- Definition of Secured Claim and Undersecured Claim
- 1 U.S.C. §506 (a) provides that a claim is secured to the extent of the value of a creditor's collateral and the claim is unsecured for the balance. The Bankruptcy Court determines value on a case by case basis and such value is to be "determined in light of the purpose of the valuation and of the proposed disposition or use of such property..."
In a recent decision by the United States Bankruptcy Court for the District of Massachusetts, Judge Queenan held in In re Mitchell v. Robbins, 119 B.R.1, 20 B.C.D. 1688 (Bankr. D. MA 1990) that for the purpose of determining adequate protection of a secured creditor's interest in property, the worth of the property was that which it would bring at a commercially reasonable sale.
Judge Queenan held that when determining adequate protection the Court must focus on the value of the creditor's interest in the property. The Court noted that 11 U.S.C. §506 (a) provides that the value of a secured claim should "be determined in light of the purpose of the valuation and of the proposed disposition or use of such property..." In the case at bar, there was no proposed disposition of the property and it was debtor's intent to retain the property. Therefore, the Court concluded that it was the property's foreclosure value that must be used when considering whether the movant's interest was adequately protected. The Court also found that since the value of the secured creditor's interest was dependent on the property being sold, the expenses to accomplish a private sale would be proper deductions in arriving at the value of a mortgagee' interest. Judge Queenan, after determining the value of the property at foreclosure, deducting the cost of foreclosure and the first mortgage, concluded that the movant's interest in the property was not adequately protected.
- Rights of Lessors and Lessees
- Executory Contracts. 11 U.S.C. §365 governs the right of lessors and lessees in Bankruptcy. The trustee or debtor is authorized under 11 U.S.C. §365 (a) to assume or reject any executory or unexpired lease of the debtor. There is no precise definition of what contracts are "executory". The term is commonly defined as a contract on which performance remains due, to some extent, on one or both sides. The non-performance by one side would constitute a material breach of the contract. The performance obligation of the other side is then affected by that breach. Frequently, leases will include a clause to the effect that if the tenant becomes insolvent or files for bankruptcy, such act will place the tenant in default under the lease and will entitle the landlord to immediately regain possession of the leasehold property. Bankruptcy Courts have viewed such clauses as inequitable and have uniformly refused to enforce them.
- Time for Assumption or Rejection. 11 U.S.C. §365 (d) provides that the
debtor has sixty days from the petition date to assume or reject an executory contract on an unexpired lease of non-residential real property. The debtor can petition the Court for an extension of the sixty days. If the debtor asks the Court to allow it to assume the lease, the debtor must (1) cure or provide adequate assurance that it will promptly cure any default; (2) compensate or provide adequate assurance of compensation for any actual pecuniary loss; (3) provide adequate assurance of future performance. Thus, if the debtor assumes the lease then it must pay the arrearages or provide adequate assurance of financial performance. It is also important to note that if the debtor does not petition the Court within sixty days to assume or reject the lease it will be deemed rejected and the non-residential real property will be immediately surrendered to the lessor. §365 (d) (4)
- Debtor Must Stay Current. The debtor is obligated to stay current with its rental obligations while it is in bankruptcy. The Bankruptcy Code provides, in 11 U.S.C. §365 (d) (3), that "(t) he trustee shall timely perform all the obligations of the debtor, ...arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected..."
- Other Contracts. The trustee or debtor in possession in a Chapter 11 proceeding may assume or reject an executory contract or unexpired leas of residential real property or of personal property of the debtor at any time before the confirmation of a plan. However, the court on request of any party to such executory contract or leas may order the trustee or debtor to determine within a specified period of time whether to assume or reject such contract or lease. §365 (d) (2).
- Chapter 7 Cases. The trustee in a Chapter 7 proceeding has sixty days after the petition date, or such additional time as the Court fixes for cause within such sixty day period to assume or reject an executory contract or unexpired lease of residential real property or of personal property of the debtor §365 (d) (1).
- Debtor's Sale of Collateral
- Sale in the Ordinary Course. Section 363 (c) (1) of the Bankruptcy Code allows a trustee or debtor to sell or lease property of the estate in the ordinary course without notice or hearing unless the Court orders otherwise.
- Sales Out of Ordinary Course. 11 U.S.C. §363 (b) (1) provides that the debtor may sell or lease property outside the ordinary course of business after notice and hearing. If there is no objection or counteroffer to a proposed sale, no hearing will be held and the debtor or trustee may sell the property. Under Rule 2002 and Rule 6004, twenty days notice of a sale to all creditors is required unless the Court orders otherwise. Section 363 (k) of the Bankruptcy Code allows a secured creditor to bid at any sale and if successful offset the amount of its claim against the purchase price.
