Chapter 1 Allowance and Amount of the Secured Claim

• Jurisdiction: United States

Chapter 1: Allowance and Amount of the Secured Claim

Stephen v. Falanga

Claims of secured creditors are preserved in bankruptcy. This is a long-standing and general consensus supported by both the current and former iterations of the Bankruptcy Code and Supreme Court precedent. Indeed, on occasion the Supreme Court has invalidated some earlier versions of the Bankruptcy Code and other acts of Congress that sought to modify the rights of secured creditors to their underlying collateral as unconstitutional takings, among other things.¹ Implicit in the public policy favoring rights of secured creditors is that the secured creditor who bargained with the debtor for rights to collateral should enjoy the benefit of those rights unless and until such time as the claim is paid in full. Thus, a properly obtained and perfected lien should flow through a bankruptcy, and a "windfall" should not befall the debtor or unsecured creditors by the mere happenstance of the debtor's bankruptcy.² However, secured creditors are not entitled to a greater bargain than they obtained pre-bankruptcy. While the Bankruptcy Code ensures that a secured creditor's rights are preserved and given first payment priority, those rights are only protected to the extent the claim does not exceed the value of the collateral subject to the secured creditor's lien.

A. Introduction and Overview of § 506

Section 506 of the Bankruptcy Code codifies the historical protection provided to secured creditors and remains a touchstone in dealing with the adjudication of a bankrupt's assets that are subject to liens from those that are not. Section 506 is comprised of four sections.

Subparagraph (a) implements a process known as "automatic bifurcation" to ensure that a secured creditor's secured claim is limited to the extent of the value of the secured creditor's interest in the collateral, with the remaining amount owed being deemed an unsecured claim.³ Implicit in the bifurcation of a secured creditor's claim is the necessary element of valuation of the collateral. Section 506(a)(1) makes clear that the bankruptcy court must conduct a valuation of the collateral in connection with the determination of a creditor's secured status. The valuation must be determined in light of the purpose of the valuation and the proposed disposition or use of the collateral by the debtor. A more detailed discussion of the valuation purposes and methods a bankruptcy court should employ is contained in Chapter 2.

Subparagraph (b) governs what are commonly referred to as "equity cushions" involving those situations where a debtor has equity in the collateral over and above what the secured creditor is owed at the time of the bankruptcy filing. In those circumstances, the secured creditor's claim will continue to accrue interest post-petition along with any reasonable fees, costs or charges provided for under the loan agreement or state statute governing the claim. Section 506(b) overrides the bar on post-petition interest contained in § 502(b)(2).⁴

Subparagraph (c) gives a debtor-in-possession or chapter 7 or 11 trustee the right to seek to recover from the secured creditor's collateral the reasonable, necessary costs and expenses of preserving or disposing of the collateral to the extent a benefit is conferred on the secured creditor.⁵

Finally, under certain circumstances, subparagraph (d) authorizes the bankruptcy court to void a lien of a secured creditor to the extent it is determined not to be an allowed secured claim.⁶

B. Amount of Secured Claim

Section 506 first appeared in the Bankruptcy Reform Act of 1978 as a major part of Congress's extensive revisions to the nation's bankruptcy laws at that time.⁷ The Supreme Court noted that "Congress worked on the formulation of the Code [sic] for nearly a decade" and "[i]t was intended to modernize the bankruptcy laws."⁸ In particular, Congress intended "significant changes from current law in ... the treatment of secured creditors and secured claims."⁹

In the course of developing the structure of the Bankruptcy Code and § 506 in particular, Congress stated that the bill codified "creditors' rights more clearly than case law" and "defined the protections to which a secured creditor is entitled."¹⁰ In fact, the legislative history surrounding the concept of bifurcation indicates that Congress was well aware that "one of the more significant changes" to prior bankruptcy laws was title 11's revamped treatment of secured creditors and their claims.¹¹ Congress acknowledged that then-existing bankruptcy law was vague as it pertained to the treatment of undersecured creditors in particular, and the proposed new § 506 was designed to make it clear that an undersecured creditor¹² "is to be treated as having a secured claim to the extent of the value of the collateral, and an unsecured claim for the balance of his claim against the debtor."¹³

Additionally, Congress emphasized that the new concept of bifurcation of undersecured claims had "important protective consequences for both creditors and the debtor."¹⁴ For the creditor, the proposed reform required determination of the amount of the secured claim and eventually the assurance of adequate protection or the right to realize upon the claim, and not have its collateral eroded by delay or use by the bankruptcy estate. As for the debtor, the determination of the amount of the secured claim facilitated reorganization and repayment by defining the precise extent of the claims against the debtor that must be treated specifically as secured claims.

