Equipment Rentals in Bankruptcy: Allocation Issues Arising from Post-Petition Payments

Courts frequently wrestle with how to apply post-petition payments for rental proceeds deriving from lenders' pre-petition collateral. The issue arises principally in single asset real estate cases, because generally post-petition proceeds of the debtor are the rents attributable to the lender's collateral.

The issue is not solely the province of single asset real estate cases, however. In many equipment financing situations, such as the financing of aircraft for chartering and inventory for equipment rental companies in which equipment is then subleased to third parties etc., the equipment lender takes a security interest in the third-party rental proceeds in addition to the equipment itself. If the customer files for bankruptcy protection, how bankruptcy courts deal with third-party rental proceeds can significantly impact the total dollar amount realized on the equipment lender's claim.

Based on developing case law coming out of single asset real estate cases, a rationale is emerging that allows the application of the pre-confirmation rental proceeds to the unsecured portion of the lender's claim. This treatment has the effect of reducing the unsecured portion of the lender's claim on a dollar-for-dollar basis and allows the lender to receive what is essentially a distribution on its unsecured claim ahead of other unsecured creditors. This article explores some of the issues surrounding post-petition rental proceeds and the ways courts have applied those payments to lenders' claims and suggests ways of using the intellectual framework established by those cases to argue for similar application in the context of an equipment lender's security interest in third-party rental proceeds.

As a starter, an equipment lender's security interest must cover the third-party rental proceeds where the equipment will be subleased to third parties. A typical non-blanket security interest includes language such as “all accessories, attachments, accessions and all proceeds (cash and non-cash), insurance proceeds and any and all chattel paper, accounts, contract rights, instruments, payments, intangibles and general intangibles arising from the sale, lease, rent (including rental of the equipment to a third party) or other disposition.” Additionally, the equipment lender must properly perfect its interest in the debtor's rental proceeds. See generally, Keneco Financial Group, Inc., 131 B.R. 90 (Bankr. N.D. Ill. 1991).

Bankruptcy Code ' 552

Provided that the equipment lender's security interest covers rental proceeds and is properly perfected, ' 552(a) of the Bankruptcy Code (“Code”) comes into play. At first glance, this section acts to limit the effectiveness of a creditor's pre-petition security interest on property acquired by a debtor post-petition. However, there is a narrow exception to ' 552(a) contained in ' 552(b)(1), which provides that when a pre-petition security agreement covering pre-petition property extends to “proceeds, products, offspring or profits” of that collateral, the terms of the security agreement will be enforced against such “proceeds, products, offspring or profits, acquired after the date of the commencement of the case ' ” 11 U.S.C. ' 552 (2013). In effect, Subsection (b)(1) creates an exception to Code ' 552's post-petition cut-off of after-acquired property liens for “ proceeds, products, offspring or profits” generated by pre-petition collateral. See Arkison v. Frontier Asset Mgmt., LLC (In re Skagit Pac. Corp.) , 316 B.R. 330, 335 (B.A.P. 9th Cir. 2004).

The reference to “nonbankruptcy law” in ' 552(b)(1) is important because state law governs perfection of a security interest in most cases, and generally this means the Uniform Commercial Code (“UCC”). Courts do look to other sources, such as legislative history, in their determinations of what does and does not constitute proceeds under ' 552. See, e.g., Stanziale v. Finova Capital Corp. (In re Tower Air, Inc.), 397 F.3d 191 (3d Cir. 2005) (creditor's security interest in engine extended to post-petition insurance payments in the definition of proceeds under Arizona's version of the UCC); and HSBC Bank USA v. UAL Corp. (In re UAL Corp.), 351 B.R. 916, 924 (Bankr. N.D. Ill. 2006), aff'd., 2008 U.S. Dist. LEXIS 24504 (N.D. Ill. Mar. 25, 2008) (referencing legislative history in the determination of what constitutes “proceeds”). The expanded definition of proceeds in revised Article 9 may enhance a secured lender's ability to realize a debtor's post-petition assets. See G. Ray Warner, The Anti-Bankruptcy Act: Revised Article 9 and Bankruptcy, 9 Am. Bankr. Inst. L. Rev. 3, 65 (2001) for a thoughtful analysis.

