Restructuring

Contributed by Amy B. Price
As any seasoned Code-breaker will tell you, the Bankruptcy Code is fun and challenging in part because of the way that it interacts with other codes.  Here, our focus is section 552 of the Bankruptcy Code, which governs the postpetition effect of a prepetition security interest.  Appreciating section 552 also requires breaking into Article 9 of the Uniform Commercial Code.
Section 552 is needed because, long before filing for bankruptcy, a debtor may grant a lender a security interest in some or all of the debtor’s property, and the security agreement giving rise to such security interest may grant the lender a lien on, among other things, “all equipment, inventory or accounts, now existing or hereafter acquired.”  This is commonly known as an “after acquired property” clause.  Pursuant to such clause, certain property acquired by the debtor going forward automatically becomes subject to the secured party’s lien (also known as a “floating lien”).  What’s more, pursuant to the UCC and the terms of the security agreement, a secured party may have a lien on the proceeds of its collateral, including the proceeds of after-acquired collateral.  Thus, prior to filing for bankruptcy, a common set of (over-simplified) facts may look like this: On Day 1, the debtor grants the lender a security interest in all of the debtor’s property and after-acquired property and all proceeds of such property.  On Day 5, the debtor buys a computer.  The lender now has a lien on the new computer.  On Day 10, the debtor sells the computer for $100 in cash.  The lender now has a lien on the $100 cash proceeds.
Upon the debtor’s filing for bankruptcy, floating liens can become a burden to the estate because they encumber assets that the debtor in possession could otherwise use in its reorganization.  On the other hand, access to value generated by original collateral, such as proceeds and rents, can be an important factor in a lender’s decision to loan money to a debtor.  Accordingly, section 552 attempts to free the debtor in possession from some of the baggage of its prepetition security interests, while preserving certain rights and interests of secured parties.  In favor of the debtor in possession, section 552(a) nullifies the after-acquired property clause in a security agreement as of the commencement of the bankruptcy case.  Specifically, section 552(a) provides that “[e]xcept as provided in subsection (b) of this section, 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 case.”  Thus, continuing with the above example, if the debtor in possession buys a computer postpetition, the secured party’s lien will not attach to the computer, even if the security agreement contains an after-acquired property clause.
Section 552(b) contains two important exceptions to section 552(a) that preserve certain interests of secured parties pursuant to their prepetition security agreements.  First, to the extent a security agreement provides for a floating lien on the “proceeds, products, offspring or profits” of prepetition collateral, section 552(b)(1) preserves such lien after the commencement of the case.  Going back to the example above, if the debtor bought the computer prepetition and then sells the computer postpetition, section 552(b)(1) says the secured party’s lien will extend to the proceeds of the sale (for example, cash proceeds).  As a result of section 552(b)(1), parties may dispute whether certain property is after-acquired collateral or the proceeds of original collateral because the distinction, though sometimes fine, will determine who has superior rights to the asset as between the debtor in possession and the secured party.  See, e.g., In re Inman, 95 B.R. 479 (Bankr. W.D. Ky. 1988) (finding money generated by fast food restaurant from the sale of food was after-acquired property, rather than proceeds of the restaurant’s inventory, because the restaurant’s earnings arose from the service provided, rather than the sale of inventory); In re Timothy Dean Restaurant & Bar, 342 B.R. 1 (Bankr. D.C. 2006) (finding room service charges were not “proceeds” attributable to the sale of food and beverage inventory on which secured creditor had a prepetition lien).
Second, section 552(b)(2) allows a secured lender to retain a floating lien on, among other things, rents and hotel room revenues generated after the commencement of the case from prepetition property, to the extent provided in a prepetition security agreement.  This section was added to the Bankruptcy Code pursuant to the Bankruptcy Reform Act of 1994 to clarify the treatment of floating liens on hotel room revenues, as opposed to rents, as a form of collateral.  Before the 1994 addition of section 552(b)(2), section 552(b)(1) (then called “section 552(b)”) applied to proceeds, products, offspring, profits or “rents,” but disputes arose over whether “rents” included hotel room revenues.  Notwithstanding the addition of section 522(b)(2), parties continue to litigate issues surrounding the assignment of rents and other forms of hotel room revenues, which is governed by state law in the first instance.  For example, as previously discussed, if the prepetition security agreement does not expressly provide for a lien on both rents and room revenues, section 552(b)(2) may be of little help to a creditor seeking to enforce a lien on such assets.
What’s more, a practical effect of section 552(b) is that the secured party often ends up with a lien on property acquired by the estate postpetition, notwithstanding section 552(a).  Because sections 552(b)(1) and (b)(2) allow a floating lien to attach to postpetition proceeds or rents generated from prepetition collateral, the debtor in possession cannot use those proceeds without complying with section 363(c)(2) of the Bankruptcy Code.  Section 363(c)(2) prohibits a debtor in possession from using cash collateral of a secured party without the secured party’s consent or approval of the bankruptcy court.  And approval of the bankruptcy court requires a showing that the secured party’s interest in the cash collateral is adequately protected.  Therefore, as a condition to using the secured party’s cash collateral, a debtor in possession often will grant a “replacement lien” in favor of the secured party on accounts or inventory generated postpetition, thereby undermining section 552(a).
Also note that sections 552(b)(1) and (b)(2) allow a court to disregard a postpetition lien on proceeds or rents “based on the equities of the case.”  Although many courts have construed this phrase narrowly, and courts seldom disregard a postpetition lien on proceeds based upon the “equities of the case,” the exception is most commonly applied where a creditor is oversecured and unencumbered cash of the estate is used to increase the value of the collateral.  See Toso v. Bank of Stockton (In re Toso), 2007 WL 7540985 (B.A.P. 9th Cir. Jan. 10, 2007).  In this instance, courts have reasoned that application of the doctrine was necessary to prevent a secured creditor from receiving a “windfall” in assets that would otherwise go to rehabilitating the debtor.
In sum, well before they find themselves in the bankruptcy arena, both debtors and secured parties should understand the postpetition effects of their prepetition security agreements and should draft and negotiate security agreements accordingly.  Moreover, as wordy and intricate as section 552 appears, many of its true complexities are not apparent on its face.  Even master code breakers can find themselves caught in the web of section 552 and Article 9, and even where courts do not invoke their express equitable powers, they may guide their decisions by the underlying need to balance secured parties’ interests against the debtor’s right to a fresh start and the availability of funds to other creditors.