Undersecured creditors may breathe a little easier.  In a recent decision, the United States Bankruptcy Court for the Northern District of Illinois denied the debtors’ request to use an undersecured creditor’s cash collateral, in the form of postpetition rents, to pay estate professional fees, holding that the undersecured creditor was not adequately protected even though the value of its collateral was stable and possibly increasing.  In re Chardon, LLC, Case No. 13-81372 (Bankr. N.D. Ill. Jan. 13, 2015)
Donald Wolf, Sr. and his two sons, Donald, Jr. and David, each commenced individual chapter 11 cases and their cases were consolidated with the chapter 11 cases of the entities through which the Wolfs operated their real estate business.  The three Wolfs collectively held all beneficial interests in a land trust that owned a commercial property known as the Huntley Building.  They also jointly and severally owed FirstMerit National Bank approximately $15 million under certain loans and guaranties.  The FirstMerit debt was cross-collateralized and secured by various of the Wolfs’ real properties as well as an assignment of rents generated by the Huntley Building.  It was undisputed that FirstMerit was undersecured.  It was also undisputed that the real property collateral had a market value that was stable and “likely will increase over the long-term.”
The Wolf debtors sought authorization to use rental income generated by the Huntley Building to pay approximately $279,000 in fees incurred by the Wolf debtors’ professionals.  The Wolf debtors alleged that, as of their request, they held approximately $326,000 in rents from the Huntley Building and that the property then generated approximately $52,000 of rental income per month.  They argued that FirstMerit was adequately protected for the proposed use of cash collateral because (i) the value of the real estate collateral was not diminishing, and (ii) the Wolf debtors would grant FirstMerit replacement liens on future rents.  In addition—although they believed it was unnecessary—the Wolf debtors offered to make future and continuing interest payments to FirstMerit on the portion of the debt attributable to the Huntley Building.
Opinion – FirstMerit Not Adequately Protected
The bankruptcy court held that FirstMerit was not adequately protected under the circumstances because FirstMerit was undersecured and the proposed forms of adequate protection were illusory.
First, the bankruptcy court determined that, even though there was “no evidence” that FirstMerit’s real property collateral was diminishing in value, using cash collateral to pay professional fees would decrease the amount and value of cash collateral held by the estate. Without an equity cushion, additional payments to FirstMerit from its own cash collateral offered no real protection because the reduction to FirstMerit’s claim would equal the reduction of its collateral value.  Replacement liens also offered no protection because FirstMerit already had a lien in future rents under section 552(b) of the Bankruptcy Code and the Wolf debtors’ proposed use of the cash collateral (i.e. payment of professional fees) would not create value that could be subject to a lien.
Building on the point that the proposed use did not create value, the bankruptcy court determined that the Wolf debtors’ professional fees were not compensable under section 506(c) of the Bankruptcy Code because the Wolf debtors failed to show that their counsel, financial advisor, and appraiser rendered services that protected or enhanced FirstMerit’s collateral.  The bankruptcy court noted that FirstMerit actually consented to use of its cash collateral for certain expenses that related to utilities, repair and upkeep, insurance, taxes, and management of the real property collateral, which it acknowledged to be necessary to maintain that collateral.  Citing the Second Circuit’s decision in Blackwood Associates, the bankruptcy court added, “the fact that services benefit the estate or reorganization generally or are allowed as administrative expenses is not sufficient to justify charging the expense of such services against a secured creditor’s collateral.”
The bankruptcy court further held that the “equities of the case” exception to section 552(b) did not permit the Wolf debtors to use FirstMerit’s cash collateral because Seventh Circuit precedent limits that exception to circumstances in which the debtor “uses other assets of the bankrupt estate (assets that would otherwise go to the general creditors) to increase the value of the collateral,” which was not the case in Chardon.  In addition, the bankruptcy court found that the Wolf debtors failed to demonstrate that it was equitable to surcharge FirstMerit’s interest in postpetition rents to pay for professionals “who provided only general services in the bankruptcy case.”  The bankruptcy court provided some insight to its reasoning, noting that routine subordination of secured creditors’ security interests under section 552(b) to attorneys’ fees and other priority claims “effectively allows the equitable exception to swallow the rule” and adding that “at the very minimum” a debtor must demonstrate that (i) rehabilitation will benefit the secured creditor, (ii) the professional fees are necessary for the secured creditor to receive such benefit, and (iii) there is not a more appropriate source to pay the professional fees.