Another provision, ' 552(b)(2), extends protection to a creditor's interest in rents that are created by pre-petition security agreements. Section 552(b)(2) presents a relatively unusual exception in the Code in that nonbankruptcy law no longer controls construction of security interests and the breadth when dealing with whether certain security interests extend to post-petition rents. See, e.g., Indian Motorcycle Associates II Ltd. Partnership v. Massachusetts Housing Financing Agency, 66 F.3d 1246 (1st Cir. 1995).

If the equipment lender has a properly perfected security interest in the rental proceeds of the subleases of its collateral and that security interest satisfies the requirements contained in ' 552(b), then the rental proceeds can constitute cash collateral pursuant to ' 363 of the Code. See Keneco Financial Group, Inc., 131 B.R. at 96 (previously cited). As cash collateral, ' 363(c)(2) generally prohibits the debtor from using the rental proceeds generated post-petition from the equipment lender's pre-petition collateral absent an agreement from the equipment lender or by court order. 11 USC ' 363(c)(2). If the equipment lender's interest in its post-petition rental proceeds is subject to a decline in value, the debtor must provide adequate protection to prevent a loss in the value of the equipment lender's collateral, which most often is in the form of cash payments. See generally, United Sav. Ass'n of Tex. v. Timbers of Inwood Forest Assocs. Ltd., 484 U.S. 365 (1988).

Adequate Protection

Once a determination has been made that the rental proceeds constitute the equipment lender's collateral under ' 552(b), are subject to adequate protection under ' 361 and adequate protection payments are made to the equipment lender, the question arises as to how those post-petition payments attributable to rental proceeds should be allocated against the equipment lender's claim. As stated by one court, “[t]here is no provision in the Bankruptcy Code which mandates how adequate protection payments shall be applied. To determine how the payments made by the Debtors to the [creditor] shall be applied, this court must consider bankruptcy statutes, the concept and purposes of adequate protection, and the parties' agreement respecting application of the payments.” In re Kain, 86 B.R. 506, 511 (Bankr. W.D. Mich. 1988). Courts recognize that money paid by the debtor during the pendency of the case must be applied against some portion of the creditor's claim; the question generally is whether those payments should reduce the secured or the unsecured portion of the creditor's claim. Gramercy Twins Assocs., 187 B.R. 112, 119 (Bankr. N.D. Ga 1991).

In the routine case where adequate protection payments are made by the debtor for the depreciation in the value of the equipment, case law suggests that such payments be applied to the secured portion of the claim. See In re Canaveral Seafoods, Inc., 79 B.R. 57, 58 (Bankr. M.D. Fl. 1987). However, where the post-petition payments are attributable to the rental proceeds of the pre-petition collateral as opposed to payments from the diminution in value of the collateral itself, case law arising in the context of single asset real estate cases suggests another possibility ' that the post-petition rental proceeds be applied first to the unsecured portion of an undersecured creditor's claim until it is reduced to zero and, when the creditor is oversecured, payments should be applied to the post-petition interest, fees, costs and charges allowed under ' 506(b) and then to principal. In re South Side House, L.L.C., 474 B.R. 391, 421 (Bankr. E.D. N.Y. 2012).

