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Secured Party in Possession

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Journal Article: 
We have a new form of chapter 11 emerging in the courts. Having invented the DIP (debtor-in-possession), American lawyers are now creating the SPIP (secured-party-in-possession). More and more chapter 11 cases seem to be no more than vehicles through which secured parties may enjoy their Article 9 rights under the umbrella, and the protective shield, of the bankruptcy laws.1 Three examples make the point, although there are many more following many different forms.

The first case illustrates a secured party in total control. In re Hotel Syracuse Inc., 275 B.R. 679 (Bankr. N.D.N.Y. 2002). The secured creditor is undersecured, and there are no other assets from which a professional fee may be paid. Nonetheless, counsel for an unsecured committee has been appointed and seeks interim compensation. The secured creditor has agreed to "carve out" some assets for debtor's counsel only, a surgery the court holds it is entitled to perform. Because counsel for the creditors' committee was not included in the secured party's carve-out, the court rules that the committee counsel will be paid if and when some unencumbered assets appear or the tooth fairy sets up at the courthouse, whichever happens first. (We made up that last part.) Of course, no fee, no counsel, no committee. Why have a chapter 11 that cannot function with a committee? Committees are statutory, as are fees for their counsel. If that important element of a bankruptcy proceeding cannot be funded, why is a proceeding under Title 11 permitted at all? Shouldn't the case be dismissed and the secured creditor be left to its state law remedies? And if the debtor and the secured creditor think there are good reasons for the case to go forward, shouldn't there be a creditors' committee around to watch over the proceedings?

The second case may illustrate a sort of Title 11 fraud. In re Nuclear Imaging Systems Inc., 270 B.R. 365 (Bankr. E.D. Pa. 2001). The secured parties had agreed to payment of the expenses of debtor's counsel only, as in the Syracuse case. During the course of the chapter 11 case, however, a supplier had shipped more than $1 million of essential supplies and was still owed more than $400,000 at the time the case was converted to chapter 7. When counsel for the debtor applied for about $100,000 in fees, the supplier objected. It didn't contest the fees as such, but wanted all funds coming in to the estate to be paid to the chapter 7 trustee in bankruptcy (TIB) for distribution pro rata according to the statutory formula. §§503(b), 507(a)(1) and 726. The court refused. The secured parties had the right to determine exactly what was done with "their" cash collateral, so it could be used only for the fees of the debtor's counsel.

The effect of the court's ruling is to send a signal to all suppliers everywhere that administrative status is not sufficient unless the supplier has a legal opinion about carve-outs and a letter of approval from the secured party. In the controlled chaos of the first days of many chapter 11s, suppliers and others will often not know the details of a first-day order that nowadays may be thicker than the Wilmington, Del., telephone book. To make it a little more challenging, the trade creditors will often be far away from Wilmington, out where the debtor is really located. The immediate effect may be to mislead and virtually defraud suppliers acting in good faith. The longer-term effect will be to discourage suppliers from cooperating in all chapter 11 cases.

Beyond those important points, how can a private party order a distribution in any proceeding under Title 11 that is different from that commanded by the statute?2 It is one thing to give the secured party the priority that the statute gives them. (It is interesting that the Code never explicitly grants first priority in the collateral to the secured party, but we'll let that pass for now.) It is something else to permit the secured party to use the great machinery of the law for its purposes and then let its "consent" amend the distribution scheme commanded by Congress. Is this the new version of Rent-a-Court?

The third case represents a sort of state-taking for purely private purposes. In re Suntastic USA Inc., 269 B.R. 846 (Bankr. D. Ariz. 2001). Here, the administrative claimants asked that the TIB be ordered to seek a surcharge of the secured party's interests, now that no one but the TIB may do so under Hartford. The court admits that in the right circumstances the TIB could be ordered to do that as part of the trustee's job to protect creditors. Here, however, because there are no unencumbered assets, a surcharge would be pointless because there are no assets not subject to the security interest. Therefore, the estate has no claim to a surcharge, and the TIB has nothing to do. Individual claimants may have such a claim, but that is their problem.

This case raises many of the same issues as in the Systems case, but two claimants require us to carry the analysis a step further. One is the utility that is out a lot of money because it was required to supply the debtor under Arizona law and perhaps §366 as well. The other is the Arizona taxing authority that didn't get any withholding from the employees who were working for the debtor during the chapter 11. These two creditors get nothing, despite their clear entitlements under §§503, 507(a)(1) and 726. They were involuntary post-petition creditors who will have to extract the funds from some other customers or taxpayers to cover what the secured party got for free. The bankruptcy court's notion that these entities can bring and win expensive, unusual lawsuits against the secured party, presumably making new law in the state courts about the effect of the process, is more than a tad unrealistic. The secured creditor took value that was provided post-petition by unsecured creditors—and the bankruptcy court blessed it.

One of us is writing an article about "dominant secured parties" like the ones described here—that is, creditors who have a lien over substantially all of the assets of the debtor. One question is whether they should be allowed to control the management of a general default under any circumstances. But, at a minimum, it seems hard to argue that they should be allowed to use the bankruptcy law, a mechanism designed to benefit creditors generally, as their own private, low-cost tool to maximize their own collections without regard to the requirements of the statute or the legitimate interests of other parties.

Richard Levin has written an excellent article on carve-out3 in which he points out a major set of complications from the perspective of counsel to a post-petition creditor, whether a committee or a supplier, even if the creditor gets approval from a dominant secured party. There is considerable ambiguity in the carve-out orders and stipulations that are adopted, with the consequence that there are a number of possible relationships of priority in the allocation of proceeds of assets between a post-petition creditor and the dominant secured party. Therefore, there are a number of possible outcomes in terms of distributions. The result is that a voluntary post-petition creditor (e.g., a supplier that is not a utility) may find it difficult to predict full payment even with a reliable estimate of the proceeds of sale of the company's assets.

If suppliers over time see that their administrative-priority protection is dependent upon an investigation of the nature and extent of outstanding security interests, and a detailed legal effort is required to protect them in a carve-out order, many of them may simply retire from the field. Many suppliers have had a somewhat sanguine view about chapter 11. They have learned, based on earlier experiences, that administrative claimants will get paid. With cases like these, that view may change. It will then be hard to lure them back into chapter 11. Thus, the emergence of the SPIP raises both questions of principle and very practical questions that may go to the future functioning of our reorganization process.

The emergence of the SPIP is ironic given the position secured creditors have taken in Congress. They have complained bitterly for years about chapter 11, and they have persuaded their friends in Congress to enact special provisions in the Code for single-asset real estate cases, invoking the principle that single-creditor cases have no business in bankruptcy. But §363 sales are becoming more and more common and may offer an attractive alternative to Article 9 sales for many secured parties. Also increasing are cases with lawsuits that the carved-in TIB can bring for the ultimate benefit of the secured party. Thus the use of bankruptcy as a sort of Super Article 9, invoked for the benefit of a single secured creditor, will be of growing importance in coming years—unless Congress or the courts decide otherwise.


Footnotes

1 Cf. Baird, Douglas G. and Rasmussen, Robert K., "The End of Bankruptcy," 55 Stan. L. Rev. 751 (2002). Return to article

2 See In re Ben Franklin Retail Stores Inc., 210 B.R. 315, 319 (Bankr. N.D. Ill. 1997) (proceeds of assets are property of the estate; lender merely has security interest). Return to article

3 Levin, Richard B., "Almost All You Ever Wanted to Know About Carve-out," 76 Am. Bankr. L.J. 445 (2002). Return to article

Journal Date: 
Monday, September 1, 2003
Bankruptcy Rule: 

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