Chapter 4 — Adequate Protection
One of the most important protections provided to secured creditors under the Bankruptcy Code is the right to adequate protection, which is “a payment, replacement lien, or other relief sufficient to protect the creditor against diminution in the value of [its] collateral during the bankruptcy.”310 It ensures that creditors get “the benefit of their bargain”311 — i.e., “that the value of [their] security interest is protected.”312 Adequate protection has its foundation in the Fifth Amendment of the Constitution, which protects property interests.313 For the debtor,314 adequate protection is a tradeoff: If the debtor wants the protections of the Bankruptcy Code and the ability to retain or use encumbered property, including to use such encumbered property as security for post-petition financing, then the debtor must ensure that the secured creditor’s position is protected from the decline in the value of its collateral during the bankruptcy case.315
This chapter will discuss the three contexts in which adequate protection arises in the Bankruptcy Code, what constitutes adequate protection and how a creditor can make a request for adequate protection. It will also discuss what happens when adequate protection fails.
Once a debtor files its bankruptcy petition, the automatic stay under § 362 prevents creditors from taking action against the debtor. For a secured creditor, the immediate effect of the automatic stay is that it cannot foreclose on its collateral. However, a secured creditor can obtain relief from the stay to foreclose “for cause.”316
While the Bankruptcy Code does not define cause, it provides that “lack of adequate protection of an interest in property” is cause to lift the stay.317 Importantly, a creditor does not lack adequate protection under § 362(d)(1) simply because it “does not [have the] ... right to immediate foreclosure.”318 Rather, a “secured creditor lacks adequate protection if the value of its collateral is declining as a result of the stay.”319 So, a creditor is not entitled to relief from the automatic stay for lack of adequate protection simply by showing that the debtor lacks equity in the collateral.320 Instead, a creditor must also show that the value of its collateral is declining.321
In a bankruptcy case, particularly one under chapter 11, a debtor will usually need to use its creditors’ collateral to operate in the ordinary course of business. The Bankruptcy Code recognizes this reality and permits a debtor to use, sell or lease property of the estate in the ordinary course of business without bankruptcy court approval,322 and if the debtor obtains court approval, then the debtor can use, sell or lease property of the estate outside of the ordinary course of business.323 However, a court will prohibit or condition a debtor from using, selling or leasing property to the extent necessary to adequately protect the secured creditor with an interest in the property proposed to be used, sold or leased.324 Courts determine the appropriateness and extent of adequate protection based on whether the secured creditor is protected from a decline in value as a result of the debtor’s use, sale or lease of the collateral.325
One of the most common types of collateral that debtors seek authority to use is cash collateral, an expansive term that includes cash, securities, cash equivalents, proceeds and rents.326 For example, if a bank makes a loan to a debtor company that makes and sells shirts, and the bank has a security interest in the shirts and the proceeds thereof, then the proceeds collected by the debtor from the sale of the shirts would be cash collateral. In order for the debtor to use cash collateral — the cash proceeds in this example — it must either have the consent of the secured creditor or court approval, as required by § 363(c)(2) of the Bankruptcy Code.327
Debtors often require post-petition financing to continue their operations in the ordinary course and to support their chapter 11 efforts. The Bankruptcy Code recognizes the difficulty that a debtor could have in obtaining post-petition financing, so it provides a debtor with incentives that it can offer to lenders in exchange for such financing. If a lender provides unsecured credit to the debtor, the lender is entitled to an administrative expense claim.328 However, it is often the case that a lender will be unwilling to provide unsecured financing and will request additional protections before it will agree to provide secured financing. The Bankruptcy Code allows a debtor to offer lenders a superpriority administrative expense claim, a lien on unencumbered property and/or a junior lien on encumbered property.329 When those protections are still not enough to entice creditors to lend to a debtor, § 364(d) provides that, subject to court approval, the debtor can “obtain[ ] ... credit or ... incur[ ] ... debt secured by a senior or equal lien on property of the estate that is subject to a lien.”330 However, the secured creditor whose lien will be subordinated by the so-called “priming lien” has the right to adequate protection of its interest in the collateral.331 A creditor whose lien is primed by the financing and is entitled to adequate protection is adequately protected if the debtor’s proposed protections “provide the pre-petition secured creditor with the same level of protection it would have had if there had not been postpetition superpriority financing.”332
Whether a creditor is entitled to adequate protection almost always turns on the value of its collateral. As an initial matter, the value of the collateral determines whether a secured creditor is oversecured or undersecured, and that distinction can affect a creditor’s entitlement to adequate protection. As will be discussed, if the value of the collateral is significantly more than the underlying debt, a court could find that that alone adequately protects a secured creditor.
An oversecured creditor is one whose collateral is worth more than the amount owed to it by the debtor. The value of the collateral above the amount of the secured creditor’s claim is known as an equity cushion. Depending on the size of the equity cushion, that alone may be sufficient to adequately protect a secured creditor’s interest. Indeed, one court commented that “a substantially oversecured creditor is not entitled to adequate protection payments.”333 However, to the extent an equity cushion is found to be insufficient protection, an oversecured creditor is entitled to adequate protection to protect against the decline in the value of its collateral.334
Unlike an undersecured creditor, an oversecured creditor is entitled under § 506(b) of the Bankruptcy Code to interest — as allowed by contract or statute — to the extent of the value of its collateral.335 However, an oversecured creditor’s right to post-petition interest is not an “interest in property” for which it is entitled to adequate protection.336 Thus, the adequate protection provided to a secured creditor is intended only to compensate it for the decline in value of its collateral, not for its diminishing equity cushion as interest accrues.
