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This is the third in a series of articles on liens in proceeds under Article 9 of the Uniform Commercial Code.
In this the third and final installment of a series of articles, we address the intersection of Article 9 liens in proceeds and the U.S. Bankruptcy Code.
In the event of a bankruptcy, the Trustee or debtor will often try to argue that the secured party's pre-petition liens do not apply to assets arising post-petition. More specifically, the Trustee or debtor will argue that section 11 U.S.C. ' 552(a) of the Bankruptcy Code prohibits the recognition of after acquired collateral provisions. Generally, the secured party should zealously oppose such claims, citing ' 552(b)(1), which extends a creditor's pre-petition lien to the post-petition proceeds of pre-petition collateral. That provision reads as follows:
(b)(1) Except as provided in Sections 363, 506(c), 522, 544, 545, 547, and 548 of this title, if the debtor and an entity entered into a security agreement before the commencement of the case and 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, products, offspring, or profits of such property, then such security interest extends to such proceeds, products, 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, except to any extent that the court, after notice and a hearing and based on the equities of the case, orders otherwise. (Emphasis added.)
It is commonly understood that a secured party's pre-petition lien in accounts and inventory is extended post-bankruptcy to their proceeds, pursuant to Section 352 (b)(1). In fact, accounts receivable and inventory are “cash collateral” under Section 363 of the Bankruptcy Code. Because cash collateral can quickly and easily disappear, this is one of the few areas in which the Bankruptcy Code places the burden of taking immediate action on the debtor, instead of on the creditor.
The Bankruptcy Code prohibits a debtor from using the cash collateral, in whole or in part, without the consent of the creditor or without a court order. 11 U.S.C. ' 363(c)(2) (2010). (A discussion of cash collateral orders is beyond the scope of this article. It should be noted, however, that any cash collateral order must include, at the very least, a post-petition replacement lien.) The debtor cannot even make payroll or pay its ordinary course expenses without the cash collateral creditor's consent or the permission of the court. Consequently, a cash collateral lien gives the creditor a great deal of leverage if the debtor needs the cash collateral to operate post-petition, which is the case in the vast majority of Chapter 11 proceedings.
Case Law
It is not so commonly understood, however, that post-petition proceeds liens are not limited to pre-petition liens in accounts and inventory. Post-petition receivables are also often the proceeds of pre-petition contracts, which are often general intangibles under Article 9 of the U.C.C. Accordingly, the secured party's pre-petition security interest in general intangibles often extends to post-petition payments received, even where the secured party did not have a pre-petition lien in accounts or inventory. Indeed, a pre-petition lien in contracts, to wit, general intangibles under Article 9, can be extended quite far post petition under the Section 552(b)(1) proceeds exemption.
On point is Cadle Co. v. Schlichtmann, 267 F.3d 14, 20-21 (1st Cir. 2001). In Cadle , a creditor had a security interest in a law firm's contingency fee agreement and the proceeds from that agreement. Although much of the work was performed after the firm had dissolved and an individual lawyer had filed for bankruptcy, and although the right to payment arose post-petition, the U.S. Court of Appeals for the First Circuit held that the creditor had a security in the post-petition fees under ' 552(b)(1).
Also instructive is United Virginia Bank v. Slab Fork Coal Co., 784 F.2d 1188 (4th Cir. 1986). That decision involved rights under a coal supply contract entered by the debtor pre-petition. The court held that payments for coal supplied post-petition were subject to a creditor's pre-petition lien. The court reasoned that creditor “UVB's rights under Slab Fork's contract with Armco were likewise intangible rights, and were subject to UVB's lien before the filing of the bankruptcy petition. It is true that coal had to be supplied to Armco by or for Slab Fork before any right to payment arose, but that is true for all the payments under the contract, whether generated pre-petition or post-petition. No change in the right to payment under the Armco contract was brought about by the filing of a bankruptcy petition, where the underlying asset and all proceeds therefrom were subject to a valid pre-petition security interest.” Id. at 1191.
