United States: Section 552 – The Impact Of State Law On Interpreting "Rents" And "Proceeds" Under 552(B)

Article by Alan P. Solow and Randall L. Klein

Section 552(a) provides the general rule that all "property acquired . . . after the commencement of the case is not subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case." Sections 552(b)(1) and (b)(2) contain important exceptions to the general rule. Under §§ 552(b)(1) and (b)(2), "proceeds, product, offspring, or profits" of prepetition property and "rents, . . . fees, charges, accounts, or other payments for the use or occupancy of rooms . . ." remain subject to prepetition liens against such prepetition property. To the extent that economic value exists prepetition, that value should be subject to being encumbered. When prepetition economic value is realized post-petition, the lender's prepetition lien on that value should attach under § 552(b). Accordingly, courts that seek to protect the secured creditor's bargain will likely broadly construe the terms contained in § 552.

Many courts, however, have looked to state law for definitions of the terms contained in § 552. If the type of property at issue does not fall within the meanings of the terms contained in § 552(b), such as "proceeds" or "rents," then the lender is deprived of a post-petition lien pursuant to § 552. This Article, based on recent case law, reexamines the question of whether state law should necessarily govern the meaning of terms found in § 552. We conclude that it should not; rather, courts should give the terms their plain meaning as a matter of statutory construction of a federal statute.

A. STATE LAW VERSUS PLAIN MEANING

Prior to the Bankruptcy Reform Act of 1994, courts grappled with the issue of whether hotel revenues were "rents" within the meaning of § 552(b). As discussed in the 1995-96 Norton's Annual Survey of Bankruptcy Law, most courts looked to state law to determine whether hotel revenues should be treated as § 552(b) "rents." In one case, however, the Fifth Circuit concluded that hotel revenues, although not "rents" per se under Louisiana law, were sufficiently "like rents" to fall within the meaning of that term under § 552.¹ As discussed in the 1994-95 Annual Survey, we viewed T-H New Orleans as having interpreted § 552(b) "rents" as a matter of federal law.²

B. FINANCIAL SEC. V. TOLLMAN-HUNDLEY DALTON, L.P.

In that Article, we also discussed Financial Sec. Assurance v. Tollman-Hundley Dalton, L.P.,³ which criticized the Fifth Circuit decision in T-H New Orleans for suggesting a federal definition of "rents." Last year, however, the Eleventh Circuit reversed the District Court in Tollman-Hundley on the precise issue of whether the term "rents" should be defined by state or federal law. The Eleventh Circuit started its analysis of the rents issue where most courts do – by reference to Butner.⁴ In Tollman-Hundley, the Bankruptcy Court, as affirmed by the District Court, cited Butner for its holding that "state law defines the terms "proceeds, product, offspring, rents or profits."⁵ The Eleventh Circuit disagreed, noting that Butner stands only for the proposition that state law determines whether a creditor's security interest extends to certain of the debtor's property rights.⁶ "Nothing in Butner suggests that state law defines the language of the federal Bankruptcy Code in general or of § 552 in particular. Neither does § 552 dictate such a result."⁷ The Eleventh Circuit concluded that Congress intended the entire phrase "proceeds, product, offspring, rents, or profits" as contained in the pre-1994 amendment § 552(b) to cover a "wide range of derivative property."⁸ As for "rents," the Eleventh Circuit continued, "a plain reading of § 552(b) indicates that Congress intended 'rents' to be construed in this broader sense [of compensation for the use of any rental property, land, buildings, equipment, etc.]."⁹ Accordingly, the term "rents" includes hotel revenues.¹⁰

In our view, although Tollman-Hundley addressed an issue (hotel revenues) that has been substantially resolved by the Bankruptcy Reform Act of 1994, the Eleventh Circuit's plain reading of § 552(b) as a matter of statutory construction of a federal statute marks an important analytical shift. In particular, we believe that, on the strength of the Tollman-Hundley analysis, more courts will be less inclined to invoke state law definitions to interpret the terms contained in § 552(b), including the term "proceeds."