In addition, when an oversecured creditor has multiple components of its collateral package, it is not necessarily entitled to adequate protection for each item of collateral in the package. For example, one court concluded that when “the value of the secured property exceed[ed] the creditor’s claim by a reasonable margin and [was] unlikely to decrease in value, then the claim [was] adequately protected, regardless of the number or types of security the creditor h[eld].”337 That court reasoned that the creditor was adequately protected because it was oversecured by at least one piece of collateral.338
Undersecured creditors are creditors whose collateral is worth less than the underlying debt. Like oversecured creditors, undersecured creditors are entitled to adequate protection to the extent the value of their collateral is declining.339 However, an undersecured creditor is not automatically entitled to adequate protection because it is undersecured.340 If an undersecured creditor’s collateral is not declining in value, it is not entitled to adequate protection.341 Similar to oversecured creditors, even when an undersecured creditor is entitled to adequate protection, such as when its lien would be primed by post-petition financing, it is only entitled to adequate protection of the value of its interest in the collateral, not the value of its lien.342
In United Savings Association of Texas v. Timbers of Inwood Forest Associates Ltd.,343 the Supreme Court discussed the limits on an undersecured creditor’s entitlement to adequate protection. In that case, the issue before the Court was whether undersecured creditors were entitled to adequate protection “for the delay caused by the automatic stay in foreclosing on their collateral.”344 The court concluded that an undersecured creditor does not have a property interest to be reimbursed as a result of the delay in foreclosing on its collateral caused by the automatic stay, and is not entitled to adequate protection “for the use of the proceeds [it] is deprived of during the term of the stay.”345
While Timbers put limits on undersecured creditors’ rights to adequate protection, courts do recognize the precarious position of an undersecured creditor, especially a junior undersecured creditor. At least one court has read Timbers to allow a junior undersecured creditor to receive adequate protection payments to the extent a senior secured creditor’s claim increased from accrued interest.346 That court concluded that such adequate protection payments are “not compensation for the delay in foreclosure or interest on the junior creditor’s claim but, in fact, are compensation for an actual erosion in the value of the junior creditor’s secured claim.”347
Valuation is the sine qua non for adequate protection. Accordingly, at what point in time the collateral is valued and the valuation methodology used can have a dramatic effect on whether and to what extent a secured creditor receives adequate protection. However, the Bankruptcy Code does not speak definitively to either of these points, forcing courts and practitioners to look to case law for guidance. This section discusses how courts determine the date upon which collateral should be valued and how such collateral should be valued for adequate protection purposes.
Courts generally agree that the proper valuation date for purposes of adequate protection is the date of the adequate protection request. Using the request date, rather than the petition date or the date of the adequate protection hearing, is considered to be most fair to all parties involved.348 By not using the petition date, courts seek to prevent situations where a creditor waits to move for adequate protection and then seeks a lump-sum payment from the debtor that could forestall reorganization.349 On the other hand, by not using the hearing date, courts seek to prevent debtors from delaying hearings so as to minimize their adequate protection obligations.350
While the Bankruptcy Code is silent on this issue, some courts rely on In re Best Products Co. Inc.351 in concluding that entitlement to adequate protection should be determined as of the date it is requested. In that case, Judge Lifland relied in part on the language of § 363(e) to conclude that “a secured creditor is entitled to adequate protection only on motion and only prospectively from the time such protection is sought.”352 The court in In re Continental Airlines353 relied on Best to conclude that the appropriate date for valuing the collateral at issue was the date on which the secured creditor filed its motion for adequate protection.354 In In re Waverly Textile Processing,355 the court, relying in part on Best, also concluded that “the date [the secured creditor] filed its motion ..., and not the petition date, is the proper date for valuing [the] collateral for adequate protection purposes.”356
The Ninth Circuit Bankruptcy Appellate Panel uses another, more nuanced, date for valuing collateral for adequate protection purposes. Specifically, that court has concluded that “the amount of adequate protection to which an undersecured creditor is entitled is equal to the amount of depreciation its collateral suffers after it would have exercised its state law remedies.”357 The court’s reasoning is that because “[a]dequate protection prevents creditors from becoming more undersecured because of the delay that bankruptcy works on the exercise of their state law remedies,... the bankruptcy court [has] to first determine when the creditor would have obtained its state law remedies had bankruptcy not intervened.”358 While the court acknowledged that other courts use the date of the request as the starting point for adequate protection, it noted that Congress could have drafted § 361 to include a “temporal limitation on adequate protection.”359
Bankruptcy courts enjoy considerable discretion in fixing the valuation method to be used for valuing collateral for adequate protection purposes.360 In exercising that discretion, some courts adopt a going-concern or fair market value approach, at least in a reorganization case.361 Depending on the collateral, a court may also use an industry-specific valuation method.362 The court may also take into account the “proposed disposition of the collateral” when determining which valuation method to use.363 Importantly, the valuation method used for purposes of adequate protection will not necessary be the valuation method used for other purposes later on in the case, such as for valuing the amount of the secured creditor’s claim for plan confirmation.364
As discussed above, in certain circumstances, the existence of a sufficient equity cushion alone can adequately protect a secured creditor.365 Thus, whether a secured creditor has an equity cushion may be one of the most important factors in determining whether it is entitled to further adequate protection.366 Courts calculate an equity cushion by deducting the value of the secured creditor’s lien, and all liens senior to that, from the value of the collateral.367 While junior liens might be relevant for other purposes, such as relief from stay under § 362(d)(2),368 they are not included for purposes of calculating a secured creditor’s equity cushion.369 This is “because the secured creditor is entitled to adequate protection only as to its claim; it may not claim protection for others.”370
Some courts compare the percentage of the equity cushion to the value of the collateral to determine whether a secured creditor is adequately protected. Generally, if an equity cushion is greater than 20 percent, it is often sufficient to adequately protect a secured creditor, while an equity cushion of less than 11 percent is often inadequate.371 Other courts look at a debtor’s prospects for reorganization to determine whether an equity cushion is sufficient — i.e., the less of a chance for a successful reorganization, the greater the equity cushion required to adequately protect the secured creditor.372 Certain courts will also consider the likelihood that the collateral will decline in value.373 Ultimately, whether an equity cushion is sufficient to adequately protect a creditor will depend on the facts of the case.374
If a secured creditor is entitled to adequate protection, a debtor can satisfy its obligation by providing one of three forms of adequate protection: cash payments, replacement liens or “such other relief ... as will result in the realization by such entity of the indubitable equivalent of such entity’s interest in such property.”375 The first two types of adequate protection are relatively straightforward concepts. It is the indubitable equivalent — something not defined in the Bankruptcy Code — that has challenged debtors, creditors and courts.
