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Bankruptcy and the Secured Creditor

In the last few years there have been a number of widely publicized bankruptcies such as Eastern Airlines and Macy's. In North Carolina we have seen Brendle's, Piece Goods and Roses Department Stores file for bankruptcy protection. From 1984 to 1991, the bankruptcy filings throughout North Carolina reflected a 40% increase. Of those filings, approximately 25-30% were Chapter 7 liquidations, 70-75% were Chapter 13 wage-earner reorganizations, and the rest were either Chapter 11 reorganizations or Chapter 12 farmer reorganizations.

This manuscript will discuss the effect of bankruptcy on secured claims. Addressed will be the impact of the automatic stay, the need for adequate protection, the debtor's valuation of secured claims, the Chapter 11 confirmation process, the trustee's avoidance powers, the rights of lessors and lessees, the debtor's use of cash collateral and the debtor's use, sale or lease of property.

A. The Automatic Stay-The Mortgagor-Debtor's Shield.

1. The Block of the Automatic Stay.

Immediately upon the filing of a bankruptcy petition under Chapters 7, 11, 12, or 13, a creditor is prohibited or stayed from taking any action which has the purpose and result of collecting a debt or taking possession of property or assets of the debtor. 11 U.S.C. § 362(a). Section 362(a) sets forth a list of activities which are subject to the automatic stay. These are:

  • the commencement or continuation of legal proceedings against the debtor to recover a claim that arose prior to the petition being filed;
  • the enforcement of a prepetition judgment against the debtor or against property of the bankruptcy estate;
  • an act to obtain possession of, or exercise control over, property of the estate;
  • an act to create, perfect or enforce any lien against property of the bankruptcy estate;
  • an act to create, perfect or enforce any lien against property of the debtor, any lien to the extent that such lien secures a prepetition claim;
  • an act to collect, assess or recover a prepetition claim against the debtor;
  • the setoff of any debt owing to the debtor that arose before the commencement of the case against any claim against the debtor; and
  • the commencement or continuation of a proceeding before the United States Tax Court concerning the debtor.

11 U.S.C. § 362(a).

Additionally, in Chapter 12 and 13 cases, creditors are prohibited from attempting to collect consumer debts from co-debtors, unless the co-debtor became liable for the debt in the ordinary course of the co-debtor's business or until the case is closed, dismissed or converted to Chapter 7. 11 U.S.C. §§ 1201 and 1301.

The Bankruptcy Court has other ample powers to stay actions not covered by the automatic stay. H.R. Rep. No. 95-595, 95th Cong., 1st Sess. (1977) at p. 342 makes specific reference to 11 U.S.C. § 105(a)(1), 28 U.S.C. § 1481(2)and the All Writs Statute, 28 U.S.C. § 1651(3).

2. What is the Scope of Stay?

Although the automatic stay is broad and encompasses most collection activities, certain exceptions exist. For example, the automatic stay is not applicable to the following:

  • post-petition transactions;
  • the commencement or continuation of a criminal proceeding against the debtor;
  • the collection of alimony, maintenance, or support from property that is not property of the estate (i.e., post-petition wages or income of the debtor);
  • the commencement or continuation of an action or proceeding by a governmental unit to enforce such governmental unit's police or regulatory power; and
  • any act to perfect an interest in the property to the extent that the trustee's rights and powers are subject to such perfection under § 546(b) of the Bankruptcy Code.

11 U.S.C. § 362(a) and (b).

The automatic stay is also inapplicable to separate legal entities such as corporate affiliates, partners in debtor partnerships or to codefendants or guarantors in pending litigation. 2 Collier on Bankruptcy ¶ 362.04 (15th ed. 1993); see also Patton V. Bearden, 8 F.3d 343 (6th Cir. 1993); In re Marley Orchards Income Fund I, Limited Partnership, 120 B.R. 566 (Bankr. E.D. Wash. 1990) (refused to extend automatic stay to general partners of a debtor-partnership under § 362(a)(3) absent evidence of a potential deficiency in partnership assets). However, some courts have extended the automatic stay to non-bankrupt third parties in "unusual circumstances." See A.H. Robins Co. V. Piccinin, 788 F.2d 994 (4th Cir. 1986), cert. denied, 479 U.S. 876 (1986); In re Litchfield Co. of South Carolina Limited Partnership, 135 B.R. 797 (W.D.N.C. 1992); In re Kanawha Trace Dev. Partners, 87 B.R. 892 (Bankr. E.D. Va. 1988).

With respect to acts against property of the estate, the automatic stay continues until such property is no longer property of the estate (i.e. where it has been abandoned under § 554(c)). 11 U.S.C. § 362(c)(1). With respect to all other acts, the automatic stay continues until the earliest (i) the case is closed; (ii) the case is dismissed; (iii) a discharge is granted or denied in the case of an individual bankruptcy proceeding; (iv) a plan is confirmed in a Chapter 11 case; or (v) the stay is terminated by order of the court, or by inaction of the court upon request for leave from the stay. 11 U.S.C. § 362(c)(2).

What happens when a secured creditor has repossessed its collateral prior to the filing of the Debtor's petition? This question was answered by the Supreme Court in United States v. Whiting Pools, Inc., 462 U.S. 198, 103 S.Ct. 2309, 76 L.Ed.2d 515 (1983). In that case, the Internal Revenue Service levied on and took possession of the debtor's property. On the following day, the debtor filed a bankruptcy petition which stayed the Internal Revenue Service from taking any further action against the property. The Internal Revenue Service instituted an adversary proceeding seeking a determination that the automatic stay provisions of Section 362 were not applicable to it or, in the alternative, requesting that the stay be lifted to permit it to sell the property. The Internal Revenue Service argued that "property of the estate" under § 541 of the Bankruptcy Code consists only of the debtor's interest in property as of the time the bankruptcy petition is filed. The Supreme Court, however, found that the debtor retained an "equitable" interest in the property since it had not yet been sold and thus ordered the Internal Revenue Service to return the property to the debtor under § 542 of the Bankruptcy Code.

This same analysis has been used with regard to foreclosure proceedings; if the sale has not been completed prior to the filing of the debtor's bankruptcy petition, then the debtor may request turnover of the property. The secured creditor faced with this situation should request adequate protection of its security interest or, in the alternative, relief from the automatic stay. According to Judge Small in the Eastern District of North Carolina, if a bankruptcy petition is filed after the foreclosure sale but prior to the expiration of the upset period, a Chapter 13 debtor is not entitled to possession or "redemption" of the property unless the secured creditor foreclosing on the property is paid in full. In re DiCello, 80 B.R. 769 (Bankr. E.D.N.C. 1987).(4)

3. What are the Sanctions for Violating the Stay?

Generally, actions taken in violation of the automatic stay are void and without effect. 2 Collier on Bankruptcy, ¶ 362.11 (15th ed. 1993).(5) Moreover, they could lead to serious consequences for the creditor. For example, the trustee and/or debtor may seek to have the creditor found in contempt and fined, enjoined under § 105 of the Bankruptcy Code from further attempts to collect the debt, or sanctioned. If the trustee and/or debtor is successful, the secured creditor may be assessed with costs and attorney's fees. Section 362(h) of the Bankruptcy Code further provides that an individual injured by a willful violation of the automatic stay may be entitled to recover punitive damages in addition to actual damages which include costs and attorney's fees. See In re Michael A. and Cynthia Capehart, Case No. B-87-2663C-13 (Bankr. M.D. NC). Attorneys should be mindful of the Fifth Circuit's decision in Pettitt v. Baker, 876 F.2d. 456 (5th Cir. 1989) in which the bankruptcy court assessed both the creditor and the creditor's law firm for a violation of the automatic stay.

Because of the Bankruptcy Court's desire to protect debtors upon the filing of the bankruptcy petition, creditors should cease all collection or enforcement activities immediately upon learning of the bankruptcy filing. See In re Melvin Andrew Withrow, Case No. C-B-87-00861 (Bankr. W.D.N.C.) Knowledge of the filing includes any verbal or written notice received by the creditor or an agent of the creditor from the debtor, the debtor's attorney, the court or any third party source.

