United States: What Happens To Your Collateral During A Bankruptcy?

Lenders and their attorneys are conditioned to believe that being over-secured is as good as life gets for a creditor.  Lenders want to secure repayment with collateral that is valuable and liquid, while their attorneys ensure that the security interest is properly perfected.  But, post-closing confidence in a job well done can quickly evaporate if the borrower files a bankruptcy case intending to sell the collateral. 

Is it true that a debtor can sell collateral without the lender's consent?   Yes, under the Bankruptcy Code it can be done ‒ even if the collateral is sold for less than the amount of outstanding debt.  So, a secured creditor must be proactive if a distressed borrower tries to sell the collateral in a bankruptcy. 

How Can This Happen?

Section 363 of the Bankruptcy Code authorizes a bankrupt entity to sell all, or part, of its assets.  Sales in the ordinary course of business do not require bankruptcy court approval, while sales outside the ordinary course require both a hearing and court approval. 

To determine whether a transaction is in the ordinary course of business, bankruptcy judges usually apply one of two tests.  The first is an objective standard, sometimes called the horizontal test, which looks at the debtor's industry to determine if the sale is the type of transaction conducted by other businesses in the ordinary course.  The other is a subjective test, sometimes called the vertical test, which looks at the expectations of creditors (i.e., whether the transaction subjects creditors to different economic risks from those which the creditor accepted and could reasonably anticipate) when extending credit.  For example, if the collateral is inventory, it can be sold in the ordinary course on customary terms, in which case the resulting proceeds of sale might constitute restricted cash collateral (but, that is an issue for a different article).  However, if the debtor proposes a bulk sale of a substantial portion of its inventory, that transaction would be outside the ordinary course of business.

On the other hand, asset sales that are outside of the ordinary course of business, including the sale of all or a significant portion of a debtor's assets, require notice to interested parties and advance approval by the bankruptcy court.  In considering a proposed sale transaction, bankruptcy courts generally are concerned with (i) the process and (ii) the result.  If a debtor conducts a fair and impartial sale process, the courts usually defer to the debtor's business judgment in deciding whether to approve a sale.  Once the sale is approved by the bankruptcy court, section 363(m) of the Bankruptcy Code provides that any reversal or modification of the sale approval will not affect the validity of the transfer.  This forces a creditor who wants to appeal the bankruptcy court's decision to obtain a stay pending appeal.  If the sale approval is not stayed, any appeal from the bankruptcy court's order will be moot.

Selling "Free and Clear" of Liens

One of the chief benefits of a bankruptcy sale is section 363(f) of the Bankruptcy Code, which gives the debtor the ability to strip liens from sale assets.  Debtors routinely use this statute to sell their property "free and clear" of liens.  Section 363(f) allows a debtor to sell property free and clear of any third-party's interest in such property if one of five conditions can be satisfied:  (1) sale free and clear of the interest is permissible under nonbankruptcy law; (2) the creditor consents; (3) if the interest is a lien, the property is sold for a price greater than the aggregate amount of all liens; (4) the interest is in bona fide dispute; or (5) the third-party "could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest." 

Under this provision, the debtor is able to sell an asset free and clear of an undisputed lien only if the sale is at a price that exceeds the amount of the lien.  This provides lenders with relatively little protection, however, since the value of a lien cannot exceed the value of the collateral (in other words, if the claim is greater than the value of the perfected interest in the collateral, the excess portion of the claim is unsecured).  Unless the lender is able to demonstrate that the sale is at a price below asset value, the debtor should be able to sell the asset free and clear of the lender's lien.

However, all is not lost since the Bankruptcy Code provides lenders with some tools to protect their interests, including the ability to "bid up" an inadequate sale price.

The Right to Credit Bid

To protect an interest in collateral that is offered for sale, the Bankruptcy Code gives a creditor the right to "credit bid" (i.e., bid debt rather than cash) up to the full amount of its claim. The threat of a lender's credit bid is designed to keep prospective bidders honest: a low ball offer could induce the lender to enter into a bidding contest.  That assumes, of course, that the secured creditor prefers to acquire the collateral in exchange for cancellation of some, or all, of the debt.  The lender might prefer this to a short sale if the lender can achieve a greater return of value on the collateral than the debtor.  But, lenders ordinarily do not want to own the collateral.  The Bankruptcy Code does provide such lenders with an alternative means of protecting their interests, although the benefits are often illusory.

Requesting Adequate Protection

A secured creditor who is proactive can seek "adequate protection" of its collateral interest.  Adequate protection is a concept that is used, but not defined, in the Bankruptcy Code.  It is almost universally accepted to require that a debtor provide some economic protection for the secured creditor's interest in the collateral, pending the resolution of the bankruptcy case.   Section 361 of the Bankruptcy Code provides some examples what forms of protection might be adequate.  In the context of a sale, one form of adequate protection might be granting the creditor a replacement lien on the sale proceeds.  This replacement lien must attach to the proceeds in the same order and priority as the pre-sale interest in the collateral to ensure that the lender receives the indubitable equivalent of its pre-sale interest in the collateral. This takes us full circle back to a free and clear sale under section 363(f) and the issue of valuation, which was mentioned above.

What is My Collateral Worth?

Valuation has been characterized by some judges as nothing more than "guesstimating."  This is more than a tacit admission that litigating valuation issues in a bankruptcy case can be problematic for several reasons.  First, during the course of a bankruptcy, there may be different reasons to value an asset and the lender's interest will vary, depending on the circumstances.  In fact, section 506(a) of the Bankruptcy Code acknowledges this vagary; it provides that value should be determined in light of several factors, one of which is the purpose of the valuation.   For example, a higher value may have the salutary effect of increasing the amount of a secured claim, while a lower value would better support a request for either adequate protection or relief from the automatic stay.

Whatever the purpose, bankruptcy courts are accustomed to adjudicating the value of assets.  Nevertheless, these issues arise in contexts that are overlain with input from competing constituencies that are distinct from the lender's concerns.  Moreover, circumstances often require a valuation determination in a timeframe that makes it difficult to engage and prepare the needed valuation experts.

For all of these reasons, the outcome of a valuation litigation can be unpredictable.   One party will ask for a higher valuation, the other will seek a lower valuation, and each will offer evidence in support of its position.   As often as not, the court comes up with a third value based upon its own reasoning.   Simply put, valuation is unpredictable, imprecise and discretionary.  But as demonstrated above, it is vitally important to secured lenders, since it controls their rights in bankruptcy and ultimately will affect their prospects for recovery.

Your Take-Away

Bankruptcy is a frustrating experience for lenders, even when they are fully perfected.  When a borrower enters bankruptcy, the lender's ability to realize the full benefit of the protections that are negotiated on the front-end of the transaction will be put to the test.  To avoid being swept along, the lender and its counsel must be diligent and actively engaged.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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