When a debtor seeks to continue the protections of the automatic stay or to use, sell or lease property subject to a lien — either as part of its operations or as collateral for post-petition financing — it may be required to make a cash payment or periodic cash payments as a form of adequate protection to the secured creditor holding that lien.376 Cash payments are “especially appropriate when the collateral is declining in value at a relatively fixed rate.”377 Even if the debtor was making fixed payments pre-petition pursuant to a loan agreement, adequate protection payments need not necessarily be in amounts equal to the pre-petition installment amounts. Rather, adequate protection cash payments should be in an amount necessary to compensate the secured creditor for the decrease in the value of its collateral.378 By making these cash payments, the debtor is ensuring that “the value of [the creditor’s] interest in the collateral remains constant.”379
Given the purpose of adequate protection payments, if the collateral does actually decrease in value during the pendency of the bankruptcy case, then the creditor can keep the adequate protection payments as compensation for its loss.380 If a creditor is undersecured, adequate protection payments that exceed the diminution in value of the secured creditor’s collateral should be used to reduce the amount of the secured claim.381 On the other hand, if a creditor is oversecured, then it can apply adequate protection payments first to post-petition interest allowed under § 506(b).382
As an alternative, or in addition, to cash payments, a debtor might grant a secured lender additional or replacement liens in substitute collateral or proceeds of collateral as a form of adequate protection. It is common in court orders approving the use of cash collateral for the debtor to grant replacement liens on its post-petition accounts as adequate protection to the secured lender whose cash collateral is being used.383 Under § 552, pre-petition security interests, with some exceptions, are not valid post-petition.384 So, a replacement or additional lien in post-petition accounts is a way of providing a secured creditor with adequate protection.385 Replacement liens are also common when a debtor sells collateral through a § 363 sale, as orders approving those sales will often provide a creditor with adequate protection by granting it a replacement lien in the proceeds of the sale.386 A replacement lien can also be granted on tangible property, so long as the substitute collateral is worth the same as or more than the original collateral. For example, one court concluded that replacement liens in gas wells adequately protected a secured creditor for the debtor’s use of cash collateral because the value of the wells was significantly higher than the cash collateral, notwithstanding the risk inherent in drilling wells.387
The indubitable equivalent form of adequate protection is the “catch-all” category of forms of adequate protection.388 It provides courts with the flexibility to fashion an appropriate adequate-protection remedy based on the facts and circumstances of a particular case.389 The term “indubitable equivalent” has a long history; it first appeared in an opinion written by Judge Learned Hand.390 In In re Murel Holding Corp.,391 Judge Hand wrote:
It is plain that “adequate protection” must be completely compensatory, and that payment ten years hence is not generally the equivalent of payment now. Interest is indeed the common measure of the difference, but a creditor who fears the safety of his principal will scarcely be content with that; he wishes to get his money or at least the property. We see no reason to suppose that the statute was intended to deprive him of that in the interest of junior holders, unless by a substitute of the most indubitable equivalence.392
Courts have attempted to define the contours of this otherwise-nebulous concept, as the Bankruptcy Code provides only one guideline: An administrative expense claim cannot be considered the indubitable equivalent.393 One consistent theme is that no matter what the debtor proposes as adequate protection under the indubitable equivalent standard, it must be “completely compensatory” and ensure that the secured creditor does not lose the benefit of the rights it bargained for pre-bankruptcy.394 The Supreme Court in Timbers added that the indubitable equivalent does not entitle a secured creditor to immediately realize the indubitable equivalent at once, “but only upon completion of the reorganization.”395 The indubitable equivalent is a purposely flexible standard, so as long as the proposed adequate protection meets these general guidelines, it can sufficiently adequately protect a secured creditor. To this end, case law provides examples of what may satisfy the indubitable equivalent standard.
