Contributed by Jordan Bryk
In a recent case out of the United States Bankruptcy Court for the District of New Jersey, Judge Kaplan denied a secured creditor’s bid for superpriority status under section 507(b) of the Bankruptcy Code.  The secured creditor, JPMorgan Chase, argued that it was entitled to a superpriority claim in the bankruptcy case of Mary Holder Agency, Inc. as a result of the asserted failure of replacement liens granted in exchange for the use of JPMorgan’s cash collateral to adequately protect JPMorgan against the diminution in value of its collateral.  The court’s decision denying the superpriority claim highlights ways that JPMorgan could have protected its interests.
Section 507(b) grants a secured creditor a superpriority claim ahead of all other unsecured claims (including all administrative expenses) if the adequate protection granted to safeguard a secured creditor’s collateral proves to be inadequate.  The court noted that “[t]he superpriority of section 507(b) is intended to compensate the secured claimant for the difference between the adequate protection provided by the debtor and any actual decrease in the value of the collateral occurring during the pendency of the bankruptcy action.”  In other words, adequate protection is intended to protect a secured creditor from erosion in the value of its collateral at the outset of a bankruptcy, but when the collateral ultimately erodes in value by an amount greater than initially expected, section 507(b) picks up the slack.
Here, JPMorgan’s loan was secured by a blanket lien on all of Mary Holder Agency’s assets.  After Mary Holder Agency filed its chapter 11 case (which was converted to chapter 7 about four months later), the court authorized the debtor’s use of JPMorgan’s cash collateral pursuant to section 363(c) of the Bankruptcy Code and granted JPMorgan replacement liens on the debtor’s postpetition receipts.  The cash collateral order, however, did not state that the replacement liens were granted as adequate protection.
After receiving a report from the chapter 7 trustee on her collection of receipts, JPMorgan filed a motion seeking to establish a superpriority administrative claim under section 507(b).  In considering JPMorgan’s request, the court noted that a secured creditor is only entitled to a superpriority claim if the following three criteria are met:  (1) the court previously directed the debtor to provide adequate protection to the secured creditor; (2) the adequate protection that was provided failed to preserve the secured creditor’s interest in its collateral; and (3) the secured creditor’s claim is allowable as an administrative expense — namely, the claim arose from a postpetition transaction that substantially benefitted the bankruptcy estate.  In this case, the court concluded that JPMorgan failed to meet all three criteria.
Judge Kaplan used the standard employed by the bankruptcy courts in the Third Circuit, which requires a court order of adequate protection before granting superpriority under section 507(b).  Other circuits, such as the Ninth and Tenth, are not as strict and have permitted the use of section 507(b) in the absence of a court order expressly providing adequate protection or where the parties have privately stipulated for adequate protection amongst themselves.  In the Second Circuit, this issue remains unsettled.
Accordingly, because the court never characterized the replacement liens as “adequate protection,” JPMorgan could not assert a right to a superpriority claim.  The court noted that the term “adequate protection” did not show up anywhere in the cash collateral order, and the court never directed the debtor to provide such adequate protection to JPMorgan.
Moreover, the court had no evidence to determine that the replacement liens had failed to preserve JPMorgan’s interest in its collateral.  The court noted that it never had ruled on the value of the underlying collateral or the extent of JPMorgan’s lien against the collateral or the adequacy of the replacement liens.  Accordingly, the court had no basis to determine that the debtor’s use of JPMorgan’s cash collateral had caused a decline in the value of JPMorgan’s collateral.
Finally, Judge Kaplan took a hard line on the requirement that the secured creditor’s claim be allowable as an administrative expense.  To meet this requirement in most jurisdictions, a secured creditor must simply establish that the debtor’s postpetition use of the secured creditor’s collateral conferred a benefit on the debtor’s estate.  Here, however, the court required that JPMorgan had engaged in an independent postpetition transaction with the debtor.  Judge Kaplan did not articulate what might constitute a postpetition transaction between a prepetition creditor and a debtor in possession and suggested that it would not follow the cases that hold that postpetition negotiations for continued use of a secured creditor’s collateral qualify as a postpetition transaction.  In any event, the court noted, it did not even have any evidence before it that any such negotiations had occurred.
Once granted, superpriority status under section 507(b) can be a powerful tool for secured creditors wishing to protect their collateral when adequate protection fails.  Mary Holder Agency shows that JPMorgan could have improved its chances to obtain a superpriority claim if it had been more proactive at the outset to protect its interests.  Although the tests will vary by jurisdiction, careful negotiation and drafting of an adequate protection stipulation or cash collateral order will go a long way towards protecting the secured creditor’s interest.