4. Obtaining Relief from the Stay.

The automatic stay merely gives the debtor a "breathing spell" once a bankruptcy petition is filed. Unless the stay is otherwise terminated, a secured creditor can obtain permission from the Bankruptcy Court to lift the automatic stay in order to foreclose its security interest in the collateral.

According to Bankruptcy Rule 4001, an action for relief from stay is a contested matter under Bankruptcy Rule 9014. A motion is filed requesting relief from the automatic stay with the court and the other party is afforded reasonable notice and an opportunity for hearing. Rule 4001(a)(1), F.R.B.P. The proper parties to a motion for relief from stay are the debtor, the trustee, if one has been appointed, and the U. S. Bankruptcy Administrator's office in a Chapter 11 case. Rule 4001(a)(1), F.R.B.P. Junior lienholders and creditors' committees may intervene in the proceeding, but are not necessary parties.

Within thirty (30) days after relief from the automatic stay is requested, the stay will terminate unless the court orders the stay continued pending the conclusion of a final hearing and determination on the request for relief. In the Western District of North Carolina, the Local Rules provide that the initial hearing on termination or modification of the stay will be a final hearing unless one of the parties requests that the hearing be a preliminary hearing.(6)

Relief from the automatic stay will be granted if the moving party can show (i) cause, including the lack of adequate protection, or (ii) no equity in the property and the property is not necessary to an effective reorganization. 11 U.S.C. § 362(b).

The party requesting the relief has the burden of proof on the issue of whether the debtor has equity in the property and the party opposing the relief (usually the debtor) has the burden of proof on all other issues, including whether or not the property is necessary to an effective reorganization.

Termination of the stay for "cause" is typically brought by a secured creditor on the grounds that its interest in the collateral is not adequately protected. Cause, however, can also include the lack of good faith in filing the bankruptcy petition. In re Victoring Construction Co., Inc., 9 B.R. 549 (Bankr. C.D. Cal. 1981).(7)

B. Adequate Protection-The Mortgagee's Sword.

Because the automatic stay prevents secured creditors from foreclosing on their collateral, the Bankruptcy Code recognizes that creditors are entitled during the pendency of a bankruptcy case to have the value of their security interest protected against any decrease in value or depreciation. Thus, a secured creditor has the right to adequate protection if a debtor proposes to use, sell or lease property which constitutes the creditor's collateral during the bankruptcy case or if the debtor proposes to secure post-petition borrowing by granting an interest in the secured creditor's collateral equal or senior to the security interest held by the creditor.

1. Illustrations of Adequate Protection Under the Bankruptcy Code.

The term "adequate protection" is not defined under the Bankruptcy Code. As a result, this issue is frequently litigated by secured creditors who want to protect their collateral during the pendency of the bankruptcy case.

Section 361 of the Bankruptcy Code offers little guidance. It suggests that adequate protection may consist of:

  1. Periodic Payments. Usually the payment is cash or a cash-equivalent. The payment(s), however, may be less than the full principal and interest required under the loan documents.
  2. Additional or Replacement Liens. Giving of an additional or replacement lien to the extent necessary to compensate for a decrease in value of the secured creditors' interest in property. If the debtor's property is fully encumbered, the granting of an additional or replacement lien does not constitute adequate protection.
  3. Indubitable Equivalent. This occurs when the creditor receives something of value which will allow it to realize the "indubitable equivalent" of its security interest. Courts sometimes find this form of adequate protection to exist when the value of the collateral exceeds the debt owed the secured creditor. The larger the excess value or "equity cushion," the more likely a court is to find a secured creditor is adequately protected by its current oversecured position. The Bankruptcy Code sets forth some limits as to what satisfies the "indubitable equivalent" standard. Under 11 U.S.C. § 361(3), an administrative expense priority would not qualify.

2. What Interests are Entitled to Adequate Protection?

Adequate protection is not automatically provided to a secured creditor under the Bankruptcy Code. Nor is it likely to be voluntarily offered by the debtor. If it is, the timing, form or amount of the adequate protection may be unacceptable. In order to protect its collateral, a secured creditor must be prepared to pursue its rights in the Bankruptcy Court by filing of a motion for relief from the automatic stay or, in the alternative, for adequate protection. In a Chapter 11 case, the motion should be made early especially if the property is deteriorating or depreciating in value.

Whether a secured creditor is entitled to adequate protection depends upon whether the secured creditor is "oversecured" (the collateral is worth more than the debt) or "undersecured" (the debt is greater than the collateral value). In general, an oversecured creditor is entitled to adequate protection of its claim. This adequate protection may be in the form of post-petition interest on its claim. Adequate protection to an oversecured creditor may also take into account payment of both principal and interest. An undersecured creditor, however, is not entitled to adequate protection in the form of post-petition interest. In order to receive adequate protection, an undersecured creditor must demonstrate that its collateral is actually losing value.

The concept of adequate protection is discussed at length by the Supreme Court in the landmark decision of United Savings Association of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365, 108 S. Ct. 626, 98 L. Ed. 2d 740 (1988). In Timbers, the Supreme Court held that adequate protection does not include payments to an undersecured creditor for "lost opportunity cost" caused by the delay in foreclosing the collateral and reinvesting the proceeds elsewhere. The facts in that case, however, involved property which was appreciating. In subsequent cases, where the property has been found to be depreciating, undersecured creditors have been entitled to receive periodic payments. In re Flagler-At-First Assoc. Ltd., 114 B.Rl 297 (S.D.Fla. 1990).

One court has interpreted Timbers to mean that an oversecured creditor is entitled to post-petition interest under § 506(b) only to the extent of the oversecured creditor's equity cushion. In re Westchase I Associates, L.P., 126 B.R. 692 (W.D.N.C. 1991). Under this rationale, if a secured creditor is only marginally oversecured, Timbers would not entitle the creditor to adequate protection payments in order to preserve the slim equity cushion. Id. at 694-695.

3. What Happens if Adequate Protection Turns Out to be Inadequate?

In the event adequate protection turns out to be inadequate, a secured creditor should file or renew its motion for relief from stay, request additional adequate protection in the form of periodic payments, or seek additional or replacement liens. In addition, § 507(b) provides that a secured creditor who is entitled to adequate protection has a first priority claim to the extent that the protection has not been adequate. 11 U.S.C. § 507(b); In re Clark at Center Leasing Co., Inc., 991 F.2d 682 (11th Cir. 1993) opinion amended on denial of rehearing by 4 F.3d 940 (11th Cir. 1993). This "super-priority" status allows an inadequately protected secured creditor the right to be paid ahead of all other administrative claims, subject to the super-priority status of any § 364(c)(1) post-petition financing claim.

The extent to which a secured creditor is entitled to a § 507(b) claim is discussed at length in In re Cheatham, 91 B.R. 382 (E.D.N.C. 1988). In that case, the creditor had consensually agreed with the Debtor to adequate protection payments which later turned out to be inadequate. The court held that the creditor's super-priority claim would be limited to the extent of adequate protection payments which were in default, plus any unexpected diminution of value of collateral caused by unforeseeable circumstances such as fire, flood or market collapse; it was not entitled to losses arising from foreseeable circumstances such as normal depreciation or wear and tear of collateral.

C. Valuation of Mortgagee's Claim.

Valuation of property is important in any bankruptcy case. It is necessary to:

  • decide whether a creditor is entitled to adequate protection of its interest under §§ 361, 362, 363, 364 and 1205 of the Bankruptcy Code;
  • decide whether the creditor is entitled to relief from the automatic stay pursuant to § 362(d) of the Bankruptcy Code;
  • decide whether the trustee of a bankrupt estate may sell property of the estate pursuant to § 363(b) or (c) of the Bankruptcy Code;
  • decide whether a plan should be confirmed pursuant to § 1129 of the Bankruptcy Code;
  • decide whether interest and attorneys' fees should be allowed pursuant to § 506(b) of the Bankruptcy Code; and
  • decide whether the full amount of claim is secured by the collateral under § 506(a) of the Bankruptcy Code.

See generally, Harden "Claims of Secured Creditors," Protection of Secured Interests in bankruptcy in North Carolina, N.B.I. (1989).