- Sale Free and Clear of Liens and Encumbrances. Section 363 (f) allows the sale of property free and clear of any liens and encumbrances on such property whether it is sole in the ordinary course or otherwise if (1) applicable non-bankruptcy law permits sale of such property free and clear (2) the creditor consents (3) if such interest is a lien then if the price at which such property is to be sold is greater than the aggregate value of all liens on the property (4) an interest is in bonafide dispute or (5) the holder could be compelled to accept a money judgment. The sale under this subsection is subject to the requirement of adequate protection for such interest. Typically the adequate protection is that the lien and encumbrances attach to the proceeds of the sale in the same order of priority
- Fraudulent Transfers. 11 U.S.C. §548 provides for the avoidance of transfers if made with the actual intention of hindering, delaying or defaulting creditors in their attempts to recover their loans. It also provides that a transfer of property made for less than reasonably equivalent consideration is vulnerable. The remedy in such situations is to permit a creditor or trustee in bankruptcy to void such transfers and the property then goes back into the estate for possible liquidation and distribution to the creditors.
This issue frequently comes into play where there is a bankruptcy filing subsequent to a foreclosure sale. The debtor's attorney likely will closely examine the circumstances surrounding the foreclosure sale to determine whether to attempt to void it as a fraudulent transfer.
It is imperative that the attorney for the foreclosing mortgagee be knowledgeable of developments in the area in order that the foreclosure sale is conducted in the manner best calculated to survive a challenge in the Bankruptcy Court.
- When does the transfer occur?
There was some confusion, prior to the 1984 amendments to the Bankruptcy Code, as to when a transfer occurred in a mortgage foreclosure. There was a question as to whether a foreclosure within one year of the bankruptcy would be protected from challenge as a fraudulent transfer if the mortgage was granted and perfected more then one year prior to the mortgagor's bankruptcy. There was an issue as to whether one could argue that the foreclosure constituted a "transfer" separate from the initial grant and perfection of the mortgage. See Durrett v. Washington National Insurance Co., 621 F.2d 201 (5th Cir. 1980) where the Court held that the foreclosure was subject to challenge as a fraudulent transfer since the "transfer" occurred at the time of the foreclosure. Also see Madrid v. Lawyers Title Insurance Corp. 725 F.2d 1197 (9th Cir. 1984), aff'g on other grounds 21 B.R. 424 (Bankr. App. 9th Cir. 1982), cert.denied, 469 U.S. 833 (1984) where the Court held that the "transfer" occurred at the time the deed was recorded, not at the time of the foreclosure.
The conflict between the Circuits was resolved by the Bankruptcy Amendments Acts of 1984 (Pub. L. 98-353), which added to the definition of "transfer" in 11 U.S.C. 101 (50) the phrase "including ... foreclosure of debtor's equity of redemption" and added the phrase "voluntarily or involuntarily" to 11 U.S.C. §548 (a) to describe the transfers subject to that section. It is now clear that the foreclosure of a mortgage within one year of the Bankruptcy filing subjects the transaction to potential challenge under 11 U.S.C. §548.
What constitutes "fair consideration"?
The Court in Durrett, supra, a case decided under the Bankruptcy Act, also addressed the issue of what constitutes "fair consideration." The Court held that the foreclosure sale was not a sale for "fair consideration" but was a fraudulent transfer. The Court based its decision on the fact that it could find no reported case in which the transfer of real property was for a price equal to less than 70% of its fair market value that had survived a challenge as a fraudulent transfer. This became known as the Durrett "rule", namely that a foreclosure sale at less than 70% of fair market value is invalid as a fraudulent transfer. See In re Madrid, supra, where the Court held that there is an irrebuttable presumption that the price received at a non-collusive foreclosure sale held in compliance with state law is "reasonably equivalent value."
The first post - Durrett bankruptcy case in Massachusetts to consider the voidability of a foreclosure sale was In re Ruebeck, 55 B.R. 163 (Bankr. D. Mass. 1985). Judge Lavien held that "reasonably equivalent" must depend on the facts of each case. The Court stated that "it would probably" accept a sale that did not shock its conscience and was conducted in the same manner that a prudent man would advertise his own property for sale. Essentially the Court would have to be satisfied that the mortgagee "had taken all reasonable steps not only to come out whole, but to realize a fair price as well." 55 B.R. at 170. The Court articulated steps that a mortgagee should take in order to protect its foreclosure sale against a challenge as a fraudulent transfer under the Bankruptcy Code. These steps included the secured creditor obtaining a pre-sale appraisal, advertising in the real estate section of a newspaper, and giving notice to real estate brokers within a limited radius of the property.
