Adequate Protection: Entitlement and Provision

by Wendell H. Adair, Jr., Kristopher M. Hansen

May 1, 2001

(TMA Global)

With the recent increase in large corporate restructurings, it is increasingly important for debtors and creditors alike to have a fundamental understanding of basic bankruptcy concepts. In response to that need, this is the second in a series of articles focusing on core bankruptcy issues. In the February 2001 column, we focused on a creditor’s entitlement to post-petition interest, fees and costs pursuant to section 506(b) of the Bankruptcy Code. In this article we discuss the concept of “adequate protection”—the Bankruptcy Code’s method for protecting a party’s interest in property when actions in a bankruptcy proceeding affect or threaten to affect that interest.

Sections 362 (automatic stay), 363 (use, sale or lease of property) and 364 (obtaining credit) of the Bankruptcy Code authorize a court to grant adequate protection of a party’s interest in property. [1] Section 362(d)(1) of the Bankruptcy Code permits a party to seek relief from the automatic stay where its interest in property is not adequately protected. Accordingly, a party is entitled to adequate protection of its interest if the automatic stay prevents it from enforcing such interest. Section 363(e) of the Bankruptcy Code permits a party to seek adequate protection of its interest in property when a debtor seeks to use, sell or lease such property. Section 364(d)(1)(B) of the Bankruptcy Code requires a debtor to provide adequate protection to a creditor where the debtor obtains credit or other debt secured by a lien on estate property that is senior to the creditor’s lien on such property.

The Bankruptcy Code does not specify what constitutes adequate protection. Rather, Section 361 of the Bankruptcy Code provides the following three examples of what may provide adequate protection of a party’s interest in property:  [2] 1) a cash payment or periodic cash payments to the extent that the party’s interest declines in value as a result of the debtor’s actions; [3] 2) an additional or replacement lien to the extent that the party’s interest declines in value as a result of the debtor’s actions;[4] or 3) such other relief, as will result in the realization of the “indubitable equivalent” of an entity’s interest in property.[5]

In addition to those set forth in Section 361 of the Bankruptcy Code, depending upon the specific factual circumstances at issue, myriad other forms of relief also may constitute adequate protection.[6]Generally, however, when adequate protection is granted in connection with the automatic stay (the purpose of which is to maintain the status quo and provide the debtor with a breathing spell from its creditors) debtors are often required to protect the collateral. Accordingly, adequate protection in the stay context may take the form of simply requiring the debtor to pay taxes, maintain insurance and keep current on senior indebtedness.[7] Where adequate protection is granted in connection with the debtor’s use, sale or lease of property, it may take the more active forms of periodic cash payments (such as the payment of a portion of rent on encumbered property) or additional or replacement liens (typically in connection with a debtor’s use of cash collateral). When granted in connection with the issuance of priming liens, the adequate protection granted to the primed creditor generally takes the form of additional and replacement liens and periodic cash payments (such as current interest).

Regardless of the form that it takes, however, the granting of adequate protection is not designed to protect a party’s entire interest in property. Rather, the “amount” of adequate protection required is limited to the amount of a party’s interest in property. If a party’s claim is greater than the value of its interest in property, the excess portion of the claim is unsecured and not entitled to protection. To illustrate, if a creditor has a $2 million claim secured by $1 million of collateral, the creditor would be entitled to adequate protection on only $1 million of its claim with the remainder of the claim being classified as unsecured. [8] Where a creditor’s claim is less than the value of the property securing the claim, the creditor is protected by the excess value, known as an equity cushion, and may not be entitled to additional adequate protection until the collateral has decreased in value to a point at which the secured claim is threatened. For example, if a creditor’s $2 million claim is secured by $5 million of collateral, the creditor will have a $3 million equity cushion and may not be entitled to periodic cash payments to protect against a decline in the value of the collateral because the decline would affect the excess value and not the creditor’s $2 million interest. If, however, the value of the collateral declined to $2.1 million, the creditor’s $2 million claim likely would be threatened and the creditor would be entitled to some additional form of adequate protection. [9]

