Chapter 3 Preserving and Protecting Collateral and Its Proceeds

• Jurisdiction: United States

Chapter 3: Preserving and Protecting Collateral and Its Proceeds

Annette W. Jarvis

A. Collateral Rights as Property Interests Protected Under the Constitution²⁰⁶

The interests of a secured creditor in the collateral securing its loans have long been regarded by the Supreme Court as property rights protected by the Due Process Clause of the Fifth Amendment. In 1934, Congress passed the Frazier-Lemke Bankruptcy Act, which restricted banks from foreclosing on a bankrupt farmer's property for five years. In Louisville Joint Stock Land Bank v. Radford,²⁰⁷ the court held that the Act violated the constitution by taking creditors' property rights without just compensation. Stating that secured creditors have "rights in specific property" and "substantive right[s]" in the "specific property held as security," the court held that "[t]he bankruptcy power, like the other great substantive powers of Congress, is subject to the Fifth Amendment. Under the bankruptcy power Congress may discharge the debtor's personal obligation.... But the effect of the act here complained of ... is the taking of substantive rights in specific property acquired by the bank."²⁰⁸

The Supreme Court reaffirmed that the Constitution protects secured claims and liens as property in United States v. Sec. Indus. Bank.²⁰⁹ In this case, the parties disagreed on whether then-new 11 U.S.C. § 522(f)(2) allowed debtors to avoid liens created before the enactment of the Bankruptcy Reform Act of 1978. The court held it did not, emphasizing the "property right" of creditors in their collateral and stating that avoiding pre-Code liens "would result in a complete destruction of the property right[s] of the secured part[ies].... The 'bundle of rights' which accrues to a secured party is obviously smaller than that which accrues to an owner in fee simple," but this does not "support[] the proposition that differences such as these relegate the secured party's interest to something less than property."²¹⁰

These property rights are not inviolate, however. Thus, while the property rights of a lender in collateral securing its loan cannot be taken without due process, including without just compensation, those property rights — or more pointedly, the contractual rights governing those property rights — can still be subject to adjustment by state and federal law. Federal bankruptcy law is replete with provisions that alter a secured creditor's rights to enforce its security interest in collateral. Upon a finding by the bankruptcy court that certain statutory requirements are met, provisions in the Bankruptcy Code can affect the remedies available to the creditor, the timing of the right to collect from collateral, the priority of the security interest in collateral, collateral retention or substitution, and, if the avoidance powers come into play, even the enforceability of the security interest in the collateral.²¹¹

Adjustments to the rights of a secured creditor in its collateral have likewise been allowed pursuant to a state's police and regulatory powers. In the case of Home Building & Loan Ass'n v. Blaisdell, et al.,²¹² the Supreme Court upheld the Minnesota Mortgage Moratorium Law, which allowed a property owner to obtain an extension of the owner's redemption rights under existing state foreclosure law. The Court explained that "the protective power of the state ... may be exercised ... in directly preventing the immediate and literal enforcement of contractual obligations by a temporary and conditional restraint where vital public interest would otherwise suffer...."²¹³ The court stated: "Without impairing the obligation of the contract, the remedy may certainly be modified as the wisdom of the nation shall direct."²¹⁴

B. Pre-Petition Collateral Review: Contemplating a Potential Bankruptcy Filing

1. Initial Review

A good loan agreement will contain well-crafted financial covenants such that a default will occur before the borrower is in desperate financial straits. If the loan agreement is "covenant light," a default may not occur until late in the cycle of the borrower's financial distress, allowing less time to potentially restructure or prepare for further financial difficulties. The timing of a default or potential default under a credit agreement and the borrower's general financial condition will drive the possibilities for a restructure and any decisions to pursue collection remedies.

When a borrower defaults on a loan or maturity of the debt is looming without any prospect for timely repayment, preserving and protecting collateral and the proceeds and products of such collateral become paramount in protecting the secured lender against loss.