A. RESTRICTIVE DEFINITIONS OF "PROCEEDS" AND "OTHER DISPOSITION" UNDER STATE LAW - IN RE MINTZ

A recent case illustrates the effect of using state law to define the term "proceeds" as used in § 552(b). In In re Mintz,¹¹ the debtor granted the secured creditor a security interest in all of the debtor's rights "to receive distributions . . . and proceeds of any kind" on account of the debtor's 8.33% limited partnership interest. In the 1994-95 Annual Survey article, we advocated that the present right to receive future income streams is, in fact, a general intangible and that such income streams, when received post-petition, should be regarded as § 552(b) "proceeds" of the prepetition general intangible. The Court concluded that the debtor's prepetition interest in future partnership distributions (as distinguished from the partnership interest itself) was, in fact, a prepetition, general intangible.¹² However, the Court concluded that post-petition partnership distributions paid to the debtor's estate did not constitute § 552(b) proceeds.¹³

Mintz acknowledged the legislative history of § 552 which states that: "the term 'proceeds' is not limited to the technical definition of that term in the UCC, but covers any property into which property subject to the security interest is converted."¹⁴ Nevertheless, the Court found more persuasive the reasoning of In re Bumper Sales, Inc.,¹⁵ where the Fourth Circuit held that the term "proceeds" should be restricted by state law. Mintz also relied upon In re Hastie,¹⁶ where the Tenth Circuit held that post-petition stock dividends are not "proceeds" of stock under applicable state law and, therefore, are not § 552(b) proceeds.¹⁷ Based on Bumper Sales and Hastie, the Court looked to the Massachusetts UCC definition of proceeds: "proceeds includes whatever is received upon the sale, exchange, collection or other disposition of collateral or proceeds."¹⁸

The Court then analyzed whether the debtor's post-petition partnership distributions were "received upon the sale, exchange, collection or other disposition" of the distribution rights. The distribution rights were not "sold" or "exchanged" and, in accordance with Massachusetts law, not "collected" as that term relates only to accounts.¹⁹ Mintz similarly dismissed the notion that the post-petition distribution represented an "other disposition" of the prepetition distribution rights since, in the Court's view "the distribution rights remain as they were before."²⁰

B. BROAD DEFINITION OF "OTHER DISPOSITION" UNDER STATE LAW

Even though the debtor in Mintz remained the "owner" of the limited partnership interest and the economic distribution rights, the issue is whether there has been a "disposition" of economic value. In our view, the post-petition income stream represents a "disposition" of the prepetition right to receive the distribution. The value of the collateral in Mintz, the distribution rights, is the aggregate value of individual distributions to be received in the future. Assume, for example, that a debtor pledges prepetition its right to five annual payments of $1,000,000 each and thereafter files a bankruptcy petition. As each payment is received post-petition, the debtor's prepetition right to receive that payment has been converted to cash – a "disposition" of that right has occurred.²¹ Put another way, the debtor in Mintz held a valuable right prepetition – the right to future partnership distributions. To deprive the secured lender of a post-petition lien on the economic realization of its prepetition collateral means, in the words of the SRJ Court, that "certain types of valuable property vanish into a black hole, unable to be financed or encumbered, only to emerge [post-petition] unencumbered and transferable.²² Accordingly, to the extent that state law informs the meaning of § 552 "proceeds" and, in turn, the concept of "disposition" of economic value, those terms should be construed so as to preserve the status quo ante and to preserve the lender's lien on prepetition value as and when that value, in the form of post-petition income streams, is realized.

C. BROAD DEFINITION OF "PROCEEDS" UNDER FEDERAL LAW

In our view, another way to reach the result advocated here is to start with the analysis recommended by the Eleventh Circuit in Tollman-Hundley. As observed by the Eleventh Circuit, the term "proceeds" is intended to cover a wide range of "derivative" property and that term should not be construed "in a restrictive sense."²³ The "derivative" property in the Mintz case is the post-petition partnership distribution. That distribution is derived from the debtor's prepetition right to receive the post-petition distribution. Using a less restrictive definition of proceeds, such as the one contained in the legislative history of § 552 ("property into which property subject to the security interest is converted"), the result in Mintz likely would have been a holding that the partnership distribution constituted "proceeds" of the prepetition right to receive that distribution (a general intangible).