When a debtor seeks to use cash collateral or obtain post-petition superpriority financing, it may argue that the secured creditor whose cash collateral is being used or whose lien is primed is adequately protected because the funds are being used for renovations or to continue a construction project, and therefore will increase the value of the collateral. For example, in one case, the court permitted the debtors to obtain superpriority post-petition financing to finance renovations to its real property.396 As a result of the financing, an existing secured lender’s liens would have been primed.397 The court found, though, that the lender was adequately protected because the renovations would increase the value of the property — “[i]n effect, a substitution occur[ed] in that the money spent for the improvements [was] transferred into value.”398 In another case, the Third Circuit rejected an argument that a secured creditor whose lien would be primed by superpriority post-petition financing was adequately protected since the proceeds of the loan would be used to continue construction.399 The court concluded that “continued construction based on projects and improvements to the property does not alone constitute adequate protection.”400
The legislative history of the Bankruptcy Code contemplates that a “guarantee by a third party outside the judicial process” could be a satisfactory form of adequate protection,401 and courts have also considered whether a third-party guaranty could serve as adequate protection. One court suggested that, depending on the financial strength of a guarantor, a third-party guaranty could be adequate protection.402 In a chapter 13 case, a court found that a mortgagee was adequately protected because the debtor’s mortgage was insured by the Federal Housing Administration.403 Another court, though, rejected the notion that a third-party guaranty could adequately protect a secured creditor, reasoning that an unsecured guaranty offers a lender “little or no protection.”404
While the standard for what constitutes the indubitable equivalent of a secured creditor’s interest — i.e., that the proposed protection is completely compensatory — is strict, the form that the indubitable equivalent can take varies widely depending on the facts of the case. For example, in one case, a debtor was required to pay its property taxes where the taxing authority had a senior lien to the lender seeking adequate protection.405 In an individual bankruptcy case where the debtor was required to move to Germany as part of his military service, the court found that the creditor with a lien on the debtor’s car was adequately protected by the indubitable equivalent of its interest because the debtor’s car insurance would apply in Germany.406 One court found that a secured creditor was adequately protected by the indubitable equivalent of its lien where the trustee used cash that would otherwise go to adequate protection payments to pay for an environmental site study in which the secured creditor could have been liable for environmental damages.407
In a single-asset real estate case, nearly all of the debtor’s income is derived from a single piece of real property, such as an apartment building.408 As discussed above, the secured creditor will often have a lien on the property and the rents generated from the property. Because there are virtually no other assets aside from the real property, the debtor cannot grant a replacement lien on another piece of unencumbered property. It could also be difficult for a debtor to provide periodic cash payments when the rents are already the secured creditor’s cash collateral and there is little or no additional income with which to make payments. Often in these cases, a debtor will seek to establish that there is an equity cushion in the property.409
Under chapter 12 of the Bankruptcy Code, family farmers and family fishermen can reorganize their operations through a plan.410 Section 1205(a), though, provides that § 361 does not apply to chapter 12 cases.411 Instead, § 1205(b) provides types of adequate protection that a chapter 12 debtor can offer a secured creditor. Those four types are:
While the first two types of adequate protection in a chapter 12 case appear similar to those that apply in the other chapters of the Bankruptcy Code, they contain one significant difference. Under § 361(1) and (2), a secured creditor is entitled to cash payments or a replacement lien for the “decrease in value of such entity’s interest in such property.”413 However, under § 1205(b)(1) and (b)(2), a secured creditor is only entitled to cash payments for the “decrease in the value of property securing a claim.”414 Another difference is that § 1205(b) does not include the indubitable equivalent standard.415 However, § 1205(b)(3) adds another form of adequate protection: fair rental value.416 If a secured creditor is entitled to adequate protection — for example, if the value of farmland is declining — then the debtor can provide the fair rental value of the farmland to the secured creditor as adequate protection “without the necessity of the rental fully compensating for a decline in land values.”417
Chapter 13 provides individual debtors with an alternative to a chapter 7 liquidation. Under chapter 13, a debtor proposes a plan to repay her debts over time.418 Because chapter 13 debtors will almost always use their encumbered assets during the pendency of their case and while effectuating their plan, the issue of adequate protection is particularly relevant. Before a debtor confirms her chapter 13 plan, she may be required to make adequate-protection payments to her secured creditor with a lien on real property.419 Chapter 13 also provides specific rules for adequate protection of a secured creditor’s interest in personal property. Before confirmation, the Bankruptcy Code requires that a chapter 13 debtor make monthly payments that adequately protect a secured creditor with a pre-petition purchase-money security interest “for that portion of the obligation that becomes due after the order for relief.”420 In addition, in order for a debtor to confirm her chapter 13 plan, she must make equal monthly payments to a creditor secured by personal property in an amount “sufficient to provide to the holder of such claim adequate protection.”421
A secured creditor may seek to lift the stay for lack of adequate protection by filing a motion in the bankruptcy court. The secured creditor has the initial burden of establishing a prima facie case that cause exists to lift the stay.422 To establish its prima facie case, the secured creditor must demonstrate that it has a secured claim against the debtor and that there is an actual or threatened decline in the value of such collateral.423 If the secured creditor makes its prima facie showing, then the burden shifts to the debtor to prove that the collateral is not declining in value, or that the secured creditor is adequately protected.424 For example, a debtor can satisfy its burden of proving that the secured creditor is adequately protected if there is a sufficient equity cushion.425
A secured creditor seeking adequate protection of its interest in property that is proposed to be used, sold or leased by the debtor must file a motion with the bankruptcy court.426 The burden of proof on a request for adequate protection under § 363(e) is minimal. Unlike a secured creditor moving for relief from the stay for lack of adequate protection, a secured creditor seeking adequate protection under § 363(e) needs to establish only that it has a valid interest in the debtor’s collateral that is being used, sold or leased.427 Indeed, § 363(p) provides that “[i]n a hearing under [§ 363] ... the [debtor] has the burden of proof on the issue of adequate protection.”428 Relatedly, when a debtor seeks court authority to use a secured creditor’s cash collateral, it bears the burden of proving that the secured creditor is adequately protected.429 This requires a debtor to either establish that the creditor is not entitled to adequate protection or to propose protections sufficient “to preserve the creditor’s interest in the cash collateral as it existed on the petition filing date.”430
A court will only approve superiority post-petition financing that primes a secured creditor’s lien if that secured creditor’s interest is adequately protected.431 Like § 363(p), § 364(d)(2) of the Bankruptcy Code specifically allocates the burden of proof on the issues of adequate protection for post-petition financing.432 When a debtor seeks court approval of superiority post-petition financing, it bears “the burden to establish that the holder of the lien to be subordinated has adequate protection.”433 A debtor does not meet its burden of proof by proposing adequate protection that is speculative — i.e., the debtor cannot rely upon an uncertain assertion that the collateral at issue will increase in value as a result of the use of the proceeds of the post-petition financing.434
