Chapter 11 Bankruptcy Revisited
By: PAUL B. JONES & CLINTON E. CUTLER
September 2000
Chapter 11 bankruptcy filings have declined throughout most of the mid to late 1990s. As a result, a lot of skill and knowledge regarding dealing with debtors in Chapter 11 has gotten rusty. We think a series of articles dealing with secured creditors' issues in Chapter 11 is in order. Future issues of Bank Focus will contain brief articles focusing on issues banks and bankers face when dealing with Chapter 11 debtors.
Cash Collateral, Part 1
One of the first issues confronting a secured lender in a Chapter 11 is the debtor's ability to use cash collateral. Under section 363(c) of the Bankruptcy Code (Code), the broad definition of cash collateral includes cash, cash equivalents, proceeds and accounts receivable. What's important about this broad definition is that this section prohibits the debtor from using cash collateral without the secured lender's consent or a court order authorizing the debtor's use. This court order is conditioned upon the debtor's providing the secured lender with adequate protection for such use.
What does this mean for the secured lender? First, it means that if the secured lender has a perfected revolving security interest in inventory and accounts receivable, the debtor, upon filing Chapter 11, cannot use any cash generated by the sale of inventory or the collection of accounts receivable. In most cases this freezes the debtor's operations. Since this concept is alien to many debtors (and sometimes their attorneys), it is extremely prudent for the secured lender (or its counsel), immediately upon becoming aware of the filing of a Chapter 11 by one of its borrowers, to send a letter to the debtor and the debtor's counsel reminding them of the prohibitions against the use of the secured lender's cash collateral and expressly stating that the secured lender has not consented to the use of cash collateral.
Second, the secured creditor and its counsel need to prepare for negotiations with the debtor and debtor's counsel to determine the conditions for the debtor's use of cash collateral. This will involve the concept of "adequate protection." Section 361 of the Code defines adequate protection to be cash payments, replacement or additional liens, or administrative expense claims or the indubitable equivalent. Each of these forms of adequate protection must be sufficient to compensate the secured lender for the loss of value to its cash collateral caused by the debtor's use. In most cases, the debtor offers the secured lender a replacement lien in the new inventory and accounts receivable. In analyzing whether this replacement lien is "adequate," the secured lender usually reviews the debtor's projections to determine such items as: are there sufficient post petition operations to generate new accounts receivable; do the projections indicate an inventory build-up through the liquidation of receivables; and are the projected operations realistic?
If the debtor and the secured creditor are able to reach an agreement, the terms of the agreement are usually set forth in a "Cash Collateral Agreement" or "Cash Collateral Stipulation." This agreement or stipulation is presented to the court and approved through a "Cash Collateral Order." Some of the items to consider in agreeing to the terms of a cash collateral agreement or stipulation include:
- attempting to make the term as short as possible thereby requiring the debtor to come back and renegotiate the terms after some historical post petition numbers;
- providing for an event of default if the debtor fails to produce results consistent with the projections used as the basis for the agreement;
- providing for perfection of the replacement or additional liens provided as adequate protection;
- providing for expedited relief in an event of default; and
- providing for the ability on a periodic basis to audit or verify the debtor's compliance with the terms of the agreement.
In the event the debtor and secured creditor cannot agree to terms, the Bankruptcy Judge determines if the debtor can use cash collateral after a hearing. In a future issue of Bank Focus, "Cash Collateral, Part 2," we will discuss the cash collateral issues the secured lender must address if there is no agreement.