Banking and Finance Law Report : Banking & Finance Lawyer & Attorney : Porter Wright Morris & Arthur Law Firm : Bankruptcy, Commercial Lending

Breaking with the Third Circuit and the Fifth Circuit, on June 28, 2011, the Seventh Circuit held that a debtor's plan of reorganization that provides for the sale of the debtor's assets free and clear of an existing security interest may only be confirmed over the objection of its secured creditor if the plan's sale procedure permits the secured creditor to credit bid its secured debt for the assets being sold. River Road Hotel Partners, LLC v. Amalgamated Bank, -- F.3d --, Nos. 10-3597 & 10-3598 (7th Cir. June 28, 2011).

The circuit split centers on the Bankruptcy Code's provisions that only permit the confirmation of a plan of reorganization over the objection of a creditor class (a so called "cram down") where the plan's treatment of such class is "fair and equitable." When the objecting class consists of secured creditors, the Bankruptcy Code requires that such fair and equitable treatment include provisions whereby either: (A) the secured creditor retains its liens in its collateral whether such collateral is retained by the debtor or transferred to another party and the secured creditor receives a specified level of cash payments under the plan, 11 U.S.C. § 1129(b)(2)(A)(i); (B) the secured creditor "realiz[es] … the indubitable equivalent" of its claim, id. § 1129(b)(2)(A)(iii); or (C) the secured creditor's collateral is sold subject to the secured creditor's right to credit bid for such property, the secured creditor retains a lien in the proceeds of the sale and the treatment of this new lien is in accordance with (A) or (B) above. Id. § 1129(b)(2)(A)(iii). Because the Bankruptcy Code does not define "indubitable equivalent" the courts, in providing their own definition have struggled over whether these three alternative "fair and equitable" treatments are mutually exclusive such that the only method for selling property free and clear is in an auction that permits credit bidding, or whether indubitable equivalent alternative is broad enough to encompass a free and clear sale that would not otherwise be "fair and equitable" because it did not honor credit bidding.

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The ability of a single asset real estate debtor in a bankruptcy case to utilize a non-consenting secured creditor's cash collateral has been limited by a recent decision from the Bankruptcy Appellate Panel of the Sixth Circuit in In re Buttermilk Towne Center, LLC, 2010 FED App. 0010P (B.A.P. 6th Cir. 2010).

Under 11 U.S.C. § 552(a)(2), a pre-petition security interest in rents extends to rents generated by a debtor post-petition. Further, 11 U.S.C. § 363 provides that a debtor can only use the cash collateral of a non-consenting secured creditor if the creditor is deemed to be "adequately protected." Prior to Buttermilk, the Sixth Circuit Court of Appeals issued the unpublished decision of Stearns Bldg. v. WHBCF Real Estate (In re Stearns Bldg.), 165 F.3d 28 (6th Cir. 1998), in which the Sixth Circuit held that a secured creditor was not adequately protected when a single asset real estate debtor only offered to provide the creditor with a replacement lien on post-petition rents that were encumbered by the secured creditor's pre-petition lien. Many courts in the Sixth Circuit have failed to follow the unpublished decision of Stearns Building, and rather have held that a pre-petition secured creditor is adequately protected when a single-asset real estate debtor provided a replacement lien on rents that were already encumbered by the creditor's pre-petition lien.

In Buttermilk, the Debtor was the owner and operator of a commercial real estate development. Bank of America was the Debtor's primary pre-petition secured lender and had a pre-petition security interest in all of the rents and profits derived from the property. Upon filing its bankruptcy petition, the Debtor sought to use the rents to pay for the administrative costs of its bankruptcy, including to pay for the post-petition legal fees of the Debtor. While Bank of America argued that the Debtor should not be able to utilize its cash collateral to fund its bankruptcy estate since it was not adequately protected due to a replacement lien on assets that it already had encumbered, the bankruptcy court concluded that Bank of America was adequately protected. In reliance on Stearns, the Bankruptcy Appellate Panel reversed the bankruptcy court and held that a non-consenting secured creditor was not adequately protected when a Debtor provided a security interest in rents that were already encumbered by the secured creditor's pre-petition lien. Therefore, going forward, in a single-asset real estate case, Buttermilk affirms the proposition that a non-consenting secured creditor must receive more than a replacement lien on rents that are already encumbered by the secured creditor's pre-petition lien in order for a debtor to be able to utilize the creditor's cash collateral to pay the administrative expenses of the bankruptcy case.
 

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The recent equitable subordination cases of In re Kreisler and Erenberg, 546 F.3d 863 (7^th Cir. 2008) and Credit Suisse v. Official Committee of Unsecured Creditors (In re Yellowstone Mountain Club, LLC), Bankr. D. Mont., No. 09-00014 show a possible deviation in the courts regarding the proper application of the doctrine of equitable subordination. Accordingly, secured lenders should stay abreast of these different interpretations and possibly consider adjusting their lending practices. Those who fail to do so could see their claims in bankruptcy move further down the chain of priority.