The relationship between a debtor’s lenders is often governed by an intercreditor agreement, which sets forth the lenders’ various lien positions and their relative rights and obligations vis-à-vis each other. A common provision in intercreditor agreements is that junior lienholders cannot be paid until senior lienholders are paid in full — essentially a contractual version of the absolute priority rule in bankruptcy. A senior lienholder, then, might try to argue that a junior lienholder is not entitled to adequate protection payments until the senior lender is paid in full. However, a court is likely to reject such an argument, in particular if there is language in the intercreditor agreement that protects a junior lienholder’s statutory right to adequate protection.435 In fact, courts have rejected attempts by creditors to use general language in an intercreditor agreement to strip junior lienholders of their right to adequate protection payments, reasoning that “[a]dequate protection is a statutory right that is taken ‘very seriously’ and a secured creditor will not be found to have waived its right to adequate protection unless there is more than an ambiguous waiver of that right.”436
Despite the parties’, and often the bankruptcy court’s, best efforts to fashion an appropriate form of adequate protection that compensates a secured creditor for the decline in value of its collateral during the bankruptcy case, there will be instances where the adequate protection provided to a secured creditor will be insufficient to cover the entire post-petition decline in the value of such creditor’s collateral. For example, there could be market forces beyond the parties’ control that lead to an unexpected decline in the value of the collateral.437 Section 507(b) can be thought of as a “statutory fail-safe” to ensure that secured creditors receive adequate protection of their interest in property in cases where the initial adequate protection proved to be inadequate.438 That section provides that if the debtor,
under section 362, 363, or 364 of this title, provides adequate protection of the interest of a holder of a claim secured by a lien on property of the debtor and if, notwithstanding such protection, such creditor has a claim allowable under subsection [507](a)(2) of this section arising from the stay of action against such property under section 362 of this title, from the use, sale, or lease of such property under section 363 of this title, or from the granting of a lien under section 364(d) of this title, then such creditor’s claim under such subsection shall have priority over every other claim allowable under such subsection.439
So, under § 507(b), a secured creditor is entitled to an administrative expense claim if (1) it has an allowable administrative expense under § 507(a)(2); (2) the court previously ordered the debtor to provide adequate protection to that secured creditor; and (3) the adequate protection previously awarded failed to compensate the secured creditor for the actual decline in the value of its collateral.440
Section 507(b) makes reference to § 507(a)(2), which provides that “administrative expenses allowed under § 503(b)” have second priority in the Bankruptcy Code’s distribution scheme. Section 503(b) governs administrative expenses, which generally “are expenses incurred after the bankruptcy petition has been filed that receive special payment priority under the Bankruptcy Code,”441 including “the actual, necessary costs and expenses of preserving the estate.”442 When adequate protection fails, § 507(b) elevates a secured creditor’s administrative expense claim arising under §§ 362, 363 or 364(d) — i.e., three instances in the Bankruptcy Code where a secured creditor may be entitled to adequate protection — above almost all other administrative expenses.
Courts take two different views on whether § 507(b) requires that a secured creditor establish a separate “actual, necessary cost and expense of preserving the estate” administrative expense claim before it is entitled to a claim under § 507(b), or whether the debtor’s use of the collateral is sufficient to meet this requirement.
A majority of courts conclude that the requirement that there be an “actual, necessary cost and expense of preserving the estate” is satisfied by the debtor’s use of the collateral in aiding its efforts to reorganize.443 For example, when a secured creditor sought a § 507(b) claim for the diminution in value of its collateral, which was a hotel, the court concluded that the creditor had a § 503(b) administrative expense claim because “the Debtor’s use of the Hotel and its proceeds went to maintain the property and operate the business, [and] was an essential aspect of its efforts to reorganize.444 Similarly, the Eleventh Circuit rejected a chapter 7 trustee’s argument that a secured creditor was not entitled to a § 507(b) claim because the secured creditor did not provide goods or services in a post-petition transaction.445 Instead, the court concluded that there was a post-petition transaction because the debtor negotiated with its secured creditor for adequate protection in lieu of lifting the stay.446 Also, the debtor used the secured creditor’s collateral to operate its business, and the expense incurred by the secured creditor for such use — i.e., the diminution in value as a result of the use — was an “actual and necessary expense[] of preserving the estate.”447
However, at least two courts have taken a stricter view of § 507(b)’s requirement that the secured creditor first be entitled to a separate, independent administrative expense claim under § 503(b). The U.S. Bankruptcy Court for the District of Massachusetts concluded that § 507(b) does not convert claims for failure of adequate protection into administrative expense claims and underscored the requirement that there be an expense incurred by the estate, not the secured creditor.448 The court also questioned the Eleventh Circuit’s reasoning that consenting to the post-petition use of collateral in exchange for adequate protection payments was a post-petition transaction under the meaning of § 503(b).449 The U.S. Bankruptcy Court for the District of New Jersey also rejected the Eleventh Circuit’s reasoning and concluded that § 507(b) requires a secured creditor to have a post-petition claim separate from its claim that its collateral declined in value.450
The failure of adequate protection means just that: The amount of adequate protection that the court awarded the secured creditor was insufficient to provide such creditor with the indubitable equivalent of its interest in the collateral. Adequate protection can fail at different times in the case. For example, one common situation — especially where a debtor abandons its efforts to reorganize — is that a secured creditor obtains relief from the automatic stay and forecloses on its collateral, but the proceeds of the foreclosure sale, together with the amount of adequate protection payments it has received during the case, are insufficient to satisfy such creditors’ secured claim.451 A secured creditor may instead seek an order determining the value of its collateral from the bankruptcy court pursuant to Bankruptcy Rule 3012 and concurrently seek allowance of a § 507(b) claim to the extent that the court finds that the value of the collateral has declined such that the adequate protection the creditor received during the case was insufficient to offset the decline in value of the collateral during the case.452 Secured creditors have also sought § 507(b) claims in connection with chapter 11 plans of reorganization, prompted by the value assigned to the collateral by the debtor in the plan that demonstrates that there has been a post-petition decline in the value of the collateral.453
A secured creditor must file a request for payment of its § 507(b) claim, and that request must be approved by the court before a secured creditor can receive payment on the claim.454 The secured creditor bears the burden of proving its entitlement to a § 507(b) claim — i.e., that the collateral declined in value, and that it is entitled to an administrative expense.455 Assuming that the secured creditor can successfully carry its burden, the court will allow the secured creditor’s § 507(b) claim as a superpriority administrative expense claim in the amount sufficient to compensate it for the diminution in value of the collateral, less any adequate-protection payments already made to it.456 To avoid litigating the issue, a debtor and its secured creditor might choose to stipulate about the amount or kind of adequate protection that the debtor will provide. For example, a debtor and its secured creditor might agree to the amount of monthly payments the debtor will provide its secured creditor to protect against the diminution in value of that secured creditor’s collateral. Most courts permit a creditor with a § 507(b) claim to recover the full amount of the diminution in value of its collateral “notwithstanding the terms of a stipulation regarding adequate protection.”457