Two Theories

There appear to be at least two main theories on the application of post-petition rental proceeds attributable to a lender's pre-petition collateral. The first, referred to as the “subtraction” theory, applies the post-petition rental payments attributable to the pre-petition collateral to the secured portion of the creditor's claim. The “subtraction” cases treat the payments as offsetting any decline in the value of the collateral, while the payment of the rents protects the creditor's overall interest. Generally, courts in these cases share the concern that application of post-petition payments would improve an undersecured creditor's position as compared with other unsecured creditors or allow the undersecured creditor to receive post-petition interest in violation of 11 U.S.C. ' 506(b). See, e.g., First Fed. Bank of Cal. v. Weinstein (In re Weinstein), 227 B.R. 284, 297 (9th Cir. B.A.P. 1998) (“Applying post-petition, pre-confirmation payments to reduce the unsecured claim would give the undersecured creditor an unwarranted bonus.”); In re IPC Atlanta Ltd. P'ship, 142 B.R. 547, 558 (Bankr. N.D. Ga. 1992) (allowing an undersecured creditor to keep post-petition payments would give the creditor more than its allowed claim and would allow the creditor to “receive interest payments or use value for which the creditor is otherwise entitled”); In re Reddington/Sunarrow Ltd. P'shp, 119 B.R. 809, 814 (Bankr. D.N.M. 1990) (“An undersecured creditor is entitled to be protected to the extent its collateral is depreciating, but its position is not to be improved in relation to other creditors.”); Confederation Life Ins. Co. v. Beau Rivage Ltd. , 126 B.R. 632, 640 (Bankr. N.D. Ga. 1991) (explaining payments to an undersecured creditor must be applied to the secured claim “[o]therwise the payments would be treated as interest payments or use value ' “); In re Spacek, 112 B.R. 162, 165 (Bankr. W.D. Tex. 1990) (Where “the value of the collateral has not decreased during the case, the adequate protection payments must be applied against the secured portion of [the creditor's] indebtedness.”).

Other courts, in light of ' 552(b), follow the “addition” view, which provides that rental proceeds should reduce a creditor's unsecured deficiency claim by satisfying the portion of the claim that is secured by the assignment of the rents. In re South Side House, L.L.C. , 474 B.R. at 412-13; In re Gramercy Twins Assocs., 187 B.R. at 122. (Post-petition adequate protection payments based on an assignment of rents should be “considered protection for the separate interest in the rents in accord with ' 552(b)” and credited against the allowed amount of the creditor's secured claim to indirectly reduce the unsecured portion.); In re Vermont Inv. Ltd. P'ship, 142 B.R. 571 (Bankr. D.D.C. 1992); In re Union Meeting Partners, 178 B.R. 664, 677 (Bankr. E.D. Penn. 1996) (finding post-petition payments should be subtracted from the aggregate claim, but not the secured portion); In re Flagler-At-First Assocs., Ltd., 114 B.R. 297 (Bankr. S.D. Fla. 1990) (post-petition rents should not be credited to principal); In re Columbia Office Assocs. Ltd. P'ship, 175 B.R. 199 (Bankr. D. Md. 1994) (payment could not be credited to the secured claim); In re Lichtin/Wade, L.L.C., 486 B.R. 665, 679 (Bankr. E.D. N.C. 2013) (finding that the “addition” cases correctly recognize the existence of the ' 552(b) security interest in post-petition rents and properly reduce the unsecured claim.).

At the heart of the “addition” cases is the idea that the grant of a security interest in the rentals generated from the lender's pre-petition collateral is an additional grant of a security interest in the rental proceeds. The “addition” view, according to one court, appears to be becoming the majority view. In re South Side House, L.L.C., 474 B.R. at 415 (Citing to 3 Collier on Bankruptcy ' 361.03 [2][a], at 361-15.). Whether courts will extend the rationale of the “addition” view involving single asset real estate cases to personal property lease rentals appears to be an open question. Under the bankruptcy claims analysis, courts have found that both an assignment of rents in real estate and a security agreement in chattel paper in personal property can be effective post-petition pursuant to ' 552(b) of the Code.

In both contexts, the rental proceeds constitute cash collateral subject to ' 363 and adequate protection under ' 361 of the Code. Given that the Code does not generally govern perfection of such interests, but rather only the effect of such perfection vis-'-vis the debtor's post-petition assets, an argument can be made that rental proceeds in either context should be treated similarly. The court in South Side House, LLC suggests that payments in a single asset case under ' 362(d)(3)(B)(ii) should be applied in the same way as adequate protection. Id. at 421.

Practical Interpretation

From a practical point of view, when equipment lenders are confronted with the situation where their customer has filed for bankruptcy and is generating rental proceeds from subleases of the equipment lenders' pre-petition collateral, they should consider seeking an order segregating the rental proceeds as cash collateral and having those proceeds allocated first against the unsecured portion of their claim. The “addition” view cases can provide an intellectual framework to guide the negotiations with the debtor. At the end of the day, most adequate protection issues in bankruptcy are resolved by agreement between the parties.

