority of the bankruptcy court. [4]
Recent Case Law
A recent case from the bankruptcy court in New Mexico provides an excellent reminder to secured lenders on how to make sure their pre-petition liens will fit within the exceptions of § 552(b). In In re Twin Pines LLC, the U.S. Bankruptcy Court for the District of New Mexico analyzed whether an automated car wash purchased post-petition and an installed drive-through bay on the debtor’s property was subject to a pre-petition mortgage by the lender. [5]
The debtor was a car-wash facility that had two separate bays with automated car-wash systems. [6] One of the two car-wash systems broke before the debtor filed bankruptcy, and the second automated car-wash system broke post-petition from age and lack of use by the debtor during the state-mandated COVID-19 closures. [7] In June 2020, after its second system failed, the debtor purchased a new Laser Wash 360 Plus system and related equipment. [8] The post-petition equipment purchase was financed by Ruidoso Capital Resources, LLC, which purchased the equipment for the debtor in exchange for a 33 percent membership interest in the debtor. [9] In addition to the car-wash system, the debtor also owned four condo units and two single-family residential homes on property adjacent to its car-wash business, all of which were leased to third-party tenants. [10]
Prior to filing bankruptcy, the debtor obtained a $525,000 loan to purchase the car wash and real property and, shortly thereafter, refinanced that initial loan, which resulted in total indebtedness in favor of First National Bank (FNB) of $995,000, which was used to construct the condo complexes on the property. [11] FNB obtained a blanket lien on the debtor’s assets, including the debtor’s real property, car wash equipment and general intangibles, along with an assignment of rents. [12]
In conjunction with its efforts to confirm a subchapter V plan, the debtor filed a motion to determine the value of the real property that served as FNB’s collateral. [13] In determining the value of the collateral, the bankruptcy court analyzed the extent of FNB’s security interest in the debtor’s assets, including the Laser Wash 360.
FNB argued that the Laser Wash 360 Plus car-wash system, purchased post-petition, was installed into one of the bays on the real property and was, therefore, a fixture under New Mexico law. [14] Thus, FNB’s position was that since the car wash was a “fixture,” it was subject to the bank’s pre-petition security interest in the debtor’s real property. [15] The court disagreed.
The Twin Pines court found that because FNB’s cash collateral was not actually used to purchase the equipment, the Laser Wash 360 Plus could not be considered “a proceed of any assets subject to FNB’s lien and is not otherwise attributable to the Debtor’s prepetition assets.” [16] The court went further to note that the “[d]ebtor did not pay for the [car wash equipment] at all: The equipment was not acquired with cash collateral or through the sale, lease, license, exchange or other disposition of [the d]ebtor’s assets.” [17] “Section 552(b) is intended to cover after-acquired property that is directly attributable to prepetition collateral, without addition of [other] estate resources.” [18] Because FNB’s collateral did not contribute in any way to the debtor’s acquisition of the post-petition car-wash equipment, FNB could not claim a security interest in it. [19]
Protecting Your Security Interest
To ensure that your pre-petition lien in the debtor’s after-acquired property will attach to post-petition assets procured by the debtor, the lender must first ensure that its loan documents explicitly attach a security interest in all “proceeds, products, offspring, or profits” of the collateral. [20] Next, to the extent possible, a lender should try to ensure that the newly acquired property can be “traced” to the lender’s pre-petition collateral. Absent doing so, the lender’s after-acquired clause may offer little protection.
[1] 11 U.S.C. § 552(a).
[2] 11 U.S.C. § 552(b)(1).
[3] 11 U.S.C. § 552(b)(2).
[4] See 11 U.S.C. § 552(b)(1), (2).
[5] In re Twin Pines LLC, No. 19-10295-j11, 2021 WL 312674 (Bankr. D.N.M. Jan. 29, 2021).
[6] Id. at *2.
[7] Id. at *3.
[8] Id.
[9] Id.
[10] Id.
[11] Id. at *4.
[12] Id. The bankruptcy court had also granted FNB a replacement “lien against property of the same type as the collateral acquired by [the d]ebtor post-petition (including after-acquired equipment) to the extent of any reduction or diminution in value of FNB’s cash collateral.” Id. at *2.
[13] Id. at *2.
[14] Id. at *17.
[15] Id.
[16] Id. at *18.
[17] Id. at *18 (citations omitted).
[18] Id. (citing 5 Collier on Bankruptcy ¶ 552.02 (16th 2020)).
[19] Id.; see also In re Energy Future Holdings Corp., 585 B.R. 341, 356 (D. Del. 2018) (“Section 552(b) requires Appellant to trace the cash generated from the operation of the TCEH Debtors’ business following the commencement of bankruptcy to prepetition Collateral or proceeds thereof.”)
[20] 11 U.S.C. § 552(b)(1).