310 In re Scopac, 624 F.3d 274, 278 n.1 (5th Cir. 2010).
311 Id.
312 In re Dynaco Corp., 162 B.R. 389, 393 (Bankr. D.N.H. 1993).
313 H.R. Rep. No. 95-595, 339, 1977 U.S.C.C.A.N. 5963, 6295.
314 Because adequate protection frequently arises in the context of a chapter 11 case where the debtor acts as a debtor in possession, the authors chose to use the term “debtor” throughout. Note that the sections of the Bankruptcy Code use the term “trustee” instead of “debtor.” However, a chapter 11 debtor-in-possession “ha[s] all the rights, other than the right to compensation ..., and powers ... of a trustee.” 11 U.S.C. § 1107(a).
315 In re Panther Mountain Land Dev. LLC, 438 B.R. 169, 189 (Bankr. E.D. Ark. 2010).
316 11 U.S.C. § 362(d)(1).
317 Id.
318 United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Assocs., 484 U.S. 365, 371 (1988).
319 In re Elmira Litho Inc., 174 B.R. 892, 902 (Bankr. S.D.N.Y. 1994).
320 In re Planned Sys. Inc., 78 B.R. 852, 862 (Bankr. S.D. Ohio 1987).
321 Id.
322 Id., § 363(b) & (c)(1).
323 Id., § 363(b).
324 Id., § 363(e); In re Big3D Inc., 438 B.R. 214, 221 (B.A.P. 9th Cir. 2010) (“[W]hile a debtor in possession may use property subject to a creditor’s lien, § 363(e) conditions that right.”).
325 In re Carbone Cos., 395 B.R. 631, 635 (Bankr. N.D. Ohio 2008).
326 11 U.S.C. § 363(a).
327 Id., § 363(c)(2).
328 Id., § 364(a)-(b).
329 Id., § 364(c).
330 Id., § 364(d)(1).
331 Id., § 363(d)(1)(B).
332 In re Swedeland Dev. Group, 16 F.3d 552, 564 (3d Cir. 1994).
333 In re Senior Care Props., 137 B.R. 527, 529 (Bankr. N.D. Fla. 1992).
334 See In re Delta Res. Inc., 54 F.3d 722, 730 (10th Cir. 1995) (“[V]iewing the allowance of postpetition interest to oversecured creditors as a limited exception only, we hold that an oversecured creditor’s interest in property which must be adequately protected encompasses the decline in value of the collateral only, rather than perpetuating the ratio of the collateral to the debt.”).
335 11 U.S.C. § 506(b).
336 Delta Res., 54 F.3d at 730.
337 In re Bluejay Props., 512 B.R. 390, at *1 (B.A.P. 10th Cir. 2014) (unpublished).
338 Id. at *4.
339 In re Settlers’ Housing Serv. Inc., 505 B.R. 483, 495 (Bankr. N.D. Ill. 2014).
340 Id.
341 Confederation Life Ins. Co. v. Beau Rivage Ltd., 126 B.R. 632, 640 (N.D. Ga. 1991).
342 In re Fontainebleau Las Vegas Holdings LLC, 434 B.R. 716, 749-50 (S.D. Fla. 2010).
343 484 U.S. 363 (1988).
344 Id. at 369.
345 See id. at 371.
346 Ridgemont Apartments Assocs. v. Atlanta English Village Ltd., 110 B.R. 77, 83 (N.D. Ga. 1989).
347 Id.
348 In re Haiflich, 63 B.R. 314, 316 (Bankr. N.D. Ind. 1986).
349 Id.
350 Id.
351 138 B.R. 155 (Bankr. S.D.N.Y.), aff’d, 149 B.R. 49 (S.D.N.Y. 1992).
352 Id. at 157.
353 146 B.R. 536 (D. Del. 1992).
354 Id. at 539-40.
355 214 B.R. 476 (Bankr. E.D. Va. 1997).
356 Id. at 479.
357 In re Big3D Inc., 438 B.R. 214, 229 (B.A.P. 9th Cir. 2010) (quoting In re Deico Elecs. Inc.), 129 B.R. 945, 947 (9th Cir. 1992)) (internal quotation marks omitted).
358 In re Deico Elecs., 129 B.R. at 947.
359 In re Big3D, 438 B.R. at 230.
360 In re WPRV-TV Inc., 102 B.R. 228, 230 (Bankr. E.D. Okla. 1988).
361 In re Beker Indus. Corp., 58 B.R. 725, 737 (Bankr. S.D.N.Y. 1986). ABI’s Commission to Study the Reform of Chapter 11 has recommended that the amount of adequate protection should be based on the foreclosure value of a secured creditor’s collateral — i.e., the amount that a creditor would receive in a hypothetical, commercial, reasonable foreclosure sale. ABI Commission to Study the Reform of Chapter 11 Final Report and Recommendations 71 (2014).