Because adequate protection is intended to protect the value of a creditor’s interest in property, a question that often arises is whether the value to be protected is the value of the interest as of the date of the request for protection or the date of the commencement of the debtor’s bankruptcy proceeding. The literal text of the Bankruptcy Code supports the view that adequate protection should be provided only from the date of the request for such relief. [10] Courts generally adhere to this rule as well, often justifying the result on the creditor’s delay in seeking protection. [11] For example, assume that, as of the petition date, a creditor’s collateral were worth $2 million and over the next month the collateral decreased in value to $1 million. Assume also that the creditor, with knowledge of the debtor’s bankruptcy proceeding, did not seek to modify the automatic stay or condition the debtor’s use, sale or lease of the collateral until after it had declined in value. Under such circumstances, courts will find it difficult to justify granting adequate protection for the period when the creditor did not seek to assert its rights, even though the value of the collateral declined during such time. The real lesson, of course, is that creditors must be diligent in protecting their collateral and must move for adequate protection as soon as possible after a debtor’s filing for bankruptcy in order to protect against any decline in the value of the collateral.

An additional concern in the adequate protection context that affects a debtor’s ability to deal with claims in its plan of reorganization is the valuation of the collateral to be protected. There are numerous methods for valuing property and many reasons for choosing one method over another. [12] Where a method is used to yield a high value, it will have the result of increasing the amount of a creditor’s secured claim. Similarly, using a method that yields a lower value reduces the size of the secured claim and may result in a larger undersecured claim. While it would appear that a secured creditor would benefit from a higher valuation (because its claim would receive better treatment in a debtor’s plan of reorganization), in the context of an adequate protection motion that may not always be the case. Indeed, if a particularly high value is assigned to collateral, it may form the basis for a court to determine that a sufficient equity cushion exists to protect the creditor and may result in no additional adequate protection being granted to the creditor. [13] Similarly troublesome, a lower valuation may result in a finding that more tangible adequate protection is required, but will increase the size of a creditor’s unsecured claim, which could result in a lower ultimate recovery under a debtor’s plan of reorganization. While a valuation for purposes of adequate protection is not binding upon a later valuation performed for a different purpose, it would be difficult for a court to ignore the existence of the earlier valuation. [14] Accordingly, parties must be wary of the ultimate treatment of a claim when deciding upon a valuation methodology in the context of an adequate protection motion.

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[1] See 11 U.S.C. § 362(d)(1); 11 U.S.C. § 363(e); 11 U.S.C. § 364(d)(1)(B) (2001). The provision of adequate protection pursuant to Sections 362 and 363 of the Bankruptcy Code will be made upon request of a party whose interest in property is affected by a debtor’s actions under such provisions. Adequate protection under Section 364 of the Bankruptcy Code is mandatory and a debtor must establish that it has adequately protected the interest of a lienholder in the debtor’s property prior to obtaining a loan with security equal or senior to the lienholder’s interest.

[2] 11 U.S.C. § 361 (2001). Section 361(3) of the Bankruptcy Code states that granting a party an allowed administrative expense claim (the highest priority of unsecured claim) pursuant to Section 503(b)(1) of the Bankruptcy Code is not considered adequate protection. While the statute was drafted to protect a party from being forced to receive as adequate protection a “mere” administrative expense claim, it does not preclude a party from consenting to take an administrative expense claim alone or as part of other adequate protection.

[3] Periodic cash payments are generally applied to the secured portion, as opposed to the undersecured portion, of a creditor’s claim because adequate protection payments are designed to compensate a creditor for a decline in the value of its collateral.

[4] Additional or replacement liens are commonly granted as adequate protection to a pre-petition secured creditor in order to protect it from new and often senior liens granted to the debtor’s post-petition lender. Such liens also customarily are granted as adequate protection to the debtor’s pre-petition secured creditors where the debtor is authorized to use such creditors’ cash collateral.