Pre-petition liens in goods, such as equipment, may also extend to post-petition receivables without a pre-petition lien in accounts or inventory. Section 9-102(a)(64) of the U.C.C. makes clear that proceeds include whatever is acquired upon the sale “or lease” of collateral. Thus, Article 9 makes clear a pre-petition first perfected security interest in the equipment continues in whatever is generated by the sale or rental of the equipment.
If the debtor sold encumbered equipment post-petition, it is beyond dispute that the pre-petition lien attached to the sale proceeds. The same should hold true for rentals. To illustrate, let's look at the history of the Bankruptcy Code's treatment of hotel and motel receipts.
Background
Prior to the 1994 amendments to the Bankruptcy Code, the issue of whether hotel and motel receipts were cash collateral of pre-petition liens often turned on whether under the applicable state law the receipts were deemed “rents” (in which case the secured party perfected by filing an Assignment of Rents) or “accounts” (in which case the secured party perfected by filing under Article 9). If the receipts were deemed rents, the post-petition receipts were deemed cash collateral of pre-petition liens as they were the proceeds of a pre-petition lien in the real estate. If the receipts were deemed accounts, the post-petition receipts were not deemed cash collateral, as they were not considered to be the proceeds of any pre-petition personal property lien.
An Example
Under the 1994 amendments, the issue was resolved in favor of secured parties with hotel and motel receipts being deemed cash collateral of pre-petition liens regardless of whether they are rents or accounts under a particular state law. Section 552(b)(2) was amended to provide that a pre-petition lien in hotel and motel receipts, continues in receipts received post-petition, and Section 363(a) was amended to include hotel and motel receipts within the definition of cash collateral.
Unlike hotel and motel receipts, there can be no dispute that the debtor's short term rentals of equipment collateral constitutes “rent” for the use of the equipment. Thus, there should be no dispute that the rental proceeds are the proceeds of pre-petition collateral and that a secured party therefore has a perfected lien in same even without any pre-petition lien in accounts or inventory, and even without a post-petition replacement lien.
A Significant Exception
Finally, while pre-petition liens can often be extended to reach post-petition receivables, this reach is not without its limits. The U.S. Supreme Court long ago confirmed a significant exception to the Section 552(b) exclusion. Local Loan Co. v. Hunt, 292 U.S. 234 (1934). The Supreme Court in Hunt held that there is no enforceable post-petition lien on property “not existent when the bankruptcy became effective or even arising from, or connected with preexisting property, but brought into being solely as the fruit of the subsequent labor of the bankrupt.” Id. at 243.
In this vein, the pre-petition security interest arguably only continues post-petition if “the debtor need not do anything after bankruptcy to make them continue.” Towers v. W, 173 B.R. 411, 413-415 (B.A.P. 9th Cir. 1994). See also Johnson v. Cottonport Bank, 259 B.R. 125, 128-129 (W.D. La. 2000); In re Rumker, 184 B.R. 621 (Bankr. S.D. Ga. 1995). But see Cadle Co., 267 F.3d 14; and United Va. Bank, 784 F.2d 1188, supra. A debtor's/trustee's avoidance claims, such as preference claims, are also generally not considered the subject of any pre-petition liens or the proceeds of same. In re Residential Capital, LLC, 497 B.R. 403, 414-15 (Bankr. S.D.N.Y. 2013) (citing In re Demma Fruit Co., 2002 Bankr. LEXIS 1781 at *11 (Bankr. D. Neb. May 28, 2002); and 5 Collier on Bankruptcy ' 552.02[5][d] (16th ed. rev. 2013). For example, a depository bank's pre-petition lien on the funds in a deposit account does not give the bank any claim to the trustee's fraudulent conveyance avoidance action to recover funds fraudulently paid out of the depository account. In re Abeles, LLC, No., 2013 Bankr. LEXIS 3932 (Bankr. E.D.N.Y. Sept. 20, 2013).
Conclusion
We hope this series of articles has helped our readers to better understand the nature and scope of Article 9 liens in proceeds. The knowledgeable and zealous secured creditor can pursue its lien quite far, through multiple transfers and even into bankruptcy court.
Frank Peretore is a founding partner of the law firm of Peretore & Peretore, P.C. A member of this newsletter's Board of Editors, he may be reached at 973-729-8991.
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