1. Procedure for Valuing Secured Claims.

Bankruptcy Rule 3012 deals with the procedure in the valuation of a secured claim. It provides that:

[t]he court may determine the value of a claim secured by a lien on property in which the estate has an interest on motion of any party in interest and after hearing on notice to the holder of the secured claim and any other person as the court may direct.

Rule 3012, F.R.B.P. A valuation proceeding is a contested matter under Bankruptcy Rule 9014. If the validity, priority or extent of a lien is at issue, in addition to the valuation of the secured claim, Bankruptcy Rule 7001(2) states that the proceeding is an adversary proceeding which is initiated by the filing of a complaint. Typically at a valuation hearing, the parties will present evidence of value, usually through testimony by appraisers or other experts.

2. Determination of Secured Status - § 506(a).

Section 506(a) permits a debtor to bifurcate a secured claim into two parts depending upon the value of the collateral. Under this analysis, a secured creditor has an allowed secured claim to the extent of the value of its collateral and an unsecured claim for any balance. 11 U.S.C. § 506(a). The question in most bankruptcy cases is how to value the collateral.

There is little guidance in the Bankruptcy Code on how to value collateral. Section 506(a) suggests that "value shall be determined in light of the purposes of the valuation and proposed disposition or use of such property, and in conjunction with any hearing on such disposition or use on a plan affecting such creditor's interest." 11 U.S.C. § 506(a).

The value assigned to collateral will generally be different depending upon whether the debtor proposes to dispose of the property or to retain it and use it. See, In re Sprecher, 65 B.R. 598 (Bankr. C.D.Ill. 1986). Several different standards have been developed by the courts for valuing property depending on the reasons for valuation. These are:

  • Fair Market Value: The fair market value of property is its value if it were to be marketed in a commercially reasonable manner, defined as what a willing buyer would pay a willing seller for the property.
  • Going Concern Value: The going concern value of the property is appropriate when the debtor is attempting to retain the collateral and continue the operation of its business.
  • Forced Liquidation Value: The forced liquidation value of property is ordinarily the lowest value, and it is the appropriate standard to use when, for example, a business has ceased operations.
  • Other Valuation Standards: These may include book value, depreciation value, and replacement value.

The value of the collateral is generally determined as of the date for which the valuation relates. 3 Collier on Bankruptcy, ¶ 506.04(2) at 35 (15th Ed. 1993). For example, the petition date is used when determining the amount of a secured claim in a Chapter 7 case for purposes for distribution while the effective date of the plan is used for determining the value of an allowed secured claim in a Chapter 11 or 13 case. Reference as to what dates are applicable should be made to the Bankruptcy Code, case law and 3 Collier Bankruptcy Practice Guide, § 52.05 at 11-12 (1986) for additional guidance. It should also be noted that the determination of value of collateral at one point in the case is not be binding at another point in the case. However, a secured creditor should be careful if it attempts to establish a low value for its collateral on a motion for relief from stay and then seeks to have a higher value for plan purposes or to obtain reimbursement of § 506(b) attorney's fees and costs.

Secured creditors should also look at the present and prospective value of their collateral. Present value determines whether there is "equity" in the property and prospective value determines whether the property is necessary for an effective reorganization. 11 U.S.C. § 362(d)(2).

(a) Determining Present Value.

In determining the present value of income-producing real estate, most appraisers use three methods:

  1. Replacement Cost. Under this approach, the appraiser will estimate the cost of new improvements, deduct depreciation, and add the value of the "dirt." The older the property, the less reliable this approach is.
  2. Comparable Sales or "Market Data" Approach. An appraiser identifies recent sales of property which are "comparable" to the existing property. Adjustments are then made to each of the "comparables" to reflect differences such as location, size, visibility and age between the subject property and each "comparable." The appraiser will then average the "comparables" to develop a factor that can be applied to the subject property.
  3. Discounted Income or Discounted Cash Flow Approach. Under this approach, the net income generated by the property, before debt service is estimated, vacancy and other operating expenses are deducted and a capitalization rate is applied. This analysis can be skewed by such key variables as occupancy levels or vacancy rates, rents per square foot and operating expenses.
(b) Determining Prospective Value.

The method used for determining prospective value for an income-producing property is, in effect, the reverse of the "discounted cash flow" approach to present value. To determine prospective value using this approach, annual net operating income is estimated over the life of a hypothetical plan. As in the case of discounted cash flow, assumptions are made as to rental rates, occupancy levels and expenses. This analysis focuses on the determination of net income for the last year of the holding. Once that figure is determined, a capitalization rate is identified for that year and applied to the net income figure to determine the estimated value for the last year of the plan. After the capacity of the property to generate cash over time is estimated, this capacity is compared with the payments required under a hypothetical plan to determine whether the debtor is capable of an effective reorganization.

3. Lien Avoidance - § 506(d).

Section 506(d) provides for the avoidance of any lien securing a claim which is not allowed except under the following explicitly enumerated circumstances: if the claim was disallowed because it had not yet matured or was for reimbursement or contribution, or because the creditor failed to file a proof of claim.

The relationship between the lien avoidance provisions of § 506(d) and the bifurcation provision under § 506(a) discussed above has given rise to a number of conflicting court decisions. Some courts have held that a lien can be "stripped" down to the value of the collateral pursuant to the bifurcation provisions under § 506(a). See Gaglia v. First Federal Savings & Loan Assoc., 889 F.2d 1304 (3d Cir. 1989); In re Jablonski, 88 B.R. 652, 658 (E.D. Pa. 1988). Other courts have held that a lien securing a claim could be avoided pursuant to § 506(d) only if, and to the extent that, the lien was disallowed. In re Dewsnup, 908 F.2d 588 (10th Cir. 1990), aff'd, Dewsnup v. Timm, 502 U.S. ____, 112 S.Ct. 773, 116 L.Ed.2d 903 (1992).

In an effort to resolve the existing split between the circuits, the Supreme Court in Dewsnup v. Timm, supra, held that § 506(d) does not permit a lien to be "stripped down" to the value of the collateral determined in accordance with § 506(a). The court noted that even though the term "allowed secured claim" might arguably have the same meaning for purposes of § 506(d) that it does for § 506(a), Congress did not intend to depart from the pre-Bankruptcy Code rule that liens pass through the case unaffected. Thus, § 506(d) can be used to avoid a lien only if the underlying claim is disallowed, not if a portion of the claim is deemed unsecured by operation of § 506(a). Dewsnup v. Timm, supra.

Because Dewsnup involved a Chapter 7 case, there was some dispute whether this holding also applied in Chapter 13 cases. Section 1322, which is applicable only in Chapter 13 cases, specifically provides that a Chapter 13 plan may modify the rights of secured creditors with one exception. This exception applies to secured creditors who have a security interest in real property which serves as a principal residence of the debtor. 11 U.S.C. § 1322(b)(2).

The apparent conflict between § 506(a) and § 1322(b)(2) was recently settled by the Supreme Court in Nobleman v. American Savings Bank, _____ U.S. _____ 113 S.Ct. 2106, 124 L.Ed.2d 228 (1993). The Nobleman court rejected the holdings of four Courts of Appeals, which had held that § 1322(b)(2) prohibited only modification of the claim holder's rights with respect to the secured portion of its claim. Instead, the court determined that § 1322(b)(2) prohibits a debtor's plan from providing that the unsecured portion of a claim that has been bifurcated under § 506(a) could be treated the same as other unsecured claims since a plan which provides that a secured claim which is not being paid in full would thereby modify the rights of the holder of the claim.

It is important to note that neither the prohibition of modification in § 1322(b)(2) nor the Nobleman decision which interprets this section is applicable to Chapter 13 creditors who have a security interest in property other than the debtor's principal residence. 5 Collier on Bankruptcy, ¶ 1322.06. Thus, a claim secured by any other real property or by personal property of the estate may be modified by the Chapter 13 plan.(8)

4. Allowance of § 506(b) Interest, Fees and Expenses.

To the extent of any surplus value in the collateral, the secured creditor is entitled to interest and reimbursement of attorneys' fees and expenses. 11 U.S.C. § 506(b).