In representing a lender of a distressed or defaulting borrower, it is important to review the loan documentation and to perform a collateral review. As part of the collateral review, several questions should be asked and investigated. The primary issues typically include:

• Has a security interest in the collateral been properly granted to the lender?
• Are both the proceeds and the products (where appropriate) of collateral also subject to the security interest?
• Is after-acquired property included in the security interest?
• Have the security interests in collateral been properly perfected?
• What is the timing of the transfer of the security interest and its perfection?
• Are there tax or other statutory liens that have taken priority over the lender's lien?
• Have any unique requirements on the perfection of collateral been fulfilled?
• If the loan is a real estate loan, do the documentation and filings cover real property, fixtures, rents and any personal property that the lender may be relying on as security for the loan or that may be essential for the continued operation of an ongoing business on the property?

Generally, the law of the state made applicable under the loan documents applies in answering many of these issues. The perfection and priority of security interests in personal property pledged to secure a loan, however, will be governed in accordance with the state law specified in the applicable state's version of UCC §§ 9-301-9-306.²¹⁵ A security interest in real estate and fixtures will be governed by the law where the property is located. Depending on the borrower and type of collateral or liens at issue, federal laws may also have some application.

2. Timing Issues

If there are collateral problems to correct or if new collateral is taken, then collection efforts likely should be delayed to mitigate potential avoidance liability under state and federal law. Timing considerations such as these should be factored into pre-petition negotiations with a borrower.

3. Potential Preference Concerns

If a lien is perfected or property is transferred within 90 days of the debtor's bankruptcy filing (or within one year if the creditor is classified as an "insider"), the perfection or transfer may be considered an avoidable preferential transfer under § 547. Section 550 specifies the transferees (initial, immediate or mediate) against whom a preference can be recovered. A lender taking or perfecting a lien to secure an antecedent debt would ordinarily qualify as an initial transferee. Pursuant to § 551, a lien that is avoided under § 547, to the extent it is property of the estate, is automatically preserved for the benefit of the bankruptcy estate.

In Lange v. Inova Capital Funding LLC,²¹⁶ a financing statement filed to perfect a security interest 18 months after the execution of the invoice purchase agreement and approximately one month prior to the filing of bankruptcy by the debtor was found to be avoidable as a preferential transfer under § 547. In In re Lee,²¹⁷ the court held that the lender's late perfection of a refinanced mortgage shortly before a debtor's bankruptcy filing was a preferential transfer subject to avoidance.²¹⁸

Normally, from a secured creditor's point of view, it is a good idea to take additional collateral to secure a defaulted loan, if available, and, in exchange for the additional collateral, to work with the borrower to explore options for an out-of-court workout of the debt. Giving the borrower additional time will serve the dual purposes of exploring optimal strategies for maximum recovery on the outstanding debt and allowing time for the preference period to run. It is always important to correct any perfection problems with existing collateral and to take the preference period into account in deciding on a course of action on a defaulted loan. While the running of the preference period is an important factor to consider in this situation, it is not necessarily determinative, depending on the risk that delay may bring with the preservation of existing, and perhaps more valuable, collateral.

4. Potential Fraudulent Transfer or Fraudulent Conveyance Concerns

In addition to concerns about preference claims, a lender's actions to correct collateral issues may be avoidable as fraudulent transfers under § 548 or under state law made applicable in bankruptcy pursuant to § 544. A "transfer" occurs under either § 548 or state fraudulent transfer law when a lender takes a security interest in new collateral or a security interest is perfected in existing collateral. Generally, under § 548, this transfer will be considered "fraudulent" when not made in exchange for reasonably equivalent value and while the debtor (1) is insolvent, (2) is left with unreasonably small capital to operate its business, or (3) intends or believes it will incur debts beyond its ability to pay.²¹⁹ Avoidance claims under state fraudulent-transfer laws, made applicable in bankruptcy by § 544, differ from state to state, but are similar in substance to § 548 claims. The reach-back period for transfers constituting fraudulent transfers under § 548 is within two years before the filing of the bankruptcy petition. The reach-back period for state fraudulent-transfer claims, made applicable in a bankruptcy case...