A. PRE-1994 AMENDMENTS ANALYSIS

One reason why some courts have looked to state law to define terms such as "rents" and "proceeds" as contained in § 552(b) is the reference in former § 552(b)²⁴ to "applicable non-bankruptcy law."²⁵ The majority opinion in Tollman-Hundley offers a preferred analysis of the phrase "applicable non-bankruptcy law" as contained in § 552(b). According to the Eleventh Circuit, such reference "prevents a creditor from using a debtor's bankruptcy to acquire rights to which he would not otherwise be entitled under state law."²⁶ For example, prior to the 1994 amendments, many courts refused to extend a creditor's prepetition lien to post-petition rents if, under applicable state law, the creditor failed to take necessary steps under state law (such as an order for possession or appointment of a receiver). However, according to the majority in Tollman-Hundley, while state law may determine whether a creditor has taken the necessary steps to continue to assert a post-petition lien on "rents," the term "rents" is not restricted by state law definitions.²⁷

B. POST-1994 AMENDMENTS ANALYSIS

It would appear that the legislative history to the 1994 amendment to § 552(b) supports the majority analysis in Tollman-Hundley. As noted above, many secured creditors were deprived of liens on post-petition rents for failing to take necessary steps under state law. Congress sought to rectify this by amending § 552(b). As noted in the House Report:

As demonstrated by the foregoing legislative history, Congress did not regard the phrase "applicable non-bankruptcy law" as defining whether or not a particular interest constituted "rents" within the meaning of § 552(b). Rather, assuming that a lender's prepetition interest extended to "rents," Congress deleted the reference to "applicable non-bankruptcy law" from new § 552(b)(2) in order to remove state law impediments to post-petition liens on post-petition "rents." Therefore, the 1994 amendment can be regarded as having weakened the precedent of cases, such as Bumper Sales, which relied upon the phrase "applicable non-bankruptcy law" in concluding that state law defines "rents," "proceeds" and other terms contained in § 552(b). Although the phrase "applicable non-bankruptcy law" remains in new § 552(b)(1), that phrase should be interpreted in the same manner as suggested by the legislative history to § 552(b)(2). In other words, state law is relevant under § 552(b)(1) to determine whether, applying the plain meanings of the terms contained in § 552(b)(1), a lender has taken sufficient steps under applicable state law for its security interest to extend to "proceeds, product, offspring or profits" of its prepetition collateral.

C. RECENT DEVELOPMENTS INTERPRETING SECTION 552(b)(2)

Despite the legislative history cited above regarding the purpose of deleting the phrase "applicable non-bankruptcy law," commentators have suggested that such deletion may not accomplish the result intended by Congress.²⁹ As Professor Carlson predicted, the clarity of the legislative history has led several courts to conclude summarily that the amendment is effective to eliminate the debate over whether the lender took sufficient steps under state law to perfect its interests in post-petition rents. See In re Homestead Partners, Ltd., 200 B.R. 274, 279 n.4 (Bankr. N.D. Ga. 1996); In re Lyons, 193 B.R. 637, 649 n.13 (Bankr. D. Mass. 1996); Indian Motorcycle Assoc. v. Mass. Housing Finance, 66 F.3d 1246, 1254 n.16 (1^st Cir. 1995); In re Barkley 3A Investors, 175 B.R. 755, 758 (Bankr. D. Kan. 1994); Matter of Newberry Square, Inc., 175 B.R. 910, 915 (Bankr. E.D. Mich. 1994); see also 4 Collier on Bankruptcy ¶ 552.03 (15^th Ed. 1995) (§ 552(b)(2) "is intended to provide a creditor with a valid postpetition interest in rents notwithstanding. . . applicable state law"); compare In re County of Orange, 191 B.R. 1005 (Bankr. C.D. Cal. 1996)("Section 552(b)(2) offers a compelling example of Congressional intent not to let states decide freely what shall be property of the debtor"). At least one court, however, has expressed some doubt as to whether the amendment is in fact effective. See Matter of Turtle Creek, Ltd., 194 B.R. 267, 276 n.6 (Bankr. N.D. Ala. 1996) ("[a]pparently, Congress intended to alleviate the necessity of analyzing state law with respect to the assignment of rents. However, the effect of revised section 552(b) is debatable.") (emphasis added).