The right to interest apparently exists whether or not the documentation so provides. In re Best Repair Co., Inc., 789 F.2d 1080 (4th Cir. 1986). In the case of attorneys' fees, state law controls although the court will review the attorneys' fees for reasonableness. See Matter of Scarboro, 13 B.R. 439 (D.C.Ga. 1981).

Judge Tart recently denied an oversecured creditor reimbursement of its attorneys' fees under § 506(b) for its post-confirmation services rendered in drafting loan modification documents. In re Gwyn, 150 B.R. 150 (Bankr. M.D.N.C. 1993). In its decision, the court set forth the following test for determining whether § 506(b) fees should be allowed: whether the services rendered were within the scope of the terms and provisions of a legal document and whether they were reasonable and necessary for collection of the amounts owed by the debtor. Under this analysis, the court declined in the Gwyn case to conclude that a contract clause for attorneys' fees for collection efforts should be broadly read to include all services rendered in connection with the debtor. The court found that the vast majority of the services rendered during the period of time covered by the fee application were not necessary for the collection of the amounts owed to the secured creditor.

D. How to Handle the Confirmation Process of Chapter 11 Plans.

1. Affect on Liens.

The general rule in bankruptcy is that valid liens that have not been disallowed or voided pass through bankruptcy unaffected. See FDIC v. Davis, 733 F.2d 1083 (4th Cir. 1984). Secured creditors, however, should carefully review the debtor's proposed plan to see if its security interest is altered. Section 1141(c) provides that after confirmation, except as provided in the plan or in the order confirming the plan, the property dealt with by the plan is free and clear of all liens and interest of creditors of the debtor. If the plan fails to provide for continuation of the security interest after confirmation, a secured creditor's rights can be extinguished. See In re Nardulli & Sons Co., Inc., 66 B.R. 871 (Bankr. W.D. Pa. 1986); In re Arctic Enterprises, Inc., 68 B.R. 71 (D. Minn. 1986).

2. Confirmation Process.

In order for a Chapter 11 plan to be confirmed, all of the requirements under §1129(a) must be satisfied. Included among these requirements are that the plan comply with bankruptcy law, be proposed in good faith and not by illegal means, disclose certain parties, payments and services in connection with the plan in Chapter 11 case, provide proper treatment for priority and retiree benefit claims and be accepted by at least one "impaired" class of claims.

Section 1129(a) further requires that the plan satisfy the "best interests of creditors" test. This test requires that as of the "effective date" of the plan, each creditor must receive payments or other property totaling not less than what it would receive in a Chapter 7 liquidation. In a partnership case, a liquidation analysis includes not only the assets of the partnership, but also the net assets of the general partner. Note that § 1129(a)(7)(B) excepts secured creditors who have made a § 1111(b)(2) election, which is discussed in section D(2)(c) below, from application of the "best interests of creditors" test.

Finally, § 1129(a)(11) requires the court to find that the plan is feasible and is not likely to be followed by liquidation or the need for further reorganization of the debtor. 11 U.S.C. § 1129(a)(11). Factors in determining feasibility include adequacy of capital structure, earning power of the business, economic conditions, ability of management, availability of credit and provisions for adequate working capital. In re Guilford Telecasters, Inc., 128 B.R. 622 (Bankr. M.D.N.C. 1991).

3. Other Considerations.

(a) Impairment of Secured Claims.

Impairment determines whether a class is required to vote for or against a proposed plan. A class which is not impaired is deemed to have accepted the plan and a formal vote is not required. If a class is impaired, the class must vote to accept the plan or the proponent must resort to the "cram down" provisions under § 1129(b) which are discussed below.

According to § 1124, a class of claims is not impaired if the plan -

(i) leaves unaltered the legal, equitable and contractual rights of a claimant;

(ii) cures a default;

(iii) reinstates maturity of a claim to its pre-default status; and

(iv) compensates claimants for damages incurred to their reasonable reliance on particular contractual provision or applicable law.

11 U.S.C. § 1124. See also In re Gillete Associates, Ltd., 101 B.R. 866 (Bankr. N.D. Ohio 1989). A secured claim that is in default will be considered "impaired" unless the plan proposes to (i) reinstate the debt on the conditions prescribed by 11 U.S.C. § 1124(2) referred to above, or (ii) "buy out" the secured creditor. If the plan proposes to "buy out" the secured creditor, the debtor must pay cash on the effective date of the plan equal to the allowed amount of the secured claim. 11 U.S.C. § 1124(3). Payment of stock or other consideration that is not cash, even if this consideration is worth more, will not trigger this provision and the secured creditor will be deemed impaired.

If the Plan does not propose to leave unaltered the rights of the secured creditor, to restore the creditor to its original position by curing the default, or "buy out" the claim under 11 U.S.C. § 1124(3), the secured claim is considered impaired. Thus, any attempt by the debtor to modify the terms of the loan documents (i.e. change the maturity date of the loan or interest rate), the security agreement or any third party agreement or guaranty, or bifurcate the claim under § 506(a) constitutes impairment of a secured creditor's claim.

(b) Classification of Secured and Deficiency Claims.

Claims and interests of creditors are classified in Chapter 11 plans for purposes of treatment. 11 U.S.C. § 1123(a)(1). A plan may place a claim or interest in a particular class only if such claim or interest is substantially similar to the other claims or interests in that class. 11 U.S.C. §1122(a). Secured creditors are usually placed in separate classes with the proposed treatment in each class tailored to meet that creditor's particular loan and collateral. If a secured creditor is undersecured, the debtor will often classify the secured portion of the claim in one class and classify the deficiency claim in another class. This dual classification poses problems in a single asset real estate cases since there is generally a primary secured creditor and several smaller trade creditors. By classifying the deficiency claim, which is usually large, with other unsecured claims, the undersecured creditor can affect the acceptance or rejection of the debtor's plan by that class.(9) Faced with this prospect, the debtor is forced to meet the demands of the undersecured creditor regarding treatment of the its claim or risk having the court deny confirmation of its plan.

To circumvent this problem, debtors have attempted to classify deficiency claims differently from the other unsecured creditors in order to achieve an affirmative vote on their reorganization plans. Such attempts have been struck down by some courts. See In re Bryson Properties XVIII, 961 F.2d 496 (4th Cir. 1992); Greystone III Joint Venture, 948 F.2d 134 (5th Cir. 1991) (as amended). However, other courts have allowed this separate classification so long as the debtor can establish a basis under 11 U.S.C. § 1122 or an articulated business purpose. In re SM 104 Ltd., 160 B.R. 202 (Bankr. S.D.Fla. 1993).

(c) Section 1111(b) Election.

Sections 1111(b) and § 1129(a)(7)(B) of the Bankruptcy Code provide secured creditors with special rights regarding treatment of their claims under a plan.

(i) Treatment of non-recourse debt - § 1111(b). Under § 1111(b)(1), a secured creditor with a non-recourse loan will be allowed a unsecured claim for any deficiency as if the creditor had personal recourse unless the collateral is sold during the reorganization process or is to be sold under the plan or unless the secured creditor makes an "election" under §1111(b)(2) to have its entire claim treated as secured.

(ii) Unsecured Creditor - §1111(b)(2). Section 1111(b)(2) permits an undersecured creditor (either recourse or non-recourse) with a lien of real or personal property to elect to have an allowed secured non-recourse claim equal to the total amount of its claim. This Section contradicts and overrides § 506(a) which permits a debtor to bifurcate the claim of an undersecured creditor into a secured claim equal to the value of the collateral and an unsecured claim for any deficiency. In order to be eligible for the § 1111(b)(2) election, the creditor:

(i) must have a claim which is secured by a lien on the debtor's property (real or personal);

(ii) demonstrate that its interest in the property is not of inconsequential value; and

(iii) show that it does not have recourse against the debtor if the property is being sold under § 363 or is to be sold under the plan. 11 U.S.C. §1111(b)(1)(B).

If a § 1111(b)(2) election is made, the secured creditor is entitled to receive the total amount of its claim with payments having a present value equal to the value of its collateral.

