Automatic Severance of After-Acquired Property Interests under 522

Automatic Severance of After-Acquired Property Interests under 522

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It is common in today's commercial financing environment to find grants of security interests in property that the debtor has yet to own (i.e., "after-acquired property"). After-acquired property interests are a valid means of attaching a security interest to future property of the debtor, irrespective of whether such property exists or even whether the debtor intends to acquire additional property. U.C.C. §9.204(a) (2005).

Due to the common grants of such security interests, some are confused by a debtor's offer of replacement liens in exchange for the use of cash collateral. Indeed, many a practitioner has heard the expression, "but I already have a replacement lien because of the after-acquired property clause." Such expressions evidence a lack of understanding of 11 U.S.C. §552(a), and its effect on after-acquired property interests.

While non-practitioners fail to understand §552(a)'s extent and effect, there is a similar lack of understanding by some bankruptcy practitioners as to the extent and effect of Revised Article 9's definition of "proceeds." "Proceeds," post-Revised Article 9, are now automatically included in a security interest on collateral, which alters the former analysis of §552(a)'s effect on "after-acquired property."1 Understanding §552(a) and Revised Article 9's automatic "proceeds" security interest, as well as the applicable exceptions, is key in addressing cash-collateral issues.

Section 552's After-Acquired Property Interest Severance

Section 552(a) cuts off liens on property acquired by the debtor after the commencement of a bankruptcy case, and reads:

"[P]roperty acquired by the estate or by the debtor after the commencement of the case is not subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case."

11 U.S.C. §552(a). The severance of security interests in after-acquired property is subject to express exceptions, which are discussed below and in next month's column. 11 U.S.C. §552(b). Irrespective of the stated exceptions, Congress enacted §552(a) and its automatic severance of after-acquired property interests in recognition of the separation between pre-petition and post-petition property and in furtherance of the fresh-start concept. See 5 King, Lawrence P., et al, Collier on Bankruptcy, §552.01[1] (15th ed. Rev. 2005). A debtor's fresh start often requires the use of property acquired post-petition free and clear of pre-bankruptcy liens.

By severing pre-petition liens on property acquired post-petition, §552(a) essentially takes a snapshot of the debtor's property as of the petition date and the security interests attached thereto. With certain exceptions set forth below, property existing prior to that snapshot remains unaffected, whereas property acquired after that snapshot is free and clear of any pre-petition security interest that would otherwise attach, even those that include a security interest in after-acquired property. 11 U.S.C. §552(a); T-H New Orleans Ltd. P'ship. v. Financial Security Assurance Inc. (In re T-H New Orleans Ltd. Pship.), 10 F.3d 1099, 1104 (5th Cir. 1993), cert. denied, 511 U.S. 1083, 114 S.Ct. 1833, 128 L.Ed.2d 461 (1994).

The severance of pre-petition security interests from after-acquired property is important in the first days of a bankruptcy case. During those first days, debtors routinely seek the use of cash collateral pursuant to the terms of 11 U.S.C. §363. It is, in part, §363's prohibitions that necessitate §552's after-acquired property severance. And it is often at the "first-day" hearing that the after-acquired security interest and §552 come together.

Cash Collateral Issues Related to After-Acquired Property

Pursuant to 11 U.S.C. §363, a debtor may not use, sell or lease property of the estate that is encumbered by a pre-petition security interest without obtaining either consent of the secured party or court authorization. 11 U.S.C. §363(c)(2). Consent or court authorization, however, is not necessary if the property to be used, sold or leased is unencumbered, (i.e., no pre-petition security interest covering the specific property). Id. Due to §552's automatic severance of pre-petition security interests on after-acquired property, often the only unencumbered property is after-acquired property.

After-acquired property, however, is usually acquired with property of the estate existing prior to the petition date. For example, a debtor acquires inventory after the petition date with, at least initially, cash acquired prior to the petition date.

