Chapter 11 debtors filed a motion to allow them to use rents to pay their professional fees over the objection of a bank that held a mortgage on the underlying property. The bankruptcy court denied the motion, and the debtors appealed to the district court.
The debtors were two brothers and their father who each owned a fractional interest in a land trust, which in turn owned commercial real estate. The debtors sought to use rents collected since the filing of their bankruptcy cases to pay certain professional fees.
The bank’s loan was secured by both the property and the rents from the property. The rents collected during the bankruptcy were held as cash collateral. The debtors were permitted to use this cash collateral to pay certain property expenses, including maintenance, without objection from the bank. However, the debtors also asked permission to use ~$278,000 to pay their attorneys’ fees and expert costs. The bank objected, asserting that the rents were part of its collateral, and the debtors did not offer adequate protection for loss in value.
The bankruptcy court ruled that that the debtors were required to provide adequate protection, and it would not exempt the postpetition rents from the bank’s collateral under the “equities of the case” provision in the Bankruptcy Code. In pursuing an appeal, the debtors acknowledged that they would not be able to successfully reorganize unless they were allowed to use the cash collateral to pay their professionals.
As background, under Section 552 of the Bankruptcy Code generally property acquired postpetition is not subject to a security interest granted in a prepetition agreement. However, there is an exception if a debtor and its secured creditor entered into a prepetition security agreement covering real property acquired before the bankruptcy that extends to rents.
[T]hen such security interest extends to such rents… acquired by the estate after the commencement of the case to the extent provided in such security agreement, except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise.
Also, rents constitute cash collateral under Section 363(a). A debtor-in-possession may not use cash collateral unless it either obtains the consent of any entity that has an interest in the cash collateral or provides adequate protection for the interest. Under Section 361 a debtor may provide adequate protection by (1) making cash payments to cover a decrease in value of the property, (2) providing an additional or replacement lien to cover the decrease, or (3) some other kind of relief that would “result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property.”
The debtors’ first line of attack was to argue that there was no reduction in value of the bank’s security interest in the cash collateral. This argument was based on the “dual valuation” method: collateral is valued differently for purposes of adequate protection under Section 361 and determination of the secured creditor’s claim under Section 506. This approach links the cash collateral value to the petition date. Since the debtors apparently were not holding any rents on the petition date, they argued that the value was $0.
One court that adopted the “dual valuation” method articulated three approaches:
- “Single valuation”: adequate protection and confirmation values are the same and are both evaluated as of the date of filing.
- “Continuous valuation”: value of the claim is updated as rents accrue.
- “Dual valuation”: value for adequate protection is set as of the date that the petition is filed and set for determination of a claim at the confirmation hearing.
This court concluded that “dual valuation” was most appropriate, with the result that the debtor could use the rents to pay professionals as long as the underlying collateral was not decreasing in value.
The Wolf district court noted that this approach has been criticized, and according to Collier was not the majority view. The court found it “particularly noteworthy” that the opinion “conflated the concepts of a security interest with an allowed secured claim.” Both Section 363 (cash collateral) and Section 552 (postpetition scope) protect a creditor’s security interest as opposed to the value of the collateral.
In short, the [debtors’] proposed approach is nothing more than an attempt to give a junior unsecured creditor priority over a senior undersecured creditor’s interest in the same collateral, notwithstanding Congress’s explicit instructions otherwise.
In response to the argument that the inability to use rents to pay professionals would adversely impact the ability of debtors to pursue a Chapter 11 reorganization, the court noted various mechanisms for dealing with fees, including the ability to give an allowed claim a first priority unsecured claim as an administrative expense. The court also rejected various other arguments, including:
- Rejection of “dual valuation” would cause a split among courts that would mean available remedies would depend upon the county where the cases filed – So what, disagreements arise frequently and trial court decisions are not binding on each other.
- Since there is no specific timeframe for valuing rents, the court should use the default rule of the petition date – But there was no support offered for the assertion that the petition date was a default date, and Section 552 suggests that the interest should be updated as rents are collected.
- The Supreme Court decision in Timbers suggests that collateral should not be valued on an ongoing basis – Even if that was an accurate reading of the case, it does not address the special circumstance of rents.
- The court’s decision prevents the debtor’s ability to provide cash payments or replacement lien is adequate protection – No, it only eliminates the ability to use property which the secured creditor already has a security interest in as adequate protection.
- As a policy matter, (1) the court’s decision in effect gives creditors a veto power over some Chapter 11 cases and (2) substantially increases the administrative costs due to the need to update valuation – (a) No, there is a system in place for payment of professional fees so there is no veto (and besides which, if there was, it would be up to Congress to modify the specialized treatment of rents in Section 552), and (b) cash collateral is not that hard to value: in most cases the question is how much cash has been collected and placed in escrow.
Finally, the court addressed the argument that it should use the Section 552 “equities of the case” exception to exclude postpetition rents from the bank’s security interests. The court noted that the one case in which the 7th Circuit addressed this issue it held that “The equity exception is meant for the case where the trustee or debtor in possession uses other assets of the bankruptcy estate (assets that would otherwise go to the general creditors to increase the value of the collateral.” The district court declined the debtors’ invitation to apply this exception more broadly.
Thus, the district court affirmed the bankruptcy court.
In real estate cases it becomes particularly difficult for a debtor to find cash to pay professionals given the conundrum of how to provide adequate protection for a mortgage lender’s interest in rents. It is one thing to use rents for the property, since it can be argued that the mortgagee benefits from that use. It is another to use rents to pursue a contested reorganization that involves a cram down of the mortgagee.
Vicki R. Harding, Esq.