A secured creditor should consider exercising a § 1111(b)(2) election if it believes that the collateral has been undervalued, the treatment accorded unsecured creditors is unattractive, the debtor has no free assets, the collateral will likely appreciate after the plan is confirmed, the plan will fail and the debtor will be liquidated, or the debtor will likely sell the collateral before the secured creditor is paid the present value of its interest in the collateral. A secured creditor should not make a § 1111(b)(2) election, except perhaps to defeat confirmation of a plan, if the present value to be received on both its secured and unsecured claim is greater than the payments it would receive under the § 1111(b)(2) election.

In order to make a § 1111(b)(2) election, Bankruptcy Rule 3014 requires that the election be made at any time prior to the conclusion of a hearing on the disclosure statement or within such later time as the court may fix. The election must be made in writing and signed unless made at the hearing on the disclosure statement. Once the election is made, a creditor cannot withdraw the election unless the plan under which the election was made either fails or is materially modified by the debtor. In re Keller, 47 B.R. 725 (Bankr. N.D. Iowa 1985).

Example of § 1111(b) Analysis: Suppose a creditor has a claim for $100,000, but the value of the collateral is only $70,000. Under § 506(a), the secured creditor would have a secured claim for $70,000 and an unsecured claim for $30,000. In order to "cram down" the plan on the secured creditor, the debtor would only have to pay the secured creditor the present value of $70,000. Now suppose that the debtor proposes in its plan to pay the present value of the secured claim ($70,000) at the rate of 8% per annum in five (5) equal annual installments of principal and interest of $17,532.20. Unsecured creditors are to receive a 5% dividend thirty (30) days after confirmation. Under the plan, the secured creditor will receive:

($70,000.00) Secured claim: $17,532.20 x 5 = $87,661.00

($30,000.00) Unsecured claim: $30,000.00 x .05 =$ 1,500.00


If the secured creditor makes an § 1111(b)(2) election, its secured claim would be $100,000 and the plan would no longer be fair and equitable since the total deferred payments in the sum of $89,661 do not equal the allowed amount of the secured claim. In order for the debtor to "cram down" the plan on the secured creditor, who has now made the §1111(b)(2) election, the debtor must propose a payment schedule that totals at least $100,000 and which has a present value of $70,000 (the value of the collateral). The debtor could thus modify the plan to pay the secured creditor the sum of $70,000 with interest at the rate of 8% per annum in nine (9) equal annual installments of $11,205.60. Under this equation, the secured creditor would receive:

($100,000.00) Secured claim: $11,205.60 x 9 = $100,850.40

4. Cram Down.

If all of the general requirements of confirmation under § 1129(a) are met, the plan may nevertheless be confirmed over the objection of a dissenting impaired class under § 1129(b). In order to "cram down" a plan, the court must find that (i) the plan does not discriminate unfairly; and (ii) the plan is fair and equitable with respect to the impaired class which has not accepted the plan. 11 U.S.C. § 1129(b).

The doctrine of unfair discrimination requires that a dissenting claim be treated in a manner consistent with the treatment afforded to other classes with similar claims against the debtor. To determine if there is unfair discrimination, the court looks at the particular treatment and decides whether the treatment is discriminatory, has a reasonable basis, is proposed in good faith, and whether the plan is feasible without such treatment. In re Pine Lake Village Apartment Co., 16 B.R. 750 (Bankr. S.D.N.Y. 1982). Discriminatory treatment with regard to secured claims can occur when a senior secured claim is impaired while a junior lien claim is unimpaired. Matter of Sandy Ridge Development Corp., 881 F.2d 1346 (5th Cir. 1989). It can also occur when a deficiency claim is treated less favorably than other unsecured claims. Greystone III Joint Venture, supra.

If the plan satisfies the prohibition against discrimination, the court then determines whether the treatment to the dissenting class is fair and equitable. With respect to secured claims, § 1129(b)(2)(A) provides that the secured creditor must:

(i) retain its lien and receive cash payments which total at least the allowed amount of its secured claim and which has a present value equal to the value of its collateral; or

(ii) retain its lien on any proceeds if the collateral is sold free and clear of the secured lien; or

(iii) realize the "indubitable equivalent" of its claim. Substitution of collateral and abandonment of collateral by the debtor to the creditor have been held to satisfy this requirement. See Matter of Sandy Ridge Development Corp., supra; In re W. B. Simons, 113 B.R. 942 (Bankr. W.D. Tx 1990); In re FCX, Inc., 853 F.2d 1149 (4th Cir. 1988).

5. Objections to Confirmation.

Following approval of the disclosure statement and prior to the confirmation hearing, a secured creditor who objects to the treatment of its claim should file an objection to confirmation with the court prior to the time fixed and, in addition, should vote to reject the plan. Grounds for objection should track the confirmation requirements under § 1129 of the Bankruptcy Code. In addition, the secured creditor should consider filing motions for dismissal or conversion and for relief from stay, if not previously filed.

Secured creditors should be particularly wary of plans in which the debtor attempts to undervalue the secured creditor's collateral during the reorganization, limit the secured creditor's claims to the collateral value and sell the collateral either as part of the plan or after confirmation to another third party. Such attempts undermine the secured creditor's § 1111(b) rights since the secured creditor is not being allowed to retain the full value of its claim. It also prevents the secured creditor in the event of a sale from participating by allowing it to bid in its claim.

Finally, secured creditors should be careful of plans in which the debtor attempts to release or avoid third party guarantees. Because these third parties and their property are not subject to the bankruptcy courts jurisdiction, these provisions are generally not allowed. However, if the secured party fails to object, such provisions may be enforceable.

E. Avoiding the Mortgage - the Powers of the Trustee.

Under § 544 of the Bankruptcy Code, a bankruptcy trustee or debtor-in-possession in a Chapter 11 case has certain "strong arm" powers under which liens and/or transactions which otherwise would have been considered valid had a bankruptcy petition not been filed can be voided.

1. Trustee as Hypothetical Lien Creditor - § 544(a)(1).

As a hypothetical lien creditor, the trustee has the right to avoid any transfer of the debtor's property or any obligation incurred by the debtor that would be voidable by a creditor who has extended credit and obtained a judicial lien on all of the debtor's property. For example, the trustee as a hypothetical lien creditor may defeat a security interest which is unperfected as of the day of the bankruptcy filing. If a UCC-1 financing statement has not been filed, was improperly filed or has lapsed, the trustee can avoid a security interest and reduce the creditor to unsecured status.

2. Trustee as Hypothetical Bona Fide Purchaser of Real Estate - § 544(a)(3).

Because there is a significant difference between mortgages on real estate and security interests in personal property, the Bankruptcy Code gives the trustee the specific powers of a bona fide purchaser of real estate in addition to its powers as a hypothetical lien creditor. Nevertheless, the goal is the same - for the trustee to be able to defeat unrecorded or improperly recorded real estate mortgages.

Under § 544(a)(3) and the North Carolina deed recording statute, a bankruptcy trustee has priority over parties with interest in real estate outside the chain of title. Daniel Flebotte v. John A. Northern, Trustee and Allstate Ent. Mart. Co. (In re Fletcher Woods, Inc., Debtor), 887 F.2d. 1079 (4th Cir. 1989) (unpublished). However, in Angeles Real Estate Company v. Kerxton, 737 F.2d 416 (4th Cir. 1984), the Fourth Circuit recognized that an equitable lien was superior to the trustee's rights under § 544(a). Also in In re Hartman Paving, Inc., 745 F.2d 307 (4th Cir. 1984), the court held that Chapter 11 debtor-in-possession could not assert the rights of a hypothetical bona fide purchaser for value to avoid an improperly acknowledged deed when the debtor-in-possession had previously acknowledged the defect. But cf., In re Sandy Ridge Oil Co., 807 F.2d 1332 (7th Cir. 1986).

3. Trustee as Successor to Actual Creditors - § 544(b).

As the representative of general creditors, the trustee or debtor-in-possession may avoid any transfer that is "avoidable under applicable law by a creditor holding an unsecured claim that is allowable." 11 U.S.C. §544(b). Consequently, this power has been used effectively to reverse bulk transfers that did not satisfy the requirements of the Bulk Sales Act and to avoid certain transfers as fraudulent that were made more than one (1) year prior to the filing of the bankruptcy and which otherwise could not have been attacked under the Bankruptcy Code.(10)

In order to bring an action to avoid a mortgage under § 544, the trustee or debtor-in-possession must file an adversary proceeding under Bankruptcy Rule 7001 within the earlier of two (2) years after the appointment of a trustee or the time the case is closed or dismissed. 11 U.S.C. § 546(a).