"Section 552 preserves to a great extent the status quo and protects state law property entitlements that existed as of the date of the filing. New, post-petition value is unencumbered. Old value is subject to perfected, pre-petition security interests in that value."³⁰ In the Mintz case, discussed above, the post-petition partnership distributions did not reflect "new value;" rather, the partnership distributions represented the economic realization of the debtor's prepetition right to collect future distributions. The "old value," i.e., the value of the debtor's right to collect partnership distributions, would have been subject to a continuing lien under § 552(b) had the court not been constrained by the state law definition of the term "proceeds." Based on the Eleventh Circuit's decision in Tollman-Hundley, the terms contained in § 552, including "rents" and "proceeds," should be given their plain meaning, whether or not strictly consistent with state law. Therefore, as a matter of construction of the Bankruptcy Code and consistent with the economic principle embodied in § 552, valuable prepetition security interests should be preserved post-petition.

1. See T-H New Orleans Ltd. Partnership v. Financial Sec. Assurance (In re T-H New Orleans Ltd. Partnership), 10 F.3d 1099 (5^th Cir. La. 1993), cert. denied, 114 S.Ct. 1833 (U.S. 1994).
2. Alan P. Solow and Randall L. Klein, Section 552 -- Post-Petition Liens on Future Income Streams, Norton's Annual Survey of Bankruptcy Law 1011, 1016 (1994-95 Ed.).
3. 165 B.R. 698 (N.D. Ga. 1994).
4. Butner v. United States, 440 U.S. 48, 99 S.Ct. 914, 59 L.Ed. 2d 136 (1979).
5. In re Tollman-Hundley Dalton, L.P., 162 B.R. 26, 29 (Bankr. N.D. Ga. 1993).
6. Tollman-Hundley, 74 F.3d at 1123.
7. Id. at 1124. Although the Fifth Circuit in T-H New Orleans interpreted § 552 "rents" more broadly than as defined by state (Louisiana) law, the Eleventh Circuit stated that it "decline[d] to follow" T-H New Orleans to the extent that court, relying on Butner, looked to state law to define § 552 rents. To the contrary, as previously noted, we believe that the Fifth Circuit decision T-H New Orleans is consistent with Tollman-Hundley insofar as each court did not limit the definition of "rents" to the applicable state law definition.
8. Id.
9. Id.
10. Id.
11. 192 B.R. 313 (Bankr. D. Mass. 1996).
12. Id. at 317.
13. Id. at 318-321.
14. Id. at 318, quoting H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 377 (1977).
15. 907 F.2d 1430, 1437 (4th Cir. 1990).
16. 2 F.3d 1042 (10th Cir. 1993).
17. For a cogent criticism of the Hastie decision, see R. Wilson Freyermuth, Rethinking Proceeds – The History, Misinterpretation and Revision of § 9-306(1), 69(3) Tulane L. Rev. 645 (1995).
18. In re Mintz, 192 B.R. at 319, citing Mass. G. L. c. 106, § 9-306(1).
19. Id.
20. Id. at 319, n.9, citing Mechanics National Bank v. Gaucher, 7 Mass. App. Ct. 143, 146, 386 N.E. 2d 1052, 1055 (1979).
21. See e.g., In re SRJ Enterprises, Inc., 150 B.R. 933 (Bankr. N.D. Ill. 1993).
22. SRJ Enterprises, 150 B.R. at 940.
23. Tollman-Hundley, 74 F.3d at 1124.
24. "…if the security interest created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds, product, offspring, or profits of such property, then such security interest extends to such proceeds, product, offspring, or profits acquired by the estate after the commencement of the case to the extent provided by such security agreement and by applicable nonbankruptcy law . . . ."
25. See, e.g., In re Bumper Sales, Inc., 907 F.2d 1430, 1437 (4^th Cir. 1990); see also Financial Sec. v. Tollman-Hundley Dalton, L.P., 74 F.3d 1120, 1125 (11^th Cir. 1996) (Clark, J.) (concurring in part and dissenting in part) (interpreting phrase "non-bankruptcy law" to mean state law).
26. Id. at 1124.
27. Id.
28. House Rep. No. 103-385, 103^rd Cong. 2^nd Sess., reprinted in 1994 U.S.C.C.A.N. 3340 at 3357.
29. See R. Wilson Freyermuth, The Circus Continues - Security Interests in Rents. Congress, the Bankruptcy Courts, and "Rents Are Subsumed in the Land" Hypothesis, 6(2), J. Bankr. L. & P. 115 (1996); David Gray Carlson, Rents in Bankruptcy, 46 SCL. Rev. 1075, 1146 (1995) ("it can be expected that the Courts will skip the statutory language and adopt this scrap of legislative history as the governing law.")
30. SRJ Enterprises, 150 B .R. at 941.