The use of encumbered pre-petition property to acquire post-petition property that, pursuant to §552(a), is unencumbered necessitates the grant of a replacement lien. See, e.g., In re Cafeteria Operators LP, 299 B.R. 400, 410 (Bankr. N.D. Tex. 2003). The use of pre-petition collateral necessitates a replacement lien because allowing a debtor to use encumbered property to create unencumbered property harms the property interests of the secured party. See, e.g., Id; Arkison v. Frontier Asset Management LLC (In re Skagit Pacific Corp.), 316 B.R. 330, 336, fn. 5 (9th Cir. BAP 2004) (citing Williamette Production Credit Assn. v. Lovelady, 21 B.R. 182, 184-85 (Bankr. D. Ore. 1982)).

Thus, and assuming the lack of a sufficient equity cushion or other mitigating circumstances, the secured creditor is entitled to adequate protection, which often comes in the form of a replacement lien. The replacement lien results in the encumbrance of the after-acquired property, thereby putting the secured party in the same position as with the pre-petition property and preventing the diminution in value of the secured party's property interests. Thus, when a debtor that uses pre-petition cash, for which a valid security interest exists, to purchase inventory after the petition date, the secured party gets a lien, via the grant of a replacement lien in a cash collateral order, in that newly acquired inventory.2

On the other hand, if the debtor seeks to use after-acquired property, (i.e., property unencumbered by pre-petition security interests pursuant to §552(a)), the debtor need not grant replacement liens or any other form of adequate protection, as there is no property interest to protect. See, e.g., Cafeteria Operators, 299 B.R. at 403. Because after-acquired property is not subject to §363's consent or court-authorization requirements, the determination of whether property constitutes after-acquired property is critical. Unfortunately, identifying what property constitutes after-acquired property is not as simple as it first appears.

After-Acquired or Not After-Acquired: That Is the Question

After-acquired property is not necessarily all property that comes into the debtor's possession post-petition. For example, a debtor's refund right under a retainer agreement is a general intangible that arose pre-petition and, therefore, remains subject to any pre-petition security interest encompassing general intangibles. See In re Serve Convenience Stores Inc., 299 B.R. 126, 132-33 (Bankr. M.D.N.C. 2003). On the other hand, a chapter 12 debtor's interest in federal disaster relief funds is after-acquired property, despite any pre-petition lien on crops, if the federal program providing the disaster relief funds does not exist on the petition date. In re Stallings, 290 B.R. 777, 782-84 (Bankr. D. Idaho 2003); Burgess v. Sikes (In re Burgess), No. 04-30189, 2006 WL 205043, *8-10 (5th Cir. Jan. 27, 2006).

In addition, §552(b) provides two exceptions to the severance of the pre-petition lien. First are proceeds, products, offspring or profits of encumbered pre-petition property, except to the extent based on the equities of the case the courts orders otherwise. 11 U.S.C. §552(b)(1). Second is the extent such after-acquired property constitutes rents of such property or the fees, charges, accounts or other payments for the use or occupancy of rooms and other public facilities in hotels, motels or other lodging properties, except to the extent based on the equities of the case the courts orders otherwise. 11 U.S.C. §552(b)(2).

In contrast to §552(a)'s automatic severance of after-acquired property interests, §552(b) "balances the Code's interest in freeing the debtor of pre-petition obligations with a secured creditor's right to maintain a bargained-for interest in certain items of collateral. It provides a narrow exception to the general rule of §552(a)." In re Bering Trader Inc., 944 F.2d 500, 502 (9th Cir. 1991). Section 552(b) balances those interests by excluding proceeds of encumbered property, albeit after-acquired, from §552(a)'s provisions.

For example, where a secured party has a pre-petition lien on inventory, the cash proceeds from the sale of the inventory are not affected by §552(a). This "proceeds" exception has become increasingly relevant due to Revised Article 9.