F. The Right of Lessors and Lessees.

Section 365 of the Bankruptcy Code provides that a bankruptcy trustee or debtor-in-possession, subject to court approval, may under certain conditions assume or reject an executory contract or unexpired lease. If the bankruptcy trustee or debtor assumes the lease, all arrearage must be cured and adequate assurance of future performance must be provided. 11 U.S.C. § 365((b). If a lease is rejected, the creditor has pre-petition claim for damages which is limited under § 502(b)(6) to the past due rent plus the rent reserved by the lease for the greater of one (1) year or fifteen percent (15%) of the remaining term of the lease, not to exceed three (3) years. See In re Bus Stop, Inc., 3 B.R. 26 (Bankr. S.D. Fla. 1980) (lessor bound by limitations of § 502(b)(6) notwithstanding that the lessor obtained a pre-petition judgment for the full amount of rents due).

In a Chapter 7 case, a trustee must assume or reject an executory contract or unexpired lease of residential real property or personal property within sixty (60) days after the order for relief or within such additional time as the court, for cause, may fix, otherwise, such contract or lease is deemed rejected. 11 U.S.C. § 365(d)(1). In a case under Chapter 11, 12 or 13, the trustee may assume or reject an executory contract or unexpired lease of residential real property or of personal property at any time prior to confirmation of a plan. 11 U.S.C. § 365(d)(2). If a non-residential real property lease is involved and the debtor is the lessee, then the trustee must assume or reject the lease within sixty (60) days after the date of the order for relief, or within such additional time as the court, for cause, shall fix, otherwise such lease shall be deemed rejected. 11 U.S.C. § 365(d)(4).

If a secured creditor does not feel that it is being adequately protected prior to the time its lease is assumed or rejected (i.e. it is not receiving rents or does not have a sufficient security deposit), it can request that the court enter an order fixing a time for the trustee or debtor-in-possession to assume or reject the executory contract or unexpired lease.

G. Use of Cash Collateral.

"Cash collateral" includes a security interest in the debtor's cash, negotiable instruments, documents of title, securities, deposit accounts and other cash equivalents. 11 U.S.C. § 363(a). Cash collateral also includes in the case of secured creditors proceeds, rents and profits received by the debtor after commencement of the bankruptcy case. Not included as "cash collateral" are proceeds in which the underlying lien is unperfected or invalid or tenant deposits.

In order for the debtor to use cash collateral, the debtor must either obtain the consent of the secured creditor or petition the court for an order, following notice and hearing, to use the cash collateral.

In determining whether the debtor will be allowed to use cash collateral, the court must find under § 363(e) that the secured creditor is adequately protected. Unfortunately subsection (e) provides little guidance to assist in this determination leaving the courts to struggle with this issue. Some courts have found that a higher standard of adequate protection is required before cash collateral may be used then that required for a motion for relief from the automatic stay under § 362. In re Berens, 41 B.R. 524 (Bankr. D.Minn. 1984); Matter of Mickler, 9 B.R. 121 (Bankr. M.D.Fla. 1981). Other courts have decided that the standard is the same. In re Marine Optical, 10 B.R. 893 (Bankr. App. 1 (Mass.) 1981); In re C.F. Simonin's Sons, Inc., 28 B.R. 707 (Bankr. E.D.N.C. 1983).

In deciding whether to allow the debtor to use cash collateral, the court must balance the "irreconcilable and conflicting interests" of the debtor and secured creditor. In re Stein, 19 B.R. 458 (Bankr. E.D.Pa. 1982). Often the debtor is in need of cash to meet payroll, pay suppliers or to maintain the property by providing utility, water and telephone service. Faced with this problem, the courts have generally fashioned a remedy whereby the debtor can continue to use cash collateral to preserve and maintain the property. Such use may be conditioned upon regular reports, periodic payments to the secured creditor, limitations or controls on the use of cash collateral, additional replacement liens and, if necessary, the appointment of an examiner or trustee.

Section 363(c)(3) sets forth the notice and hearing requirements regarding the debtor's use of cash collateral as follows:

Any hearing under paragraph (2)(B) of this subsection may be a preliminary hearing or may be consolidated with a hearing under subsection (C) of this section, which shall be scheduled in accordance with the needs of the debtor. If the hearing under paragraph (2)(B) of this subsection is a preliminary hearing, the court may authorize such use, sale or lease only if there is a reasonable likelihood that the trustee will prevail at the final hearing under subsection (e) of this section. The court shall act promptly on any requests for authorization under paragraph (2)(B) of this subsection.

Bankruptcy Rule 4001(b) further addresses the procedural requirements which must be met prior to the debtor using cash collateral. Under this rule, a motion for authorization to use cash collateral shall be made in accordance with Rule 9014 and shall be served on any entity which has an interest in the cash collateral, on any committee appointed under the Code or on such other entities as the court may direct. The court may commence a final hearing on a motion for authorization to use cash collateral no earlier than fifteen (15) days after service of the motion. If the motion so requests, the court may conduct a preliminary hearing before such fifteen (15) day period expires, but the court may authorize the use of only that amount of cash collateral as is necessary to avoid "immediate and irreparable harm" to the estate pending a final hearing.

The existence of "immediate and irreparable harm" has been used by some bankruptcy courts in North Carolina to permit emergency cash collateral orders to be entered on an ex parte basis. In most cases, these emergency orders are entered after notice to the secured creditor or with the secured creditor's consent. A preliminary hearing will then be immediately scheduled with notice of the hearing generally given to the debtor, the debtor's attorney, the trustee, if appointed, the United States Bankruptcy Administrator, any secured creditors whose interests may be affected, the Internal Revenue Service and the twenty (20) largest unsecured creditors (if a creditors' committee has not yet been appointed).

At the preliminary hearing, the order is scrutinized by the court and the other parties to determine whether the secured creditor is adequately protected and/or whether the debtor took a "dive" by cross-collateralizing pre-petition and post-petition assets or waiving the right to contest the validity of the secured creditor's lien.

In the absence of either consent by the secured creditor or court approval to use the cash collateral, the debtor is required under § 363(c)(4) to segregate and account for any cash collateral in its possession, custody or control.

In the event that the debtor fails to obtain authorization to use, sell or lease collateral without prior consent or court approval or to segregate cash collateral, the secured creditor may:

  • Seek injunctive relief under § 105;
  • Request the appointment of an examiner or a trustee under § 1104;
  • Move for conversion or dismissal of the case under 1112;
  • Move for relief from the automatic stay under § 362(b)(1);
  • Seek an order conditioning the use of cash collateral or property under § 363(c) or denying such use under § 363(c)(2)(B);
  • Move for retroactive adequate protection;
  • Request an order modifying the Debtor's ability to operate under Chapter 11 under §§ 1107 and 1108; and
  • Request sanctions against both the debtor and the debtor's attorney.

1. Assignment of Rents.

Usually a secured creditor receives a security interest in rents and profits either through a provision in a deed of trust or through a separate assignment of rents. Sometimes the assignment is "absolute" i.e. the right to receive rents and profits automatically; other times, the assignment does not take effect until there is some type of default by the debtor, such as nonpayment of the mortgage.

In 1991, the North Carolina Legislature amended N.C. Gen. Stat. § 47-20 governing the perfection of security interest in rents by recordation. This legislation was in reaction to several confusing and controversial bankruptcy court decisions in both the Western and Eastern Districts of North Carolina. In In re Westchase I Associates, L.P., 119 B.R 521 (Bankr. W.D.N.C. 1990), remanded 126 B.R. 692 (W.D.N.C. 1991) and In re Forest Ridge II, Limited Partnership, 116 B.R.937 (Bankr. W.D.N.C. 1990), Judge Marvin Wooten of the United States Bankruptcy Court for the Western District of North Carolina held that notwithstanding the existence of an assignment of rents provision, a secured creditor did not have perfected security interest in post-petition rents and profits unless the secured creditor had taken actual possession or constructive possession, such as the appointment of a receiver of the real property. In contrast, Judge Small in In re Raleigh/Spring Forest Apartments Associates, 118 B.R. 42 (Bankr. E.D.N.C. 1990), differentiated between perfection of a security interest in rents and profits and enforcement of a security interest in rents and profits. Judge Small concluded that a creditor need only record its assignment in order to be perfected therein. Id. at 45. However, Judge Small pointed out that perfection does not mean enforcement. Since the creditor had not taken steps to enforce the security interest in the rents at the time the petition was filed, Judge Small allowed the debtor to use the post-petition rents to maintain the property and to pay reasonable post-petition administrative expenses with any rents above those required to maintain the property sequestered for the benefit of the secured creditor. Id.

