On Aug. 24, 2012, Judge Robert Jones for the U.S. Bankruptcy Court for the Northern District of Texas held in In re Geijsel1 that adequate protection payments paid out of a debtor’s cash collateral must be applied against a secured creditor’s principal amount and thus not reduce that creditor’s secured claim if such payments are deemed unnecessary. The Geijsel decision is significant because, in endorsing the “addition view,” the court held that an undersecured creditor can be elevated to oversecured status through the use of cash collateral to make adequate protection payments. The decision, while encouraging for secured creditors, could significantly inhibit a debtor’s ability to satisfy its other creditors’ claims because it provides secured creditors with an entitlement to post-petition interest and fees when they would otherwise be ineligible.
Although the Bankruptcy Code affords debtors with breathing room to restructure their businesses during a bankruptcy case, there are limits to the flexibility afforded by such breathing room. The code also provides a broad array of protections for the interests of secured creditors. Most importantly, the Bankruptcy Code insulates creditors from the diminution in the value of their collateral or from the sale or use of their collateral by requiring a debtor to provide adequate protection. Pursuant to §§362 and 363, a debtor may use, sell, or lease collateral if it provides adequate protection of a secured creditor’s interest, which may be in the form of “cash payment[s] or periodic cash payments.”2
When adequate protection payments are made to an undersecured creditor, a key issue that arises is whether the payment should be applied to the secured or unsecured claim of the creditor. Bankruptcy Code §552(b) provides that even though property of the estate that is acquired by the debtor after the commencement of a case is generally not subject to a floating lien, a security interest may nevertheless continue in the “proceeds, products, offspring, or profits” of the debtor’s property.3 Periodic adequate protection payments could potentially come from encumbered cash that is subject to a security interest pursuant to §552(b).
Courts are divided over how to apply adequate protection payments made from encumbered cash. Some courts, adopting the “subtraction view,” have held that when post-petition cash collateral is used as unneeded adequate protection, such payments should be applied to reduce the secured portion of a creditor’s claim.4 These courts have reasoned that once a creditor’s collateral is used to pay a claim, it is only fair that the use of the collateral be credited against its secured claim. If adequate protection payments are applied to the secured claim, as applied under the subtraction view, then the undersecured creditor would be in no way better off because it was already entitled to a 100 percent recovery on the secured claim. However, a majority of courts, adhering to the “addition view” have held that unnecessary adequate protection payments made from post-petition cash collateral should be applied against a creditor’s unsecured claim, thereby leaving the secured claim unaltered.5 The addition view embraces the notion that a creditor should get nothing more or nothing less than it is entitled to on account of its claim.
Whether a court adheres to the addition or subtraction view could have serious consequences on an undersecured creditor’s recovery. For example, a creditor who lent $30 million and obtained a mortgage against property worth $20 million would have a secured claim worth $20 million and an unsecured claim worth $10 million. Assuming that unsecured creditors receive only 10 percent on their claims and that the undersecured creditor is entitled to receive $4 million in adequate protection payments, then under the subtraction view, the creditor’s secured claim would be reduced to $16 million and it would receive $1 million on its unsecured claim. Under this scenario, the creditor would be entitled to recover only $17 million on its claim. In contrast, under the addition view, the creditor would recover its $20 million secured claim plus the $4 million adequate protection payments and $600,000 on its remaining unsecured claim. Thus, the creditor would recover $24.6 million on its claim. Accordingly, the addition view ensures that a creditor will receive a larger recovery.
The Geijsels, individually and through their wholly owned limited liability company, The Luckie Dutchman LLC, owned and operated a dairy farm and dairy facilities. To facilitate the acquisition of this property and to secure working capital, the debtors entered into a series of loans with Lone Star, FLCA and Lone Star, PCA (collectively, “Lone Star”) in the aggregate principal amount of $9.8 million. All of the debtors’ loans with Lone Star were secured on a first priority basis on virtually all of the debtors’ real and personal property, including the proceeds and profits from that property and the debtors’ cash. Prior to filing for bankruptcy on June 15, 2010, the debtors defaulted on their loans with Lone Star.
During the pendency of the case, the debtors received interim approval to use Lone Star’s cash collateral. In exchange, the debtors paid Lone Star $50,000 in monthly adequate protection payments. In addition, Lone Star, the debtors’ largest creditor, filed three proofs of claim in the debtors’ cases: (i) a claim by Lone Star PCA for $5.3 million that was listed as fully secured by collateral with a value of $7.4 million; (ii) a claim by Lone Star FLCA for $4.5 million that was fully secured by collateral with a value of $7.4 million; and (iii) a claim by Lone Star FLCA in the LLC’s case for a fully secured claim in the amount of $1.4 million. In all three proofs of claim, Lone Star also sought attorney fees. Lone Star’s claims totaled $9.77 million in the aggregate, but were secured by collateral worth only $8.59 million as of the petition date.
