Chapter 4 Adequate Protection

• Jurisdiction: United States

Chapter 4: Adequate Protection

Stephen D. Piraino and Damian S. Schaible

One of the most important protections provided to secured creditors under the Bankruptcy Code is the right to adequate protection, which is "a payment, replacement lien, or other relief sufficient to protect the creditor against diminution in the value of [its] collateral during the bankruptcy."³¹⁰ It ensures that creditors get "the benefit of their bargain"³¹¹ — i.e., "that the value of [their] security interest is protected."³¹² Adequate protection has its foundation in the Fifth Amendment of the Constitution, which protects property interests.³¹³ For the debtor,³¹⁴ adequate protection is a tradeoff: If the debtor wants the protections of the Bankruptcy Code and the ability to retain or use encumbered property, including to use such encumbered property as security for post-petition financing, then the debtor must ensure that the secured creditor's position is protected from the decline in the value of its collateral during the bankruptcy case.³¹⁵

This chapter will discuss the three contexts in which adequate protection arises in the Bankruptcy Code, what constitutes adequate protection and how a creditor can make a request for adequate protection. It will also discuss what happens when adequate protection fails.

A. The Context in Which Adequate Protection Arises

1. Section 362: Cause to Lift the Automatic Stay

Once a debtor files its bankruptcy petition, the automatic stay under § 362 prevents creditors from taking action against the debtor. For a secured creditor, the immediate effect of the automatic stay is that it cannot foreclose on its collateral. However, a secured creditor can obtain relief from the stay to foreclose "for cause."³¹⁶

While the Bankruptcy Code does not define cause, it provides that "lack of adequate protection of an interest in property" is cause to lift the stay.³¹⁷ Importantly, a creditor does not lack adequate protection under § 362(d)(1) simply because it "does not [have the] ... right to immediate foreclosure."³¹⁸ Rather, a "secured creditor lacks adequate protection if the value of its collateral is declining as a result of the stay."³¹⁹ So, a creditor is not entitled to relief from the automatic stay for lack of adequate protection simply by showing that the debtor lacks equity in the collateral.³²⁰ Instead, a creditor must also show that the value of its collateral is declining.³²¹

2. Section 363: Use of Collateral

In a bankruptcy case, particularly one under chapter 11, a debtor will usually need to use its creditors' collateral to operate in the ordinary course of business. The Bankruptcy Code recognizes this reality and permits a debtor to use, sell or lease property of the estate in the ordinary course of business without bankruptcy court approval,³²² and if the debtor obtains court approval, then the debtor can use, sell or lease property of the estate outside of the ordinary course of business.³²³ However, a court will prohibit or condition a debtor from using, selling or leasing property to the extent necessary to adequately protect the secured creditor with an interest in the property proposed to be used, sold or leased.³²⁴ Courts determine the appropriateness and extent of adequate protection based on whether the secured creditor is protected from a decline in value as a result of the debtor's use, sale or lease of the collateral.³²⁵

One of the most common types of collateral that debtors seek authority to use is cash collateral, an expansive term that includes cash, securities, cash equivalents, proceeds and rents.³²⁶ For example, if a bank makes a loan to a debtor company that makes and sells shirts, and the bank has a security interest in the shirts and the proceeds thereof, then the proceeds collected by the debtor from the sale of the shirts would be cash collateral. In order for the debtor to use cash collateral — the cash proceeds in this example — it must either have the consent of the secured creditor or court approval, as required by § 363(c)(2) of the Bankruptcy Code.³²⁷