New N.C. Gen. Stat. § 47-20, which became effective on October 1, 1991, provides, in pertinent part, that:

(i) recordation of an assignment of rents in the county registry where the property is located perfects the assignee's interest in writs from the time of recordation;

(ii) the assignment of rents may be a separate instrument or be a part of another instrument such as a deed of trust; and

(iii) the assignee's entitlement is not contingent upon the appointment of a receiver or the taking of possession of the property.

This legislation also defines a "collateral assignment" as an assignment to convey an interest in rents as additional security, from a mere "assignment of leases, rents, issues or profits" which is a cash-all definition applied to any assignment. It further defines "rents, issues or profits" to include rents paid under the terms of a conventional lease, as well as hotel receipts. Generally, however, hotel receipts are personal property in the nature of accounts receivables which must be perfected by filing a financing statement in accordance with Article 9 of the UCC. See N.C. Gen. Stat. § 25-9-106; In re Ashoka Enterprises, Inc., 125 B.R. 845; In re Shore Haven Motor Inn, Inc., 124 B.R. 617, (Bankr. S.D. Fla. 1991); In re Oceanview/Virginia Beach Real Estate Associates, 116 B.R. 57 (Bankr. E.D. Va. 1990).

2. Ousting and Jousting with a State Court-Appointed Receiver.

Assuming that the borrower is not in bankruptcy, a secured creditor will generally request the appointment of a state-court receiver following default in order to seize control of the property's rents. N.C. Gen. Stat. § 1-502. Since the appointment of a receiver is an ancillary remedy, the request for the appointment is usually made contemporaneously with the filing of a foreclosure action. If it appears that the rents may be dissipated or otherwise squandered by the debtor unless immediate action is taken, a state court judge will appoint a temporary receiver without notice to the debtor. A show cause order is then issued and the debtor is notified of a hearing to determine whether the temporary receiver should be made permanent. N.C. Gen. Stat. § 1-502. A receiver under North Carolina law is given specific powers by statute and case law so that he may properly control, preserve and settle the property and assets, including rents, of the insolvent debtor. See N.C. Gen. Stat. § 1-507.3. In the event that the borrower-debtor files a bankruptcy petition following the appointment of a receiver, a secured creditor may file a motion to continue the receivership pursuant to 11 U.S.C. §§ 105 or 543. Because the Bankruptcy Code overrides and supersedes state law legislation governing receiverships, this motion may not be successful unless the conditions set forth in § 543(d)(1) or (2) can be shown. If the motion for a receiver is denied, the secured creditor should then either seek the appointment of a trustee or, as a condition to the entry of cash collateral order, demand that the receiver be appointed as "property manager" to operate the property and receive rent. It should be noted that § 105(b) of the Bankruptcy Code specifically prohibits bankruptcy judges from appointing receivers in a bankruptcy case.

Pursuant to 11 U.S.C. § 543, a trustee or debtor-in-possession may request that the previously appointed state-court receiver deliver and account for the rents from the property. Following notice and hearing, the bankruptcy court, however, may excuse compliance with this section if the interest of creditors would be better served by permitting the receiver to continue in possession, custody or control of such property. 11 U.S.C. § 543(d)(1). If the receiver is an assignee for the benefit of the debtor's creditors that was appointed or took possession more than 120 days before the date of the bankruptcy petition, the Bankruptcy Court shall excuse compliance unless necessary to prevent fraud or injustice. 11 U.S.C. § 543(d)(2). Subsection (d) reinforces the bankruptcy court's general abstention policy which is set forth in § 306 of the Bankruptcy Code.

Once a receiver has knowledge of the commencement of a bankruptcy case, the receiver is prohibited from making disbursements or taking an action in the administration of the debtor's property, including rents or profits, except as is necessary to preserve the property. 11 U.S.C. § 543(a). Thus, court authorization must be obtained by the receiver before he or she makes any disbursements. If an improper or excessive disbursement is made, other than in accordance with applicable law or with the approval of the bankruptcy court, the receiver can be surcharged. 11 U.S.C. § 543(c). In addition, § 105(a) permits the bankruptcy court to surcharge a receiver who refuses to turn over property promptly to the trustee and who requests a hearing under § 543(d) as a dilatory tactic. 4 Collier on Bankruptcy, ¶ 543.05 (15th Ed. 1993).

There is some question whether a receiver is entitled to adequate protection if the receiver is forced to turn over the collateral in its possession. According to In re Property Management & Investments, Inc., 17 B.R. 728 (Bankr. N.D. Fla. 1982), a custodian is not entitled to adequate protection as a condition to turn over. In contrast, the Supreme Court in United States v. Whiting Pools, Inc., 462 U.S. 198, 103 S.Ct. 2309, 76 L.Ed.2d 515 (1983), held that an entity that is required to turn over property of the estate in which it has an interest is entitled to adequate protection of that interest pursuant to § 542 of the Bankruptcy Code. Following the rationale in Whiting Pools, some courts have found secured creditors to be "custodians" within the meaning of §§ 101 and 543 and have held that such creditors are entitled to adequate protection as a condition of turn over. See In re Brickel, 11 B.R. 353 (Bankr. D. Me. 1981); Matter of Williams, 6 B.R. 789 (Bankr. E.D. Mich. 1980); Smitty's, Inc. v. Southeast National Bank, 1 C.B.C.2d 366 (M.D. Fla. 1979).

H. Use, Sale or Lease of Property.

In a Chapter 11 bankruptcy proceeding, a debtor may use, lease or sell property under § 363(b) or (c) even though the property may be subject to a security interest. This authority to use, sell or lease property overrides any provision in a contract which purports to terminate or modify the debtor's interest in property, based upon the insolvency or financial condition of the debtor, the filing of a bankruptcy petition, or the appointment of a trustee or receiver. 11 U.S.C. § 363(l). Notwithstanding this authority, § 363 affords the secured creditor some relief by imposing certain restrictions on the debtor's use, sale or lease of its collateral.

1. Ordinary Course of Business - § 363(c).

Section 363(c) allows the trustee or debtor to use, sell or lease collateral or other property in which a creditor has an interest in the ordinary course of business without notice or prior court hearing. There is some restriction on this broad grant of power. First, the business of the debtor must be authorized to operate under either § 721, 1108, 1304, 1203 or 1204 of the Bankruptcy Code. Second, the order permitting the trustee or debtor to operate the business must not contain any restrictions on this use, sale or lease of property. Third, §§ 363(a), 1110 and 1168 place certain restrictions on the use, sale or lease of property with regard to cash collateral, aircraft equipment and sailing vessels, and rolling stock equipment, respectively.

2. Transactions Other than in the "Ordinary Course of Business."

In order for a trustee or debtor to use, sell or lease property of the estate other than in the "ordinary course of business," notice and hearing are required under § 363(b)(1) of the Bankruptcy Code. 3 Collier on Bankruptcy, ¶ 363.03 (15th ed. 1993), suggests that a court order is not always required prior to any such use, sale or lease of property. In support of this argument, Collier points to § 102(l) which states that "notice and hearing" means "after such notice as is appropriate in the particular circumstances, and such opportunity for a hearing as is appropriate in the particular circumstances," but authorizes the act without an actual hearing if one is not timely requested or there is insufficient time for a hearing.

