Chapter 5 Sale, Use or Lease of Collateral

• Jurisdiction: United States

Chapter 5: Sale, Use or Lease of Collateral

Hon. Mark X. Mullin, David L. Staab and Jarom J.Yates

To facilitate a successful reorganization, a debtor must have the ability to fund its operations. In most situations, a debtor will have insufficient unencumbered collateral to pay expenses as they arise. Section 363 of the Bankruptcy Code addresses this obstacle by empowering the debtor to sell, use or lease property of the bankruptcy estate.⁴⁵⁸ Section 363 affords the debtor various levels of discretion depending on the type of collateral and whether or not the debtor's actions are in the ordinary course of business.⁴⁵⁹

A. Use of Collateral

As to the type of collateral, § 363 differentiates between cash collateral and all other types of collateral, with greater restrictions being placed upon cash collateral.⁴⁶⁰ The Bankruptcy Code also generally provides greater protection to lienholders when a debtor contemplates actions outside the ordinary course of business.⁴⁶¹ Regardless of the type of collateral or whether the action is in the ordinary course of business, a creditor may request that the debtor provide adequate protection for the value of the creditor's secured interest.⁴⁶² Some creditors may seek adequate protection through the use of priming liens, which bankruptcy courts are generally reluctant to approve.⁴⁶³

1. Use of Collateral Generally

A debtor may use collateral in the ordinary course of business without court approval.⁴⁶⁴ For transactions outside the ordinary course of business, a debtor may use collateral only after notice and a hearing.⁴⁶⁵ The ordi-nary-course-of-business distinction is discussed in more detail below.⁴⁶⁶ These general rules do not apply to the use of cash collateral.⁴⁶⁷

2. Use of Cash Collateral

Cash collateral is broadly defined and includes, among other things, cash, cash equivalents, negotiable instruments, documents of title, securities, deposit accounts and proceeds from prepetition encumbered assets.⁴⁶⁸ Unlike other types of encumbered property, cash collateral may not be used by the debtor unless (1) each entity that has an interest in the cash collateral consents, or (2) the court, after notice and a hearing, grants authorization upon a showing that the lienholder's interest is adequately protected.⁴⁶⁹ Court approval, therefore, is required regardless of whether the proposed use of cash collateral is within the ordinary course of business.⁴⁷⁰

In practice, the debtor's preferred matter of course is to reach an agreed-upon cash-collateral order with the pre-petition secured credi-tor.⁴⁷¹ As part of the agreement, secured creditors often seek replacement liens, periodic payments or other forms of adequate protection.⁴⁷² In circumstances where the parties fail to reach an agreement, § 363 contains several provisions that provide additional protections to pre-petition secured creditors.⁴⁷³ For instance, the debtor must segregate and account for cash collateral, unless the requirement is waived by the applicable secured creditor or the court.⁴⁷⁴ Additionally, a secured creditor can request adequate protection of its interest⁴⁷⁵ and seek relief from the automatic stay.⁴⁷⁶

3. Adequate Protection

Under § 363(e), a pre-petition secured creditor may request adequate protection at any time.⁴⁷⁷ In a hearing related to the use of collateral, the debtor has the burden of proof on the issue of adequate protection, and the creditor has the burden of proof on the issue of the validity, priority or extent of its asserted interest.⁴⁷⁸ Adequate protection is not defined in the Bankruptcy Code, but § 361 provides examples of adequate protection.⁴⁷⁹

4. Priming Liens

In most chapter 11 cases, the debtor is unable to operate its business through the use of cash collateral alone. The Bankruptcy Code recognizes this reality, and § 364 empowers the debtor to enter into post-petition financing arrangements.⁴⁸⁰ One particular type of financing that could potentially jeopardize pre-petition lienholders' collateral is the "priming lien" contemplated by § 364(d).⁴⁸¹ A priming lien is only available as a last resort to the debtor, and approval requires notice and a hearing.⁴⁸² In the hearing, the debtor must show that financing is otherwise unavailable⁴⁸³ and that the interests of the existing lienholders are adequately protected.⁴⁸⁴

The intent behind the adequate protection requirement under § 364(d) is to protect an existing lienholder from any decrease in the value of its security interest as a consequence of the priming lien.⁴⁸⁵ In determining whether adequate protection exists, most courts primarily focus on the existence of a sufficient equity cushion.⁴⁸⁶ If the equity cushion is large enough to protect the pre-petition lienholder's interest (and the other requirements of § 364 are satisfied), then courts may allow the debtor to grant a priming lien;⁴⁸⁷ otherwise, the court may deny the priming lien because the lien-holder is not adequately protected.⁴⁸⁸ In general, courts are reluctant to grant priming liens under § 364(d).⁴⁸⁹