Given the complexities of this area of the law and sparse case law on the issue, it is also advisable to address, or at least determine not to address, the allocation issue in all cash collateral and/or adequate protection agreements, not just those situations involving rental proceeds from third parties. Experience and case law suggest that courts will give deference to the parties' agreement on the allocation issue in their determinations as long as it is reasonable. See, e.g. In re Flagler-at-First Assoc., Ltd., 114 B.R. at 299. (The court had an indication of how the parties intended that the payments be treated because attorneys expressly agreed to a turnover of excess rents to preserve the status quo and prevent any erosion of the creditor's position on the property.); In re Reddington/Sunarrow Ltd. P'shp, 119 B.R. at 811. (The cash collateral order does not furnish any guidance to the court. The order only states that “the Debtor shall ' pay to [creditor] the 'net cash flow' which for the purposes of this Order shall be all rental income and other cash collateral received by the Debtor ' “); In re Markos Gurnee Partnership, Diplomat North, Inc., 252 B.R. 712, 718-719 (Bankr. N.D. Ill. 1997) (agreement stating that the adequate protection payments were “non-refundable” was not reasonable because it presumed that the creditor's secured claim would not be reduced by any payments and assumed that it should retain all post-petition payments and the entire value of the collateral). Finally, where a portion of the post-petition rental proceeds includes sales, use or excise tax, those amounts should be excluded from application to any portion of the equipment lender's claim.

Conclusion

There is a complex interplay between the Code and the UCC whenever a debtor generates rental proceeds from the lender's pre-petition collateral. As a consequence, at the documentation stage, careful consideration should be given to ensure that the security interest of the equipment lender attaches to those rental proceeds and that those interests are properly perfected. If the customer files for bankruptcy protection, the equipment lender should evaluate as early as possible the cash collateral and adequate protection issues relating to those rental proceeds and seek to have post-petition payment attributable to those rental proceeds segregated and applied first to the unsecured claim utilizing the rationale of the “addition” view cases discussed in this article.

Dennis Dressler , a member of this newsletter's Board of Editors, is a member of Dressler | Peters, LLC, a Chicago-based law firm focused on representing banks and equipment finance companies in complex litigation, bankruptcy, out-of-court workouts and fraud litigation. He may be contacted at [email protected].

Courts frequently wrestle with how to apply post-petition payments for rental proceeds deriving from lenders' pre-petition collateral. The issue arises principally in single asset real estate cases, because generally post-petition proceeds of the debtor are the rents attributable to the lender's collateral.

The issue is not solely the province of single asset real estate cases, however. In many equipment financing situations, such as the financing of aircraft for chartering and inventory for equipment rental companies in which equipment is then subleased to third parties etc., the equipment lender takes a security interest in the third-party rental proceeds in addition to the equipment itself. If the customer files for bankruptcy protection, how bankruptcy courts deal with third-party rental proceeds can significantly impact the total dollar amount realized on the equipment lender's claim.

Based on developing case law coming out of single asset real estate cases, a rationale is emerging that allows the application of the pre-confirmation rental proceeds to the unsecured portion of the lender's claim. This treatment has the effect of reducing the unsecured portion of the lender's claim on a dollar-for-dollar basis and allows the lender to receive what is essentially a distribution on its unsecured claim ahead of other unsecured creditors. This article explores some of the issues surrounding post-petition rental proceeds and the ways courts have applied those payments to lenders' claims and suggests ways of using the intellectual framework established by those cases to argue for similar application in the context of an equipment lender's security interest in third-party rental proceeds.

As a starter, an equipment lender's security interest must cover the third-party rental proceeds where the equipment will be subleased to third parties. A typical non-blanket security interest includes language such as “all accessories, attachments, accessions and all proceeds (cash and non-cash), insurance proceeds and any and all chattel paper, accounts, contract rights, instruments, payments, intangibles and general intangibles arising from the sale, lease, rent (including rental of the equipment to a third party) or other disposition.” Additionally, the equipment lender must properly perfect its interest in the debtor's rental proceeds. See generally, Keneco Financial Group, Inc., 131 B.R. 90 (Bankr. N.D. Ill. 1991).

