The United States District Court for the Southern District of New York held in 2000 that when a court denies a creditor's motion for stay relief or adequate protection because the creditor is protected by an "equity cushion," the mere denial of adequate protection does not entitle the creditor to a superpriority claim for the diminution in value of its collateral if the equity cushion subsequently proves to be inadequate. Instead, the court concluded that a creditor is entitled to a superpriority claim for failure of adequate protection only if the court actually granted adequate protection that subsequently proves to be inadequate.
The Concept of "Adequate Protection"
The filing of a petition for relief under the Bankruptcy Code triggers one of the fundamental protections the Code affords to debtors - the automatic stay, which enjoins the commencement or continuation of substantially all acts or actions against the debtor and property of the bankruptcy estate. Because the stay deprives a creditor of the benefit of its bargain and suspends or eliminates a creditor's ability to resort to its remedies under state law, the Bankruptcy Code includes a provision that permits a secured creditor to ask the court for "adequate protection" of its collateral. If the court finds it necessary to provide adequate protection of the secured creditor's interest in the collateral, the court must condition the debtor's use, sale, or lease of property serving as that creditor's collateral to protect the creditor's interest.
The court may require the debtor to provide such protection in various ways, including periodic cash payments and additional liens. Moreover, section 507(b) of the Code provides that if the debtor is required to provide adequate protection pursuant to sections 362, 363, or 364 of the Bankruptcy Code, and if that protection ultimately is inadequate to protect the creditor from loss in value of the collateral, that creditor's claim for lost value is entitled to superpriority; that is, priority over every other allowable administrative or general unsecured claim except superpriority claims and liens granted to postpetition lenders.
Eastern Airlines Bondholders Sued Indenture Trustees
LNC Investments, Inc. v. First Fidelity Bank concerns equipment trust bonds issued in three series by Eastern Airlines to raise funds to pay for certain aircraft operated by Eastern. Title to the aircraft was held in trust to secure Eastern's payments under the bonds. When Eastern filed its chapter 11 case on March 9, 1989, the value of the aircraft in the collateral pool exceeded the aggregate value of the outstanding bonds by more than $228 million. Thus, the bondholders had an equity cushion; that is, they were oversecured to the extent of the difference between the value of the collateral and the obligations that it secured.
On November 14, 1990, the indenture trustees under the bonds were sufficiently worried about the declining value of the collateral to file a motion requesting the bankruptcy court to lift the automatic stay to permit them to foreclose on the collateral or, alternatively, to provide them with adequate protection. Their motion for relief was still undecided when Eastern ceased all operations in January 1991. Although all remaining collateral was transferred to the indenture trustees, the value of the assets in Eastern's estate was insufficient to pay even all administrative (first priority unsecured) claims, and there was nothing left to pay any distribution to second and third series bondholders. Faced with this sizable economic loss, bondholders brought suit against the indenture trustees, asserting that their failure to file a lift stay/adequate protection motion earlier in Eastern's chapter 11 case constituted a breach of their duty to fulfill their fiduciary responsibilities prudently.
The district court stated that even if the trustees' actions were imprudently delayed, the trustees would not be liable to the bondholders unless the bondholders could demonstrate that the trustees' actions caused them damage. In response, the bondholders contended that if the trustees had filed the adequate protection motion early enough for the bankruptcy court to have issued a decision, the bondholders' claims would have been entitled to superpriority status under section 507(b) even if the bankruptcy court had denied their request.
According to the bondholders, a secured creditor whose request for adequate protection is denied by the court on the ground that it is adequately protected by the existence of an equity cushion is entitled to superpriority status pursuant to section 507(b) if the equity cushion subsequently proves inadequate. The essence of the bondholders' argument is that section 507(b) is intended for the protection of secured creditors andthere is no principled difference between a bankruptcy court's ordering additional protection which later proves to be inadequate, and the court's denying that relief based upon the equally erroneous conclusion that the pre-existing protection is adequate. In both instances, the bankruptcy court's error and the adverse consequences to the secured creditor are precisely the same.
Therefore, the bondholders argued that all a secured creditor has to do to obtain superpriority status is to "raise your hand and ask." They contended that once a secured creditor begins the process of seeking adequate protection, "if things go wrong, you get the super priority [sic]."
The trustees disagreed with the bondholders' reading of the statute. They asserted that the right to a superpriority claim arises only when a court actually grants an adequate protection motion but the additional protection subsequently proves inadequate. Since the bondholders' claim for damages rested on their reading of section 507(b), the district court had to rule on the proper interpretation of that section in order to determine whether the bondholders were damaged by the trustees' failure to file an adequate protection motion earlier in the case.
Court Relied on "Plain Meaning" And Statutory Context
In the absence of dispositive judicial precedent or legislative history, the court focused on an examination of the statutory provisions concerning secured creditors. Although the court acknowledged that both parties offered reasonable and plausible interpretations of an ambiguous statute, after considering the intent of section 507(b) within the framework of the overall statutory scheme, the court ruled in favor of the trustees' interpretation.
The court was persuaded by:
- the "plain meaning" of the statutory language,
- the bondholders' inability to show that the trustees' interpretation leads to an absurd result, and
- conformity of the trustee's interpretation with Bankruptcy Code objectives.
The court noted that the primary objective of the Bankruptcy Code is the rehabilitation of the debtor. Because superpriority claims have priority over all other administrative and general unsecured claims except superpriority claims and liens granted to postpetition lenders, the court stated that they may chill the willingness of others to do business with a debtor postpetition. Thus, they are inimical to a debtor's economic survival and may prevent a debtor's successful reorganization.
The court also pointed to the limitations contained in the language of section 507(b). The plain language states that it is triggered if "a debtor in possession who under section 362, 363, or 364 of [the Code], provides adequate protection." Therefore, the court concluded that the superpriority provision is triggered only if a court has ordered the debtor in possession to provide adequate protection under one of the three designated sections, and the debtor-provided protection proves to be inadequate. Thus, the court rejected the notion that the statutory scheme was intended to tip so far in favor of secured creditors as the bondholders alleged.
The court acknowledged the force of the bondholders' argument that "it is anomalous for the granting and denial of an adequate protection motion to have such disparate consequences, when the bankruptcy court's error in assessing adequacy and the consequent prejudice to the secured creditor are the same." Nevertheless, the court observed that it is up to Congress, not the courts, to remedy the anomaly. The court concluded that the trustees' interpretation of section 507(b) conforms more closely to the language of that subsection and to the intent of other related provisions of the Code.
LNC Investments, Inc. v. First Fidelity Bank, 247 B.R. 38 (S.D.N.Y. April 11, 2000).