B. Sales of Collateral

A debtor-in-possession will often look to sell assets in bankruptcy to raise cash, dispose of nonessential assets, or in many cases sell substantially all of the debtor's assets. In most bankruptcy cases, many, if not all, of the debtor's assets are encumbered by liens and other interests. The Bankruptcy Code permits a debtor to sell assets free and clear of liens provided certain requirements are met.

1. Ordinary Course of Business

When a company files for protection under chapter 11, the company becomes a debtor-in-possession. The debtor-in-possession, or debtor, is permitted to continue operating the debtor's business.⁴⁹⁰ Thus, a grocery store chain, for example, is permitted to continue operating its grocery store business after filing for bankruptcy protection. This includes continuing to sell inventory in the ordinary course of the debtor's business.⁴⁹¹ The debtor is not required to receive special court permission authorizing the debtor to transact business in the ordinary course, including sales of inventory.⁴⁹² If, however, such inventory constitutes a secured creditor's collateral, the proceeds of such inventory sales may constitute cash collateral, and the debtor may not "use, sell, or lease" such cash collateral without either (1) the consent of each secured creditor with an interest in the cash collateral or (2) court authorization in accordance with § 363. While a debtor is permitted to use, lease or sell assets in the ordinary course of its business, a debtor may not sell, use or lease property of the estate, including assets encumbered by liens or other interests, outside of the ordinary course of business without court approval.

The Bankruptcy Code does not define what constitutes the ordinary course of business. In interpreting § 363, courts typically apply a two-step analysis to determine whether a particular transaction is a transaction "in the ordinary course of business." The two steps of the analysis are (a) the horizontal dimension test and (b) the vertical dimension test, or "creditor expectation" test.⁴⁹³ "The purpose of both tests is to determine whether a transaction is so out of the ordinary course as to entitle creditors to notice and a hearing beforehand."⁴⁹⁴ The debtor has the burden of showing that a transaction constitutes a transaction in the ordinary course of the debtor's business.⁴⁹⁵ Whether a transaction is a transaction outside the ordinary course of business is of great importance because a transaction outside the ordinary course of business that is not approved by the bankruptcy court is voidable.⁴⁹⁶

a. The Horizontal Test

The focus of the horizontal test is "whether, from an industry-wide perspective, the transaction is of the sort commonly undertaken by companies in that industry."⁴⁹⁷ Thus, under the horizontal test, "the test is whether the post-petition transaction is of a type that other similar businesses would engage in as ordinary business."⁴⁹⁸ The "analysis is aimed at determining whether the challenged transaction is abnormal or unusual for the industry."⁴⁹⁹

Thus, for example, a grocery store would not need court approval to continue selling its inventory and ordering and purchasing replacement inventory because that is what all grocery stores do in the ordinary course of business. A grocery store in bankruptcy, however, would likely need court approval to sell fixtures, shelving or other assets that did not constitute its normal inventory. Similarly, a widget manufacturer would be permitted to continue selling its widgets, but the widget manufacturer would likely need court approval to sell one of its facilities or a piece of machinery used to manufacture widgets.

b. The Vertical Test

While the horizontal test focuses on a particular transaction from an industry-wide perspective, the vertical test "analyzes the transactions 'from the vantage point of a hypothetical creditor[,] and [the inquiry is] whether the transaction subjects a creditor to economic risk of a nature different from those he accepted when he decided to extend credit.'"⁵⁰⁰ "The vertical test 'reviews the transaction from the perspective of creditors, asking whether the transaction is one that creditors would reasonably expect the debtor or trustee to enter into.'"⁵⁰¹ As noted by one court, the vertical test essentially compares the proposed transaction with the "debtor's pre-peti-tion business practices and conduct."⁵⁰²

2. Sales Outside the Ordinary Course

If a sale constitutes a transaction outside the ordinary course of the debtor's business, the sale may only be permitted with court approval "after notice and a hearing."⁵⁰³

a. Business Judgment Test

Courts typically apply the business judgment test to determine whether the sale, lease or use of property of the estate outside the ordinary course of business is permissible.⁵⁰⁴ The business judgment test requires that the sale "must be supported by an articulated business...