Revised Article 9 changed the definition and application of "proceeds." "Proceeds" means the following property: (a) whatever is acquired upon the sale, lease, license, exchange or other disposition of collateral; (b) whatever is collected on, or distributed on account of, collateral; (c) rights arising out of collateral; (d) to the extent of the value of collateral, claims arising out of the loss, nonconformity or interference with the use of, defects or infringement of rights in, or damage to, the collateral or (d) to the extent of the value of collateral and to the extent payable to the debtor or the secured party, insurance payable by reason of the loss or nonconformity of, defects or infringement of rights in, or damage to, the collateral. UCC §9.102(64) (2005). In addition to an expanded definition, a security interest in properly attaches to any identifiable proceeds of collateral. UCC §9.315 (a)(2) (2005).

Thus, due to the amendments to Article 9 of the UCC, "proceeds" now automatically extends to after-acquired property that is derived from the original collateral, even if there is no disposition of the original collateral.3 In addition, a security interest in property extends to proceeds even in the absence of any language in the security agreement. Id.

Therefore, irrespective of §552(a)'s language, a pre-petition security interest in property creates a valid and continuing lien on the proceeds of such property, such as cash from the sale of inventory. As such, what would otherwise constitute after-acquired property remains subject to the pre-petition security interest, thereby requiring consent or court authorization to use. T-H New Orleans, 10 F.3d at 1104.

However, and as will be further discussed in next month's column, §552(b) does not exempt proceeds from post-petition accounts receivables, nor proceeds from proceeds that accrue post-petition. See, e.g., Skagit Pacific, 316 B.R. at 336 (citing In re HRC Joint Venture, 175 B.R. 948, 953 (Bankr. S.D. Ohio 1994); In re Texas Tri-Collar Inc., 29 B.R. 724, 726-27 (Bankr. W.D. La. 1983); In re Cross Baking Co., 818 F.2d 1027, 1032 (1st Cir. 1987)). For example, in Skagit Pacific, where a debtor collected pre-petition balances on outstanding pre-petition accounts and used such proceeds in operations to create new accounts receivables, the court held that the proceeds from the pre-petition accounts receivables remained collateral, but when converted into proceeds from post-petition accounts receivables, the pre-petition security interest was severed. Skagit Pacific, 316 B.R. at 336; see, also, Cafeteria Operators, 299 B.R. at 410.

Skagit and Cafeteria Operators, which will be discussed next time, are good examples of what will likely be a long line of cases analyzing and determining the post-petition effect and extent of Revised Article 9's "proceeds" definition and automatic attachment. As a new wave of bankruptcies approaches and new cash collateral fights are brought, the issues addressed in Skagit and Cafeteria Operators will undoubtedly be prevalent.

Conclusion

Section 552(a)'s after-acquired security interest severance and the amendments to Article 9 of the UCC are inter-connected such that practitioners must understand their provisions and exceptions both alone and together. Looking at §552(a) in a vacuum creates a false simplicity, usually leading to an incorrect analysis. However, the assumption that Revised Article 9's definition of proceeds and automatic attachment of the lien extends a pre-petition security interest indefinitely is also faulty. Courts have and will create exceptions, just as Congress created §552(b)'s exception for proceeds. To complicate matters, Congress created a dangerous and stealthy exception, hidden in the last phrase of subsection (b). As will be discussed in next month's practice and procedure column, the above review is just the beginning.


Footnotes

1 See Warner, G. Ray, "Perfection in Proceeds under Revised Article 9," 20, 1 Am. Bankr. Inst. J. 16 (Feb. 2001); Warner, G. Ray, "Proceeds in Bankruptcy Under Revised Article 9," 20, 2 Am. Bankr. Inst. J. 22 (March 2001).

2 11 U.S.C. §361 contemplates the grant of adequate protection such as a replacement lien only to the extent that the debtor's use of the cash collateral deceases the value of the secured party's property interests, a concept that is beyond the scope of this article.

3 See U.C.C. §§9.102(64), 9.203(f), 9.315 (2005); see, also, Warner, G. Ray, "Proceeds in Bankruptcy under Revised Article 9," 20, 1 Am. Bankr. Inst. J. 22 (March 2001).

Journal Date: 
Saturday, April 1, 2006