C. Function of § 506(a): To Determine Secured Creditor Status

Section 506(a) of the Bankruptcy Code governs the determination of a creditor's secured status. It is designed to ensure that the rights of a secured creditor are preserved, but only to the extent of the value of the secured creditor's collateral.¹⁵ The pertinent language of § 506(a)(1) provides:

An allowed claim of a creditor secured by a lien on property in which the estate has an interest, or that is subject to setoff under section 553 of this title, is a secured claim to the extent of the value of such creditor's interest in the estate's interest in such property, or to the extent of the amount subject to setoff, as the case may be, and is an unsecured claim to the extent that the value of such creditor's interest or the amount so subject to setoff is less than the amount of such allowed claim. Such value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use or on a plan affecting such creditor's interest.¹⁶

As such, upon the filing of a bankruptcy case, the claim of a secured creditor is "automatically" bifurcated to the extent that the value of the collateral does not exceed the amount owed. The process for the bankruptcy court to make this determination is governed by § 506 in the context of § 502, which provides for the allowance of all claims in a bankruptcy case.

D. Bifurcation under § 506

Section 506 of the Bankruptcy Code governs the bankruptcy court's determination of the amount of a secured claim. In particular, through a procedure commonly known as "bifurcation" or "automatic bifurcation," § 506(a)(1) provides that a claim is secured only to the extent of the value of collateral or property to which the lien attached. After such a determination, the remainder of the claim is deemed unsecured by operation of law.¹⁷

Despite the seemingly "automatic" language of § 506(a)(1), practically speaking, bifurcation of the claim is only "automatic" once the bankruptcy court has determined the claim's allowance in accordance with § 502. Even then the bifurcation process is not complete until the bankruptcy court can determine an appropriate value of the underlying collateral securing the lien. In this respect, § 506(a) implies that allowance of the secured claim pursuant to § 502 is a prerequisite to bifurcation, and bifurcation only occurs when the bankruptcy court values the collateral pursuant to § 506(a).

E. What Is a Secured Claim? Types of Secured Claims

Before § 506 comes into play, a creditor must hold a secured claim. In this regard, while a debtor is required to file a schedule with its bankruptcy petition identifying creditors holding secured claims, the debtor's schedule of secured claims is not dispositive.¹⁸ Rather, § 506 provides that a secured claim exists if the claim of the creditor is secured by a lien on property in which the estate has an interest, or that is subject to setoff under § 553 of the Code.¹⁹ The Code further defines the term "lien" to mean "charge against or interest in property to secure payment of a debt or performance of an obligation."²⁰ Thus, generally, a person holds a secured claim if, as of the filing of the bankruptcy petition, the claim is secured by any property of the debtor.

Two types of secured claims exist: (1) voluntary or consensual liens; and (2) involuntary or nonconsensual liens. Voluntary or consensual secured claims are created by agreement between the debtor and the creditor and are referred to specifically in the Bankruptcy Code as a defined "security interest."²¹ Involuntary secured claims are those types of secured claims that arise by operation of law and do not require the consent of the debtor, such as judicial or statutory liens. The Code defines a "judicial lien" as a "lien obtained by judgment, levy, sequestration, or other legal or equitable process or proceeding."²² The Code defines a "statutory lien" as a "lien arising solely by force of a statute on specified circumstances or conditions, or lien of distress for rent, whether or not statutory, but does not include security interest or judicial lien, whether or not such interest or lien is provided by or is dependent on a statute and whether or not such interest or lien is made fully effective by statute."²³

Common types of consensual liens...