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A Cautionary Tale for Over-Secured Creditors

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May 25, 2016
Law360

It is a familiar principle to secured lenders that in a borrower’s bankruptcy, the lender, if it is over-secured as of the bankruptcy filing date, is entitled to receive post-petition interest, attorneys’ fees and other charges arising post-petition to the extent of the value of its collateral. It is also understood that, under Section 507(b) of the Bankruptcy Code, if the debtor’s usage of the lender’s cash collateral has impaired the overall value of the lender’s collateral, any resulting shortfall in the full satisfaction of the lender’s claim from its collateral will be made up in the form of a superpriority unsecured claim against the remainder of the debtor’s estate.

A recent decision issued by a federal district court in North Carolina challenges this principle in cases where the value of an over-secured lender’s collateral diminishes during the course of the bankruptcy case, and raises questions for secured lenders about how to avoid the result suffered by the secured lender in that case.

Background

In Construction Supervision,1 Branch Banking and Trust Co. (BB&T) made loans to the debtor secured by (among other assets) the borrower’s accounts receivable. When Construction Supervision filed its Chapter 11 petition, BB&T held claims of $1,265,868.55 in principal and matured interest, while the debtor’s accounts receivable were valued at $5,514,574.50. On their face, these values suggested that BB&T was comfortably over-secured, and could expect to recover not only its prebankruptcy claims for principal and interest but also interest, attorneys’ fees and other charges arising post-petition, pursuant to Section 506(b) of the Bankruptcy Code.

The facts were more complicated than that, however. The debtor, Construction Supervision, sought permission from the bankruptcy court to use the cash portion of BB&T’s collateral — that is, the proceeds of accounts receivable — during the bankruptcy case, asserting that BB&T’s claim was secured by property “valued far in excess of the [debtor’s] obligations.” BB&T objected, arguing that it was not adequately protected because many of the receivables were aged or otherwise suspect. In the alternative, if the bankruptcy court were inclined to permit the use of cash collateral, BB&T argued that it was entitled to monthly adequate protection payments to preserve the value of its interest in Construction Supervision’s accounts receivable.

The bankruptcy court granted Construction Supervision’s request to use the proceeds of accounts receivable during the bankruptcy case, but also ruled that BB&T’s interests in the accounts receivable were not adequately protected. To compensate BB&T for the possible diminution in the value of its collateral, the bankruptcy court required Construction Supervision to make monthly payments to BB&T. During the course of the case, the bankruptcy court granted a total of nine cash collateral motions and ordered Construction Supervision to pay BBT adequate protection payments in various amounts that totaled $62,900 by the end of the case.

Meanwhile, during the course of the case, various subcontractors and material providers surfaced, asserting security interests in the accounts receivable which were (under state law) senior in priority to the interests of BB&T. This, of course, reduced the value of BB&T’s interest in the accounts receivable. Finally, after eight months of attempting to reorganize under Chapter 11, the case was converted to Chapter 7. The Chapter 7 trustee proceeded to liquidate the debtor’s assets and, by the conclusion of the process, BB&T had received a total of $1,300,736.79, inclusive of the adequate protection payments of $62,900. This amount exceeded BB&T’s prebankruptcy claim by $34,868.24, and BB&T applied this amount to its post-petition interest, costs and fees. The amount, however, was not enough to pay all of the interest, attorneys’ fees and other charges that BB&T incurred during the bankruptcy case.

BB&T then filed a motion in the bankruptcy court requesting a superpriority unsecured claim under Section 507(b) for the amount of its post-petition interest, costs and fees that it did not realize from the proceeds of its collateral. BB&T argued that it was substantially over-secured when the bankruptcy case was filed, but that its security was diminished by the debtor’s use of its cash collateral during the case — leaving BB&T unable to recover its post-petition expenses from its collateral under Section 506(b). The bankruptcy court denied BB&T’s motion and the appeal before the federal district court ensued.

The district court affirmed, holding that Section 507(b) only applies when the “value” of a secured lender’s “interest” in its collateral is impaired, and that the only “interest” protected is the “value” of the secured lender’s claim — principal, matured interest and other charges compensable under the loan documents — as of the date the bankruptcy case is filed. The district court held that Section 507(b) does not protect the value of the secured lender’s collateral as of the petition date, and thus cannot be invoked to recover post-petition interest, fees and other charges that are unable to be paid when the collateral value declines during the bankruptcy case. Because BB&T received repayment in full of it’s claim as it stood on the bankruptcy filing date, the district court found that the adequate protection payments made to BB&T had served their purpose — ensuring that BB&T’s prepetition claim was paid in full — and that the value of BB&T’s interest in its collateral was not impaired for purposes of Section 507(b).2

Analysis

It emerges from Construction Services that the allowed amount of a secured claim under Section 506(b) (i.e., inclusive of post-petition fees) is not identical to the amount of secured claim that is entitled to protection under Section 507(b) of the Bankruptcy Code. This likely was not the governing assumption prior to the issuance of this decision.

While the decision may yet be appealed to the U.S. Court of Appeals for the Fourth Circuit, the decision provides a cautionary tale to over-secured creditors in bankruptcy cases: make every effort to obtain regular payment of post-bankruptcy interest, attorneys’ fees and other charges as they are incurred.3 This can be accomplished (the debtor’s cash flow permitting) by negotiating provisions for such payment in the cash collateral orders by which the debtor is permitted to use the lender’s collateral during the case, and by insisting that regular payment of such expenses be included in the debtor’s post-bankruptcy budget. The lesson from Construction Supervision is that accruing such expenses for payment at a later point in the case may result in nonpayment and no remedy.


  1. In re Construction Supervision Services Inc. (Branch Banking and Trust Co. v. Stephen L. Beaman), Case No. 15-CV-434, United States District Court for the Eastern District of North Carolina (May 9, 2016).
  2. The district court also affirmed the ruling of the bankruptcy court that BBT had failed to prove that the diminution of the value of its collateral during the bankruptcy case was due solely to Construction Supervision’s use of the accounts. The district court agreed that BBT had failed to rule out that the diminution was, instead, caused by the subcontractors’ intervening senior liens.
  3. Even though the amount of the secured lender’s claim is fixed as of the petition date, the value of its collateral is not. Whether the secured lender is indeed over-secured is a determination that in some federal judicial circuits will be made toward the end of the case. Thus, the debtor may agree to pay post-petition amounts only on a provisional basis, subject to the determination later that the lender was entitled to payment thereof under Section 506(b).

This article was published by Law360 on May 25, 2016 and is republished with permission.

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