Sunday, October 31, 2010

New Opinion Raises Difficult Questions on Adequate Protection

A new opinion in the Scopac case raises difficult questions about adequate protection. In Matter of Scopac, No. 09-40307 (5th Cir. 10/19/10), which can be found here, the Fifth Circuit ruled that secured creditors were entitled to a super priority claim for failure of adequate protection even though its pre-petition collateral had appreciated in value during the case. The court ruled that income collected from sale of timber during the pendency of the case was an additional item of collateral entitled to adequate protection. Because the proceeds were spent during the case, the creditors were entitled to a super priority claim.

What Happened

Scopac and related entities filed for chapter 11 in January 2007. Its primary assets were 200,000 acres of redwood timberland and cash on hand. There were three major groups of creditors. Bank of America had a senior lien on the Debtors’ assets in the amount of $36.2 million. The Noteholders had a junior lien on the Debtors’ assets in the amount of $714 million. Marathon, a private equity fund, was owed $160 million.

The Court entered a series of cash collateral orders during the case requiring that the creditors receive adequate protection.

After exclusivity expired, Marathon and Mendocino Redwood Company filed a creditors’ plan. The plan sought to impose a “low-ball valuation of the timberland.” In response, the Noteholders filed a motion for a super priority administrative claim under Sec. 507(b). The Court found that the value of the timberland was $510 million and that this value had actually increased while the case was pending. The court denied the motion for super priority claim.

The Noteholders filed separate appeals from the confirmation order and the order denying the 507(b) motion. The Fifth Circuit granted a direct appeal of the confirmation order and affirmed that order. The 507(b) appeal went to the District Court which dismissed it. The District Court ruled that the appeal of the confirmation order divested it of jurisdiction.

The appeal to the Fifth Circuit raised the following issues:

1. Was there jurisdiction for separate appeals of the confirmation order and the 507(b) order?

2. Was the appeal equitably moot?

3. Were the noteholders entitled to a super priority claim for failure of adequate protection?

Jurisdiction

The Fifth Circuit disagreed with the District Court on the jurisdiction issue. The court quite sensibly noted that it had “repeatedly recognized that when a notice of appeal has been filed in a bankruptcy case, the bankruptcy court retains jurisdiction to address elements of the bankruptcy proceeding that are not the subject of the appeal.” It also said that the bankruptcy court retained jurisdiction over issues which “touc(h) upon the issues involved in a pending appeal “ so long as they do not have “any impact on the appeal.”

Under this test, the court found that the 507(b) order would not undo the confirmation order and that the appeals could proceed separately.

Equitable Mootness

The Fifth Circuit also found that equitable mootness was not a silver bullet to dispatch the appeal. So long as there was some relief which could be granted and the appeal would not upset the rights of third parties, the appeal was not equitably moot. Here, Marathon and Mendocino did not qualify as “third parties,” since they were sophisticated parties who understood the risks involved in consummating the plan while an appeal was pending.

Failure of Adequate Protection

The court defined adequate protection as “a term of art in bankruptcy practice . . .; in short, it is a payment, replacement lien, or other relief sufficient to protect the creditor against diminution in the value of his collateral during the bankruptcy.” Opinion, p. 4, n. 1.

The court explained the relationship between adequate protection and failure of adequate protection as follows:

This court has explained that adequate protection of a secured creditor’s collateral and its fallback administrative priority claim are tradeoffs for the automatic stay that prevents foreclosure on debtors’ assets: the debtor receives “breathing room” to reorganize, while the present value of a creditor’s interests is protected throughout the reorganization. (citation omitted). A secured creditor whose collateral is subject to the automatic stay may first seek adequate protection for diminution of the value of the property, 11 U.S.C. §§ 362(d)(1), 363(e), 364(d), and then, if the protection ultimately proves inadequate, a priority administrative claim under § 507(b). Section 507(b) of the Bankruptcy Code allows an administrative expense claim under § 503(b) where adequate protection payments prove insufficient to compensate a secured creditor for the diminution in the value of its collateral. “It is an attempt to codify a statutory fail-safe system in recognition of the ultimate reality that protection previously determined the ‘indubitable equivalent’ . . . may later prove inadequate.” (citation omitted).

Opinion, pp. 12-13.

However, the Court’s actual analysis was based almost entirely on the language of the cash collateral orders. Cash Collateral was defined as including “(t)he proceeds and product of the Prepetition Collateral.” The cash collateral orders contained the following provisions with regard to super-priority liens:

Each of BofA and the Trustee . . . is also granted a superpriority cost of administration priority claim under 11 U.S.C. § 507(b) to the extent of the postpetition diminution of their respective interests in the Prepetition Collateral and the Cash Collateral.

. . . .

No costs or expenses of administration or other costs or expenses of Scopac that have been or may be incurred in its Chapter 11 case shall be charged either against BofA’s or the Trustee’s Prepetition Collateral or Cash Collateral pursuant to Section 506(c) of the Bankruptcy Code without the prior express written consent of each of BofA and the Trustee.

