Chapter 11 Bankruptcy Revisited
By: CLINTON E. CUTLER & PAUL B. JONES
September 2001
Our September 2000 article addressed consensual use of cash collateral by agreement with the debtor in possession in a chapter 11 bankruptcy. But what happens if there is no agreement with the lender concerning the use of cash collateral?
Under the Bankruptcy Code, the court may authorize use of cash collateral over the objection of the lender. The debtor initiates such a request by motion. The motion cannot be heard sooner than 15 days after service of the motion unless the court finds there is an emergency that justifies reducing notice of the hearing. In that event, the court may authorize such use of cash collateral as is necessary to avoid immediate and irreparable harm. Initially, the debtor will seek use of cash collateral on an expedited basis because of a need to meet payroll or pay critical vendors to continue the operations. It therefore is not unusual for a hearing on use of cash collateral to convene a few days after the bankruptcy case is started.
The court must make three inquiries to authorize a proposed use of cash collateral. First, the court must identify the nature of the lender's liens and the value of the property securing those liens. This valuation may encompass all of the lender's collateral and not just cash collateral, which is typically cash equivalents, accounts receivable, and inventory. The debtor has the burden of proof to establish the value of the collateral. While there is room for argument, values generally will be viewed in light of the proposed use of the cash collateral, typically on a going concern basis.
Second, the court must identify the risk to the creditor if the debtor is allowed to use cash collateral. Generally, the risk will be from continuing losses arising from ongoing operations. The debtor will typically try to show that the value of the cash collateral will be roughly equivalent or higher than what was on hand at the start of the case. If the debtor has historically lost money on a cash flow basis, the debtor's projections and budgets need to be closely scrutinized to determine if the new budgets are feasible and realistic. The lender should be prepared to challenge the projections based on the historical performance of the debtor.
Third, the court must determine if the debtor's "adequate protection" proposal protects the lender from the identified risks. In making this inquiry, courts often refer to whether the adequate protection offered gives the lender the indubitable equivalence of what it has for collateral as of the start of the period. The test does not require the debtor to protect against all risks; rather, the adequate protection proposal must protect the lender from reasonable risks.
Adequate protection is a flexible concept and may take many forms, such as a grant of additional liens on other property not already subject to the lender's lien, or an equity cushion where the value of the collateral exceeds the amount owed to the bank. The most typical form of adequate protection is the grant of a replacement lien on receivables or inventory generated after the commencement of the case to replace the cash collateral on hand at the start of the case, which will be spent in the operation of the business.
In addition to proposed use of cash collateral, some debtors will propose to obtain borrowings on a secured basis. The impact of borrowing money post-petition from the lender's perspective will be addressed in a future Bank Focus article.