Last month's Practice & Procedure column discussed the application of 11 U.S.C. §552(a)'s automatic severance of after-acquired property interests, as well as §552(b)'s proceeds exception thereto. The proceeds exception, as detailed last month, increased in potency due to Revised UCC Article 9. Revised Article 9, after all, creates an automatically attaching and perfecting security interest in proceeds of encumbered collateral. See UCC §§9.102(64), 9.203(f), and 9.315(a)(2) (2005). Thus, a perfected security interest in pre-petition property, without more, results in the proceeds thereof surviving §552(a)'s automatic severance and remaining cash collateral subject to 11 U.S.C. §363's restrictions.

While secured creditors embrace §552 (b)'s proceeds exception, many are unaware of §552(b)'s hidden danger: the "equity" exception. In addition, depending on one's interpretation, a debtor might effectuate a surcharge without the prerequisites and standards for an 11 U.S.C. §506 surcharge. 5 King, Lawrence P., et. al., Collier on Bankruptcy, §552.02[4][c] (15th ed. Rev. 2005). Furthermore, §552(b)'s equity exception has the potential to work, for all practical purposes, a partial avoidance of an oversecured creditor's property interests, thereby diminishing an otherwise healthy equity cushion. Though often ignored, this provision can alter the course of a bankruptcy case in more ways than one.

Section 552, the Proceeds Exception and the Equity Exception

Pursuant to §552(a), "property 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). Section 552(b), however, provides an exception to §552(a) for proceeds, products, offspring or profits of encumbered pre-petition property, except to any extent that the court, after notice and hearing and based on the equities of the case, orders otherwise. 11 U.S.C. §552(b)(1). Further excepted are rents 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 any extent that the court, after notice and hearing and based on the equities of the case, orders otherwise. 11 U.S.C. §552(b)(2).

Despite the broad proceeds exception(s), §552(b) does not provide an all-encompassing security interest preservation. Instead, one must first consider whether the property arising post-petition truly constitutes proceeds of encumbered pre-petition property, as well as whether §552(b)'s equity exception applies.

When Proceeds Are Not "Proceeds"

Proceeds of encumbered pre-petition property do not necessarily include the entire amount received from the disposition thereof. Instead, the disposition of encumbered pre-petition property may yield both proceeds and additional property that does not constitute proceeds for §522(b) purposes. See, e.g., In re Cafeteria Operators LP, 299 B.R. 400 (Bankr. N.D. Texas 2003).

In Cafeteria Operators, for example, the court held that revenue generated by the debtor's labor, in preparing food for human consumption, was not necessarily subject to a pre-petition security interest in the raw food inventory. Cafeteria Operators, 299 B.R. at 408-09. The court reasoned that "restaurant customers are paying some premium to have the food prepared prior to consumption and served to them." Id. at 409.

Therefore, only that portion of the revenues attributable to the raw food inventory constituted proceeds and the secured creditor's cash collateral. Id. The court did not, however, find that all revenue received from food sales was unencumbered, only that portion that was attributable to food preparation (i.e., the debtor's labor). Id. The court in Cafeteria Operators further found, though noting that such additional findings were not necessary, that even if all of the debtor's revenue from the sale of prepared food, which would include revenue generated from human labor, constituted proceeds, the equities of the case would require the court to limit the extent of the pre-petition security interest's post-petition continuation so as to prevent the secured creditor from receiving a windfall via the debtor's labor. Id. at 409-10. Such a windfall would occur when the proceeds were of significantly higher value than the raw food inventory, for which the increase in value was directly attributable to the debtor's labor. Id.

Though many cite Cafeteria Operators for support in applying the equities exception, Cafeteria Operators first and foremost defines, irrespective of the equities, proceeds under §552(b). Other courts have defined proceeds to exclude proceeds from post-petition accounts receivables and proceeds from proceeds that accrue post-petition. See, e.g, In re Skagit Pacific Corp., 316 B.R. 330, 336 (9th Cir. BAP 2004) (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)).

Indeed, in Skagit Pacific, a debtor collected pre-petition balances on outstanding pre-petition accounts and used such proceeds in operations to create new accounts receivables. In subsequently analyzing the extent of the pre-petition security interests' continuation, the court held that proceeds from the pre-petition accounts receivables remained collateral, but when converted into proceeds from post-petition accounts receivables, without the benefit of a 11 U.S.C. §361 replacement lien, §552(a) acted to sever the pre-petition security interest. Skagit Pacific, 316 B.R. at 336. Clearly, Skagit Pacific demonstrates the necessity and importance of replacement liens, irrespective of Revised Article 9.

Nonetheless, even where proceeds from the disposition of collateral are undoubtedly proceeds, such property interests are not necessarily beyond attack. Indeed, another avenue of attack lurks in plain sight: an exception to the proceeds exception based on the "equities" of the case. See 11 U.S.C. §552(b).