The debtors submitted a plan of reorganization that provided that administrative claims and certain prepetition claims would be paid in full and in cash upon the effective date of the plan. Secured creditors, including Lone Star, would be paid the present value of their secured claims in light of the term and interest rate provided. The payments under the plan would require the debtors to maintain a “cash cushion” of approximately $1 million, which the debtors claimed that they had. The debtors’ plan further provided that it would not pay any attorney fees or other allowable claims under §506(b) to the extent that such claims were not oversecured. With the exception of Lone Star, all of the debtors’ secured creditors voted in favor of the plan.
Relying on Lone Star’s proofs of claim, the debtors argued that Lone Star’s claims were fully secured, but were not oversecured. The debtors contended that it would be critical to value the amount of Lone Star’s claims as of the petition date, and not at a later date. Because the value of Lone Star’s collateral did not exceed the claim amount as of the petition date, the debtors asserted that Lone Star was not entitled to receive post-petition interest or attorney fees. Lone Star, however, asserted that its claims were oversecured because the value of the dairy assets increased during the pendency of the case. Accordingly, Lone Star argued that it was entitled to post-petition interest and attorney fees.
The unsecured creditors’ committee, in alliance with the debtors, argued that Lone Star’s claims should only be measured as of the petition date and not at a later date. Specifically, the committee noted that although the value of Lone Star’s collateral increased during the debtors’ cases, its claim was unsecured as of the petition date. Thus, the committee contended that Lone Star was not entitled to post-petition interest and fees because it was not oversecured as of the petition date.
The court ultimately held that Lone Star was entitled to post-petition interest and fees because its claims were oversecured by virtue of the debtors’ adequate protection payments to Lone Star.
In reaching its decision, the Geijsel court adopted the “addition view” and held that the unneeded adequate protection payments should be applied to reduce the principal debt of Lone Star’s claims, thus leaving its secured portion unaltered. Examining precedential case law, the bankruptcy court found that other courts did not state that it would be “unfair to allow a secured creditor to collect ‘ahead’ of another creditor through the application of post-petition cash collateral.”6 On the contrary, the court found that the “addition view” is supported by §552(b), which preserves certain post-petition security interests, including where, as here, the creditor has a security interest in post-petition cash collateral and proceeds. Section 552(b), according to the court, permits secured creditors to collect ahead of junior creditors through the application of post-petition cash collateral.
Disagreeing with courts that employed the “subtraction view,” the court held that the “addition view” does not abuse the goal of adequate protection because it gives a secured creditor with an interest in post-petition proceeds or profits the right to benefit from its bargain. Specifically, the Geijsel court noted that a creditor that “bargained for and received a perfected security interest in post-petition proceeds…should not have to subtract this additional, separate collateral already received from the value of the other collateral remaining as of the effective date of the plan.”7 Consequently, the court held that the “addition view” was mandated here because it recognized “the potential increase in the value of Lone Star’s collateral from the petition date as a result of the income derived.”8 Crediting the adequate protection payments to Lone Star’s claim would implement this approach.
Disagreeing with the committee, the court held that a creditor, like Lone Star, can become oversecured during the course of a bankruptcy proceeding. Because the debtors’ cash position increased and adequate protection payments would be credited against the principal of Lone Star’s claim, the court found that Lone Star was an oversecured creditor. Section 506(b) provides that an oversecured creditor, like Lone Star, is entitled to the interest on its claims and “any reasonable fees, costs, or charges.”9 Because Lone Star was an oversecured creditor, the court held that it was entitled to receive post-petition interest and fees.
The Geijsel decision has interesting and far-reaching implications regarding the treatment of a secured creditor’s claim during a bankruptcy case and related entitlements. Where, as in Geijsel, the secured creditor has a lien in post-petition cash collateral and the debtor makes adequate protection payments using that cash collateral, a court will likely employ the “addition view.” Accordingly, such adequate protection payments would likely be credited against the secured creditor’s principal claim, which would leave the secured portion of the claim intact. Creditors should bear in mind that the application of the addition view could elevate a secured creditor’s claim from undersecured to oversecured, as it did in Geijsel, which would entitle that creditor to post-petition interest and fees. In some cases, it is important to be mindful that such elevation could ultimately inhibit a debtor’s ability to pay other creditors and to confirm its plan.
John J. Rapisardi is a partner and the co-head of the financial restructuring department of Cadwalader, Wickersham & Taft and an adjunct professor at Pace University School of Law. Michael J. Cohen and Thomas J. Curtin, associates of the firm, assisted in the preparation of this article.
1. Case No. 10-43979-11 (Bankr. N.D. Tex. Aug. 24, 2012).
2. 11 U.S.C. §361(a).
3. Id. §552(b).
4. See In re Kain, 86 B.R. 506 (Bankr. W.D. Mich. 1988).
5. See, e.g., In re Weinstein, 227 B.R. 284 (9th Cir. B.A.P. 1998); Beal Bank v. Waters Edge Ltd., 248 B.R. 668, 685 (D. Mass. 2000); In re Gramercy Twins, 187 B.R. 112, 120-21 (Bankr. S.D.N.Y. 1995).
7. Case No. 10-43979-11, at 44.
8. Id. at 45.
9. 11 U.S.C. §506(b).