Bankruptcy Code ' 552

Provided that the equipment lender's security interest covers rental proceeds and is properly perfected, ' 552(a) of the Bankruptcy Code (“Code”) comes into play. At first glance, this section acts to limit the effectiveness of a creditor's pre-petition security interest on property acquired by a debtor post-petition. However, there is a narrow exception to ' 552(a) contained in ' 552(b)(1), which provides that when a pre-petition security agreement covering pre-petition property extends to “proceeds, products, offspring or profits” of that collateral, the terms of the security agreement will be enforced against such “proceeds, products, offspring or profits, acquired after the date of the commencement of the case ' ” 11 U.S.C. ' 552 (2013). In effect, Subsection (b)(1) creates an exception to Code ' 552's post-petition cut-off of after-acquired property liens for “ proceeds, products, offspring or profits” generated by pre-petition collateral. See Arkison v. Frontier Asset Mgmt., LLC (In re Skagit Pac. Corp.) , 316 B.R. 330, 335 (B.A.P. 9th Cir. 2004).

The reference to “nonbankruptcy law” in ' 552(b)(1) is important because state law governs perfection of a security interest in most cases, and generally this means the Uniform Commercial Code (“UCC”). Courts do look to other sources, such as legislative history, in their determinations of what does and does not constitute proceeds under ' 552. See, e.g., Stanziale v. Finova Capital Corp. (In re Tower Air, Inc.), 397 F.3d 191 (3d Cir. 2005) (creditor's security interest in engine extended to post-petition insurance payments in the definition of proceeds under Arizona's version of the UCC); and HSBC Bank USA v. UAL Corp. (In re UAL Corp.), 351 B.R. 916, 924 (Bankr. N.D. Ill. 2006), aff'd., 2008 U.S. Dist. LEXIS 24504 (N.D. Ill. Mar. 25, 2008) (referencing legislative history in the determination of what constitutes “proceeds”). The expanded definition of proceeds in revised Article 9 may enhance a secured lender's ability to realize a debtor's post-petition assets. See G. Ray Warner, The Anti-Bankruptcy Act: Revised Article 9 and Bankruptcy, 9 Am. Bankr. Inst. L. Rev. 3, 65 (2001) for a thoughtful analysis.

Another provision, ' 552(b)(2), extends protection to a creditor's interest in rents that are created by pre-petition security agreements. Section 552(b)(2) presents a relatively unusual exception in the Code in that nonbankruptcy law no longer controls construction of security interests and the breadth when dealing with whether certain security interests extend to post-petition rents. See, e.g., Indian Motorcycle Associates II Ltd. Partnership v. Massachusetts Housing Financing Agency , 66 F.3d 1246 (1st Cir. 1995).

If the equipment lender has a properly perfected security interest in the rental proceeds of the subleases of its collateral and that security interest satisfies the requirements contained in ' 552(b), then the rental proceeds can constitute cash collateral pursuant to ' 363 of the Code. See Keneco Financial Group, Inc., 131 B.R. at 96 (previously cited). As cash collateral, ' 363(c)(2) generally prohibits the debtor from using the rental proceeds generated post-petition from the equipment lender's pre-petition collateral absent an agreement from the equipment lender or by court order. 11 USC ' 363(c)(2). If the equipment lender's interest in its post-petition rental proceeds is subject to a decline in value, the debtor must provide adequate protection to prevent a loss in the value of the equipment lender's collateral, which most often is in the form of cash payments. See generally, United Sav. Ass'n of Tex. v. Timbers of Inwood Forest Assocs. Ltd. , 484 U.S. 365 (1988).

Adequate Protection

Once a determination has been made that the rental proceeds constitute the equipment lender's collateral under ' 552(b), are subject to adequate protection under ' 361 and adequate protection payments are made to the equipment lender, the question arises as to how those post-petition payments attributable to rental proceeds should be allocated against the equipment lender's claim. As stated by one court, “[t]here is no provision in the Bankruptcy Code which mandates how adequate protection payments shall be applied. To determine how the payments made by the Debtors to the [creditor] shall be applied, this court must consider bankruptcy statutes, the concept and purposes of adequate protection, and the parties' agreement respecting application of the payments.” In re Kain, 86 B.R. 506, 511 (Bankr. W.D. Mich. 1988). Courts recognize that money paid by the debtor during the pendency of the case must be applied against some portion of the creditor's claim; the question generally is whether those payments should reduce the secured or the unsecured portion of the creditor's claim. Gramercy Twins Assocs., 187 B.R. 112, 119 (Bankr. N.D. Ga 1991).