3. Section 364: Superpriority Post-Petition Financing

Debtors often require post-petition financing to continue their operations in the ordinary course and to support their chapter 11 efforts. The Bankruptcy Code recognizes the difficulty that a debtor could have in obtaining post-petition financing, so it provides a debtor with incentives that it can offer to lenders in exchange for such financing. If a lender provides unsecured credit to the debtor, the lender is entitled to an administrative expense claim.³²⁸ However, it is often the case that a lender will be unwilling to provide unsecured financing and will request additional protections before it will agree to provide secured financing. The Bankruptcy Code allows a debtor to offer lenders a superpriority administrative expense claim, a lien on unencumbered property and/or a junior lien on encumbered property.³²⁹ When those protections are still not enough to entice creditors to lend to a debtor, § 364(d) provides that, subject to court approval, the debtor can "obtain[ ] ... credit or ... incur[ ] ... debt secured by a senior or equal lien on property of the estate that is subject to a lien."³³⁰ However, the secured creditor whose lien will be subordinated by the so-called "priming lien" has the right to adequate protection of its interest in the collateral.³³¹ A creditor whose lien is primed by the financing and is entitled to adequate protection is adequately protected if the debtor's proposed protections "provide the pre-petition secured creditor with the same level of protection it would have had if there had not been postpetition superpriority financing."³³²

B. Entitlement to Adequate Protection

Whether a creditor is entitled to adequate protection almost always turns on the value of its collateral. As an initial matter, the value of the collateral determines whether a secured creditor is oversecured or under-secured, and that distinction can affect a creditor's entitlement to adequate protection. As will be discussed, if the value of the collateral is significantly more than the underlying debt, a court could find that that alone adequately protects a secured creditor.

1. The Interest to Be Protected

a. Oversecured Creditors

An oversecured creditor is one whose collateral is worth more than the amount owed to it by the debtor. The value of the collateral above the amount of the secured creditor's claim is known as an equity cushion. Depending on the size of the equity cushion, that alone may be sufficient to adequately protect a secured creditor's interest. Indeed, one court commented that "a substantially oversecured creditor is not entitled to adequate protection payments."³³³ However, to the extent an equity cushion is found to be insufficient protection, an oversecured creditor is entitled to adequate protection to protect against the decline in the value of its collateral.³³⁴

Unlike an undersecured creditor, an oversecured creditor is entitled under § 506(b) of the Bankruptcy Code to interest — as allowed by contract or statute — to the extent of the value of its collateral.³³⁵ However, an over-secured creditor's right to post-petition interest is not an "interest in property" for which it is entitled to adequate protection.³³⁶ Thus, the adequate protection provided to a secured creditor is intended only to compensate it for the decline in value of its collateral, not for its diminishing equity cushion as interest accrues.

In addition, when an oversecured creditor has multiple components of its collateral package, it is not necessarily entitled to adequate protection for each item of collateral in the package. For example, one court concluded that when "the value of the secured property exceed[ed] the creditor's claim by a reasonable margin and [was] unlikely to decrease in value, then the claim [was] adequately protected, regardless of the number or types of security the creditor h[eld]."³³⁷ That court reasoned that the creditor was adequately protected because it was oversecured by at least one piece of collateral.³³⁸

b. Undersecured Creditors

Undersecured creditors are creditors whose collateral is worth less than the underlying debt. Like oversecured creditors, undersecured creditors are entitled to adequate protection to the extent the value of their collateral is declining.³³⁹ However, an undersecured creditor is not automatically entitled to adequate protection because it is undersecured.³⁴⁰ If an undersecured creditor's collateral is not declining in value, it is not entitled to adequate protection.³⁴¹ Similar to oversecured creditors, even when an undersecured creditor is entitled to adequate protection, such as when its lien would be primed by post-petition financing, it is only entitled to adequate protection of the value of its interest in the collateral, not the value of its lien.³⁴²

In United Savings Association of Texas v. Timbers of Inwood Forest Associates Ltd.,³⁴³ the Supreme Court discussed the limits on an undersecured creditor's entitlement to adequate protection. In that case, the issue before the Court was whether undersecured creditors were entitled to adequate protection "for the delay caused by the automatic stay in foreclosing on their collateral."³⁴⁴ The court concluded that an undersecured creditor does not have a property interest to be reimbursed as a result of the delay in foreclosing on its collateral caused by the automatic stay, and is not entitled to adequate protection "for the use of the proceeds [it] is deprived of during the term of the stay."³⁴⁵

While Timbers put limits on undersecured creditors' rights to adequate protection, courts do recognize the precarious position of an undersecured creditor, especially a junior undersecured creditor. At least one court has read Timbers to allow a junior undersecured creditor to receive adequate protection payments to the extent a senior secured creditor's claim...