362 See, e.g., In re Waverly Textile Processing Inc., 214 B.R. 476, 480 & n.5 (Bankr. E.D. Va. 1997) (using an insurance industry standard method to calculate the value of the secured creditor’s collateral, which was an unearned insurance premium).
363 In re Residential Capital, 501 B.R. 549, 594 (Bankr. S.D.N.Y. 2013).
364 In re SW Boston Hotel Venture LLC, 748 F.3d 393, 410-411 (1st Cir. 2014).
365 See supra 2.A.1.
366 In re Panther Mountain Land Dev. LLC, 438 B.R. 169, 190 (Bankr. E.D. Ark. 2010).
367 In re Indian Palms Assocs., 61 F.3d 197, 207 (1st Cir. 1995).
368 That section requires courts to grant stay relief if “the debtor does not have an equity interest in [the] property[] and ... such property is not necessary to an effective reorganization.”
369 In re Elmira Litho Inc., 174 B.R. 892, 904 (Bankr. S.D.N.Y. 1994).
370 Indian Palms, 61 F.3d at 207.
371 See In re McKillips, 81 B.R. 454, 458 (Bankr. N.D. Ill. 1987) (surveying cases).
372 See In re Senior Care Props. Inc., 127 B.R. 527, 528-29 (Bankr. N.D. Fla. 1992).
373 See, e.g., In re Bluejay Props. LLC, 512 B.R. 390, at *1 (B.A.P. 10th Cir. 2014) (unpublished decision).
374 In re Gallegos Research Group, 193 B.R. 577, 584 (Bankr. D. Colo. 1995).
375 11 U.S.C. § 361(1)-(3).
376 In re Falwell Excavating Co., 47 B.R. 217, 219 (Bankr. W.D. Va. 1985).
377 In re Cason, 190 B.R. 917, 924 (Bankr. N.D. Ala. 1995).
378 11 U.S.C. § 361.
379 In re Weinstein, 227 B.R. 284, 296 (B.A.P. 9th Cir. 1998).
380 In re 354 E. 66th St. Realty Corp., 177 BR. 776, 782 (Bankr. E.D.N.Y. 1995); see also In re SunCruz Casinos LLC, 298 B.R. 833, 844 (Bankr. S.D. Fla. 2003).
381 In re Maun, 95 B.R. 94, 96 (Bankr. S.D. Ill. 1989).
382 In re Vest Assocs., 217 B.R. 696, 705 (Bankr. S.D.N.Y. 1998).
383 In re McTyre Grading & Pipe Inc., 180 B.R. 308, 309 (Bankr. N.D. Ga. 1995).
384 11 U.S.C. § 552(a).
385 See In re Las Vegas Monorail Co., 429 B.R. 317, 344 (Bankr. D. Nev. 2010). When a debtor owns encumbered rent-producing real property, it may not propose granting a replacement lien on rents as adequate protection to its mortgagee. Under § 552(b)(2), a pre-petition security agreement in rents and hotel revenues continues post-petition. 11 U.S.C. § 552(b)(2). As a result, courts find that a pre-petition lender with a security interest in rent or hotel revenues is not adequately protected by the a so-called “replacement lien” in those rents or revenues. See, e.g., In re Buttermilk Towne Center LLC, 442 B.R. 558, 564-67 (B.A.P. 6th Cir. 2010); In re Hari Ram Inc., 507 B.R. 114, 125 (Bankr. M.D. Pa. 2014).
386 See In re WestPoint Stevens Inc., 600 F.3d 231, 257 (2d Cir. 2010).
387 In re O’Connor, 808 F.2d 1393, 1398 (10th Cir. 1987).
388 See, e.g., In re Swedeland Dev. Group, 16 F.3d 552, 564 (3d Cir. 1994).
389 See In re 495 Cent. Park Ave. Corp., 136 B.R. 626, 631 (Bankr. S.D.N.Y. 1992).
390 In re Sheehan, 38 B.R. 859, 864 (Bankr. D.S.D. 1984).
391 75 F.2d 941 (2d Cir. 1935).
392 Id. at 942.
393 11 U.S.C. § 361(3).
394 In re Fontainebleau Las Vegas Holdings LLC, 434 B.R. 716, 749 (S.D. Fla. 2010).
395 United Sav. Ass’n of Tex. v. Timbers of Inwood Forest Assocs., 484 U.S. 365, 377 (1988).
396 In re 495 Cent. Park Ave. Corp., 136 B.R. 626, 631 (Bankr. S.D.N.Y. 1992).
397 Id. at 628.
398 Id. at 631.
399 In re Swedeland Dev. Group, 16 F.3d 552, 566 (3d Cir. 1994).
400 Id.
401 H.R. Rep. No. 95-595, 340, 1977 U.S.C.C.A.N. 5963, 6297.
402 Id. & n.14.
403 Commonwealth of Pa. State Emp. Retirement Fund v. Roane, 14 B.R. 542, 545 (Bankr. E.D. Pa. 1981).
404 In re Carolina Utils. Supply Co., 118 B.R. 412, 417 (Bankr. D.S.C. 1990).
405 In re Lane, 108 B.R. 6, 11 (Bankr. D. Mass. 1989).
406 In re McGlockling, 296 B.R. 884, 889 (Bankr. S.D. Ga. 2003).
407 In re Mid-Atlantic Fuels Inc., 121 B.R. 207, 210 (Bankr. S.D. Va. 1990).
408 11 U.S.C. § 101(51B).