In the routine case where adequate protection payments are made by the debtor for the depreciation in the value of the equipment, case law suggests that such payments be applied to the secured portion of the claim. See In re Canaveral Seafoods, Inc., 79 B.R. 57, 58 (Bankr. M.D. Fl. 1987). However, where the post-petition payments are attributable to the rental proceeds of the pre-petition collateral as opposed to payments from the diminution in value of the collateral itself, case law arising in the context of single asset real estate cases suggests another possibility ' that the post-petition rental proceeds be applied first to the unsecured portion of an undersecured creditor's claim until it is reduced to zero and, when the creditor is oversecured, payments should be applied to the post-petition interest, fees, costs and charges allowed under ' 506(b) and then to principal. In re South Side House, L.L.C., 474 B.R. 391, 421 (Bankr. E.D. N.Y. 2012).

Two Theories

There appear to be at least two main theories on the application of post-petition rental proceeds attributable to a lender's pre-petition collateral. The first, referred to as the “subtraction” theory, applies the post-petition rental payments attributable to the pre-petition collateral to the secured portion of the creditor's claim. The “subtraction” cases treat the payments as offsetting any decline in the value of the collateral, while the payment of the rents protects the creditor's overall interest. Generally, courts in these cases share the concern that application of post-petition payments would improve an undersecured creditor's position as compared with other unsecured creditors or allow the undersecured creditor to receive post-petition interest in violation of 11 U.S.C. ' 506(b). See, e.g., First Fed. Bank of Cal. v. Weinstein (In re Weinstein), 227 B.R. 284, 297 (9th Cir. B.A.P. 1998) (“Applying post-petition, pre-confirmation payments to reduce the unsecured claim would give the undersecured creditor an unwarranted bonus.”); In re IPC Atlanta Ltd. P'ship, 142 B.R. 547, 558 (Bankr. N.D. Ga. 1992) (allowing an undersecured creditor to keep post-petition payments would give the creditor more than its allowed claim and would allow the creditor to “receive interest payments or use value for which the creditor is otherwise entitled”); In re Reddington/Sunarrow Ltd. P'shp, 119 B.R. 809, 814 (Bankr. D.N.M. 1990) (“An undersecured creditor is entitled to be protected to the extent its collateral is depreciating, but its position is not to be improved in relation to other creditors.”); Confederation Life Ins. Co. v. Beau Rivage Ltd. , 126 B.R. 632, 640 (Bankr. N.D. Ga. 1991) (explaining payments to an undersecured creditor must be applied to the secured claim “[o]therwise the payments would be treated as interest payments or use value ' “); In re Spacek, 112 B.R. 162, 165 (Bankr. W.D. Tex. 1990) (Where “the value of the collateral has not decreased during the case, the adequate protection payments must be applied against the secured portion of [the creditor's] indebtedness.”).

Other courts, in light of ' 552(b), follow the “addition” view, which provides that rental proceeds should reduce a creditor's unsecured deficiency claim by satisfying the portion of the claim that is secured by the assignment of the rents. In re South Side House, L.L.C. , 474 B.R. at 412-13; In re Gramercy Twins Assocs., 187 B.R. at 122. (Post-petition adequate protection payments based on an assignment of rents should be “considered protection for the separate interest in the rents in accord with ' 552(b)” and credited against the allowed amount of the creditor's secured claim to indirectly reduce the unsecured portion.); In re Vermont Inv. Ltd. P'ship, 142 B.R. 571 (Bankr. D.D.C. 1992); In re Union Meeting Partners, 178 B.R. 664, 677 (Bankr. E.D. Penn. 1996) (finding post-petition payments should be subtracted from the aggregate claim, but not the secured portion); In re Flagler-At-First Assocs., Ltd., 114 B.R. 297 (Bankr. S.D. Fla. 1990) (post-petition rents should not be credited to principal); In re Columbia Office Assocs. Ltd. P'ship, 175 B.R. 199 (Bankr. D. Md. 1994) (payment could not be credited to the secured claim); In re Lichtin/Wade, L.L.C., 486 B.R. 665, 679 (Bankr. E.D. N.C. 2013) (finding that the “addition” cases correctly recognize the existence of the ' 552(b) security interest in post-petition rents and properly reduce the unsecured claim.).