The doctrine of equitable subordination allows a bankruptcy court, using principles of equity, to subordinate all or part of one creditor’s claim to all or part of another creditor’s claim where the inequitable conduct of one creditor has caused injury to the interests of another creditor. Codified at 11 U.S.C. § 510(c), the doctrine is simple to state and yet, at least it would appear, is rather difficult to apply.

Courts have adopted the Mobile Steel Test as a method to decide when it is appropriate to invoke the doctrine of equitable subordination. The Mobile Steel Test, as its name suggests, originates in the case of In re Mobile Steel Co., 563 F.2d 692 (5^th Cir. 1977). The Mobile Steel Test lays out three conditions that must be satisfied before exercising the power of equitable subordination. They are as follows:

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The Chapter 11 bankruptcy filings by Chrysler, LLC and General Motors are likely to create a ripple effect of defaults and lawsuits through all tiers of the automotive supply chain and will impact businesses connected to that supply chain. Although Chrysler has emerged from bankruptcy as Chrysler Group LLC and all signs suggest that General Motors will attempt to emerge from Chapter 11 proceedings very rapidly, the underlying bankruptcy cases may proceed for months, if not years. The ripple effect could cause primary or lower tier suppliers to stretch payables or seek their own bankruptcy protection. Taking steps now may help protect you against the effects of insolvent customers or suppliers and prepare your company for a possible waive of bankruptcy avoidance and preference actions.

The keys are simple: pay attention to Chrysler notices, GM news, and your customers and suppliers; use common sense business judgment when dealing with your customers and suppliers; preserve relevant records, identify knowledgeable personnel; and conduct a preference analysis. 

 1.         Pay Attention.

 In the Chrysler and General Motors Chapter 11 cases, certain suppliers were designated “critical vendors” and continued to be paid as if the bankruptcy case had not been filed. It is important to pay attention to those proceedings if your business is closely linked to the automotive supply chain. To begin, stay on top of all notices from the Chrysler and GM Bankruptcy Courts. Similarly, use common sense and closely scrutinize current relationships with your suppliers and customers. If you sell to Tier One suppliers, you may wish to consider exercising rights under the Uniform Commercial Code to obtain additional assurances of future performance from them. Such assurances will verify that the Tier One supplier will have the ability to pay for the product you deliver. Additionally, if your customers are insolvent, you have a right to stop goods in transit, return items yet to be delivered, and reclaim goods already delivered. Additionally, if your customer has become a “slow pay,” consider additional credit limitations, review margins, and adjust payment methods to C.O.D. or cash in advance.

 If your supplier appears to be insolvent or is likely to end up in a bankruptcy proceeding, develop alternative sources of supply and, as appropriate, consider termination of existing supply arrangements with the vendor before the bankruptcy proceeding.

 2.         Protect Yourself From Bankruptcy Preference Actions.   

 Bankrupt entities in automotive supply chain may pursue avoidance actions against suppliers and other creditors, so it is always helpful to prepare in advance for possible recovery actions when you have received payments from an entity that is now in a bankruptcy proceeding.

 Under the bankruptcy code, a debtor generally has two years to file suit to avoid and recover payments made to creditors during the 90-day preference period[1] before it sought bankruptcy protection. In general, a debtor may avoid payments made during the preference period if they were not made in the ordinary course of its business relationship with the creditor or otherwise were not made on terms customary within the industry and result in the creditor receiving more than it would have received had the debtor filed a Chapter 7 liquidation. Because a debtor can initiate a preference action months or years after the underlying transaction, taking the following steps now will help you maximize your potential defenses and minimize your exposure to a preference claim if it is filed: 

•  A complete set of business records can be the best defense to a preference action so, as soon as you learn that one of your customers is now a debtor in bankruptcy, organize and store your records, electronically or manually, of any transactions that resulted in a payment from the debtor within 90 days before the bankruptcy filing. Retain those records for at least 36 months or until advised otherwise by legal counsel. If the debtor files a preference action against you, you will save time and money by having the records on hand and available to your legal counsel.  
• Identify personnel, including staff in the sales and accounts receivable areas, with knowledge of the transactions and record their information. If key personnel leave the debtor, obtain up-to-date contact information. Their assistance and testimony may be important in successfully defending a preference action. In addition, identify what is ordinary cause in your business or industry. Determine if value was given by extending credit after each payment was made during the 90 days. 
•  After gathering your business records, conduct a preference analysis to determine the company’s potential exposure to a preference action. Legal counsel can help with this analysis. If the preference exposure is significant, budget for the potential repayment and for legal fees.      

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