Bankruptcy Rules 2002(a)(2) and 6004(b) govern the applicable notice provisions. Bankruptcy Rule 2002(a)(2) requires twenty (20) days notice by mail of a "proposed use, sale or lease of property of the estate other than in the ordinary course of business unless the court, for cause, shortens the time or directs another method of giving notice." Note that this rule permits notice to be sent by first class mail. Parties entitled to notice include those creditors whose interest will be affected by the sale, the bankruptcy administrator, the trustee, if one is appointed, the debtor, the creditors' committee, if appointed, and those creditors who have filed notices of appearance pursuant to Bankruptcy Rule 2002(a)(2). Where notice by mail is impracticable, subdivision (k) permits notice by publication.

If the debtor or trustee fails to give notice to a secured party whose lien will be affected by the subsequent sale or lease of property, the entity which purchases or leases such property takes the property subject to the lien.

Bankruptcy Rule 6004(b) permits the adoption of a general notice where all of the non-exempt property of the estate has an aggregate gross value less than $2,500. In this manner, the trustee or debtor can use, sell or lease property outside the "ordinary course of business" without the requisite court approval for each transaction.

If a secured creditor receives notice that the trustee or debtor intends to use, sell or lease its collateral, Bankruptcy Rule 6004(b) directs the secured creditor to file and serve its objection upon the moving party at least five (5) days prior to the date set for the hearing or within the time fixed by the court. Any objection to the proposed use, sale or lease of property is treated as a contested matter and governed by Bankruptcy Rule 9014.

All sales not in the ordinary course of business may be by either private sale or by public auction. Bankruptcy Rule 6004(f)(1) states that unless it is impracticable, an itemized statement of the property sold, the name of each purchaser, and the price received for each item or for the property as a whole if sold in bulk shall be filed on completion of the sale. This report can be filed by the trustee, the debtor or the auctioneer, if one is appointed.

3. Sale of Collateral Free and Clear of Liens.

The debtor or trustee may sell property free and clear of any liens only if -

(i) applicable non-bankruptcy law permits sale of such property free and clear of such interests;

(ii) such entity consents;

(iii) such interest is a lien and a price at which such property is to be sold is greater than the aggravate value of all liens on such property;

(iv) such interest is bona fide dispute; or

(v) such entity could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.

11 U.S.C. § 363(f).

At a sale of property that is subject to a lien, the secured creditor, unless the court orders otherwise, may bid at such sale and, if successful in purchasing the property, may offset its claim against the purchase price of such property. 11 U.S.C. § 363(k).

A secured creditor should always require as part of the order authorizing the property to be sold that its lien be transferred to the proceeds of sale and that the proceeds be distributed at sale unless otherwise ordered by the court.

Section 506(c) allows a trustee or debtor to deduct "reasonable, necessary costs and expenses" for selling the property as a cost of administration prior to turning over the proceeds to the secured creditor. However, in C.I.T. Corp. v. A&A Printing, Inc., 70 B.R. 878 (M.D.N.C. 1987), the court found that this provision did not permit the trustee to charge the secured creditor with any portion of the rent or security expenses incurred by the estate.

What constitutes "reasonable, necessary costs and expenses" under § 506(c) is fact specific. See Matter of Trim-X, Inc., 695 F.2d 296 (7th Cir. 1982). Costs, which are not clearly related to preservation or disposition of collateral, require additional examination before they can be charged against the sales proceeds. This examination includes the purpose for which the costs and expenses were incurred; who derived the benefit; and the extent of the benefit. Generally, appraisal fees, auctioneer fees, advertising costs, moving expenses, storage changes, maintenance and repair costs and marketing costs are allowed, while administrative costs, overhead, trustee commissions and attorneys' fees are not.

4. Adequate Protection.

At the request of a creditor who has an interest in property to be used, sold or leased by the trustee or debtor, the court may prohibit or condition such use, sale or lease as is necessary to provide adequate protection to the secured creditor of its interest. The bankruptcy trustee or debtor-in-possession has the burden of proof on the issue of adequate protection and the secured creditor who has asserted a lien on the property to be sold has the burden of proof on the validity, priority or extent of the lien. 11 U.S.C. § 363(o).

5. Appeal.

Unless a creditor obtains a stay pending an appeal under Bankruptcy Rule 8005, the reversal or modification on appeal of an authorization under § 363(b) or (c) does not affect the validity of the use, sale or lease under such authorization. 11 U.S.C. § 363(n). Thus, an entity who leases or purchases such property in good faith would not be affected by the reversal or modification, even if that entity had knowledge of the appeal.


1. Section 105(a) of the Bankruptcy Code provides that "[t]he Bankruptcy Court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title." 11 U.S.C. § 105(a). This provision has been relied upon to effectively continue a stay which has terminated under § 362(d) or for failure to enter an order within thirty (30) days after the request for relief. In re Walker, 3 B.R. 213 (W. D. Va. 1980). It has also been used to extend the automatic stay to non-debtor third parties. See A.H. Robins Co. V. Piccinin, 788 F.2d 994 (4th Cir.), cert. denied, 479 U.S. 876 (1986); In re Kanawha Trace Dev. Partners, 87 B.R. 892 (Bankr. E.D. Va. 1988).

2. 28 U.S.C. § 1481 provides that "[a] Bankruptcy Court shall have the powers of a court of equity, law, and admiralty, but may not enjoin another court or punish a criminal contempt not committed in the presence of the judge of the court or warranting a punishment of imprisonment."

3. 28 U.S.C. §1651 provides, in pertinent part, that "[t]he Supreme Court and all Courts established by an Act of Congress may issue all writs necessary or appropriate in aid of their respective jurisdictions and agreeable to the usages and principles of law."

4. Effective October 1, 1993, new N.C. Gen. Stat. § 45-21-22 provides that when a Debtor files bankruptcy after the Clerk's order authorizing a foreclosure sale and before the ten (10) day upset bid period has passed, and the stay is thereafter lifted, the trustee is not required to initiate a new hearing, but most advertise and hold the sale in accordance with the original order and the provisions of Chapter 305.

5. Section 549(c) of the Bankruptcy Code contains an important limitation on this principal by protecting good faith purchasers of real property and purchasers at a judicial sale of real property located in a county other than the one in which the case was commenced, unless a copy of the petition was filed in the office in such county in which conveyances of real property are recorded.

6. A preliminary hearing typically differs from a final hearing in that no evidence is presented. Instead, the court hears declarations of counsel who summarize the evidence and applicable law. A party may, however, request that the preliminary hearing be a full evidentiary hearing at which time evidence and testimony will be presented to the court. If there is a "reasonable likelihood" that the party opposing the relief from stay will prevail at the final hearing, the court will order that the stay be continued. The Bankruptcy Code requires that a final hearing be commenced no later than thirty (30) days at the conclusion of a preliminary hearing. 11 U.S.C. § 362(e).

7. The 4th Circuit in Caroline Corp. v. Miller (In the Matter of Caroline Corp.), 886 F.2d 693 (4th Cir. 1989), has set forth the following two-prong test for determining whether a petition is filed in bad faith:

Upon consideration, we agree with those courts that require that both objective utility and subjective bad faith be shown in order to warrant dismissal for one of good faith in filing. This means that if the only question raised is whether a reorganization is realistically possible, i.e., if there is no question of the petitioner's subjective good faith in filing, threshold dismissal of a petition is not warranted. In those circumstances, the question of ultimate futility is better left to post-petition developments. By the same token, even if subjective bad faith in filing could properly be found, dismissal is not warranted if futility could not be found.

8. In order to qualify under § 1322(b)(2), the residence must constitute real property. 11 U.S.C. § 1322(b)(2). A mobile home, for example, may not constitute real property under applicable non-bankruptcy law and, therefore, the rights of the secured creditor can be modified and the lien stripped down. In re Thurston, 73 B.R. 138 (Bankr. N.D. Tex. 1987).

9. A class of claims is deemed to have accepted a plan if the creditors holding at least two-thirds an amount and more than one-half the number of the allowed claims of such class have voted to accept the plan. 11 U.S.C. § 1126(c). Remember that the debtor must have at least one "impaired" class voting to accept its plan; otherwise, it cannot be confirmed under § 1129. 11 U.S.C. § 1129(a)(10).

10. N.C. Gen. Stat. § 39-15 provides for a three-year statute of limitations on fraudulent conveyance actions while the comparable bankruptcy statute § 548 has only a one-year reach back

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