At the heart of the “addition” cases is the idea that the grant of a security interest in the rentals generated from the lender's pre-petition collateral is an additional grant of a security interest in the rental proceeds. The “addition” view, according to one court, appears to be becoming the majority view. In re South Side House, L.L.C., 474 B.R. at 415 (Citing to 3 Collier on Bankruptcy ' 361.03 [2][a], at 361-15.). Whether courts will extend the rationale of the “addition” view involving single asset real estate cases to personal property lease rentals appears to be an open question. Under the bankruptcy claims analysis, courts have found that both an assignment of rents in real estate and a security agreement in chattel paper in personal property can be effective post-petition pursuant to ' 552(b) of the Code.

In both contexts, the rental proceeds constitute cash collateral subject to ' 363 and adequate protection under ' 361 of the Code. Given that the Code does not generally govern perfection of such interests, but rather only the effect of such perfection vis-'-vis the debtor's post-petition assets, an argument can be made that rental proceeds in either context should be treated similarly. The court in South Side House, LLC suggests that payments in a single asset case under ' 362(d)(3)(B)(ii) should be applied in the same way as adequate protection. Id. at 421.

Practical Interpretation

From a practical point of view, when equipment lenders are confronted with the situation where their customer has filed for bankruptcy and is generating rental proceeds from subleases of the equipment lenders' pre-petition collateral, they should consider seeking an order segregating the rental proceeds as cash collateral and having those proceeds allocated first against the unsecured portion of their claim. The “addition” view cases can provide an intellectual framework to guide the negotiations with the debtor. At the end of the day, most adequate protection issues in bankruptcy are resolved by agreement between the parties.

Given the complexities of this area of the law and sparse case law on the issue, it is also advisable to address, or at least determine not to address, the allocation issue in all cash collateral and/or adequate protection agreements, not just those situations involving rental proceeds from third parties. Experience and case law suggest that courts will give deference to the parties' agreement on the allocation issue in their determinations as long as it is reasonable. See, e.g. In re Flagler-at-First Assoc., Ltd., 114 B.R. at 299. (The court had an indication of how the parties intended that the payments be treated because attorneys expressly agreed to a turnover of excess rents to preserve the status quo and prevent any erosion of the creditor's position on the property.); In re Reddington/Sunarrow Ltd. P'shp, 119 B.R. at 811. (The cash collateral order does not furnish any guidance to the court. The order only states that “the Debtor shall ' pay to [creditor] the 'net cash flow' which for the purposes of this Order shall be all rental income and other cash collateral received by the Debtor ' “); In re Markos Gurnee Partnership, Diplomat North, Inc., 252 B.R. 712, 718-719 (Bankr. N.D. Ill. 1997) (agreement stating that the adequate protection payments were “non-refundable” was not reasonable because it presumed that the creditor's secured claim would not be reduced by any payments and assumed that it should retain all post-petition payments and the entire value of the collateral). Finally, where a portion of the post-petition rental proceeds includes sales, use or excise tax, those amounts should be excluded from application to any portion of the equipment lender's claim.

Conclusion

There is a complex interplay between the Code and the UCC whenever a debtor generates rental proceeds from the lender's pre-petition collateral. As a consequence, at the documentation stage, careful consideration should be given to ensure that the security interest of the equipment lender attaches to those rental proceeds and that those interests are properly perfected. If the customer files for bankruptcy protection, the equipment lender should evaluate as early as possible the cash collateral and adequate protection issues relating to those rental proceeds and seek to have post-petition payment attributable to those rental proceeds segregated and applied first to the unsecured claim utilizing the rationale of the “addition” view cases discussed in this article.

Dennis Dressler , a member of this newsletter's Board of Editors, is a member of Dressler | Peters, LLC, a Chicago-based law firm focused on representing banks and equipment finance companies in complex litigation, bankruptcy, out-of-court workouts and fraud litigation. He may be contacted at [email protected].