Opinion – Rejection of Addison Properties
The bankruptcy court rejected the prior decision of the same court in Addison Properties, in which the court held that a secured creditor’s claim should be fixed at the beginning of the case for the purpose of determining adequate protection and, therefore, postpetition proceeds covered by section 552(b) do not increase the amount of a secured creditor’s claim entitled to adequate protection.  The Wolf debtors relied on Addison Properties to argue that FirstMerit would be adequately protected for the use of its cash collateral so long as the Huntley Building was not decreasing in value.
The bankruptcy court rejected Addison Properties for three main reasons.  First, Addison Properties adopted a “dual valuation approach” for secured claims (i.e. one valuation at the beginning of the case for adequate protection purposes and second at the end of the case for confirmation purposes) in large part to avoid “dramatically” enhancing the rights of secured creditors by inflating their claims due to temporary fluctuations in asset values or revenues.  The bankruptcy court, however, observed that rent is often “readily quantifiable and predictable” and, in a situation where the debtor’s revenue is rent, such as Chardon, accounting for postpetition rents would not enhance a secured creditor’s rights by providing greater protection than it had through foreclosure, which would entitle the secured creditor to collect rents.  Moreover, a debtor always has the ability to surcharge expenses necessary to protect real property or collect rental revenue under section 506(c) and cut short a secured creditor’s interest in postpetition rent under the equities of the case exception in section 552(b). Thus, the bankruptcy court found that fluctuating rental revenues did not justify satisfying general administrative expenses with cash collateral.
Second, the bankruptcy court considered decisions from the Northern Illinois District Court and Seventh Circuit and concluded that section 552(b) establishes a separate security interest in postpetition rents, which interest is entitled to adequate protection.  Under the dual valuation approach, however, that separate security interest in postpetition rents would be valued at zero and receive no adequate protection because that approach disregards postpetition rents for adequate protection purposes.  Thus, the bankruptcy court held that the dual valuation approach was inconsistent with section 552(b).  It is worth noting, however, that the bankruptcy court’s concerns in this regard may be obviated, if not resolved, where the secured creditor is adequately protected by an equity cushion that is greater than the postpetition rents to be used.
Finally, the bankruptcy court surveyed recent decisions from outside the Seventh Circuit (including a decision we addressed previously) and concluded that a majority of courts have held, in a variety of contexts, that a secured creditor’s interest in postpetition rents is separate from its interest in the underlying real property.  Thus, the bankruptcy court concluded that a “fair reading” of sections 506(a) and 552(b) of the Bankruptcy Code requires that a secured creditor’s separate interest in postpetition rents must be considered for adequate protection purposes.
The Wolf debtors have appealed the bankruptcy court’s decision.  We’ll monitor the appeal and report on events as they unfold.
When a creditor is undersecured, the use of its cash collateral generally represents a dollar-for-dollar reduction in that creditor’s collateral.  Nevertheless, undersecured creditors may—and often do—consent to use of their cash collateral to pay estate professional fees when the debtor has few or no unencumbered assets with which to fund restructuring expenses.  If, however, an undersecured creditor determines that a restructuring is not in its best interests, refusing to fund restructuring expenses from cash collateral may be one of its more effective tools.  In Chardon, the bankruptcy court addressed non-consensual use of an undersecured creditor’s cash collateral, in the form of postpetition rent, to pay estate professional fees and determined that such use was impermissible unless the secured creditor received adequate protection from unencumbered collateral—which generally excludes postpetition rent per section 552(b)—or the debtor met the more rigorous standard to surcharge collateral.  Undersecured creditors have many things to worry about, but the decision in Chardon offers those creditors some comfort as they attempt to protect their collateral from further diminution.