409 See In re Buttermilk Towne Ctr. LLC, 442 B.R. 558, 559 (B.A.P. 6th Cir. 2010).
410 See 11 U.S.C. §§ 1201, et seq.
411 Id., § 1205(a).
412 Id., § 1205(b).
413 Id., § 361(1)-(2).
414 Id., § 1205(b)(1)-(2); see also In re Westcamp, 78 B.R. 834, 837 (Bankr. S.D. Ohio 1987) (“Section 1205 ... makes it clear that the value of the property, not the value of the creditors ‘interest’ in property, must be protected.”).
415 In re Westcamp, 78 B.R. at 837.
416 11 U.S.C. § 1205(b)(3).
417 In re Turner, 82 B.R. 465, 468 (Bankr. W.D. Tenn. 1988).
418 11 U.S.C. §§ 1301, et seq.
419 In re Perez, 339 B.R. 385, 398-99 (Bankr. S.D. Tex. 2006).
420 11 U.S.C. § 1326.
421 Id. § 1325(a)(5)(B)(iii)(II).
422 In re Elmira Litho Inc., 174 B.R. 892, 902 (Bankr. S.D.N.Y. 1994).
423 In re Self, 239 B.R. 877, 881 (Bankr. E.D. Tex. 1999); In re Planned Sys. Inc., 78 B.R. 852, 860 (Bankr. S.D. Ohio 1987).
424 In re Armenakis, 406 B.R. 589, 621 (Bankr. S.D.N.Y. 2009).
425 In re Panther Mountain Land Dev. LLC, 438 B.R. 169, 193 (Bankr. E.D. Ark. 2010).
426 See In re Big3D Inc., 438 B.R. 214, 227 (B.A.P. 9th Cir. 2010).
427 In re AMR Corp., 490 B.R. 470, 477 (S.D.N.Y. 2013).
428 11 U.S.C. § 363(p).
429 Id. § 363(p)(1); In re Hari Ram Inc., 507 B.R. 114, 120 (Bankr. M.D. Pa. 2014).
430 In re Carbone Cos., 395 B.R. 631, 635 (Bankr. N.D. Ohio 2008).
431 11 U.S.C. § 364(d)(1)(B).
432 Id. § 364(d)(2).
433 In re Swedeland Dev. Group, 16 F.3d 552. 564 (3d Cir. 1994).
434 See In re YL W. 87th Holdings I LLC, 423 B.R. 421, 443-44 (Bankr. S.D.N.Y. 2010).
435 See In re Westpoint Stevens Inc., 600 F.3d 231, 261 (2d Cir. 2010).
436 See, e.g., id.
437 In re Callister, 15 B.R. 521, 533 (Bank. D. Utah 1981) (“The loss resulting from market forces therefore ought not equitably to be saddled on [the secured creditor] but on (the estate) for whose supposed benefit the restraint was imposed.”) (second alteration in original) (internal quotation marks omitted).
438 See, e.g., In re Scopac, 624 F.3d 274, 282 (5th Cir. 2010).
439 11 U.S.C. § 507(b).
440 See In re J.F.K. Acquisitions Grp., 166 B.R. 207, 212 (Bankr. E.D.N.Y. 1994). Notably, a court will not grant a secured creditor a § 507(b) superpriority administrative expense claim if the court previously denied that creditor’s request for adequate protection. See, e.g., In re Five Star Partners L.P., 193 B.R. 603, 609-10 (Bankr. N.D. Ga. 1996) (“Because the Debtor was not required to provide, and did not provide, adequate protection to [the secured creditor] within the meaning of section 507(b), [the secured creditor] has no claim under that section.”).
441 In re Lehman Bros. Holdings Inc., 508 B.R. 283, 289 (S.D.N.Y. 2014).
442 11 U.S.C. § 503(b)(1)(A).
443 See, e.g., In re Cal. Devices Inc., 126 B.R. 82, 84 (Bankr. N.D. Cal. 1991).
444 J.F.K. Acquisitions, 166 B.R at 212.
445 In re Carpet Ctr. Leasing Co. Inc., 991 F.2d 682, 686 (11th Cir. 1993).
446 Id.
447 Id. at 687.
448 In re Ralar Distribs. Inc., 166 B.R. 3, 8-9 (Bankr. D. Mass. 1994), aff’d, 69 F.3d 1200 (1st Cir. 1995).
449 See id.
450 In re Mary Holder Agency Inc., No. 11-34280 (MBK), 2012 WL 4434362 (Bankr. D.N.J. Sept. 24, 2012).
451 See, e.g., In re Cal. Devices Inc., 126 B.R. at 83, 86.
452 J.F.K. Acquisitions, 166 B.R at 212.
453 In re Scopac, 624 F.3d 274, 278 (5th Cir. 2010).
454 Cf. In re Atcall Inc., 284 B.R. 791, 797 (Bankr. E.D. Va. 2002).
455 See In re Scopac, 624 F.3d at 284; Ford Motor Credit Co. v. Dobbins, 35 F.3d 860, 866 (4th Cir. 1994).
456 See In re McGill, 78 B.R. 777, 782 (Bankr. D.S.C. 1986).
457 In re Blehm Land & Cattle Co., 859 F.2d 137, 140-41 (10th Cir. 1988). Some courts have not allowed a secured creditor’s request for a § 507(b) claim where the failure of adequate protection was the result of an error in the stipulation — typically, an error in the stipulated value of the collateral or of the amount of adequate protection payments. See, e.g., In re Callister, 15 B.R. 521, 532 (Bankr. D. Utah 1981). However, more recently courts have rejected Callister, arguing that its approach discourages parties from consensually resolving adequate protection issues. See, e.g., In re Two Bros. XI Inc., No. 2:10-bk-23048-DPC, 2013 WL 1856332 (Bankr. D. Ariz. 2013); In re Cal. Devices Inc., 126 B.R. at 85.