The Court reasoned that the Noteholders were entitled to adequate protection of both their original cash collateral and funds received from sales of timber.

The cash collateral orders protected the Noteholders in two ways. They protected against a diminution in the value of the $48.7 million cash collateral that existed at the date of filing. They also specifically granted a continuing lien in the proceeds of the prepetition collateral, i.e., the $29.7 million generated proceeds from timber sales during the reorganization. The bankruptcy court entirely omitted the second component from its calculations and failed to credit those proceeds to the Noteholders’ § 507(b) claim.

Opinion, at 14.

Under the Fifth Circuit’s opinion, the conclusion that the Noteholders were entitled to compensation for diminution of their collateral flowed from the following logic:

1. The Noteholders were entitled to be compensated for diminution of the Prepetition Collateral and Cash Collateral under the Cash Collateral Orders;

2. The proceeds from sale of timber were included in the definition of Cash Collateral.

3. Therefore, the Noteholders were entitled to be adequately protected for the value of post-petition sales of timber.

The conclusion appears to follow from the language of the cash collateral orders. However, the larger issue is whether the Noteholders should have been entitled to adequate protection of the value received from post-petition sales of timber. The Fifth Circuit’s prior opinion in Matter of Stembridge, 394 F.3d 383 (5th Cir. 2004) held that a secured creditor was entitled to adequate protection of the value of its collateral as of the petition date. In this case, the value of the collateral actually appreciated during the pendency of the case. Was it simply a matter of bad drafting that the Noteholders were entitled to adequate protection for both the prepetition collateral and the postpetition income?

An argument advanced by the Noteholders in their Brief (but not mentioned by the Fifth Circuit) was that Section 552(a) provides for the secured creditor’s lien to extend to “proceeds and product” of prepetition collateral. The Fifth Circuit, on the other hand, mentioned that “proceeds and product” were included in the definition of cash collateral under Section 363(a). Does the definition of proceeds and product as collateral make these items pre-petition collateral entitled to adequate protection?

Consider two examples:

1) The debtor is a fast-food restaurant. On the petition date, the Debtor has $100 worth of hamburger meat and potatoes. The Debtor’s employees cook the hamburger meat and potatoes and sell $300 worth of combo meals. In order to generate this income, they must spend $100 on wages, utilities and supplies. Is the creditor entitled to be adequately protected for the original $100 value, the $300 in proceeds received or the $200 in net proceeds? If the secured creditor had foreclosed, it would have only recovered $100 worth of hamburger and potatoes. The increase in value from $100 to $300 is the result of the post-petition efforts of the Debtors’ employees. Thus, the creditor would only be entitled to adequate protection of the initial $100 in value.

2) The Debtor operates an apartment complex. The apartment complex is valued at $1 million on the petition date. Each month the apartment complex generates $10,000 in rents. It costs $5,000 per month to operate the apartment complex. The apartment complex has an economic life of 30 years. Each month, the apartment complex generates $5,000 in net rents. However, the project decreases in value by 1/360. So long as 1/360 is reinvested in the property and values remain constant, the property has the same capacity to generate rents. Therefore, the creditor would not be entitled to adequate protection of the net profits of $5,000 per month.

3) Apply these hypotheticals to the case of timber. On the petition date, the debtor owns timberland worth $500 million. During the pendency of the case, the Debtor harvests $30 million worth of timber. Assuming that market values remained constant, would the harvesting of $30 million worth of timber decrease the value of the remaining property by $30 million, thus entitling the creditor to adequate protection for the diminution in value? We don’t know. If the selective harvesting of timber allowed greater sunlight to reach the remaining timber so that it grew up to replace the timber which was cut, then the creditor did not lose any value. On the other hand, if vast areas were clear cut and not replaced, then the creditor would have suffered a substantial loss. Further complicating the hypothetical is the question of market forces. If during the pendency of the case, timber property appreciated by 20% due to forest fires in Russia, the secured creditor could not claim diminution in value. If the secured creditor had foreclosed on the petition date and immediately sold the collateral, it would not have received the benefit. Instead, the subsequent purchaser would have received the increased value. On the other hand, if global warming led to an overabundance of timberland reducing the value of all timberland, then the secured creditor would have suffered a diminution in value.

The opinion in Scopac may be defensible based upon the language of the cash collateral orders. However, it fails to answer the question of whether the timber proceeds were part of the pre-petition collateral or the debtor's post-petition efforts. The opinion should not be interpreted to mean that the secured creditor is entitled to adequate protection for both the value of the pre-petition collateral and any post-petition income received. In drafting cash collateral orders, practitioners should be careful to state that the secured creditor is entitled to be adequately protected for the value as of the petition date, nothing more and nothing less. Otherwise, the secured creditor could be granted a windfall as may have occurred in the Scopac case.

4 comments:

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