[5] The “indubitable equivalent” does not mean that collateral needs to be replaced with an identical type of collateral.

[6] The type of adequate protection generally depends upon the type of collateral in question. Where leased real property is at issue, adequate protection of the lessor’s interest in the property may take the form of current lease payments. If the value of the collateral is not declining, then adequate protection of real property may be provided by the maintenance of insurance, the payment of taxes and appropriate reporting of the debtor’s financial status to the lessor. Where the collateral is inventory and accounts receivable, a debtor may provide adequate protection by supplying current accounting information and additional or replacement collateral where the creditor possesses a lien on after-acquired inventory and accounts receivable.

[7] See In re Briggs Transp. Co., 780 F.2d 1339 (8th Cir. 1985) (payment of taxes); Allied Credit Corp. v. Davis (In re Davis) , 989 F.2d 208 (6th Cir. 1993) (maintenance of insurance); Ridgemont Apartments Assocs., Ltd. V/ Atlanta English Village, Ltd. , 110 B.R. 77 (N.D. Ga.) aff’d without opinion, 890 F.2d 1166 (11th Cir. 1989) (current interest payments to oversecured creditors).

[8] The automatic stay generally prevents the undersecured creditor from foreclosing on its collateral. Certain courts had held that an undersecured creditor was entitled to be paid interest on the undersecured portion of its claim in order to adequately protect such creditor for the delay in foreclosure caused by the automatic stay. The United States Supreme Court, however, rejected this position in holding that undersecured creditors are not entitled to compensation under Section 362(d)(1) of the Bankruptcy Code for any delay in foreclosing on collateral caused by the automatic stay because doing so would be inconsistent with the language and intent of Sections 506(b) (entitlement to post-petition, interest, fees and costs), 552(b) (post-petition effect of security interest) and 362(d)(2) (relief from the stay where the debtor lacks an interest in property and the property is not necessary to an effective reorganization) of the Bankruptcy Code. United Savings Ass’n of Texas v. Timbers of Inwood Forest Assocs., Ltd., 484 U.S. 365 (1988).

[9] Generally, courts have held that an equity cushion of 20 percent or more is adequate, while a cushion of 11 percent or less is insufficient. See e.g. , Kost v. First Interstate Bank of Greybill (In re Kost), 102 B.R. 829 (D. Wyo. 1989).

[10] As noted above, the language of Sections 362(d)(1), 363(e) and 364(d)(1)(B) authorize adequate protection upon the happening of a specified event. Literally read, such language indicates that relief should be granted so as to adequately protect the creditors’ interests as of the date of the request.

[11] See In re Carson, 190 B.R. 917 (Bankr. N.D. Ala. 1995) (awarding adequate protection from the date the motion for relief is filed and collecting authorities for same); In re Continental Airlines, Inc., 146 B.R. 536 (Bankr. D. Del. 1992) (same); In re Best Prods. Co. , 138 B.R. 155 (Bankr. S.D.N.Y. 1992) (same). But see In re Ritz-Carlton of D.C., Inc., 98 B.R. 170 (S.D.N.Y. 1989 (awarding relief from petition date).

[12] Liquidation, going concern, market and myriad other standards may be utilized in the valuation of collateral.

[13] See In re Glenn, 181 B.R. 105 (Bankr. E.D. Okla. 1995).

[14] With respect to the value to be assigned to collateral Section 506(a) of the Bankruptcy Code provides that “[s]uch value shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property … ” 11 U.S.C. § 506(a) (2001).

Wendell H. Adair Jr.
Partner
Stroock & Stroock & Lavan LLP
wadair@stroock.com

Adair can be reached at (212) 806-5870.

Kristopher M. Hansen
Associate
Stroock & Stroock & Lavan LLP

Hansen holds law and bachelor’s degrees from Fordham University, and can be reached at (212) 806-6056.


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