The Equity Exception

Just as every rule has its exception, both subsections of §552(b) include their own exception, as both end with the same phrase: "except to any extent that the court, after notice and hearing and based on the equities of the case, orders otherwise." 11 U.S.C. §552(b)(1) and (b)(2). As stated, the last phrase of each subsection provides an express exception to the proceeds exception of §552(a)'s automatic severance of after-acquired property interests. The language of this express exception authorizes a court to order that property, which would otherwise constitute proceeds under §552(b) and therefore remain subject to an encumbered pre-petition security interest, is not subject to the pre-petition security interest.

Section 552(b)'s equity exception is typically applied in reorganizations, as opposed to liquidations, to prevent oversecured creditors from receiving a windfall by realizing upon property that arose or increased in value post-petition, the value of which would otherwise further the debtor's reorganization. Stanziale v. Finova Capital Corp. (In re Tower Air Inc.), 397 F.3d 191, 205 (3d Cir. 2005). The debtor's reorganization should benefit from the debtor's efforts and/or use of other assets of the estate that result in the appreciation of collateral, as allowing the secured creditor to receive the benefit of such efforts and/or from the use of unencumbered assets would result in a windfall to which the secured creditor is not entitled. Id. (citing In re Bennett Funding Group Inc., 255 B.R. 616, 634 (N.D.N.Y. 2000)).

Though a seemingly harsh result, a quick study of unencumbered vs. encumbered assets, and the beneficiaries of each, clarifies matters. Specifically, and generally speaking, unencumbered assets of the bankruptcy estate benefit unsecured creditors, whereas secured creditors have their encumbered assets for satisfaction of their claims. Where a secured creditor is undersecured, the undersecured portion is lumped with all other unsecured creditors who must seek satisfaction of their claims from unencumbered assets of the estate.

Thus, if proceeds from the disposition of encumbered property increased in value from the use of unencumbered assets, then the secured creditor has benefited to the detriment of unsecured creditors from property that should benefit unsecured creditors. On the other hand, where no unencumbered assets, or efforts from the debtor, were used to enhance the value of collateral, the value of which increased despite the debtor's use of the creditor's cash collateral, no such windfall exists and the "equities" would not support an erosion of collateral. See, e.g., In re Muma Services Inc., 322 B.R. 541, 559 (Bankr. D. Del. 2005); In re The Bennett Funding Group Inc., 255 B.R. 616, 634 (N.D.N.Y. 2000).

Similarly, where a debtor's conduct damaged a secured creditor's collateral and expended funds recovered from insurance to repair that collateral, such expenditures do not equate to a windfall. In re Tower Air Inc., 397 F.3d 191, 205 (3d Cir. 2005). Instead, a creditor in such a situation is merely recovering what it is due as a secured creditor with a valid proceeds security interest in insurance proceeds. Id.

Accordingly, the "equities" of the case require an analysis of the facts and circumstances of each case. For example, where a bankruptcy estate puts significant effort into disposing encumbered property, or man hours are used to finish incomplete inventory that increase the amounts realized from such disposition, the equities of the case may require the court to apportion the proceeds. See In re Patio & Porch Systems Inc., 194 B.R. 569, 575 (Bankr. D. Md. 1996); see, also, In re First Nat'l. Bank v. Willis (In re Jones), 908 F.2d 859 (11th Cir. 1990) (holding that a secured creditor's interest in a debtor's life insurance policy did not extend to increase in cash surrender value attributable to post-petition premium payments).

Thus, although §552(b) authorizes a court to hold that a portion of an otherwise automatically attached and perfected security interest is free and clear of such security interest, §552(b)'s equity exception is not tantamount to an avoidance of the entire security interest. Instead, courts should consider what portion, if any, of the secured creditor's property interests in proceeds should be unencumbered and held by the debtor free and clear based on the equities of the case. In other words, what portion should benefit the bankruptcy estate as a whole, instead of benefiting the secured creditor only, despite the secured creditor's property interests.

Conclusion

To some, §552(b)'s equity exception to the proceeds exception of §552(a) resembles a surcharge and/or an avoidance of liens. Though not couched in such terms, it has the same practical effect: creating unencumbered assets from otherwise validly encumbered assets.

The difference, however, is that §552(b)'s equity exception is a limitation on what constitutes proceeds under §552(b), being, in turn, an exception to §552(a)'s automatic severance of after-acquired property interests. Thus, applying §552(b)'s equity exception does not require the constitutional due process safeguards that an avoidance action requires as it does not alter property interests, but redefines and limits property interests.

While case law attempts to differentiate between circumstances that define proceeds from those that require an examination of the equities, they certainly share common grounds. Nonetheless, where the proper facts and circumstances exist, a close look at §552's entire text may reveal a lifeline for an otherwise overwhelmed debtor.