Sixth Circuit Holds that Giving Undersecured Lender Replacement Liens in its Own Collateral Does Not Provide Adequate Protection for a Debtor’s Ability To Use Cash Collateral

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In In re Buttermilk Towne Center, LLC, 54 Bankr. Ct. Dec. 13 (6th Cir. 2010), the Court of Appeals for the Sixth Circuit dealt with the right of a Kentucky debtor to use rents previously pledged as collateral for a loan to pay bankruptcy expenses.  In Buttermilk, the lender, Bank of America, was undersecured and the debtor, a real estate developer whose sole asset was the property under development, had no cash to pay its bankruptcy expenses, including legal fees.  The debtor wished to use rents to maintain the property and pay the costs of administering its bankruptcy case.

In Buttermilk, the debtor sought the court’s permission to use cash collateral over the objection of the bank.  The bank was secured by a mortgage on the property, along with an assignment of all rents collected from the property.  After filing for bankruptcy, the debtor sought to use the rents as cash collateral to fund its operation and administrative costs.  The bank objected, arguing that the rents were not cash collateral because they were not the debtor’s property.  Alternatively, the bank argued that even if the rents were cash collateral, the Bankruptcy Code required the bank to receive adequate protection for the use of those rents and that adequate protection was not provided.  The debtor countered that it would provide adequate protection by granting the bank additional liens on the property and the rents.

The court held that the rents were property of the estate. The court was convinced that the rent assignment was intended as security for the bank’s loan to the debtor.  The court concluded that, under Kentucky law, the rents were property of the estate.  The court noted the difference between Kentucky and New Jersey law on this point, distinguishing the Third Circuit’s holding in Jason Realty L.P. v. First Fidelity Bank, N.A. (In re Jason Realty, L.P.), 59 F.3d 423 (3d Cir. 1995).  The Third Circuit held that, under New Jersey law, an assignment of rents conveyed ownership of those rents to the assignee.  There was no comparable law in Kentucky.

Finally, having concluded that the rents were cash collateral, the court determined the debtor did not provide the bank with adequate protection.  The Buttermilk court reasoned that since the debtor was “out of the money,” the bank would not be adequately protected by replacement liens in the rents.  The court found that, if the debtor was permitted to use the rents for purposes other than maintaining the property, it would result in a diminution of the bank’s secured claim.

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