John Queenan in In re General Industries Inc. 79 B.R. 124 (Bankr. D. Mass 1987) rejected the Ruebeck decision as being too narrow. He believed that the Uniform Commercial Code's broad rule of commercial reasonableness should govern. The Court rejected the foreclosure sale at issue since it did not satisfy the commercial reasonableness test. Commercially reasonable efforts in the sale of the Debtor's real estate, according to the Court, should have included advertising in the real estate section of the local newspaper (not the legal notice section), as well as mailings to more than one real estate broker. The foreclosure sale concluded the Court, was not conducted in a "commercially reasonable" manner, and thus was voidable as a fraudulent transfer under 11 U.S.C. §548. Because the purchaser at the foreclosure sale paid value and acted in good faith, the Court allowed him to retain a lien on the property in the amount equal to the sum of his purchase price and the amount he spent on improvements to the property.
- Financing the Operation of the Debtor--Obtaining Credit/ Post-Petition Borrowing
- Authority. 11 U.S.C. §364 governs the authority of a debtor in possession or trustee to obtain credit and incur debt during the pendency of a case.
- Ordinary Course. A debtor under 11 U.S.C. §364 (a) may obtain unsecured credit and incur unsecured debt in the ordinary course without Court approval. Such post-petition debt is treated as an administrative expense under 11 U.S.C. §503 (b) (1). Thus, the debtor is able to purchase inventory or supplies on credit and incur trade debt without requiring Court approval, as long as it is in the ordinary course. It should be noted that the priority afforded by the grant of a administrative claim may prove illusive. For example, if the case is converted to Chapter 7, the expenses of the proceeding will under 11 U.S.C. §726 (b) have priority over expenses of administration of a superseded Chapter 11 proceeding. In addition, a secured creditor who is affordable adequate protection that later proves inadequate will be entitled to a priority claim under 11 U.S.C. §507 (b), which will have priority over general administrative claims.
- Outside the Ordinary Course. If the debtor wishes to obtain unsecured credit outside of the ordinary course of business, Court approval is required. However, the lender may be relegated to the status of general unsecured creditor where a debtor fails to obtain Court approval and the borrowing is considered out of the ordinary course of business. Thus due to the severe consequences from mislabeling a transaction, a lender will be well advised to err on the side of caution where there is any doubt.
- Superpriority. Typically, a debtor will be unable to obtain unsecured credit for significant operating capital or may also need to grant further security as part of its agreement regarding the use of cash collateral, as discussed above. 11 U.S.C. §364 (c) allows a debtor to obtain credit upon a superpriority or secured basis. This alternative is only available when a debtor demonstrates that it has been unable to obtain unsecured financing pursuant to 11 U.S.C. §364 (a) & (b). The Court may after notice and hearing, authorize the debtor to obtain credit or incur debt: (1) by granting the debt priority over all administrative expenses (known as "superpriority" (2) by securing the debt with a lien on property or the estate that is not subject to a lien or (3) by securing the debt with a junior lien on property of the estate that is subject to a pre-existing lien. These options are not exclusive and may be employed individually or in tandem. The administrative priority granted by 11 U.S.C. §364 (c) (1) is known as a "superpriority" because it takes precedence over such administrative expense claims or taxes and fees for services rendered after the filing.
- Superlien. The last alternative, which is available only where a debtor has failed to obtain credit on other terms, is the granting of a superlien by the debtor. 11 U.S.C. §364 (d) allows the debtor to obtain credit secured by a senior or equal lien on property of the estate which is already subject to a lien. The debtor, to obtain a superlien, must demonstrate to the Bankruptcy Court not only that it is unable to obtain credit otherwise, but also that the interest of the lienholder is adequately protected.
- Protection Against Reversal or Modification. 11 U.S.C. §364 (e) provides protection to creditors from reversal or modification on appeal of a financing order. It provides that a reversal or modification does not affect the validity of any debt incurred, priority or lien so granted to an entity that extended such credit in good faith. This safe harbor applies whether or not the creditor knows of the pendency of the appeal, unless a stay is obtained.