What is the Cash Collateral Motion in Chapter 11?
Cash Collateral is defined as cash, cash equivalents like marketable securities, and the proceeds from the sale of liquid assets such as accounts receivable and inventory belonging to the debtor.
Often, cash collateral will have security interests attached that prohibit the debtor from using the collateral without the prior consent from the holder of the lien (or a Court order).
Cash Collateral Usage: First Day Motion
At the onset of Chapter 11 bankruptcies, a debtor can file a First Day Motion for cash collateral usage among other requests such as debtor in possession financing (DIP).
The motion for cash collateral use is ordinarily made on the notion that the cash represents a source of “emergency liquidity” – hence, the Court frequently grants and authorizes the debtor to use the cash for non-discretionary expenditures determined to be necessary for operations.
Occasionally, the request can be straightforward if the debtor receives immediate approval to use its cash tied to a secured creditor – an occurrence that stems from the trust in the integrity of the debtor and its upcoming plan.
Often, the consensual decision by the creditor to give permission to the debtor can start the reorganization process on the right track.
For a debtor struggling to endure shortages in liquidity, it could appear counter-intuitive as to why a motion would be required to use the cash it has on hand in times of desperation. But recall the most frequent financial distress catalyst is related to debt financing.
Prior to becoming insolvent or near concerning levels of default risk, the borrower likely obtained bank debt at cheaper rates by pledging its assets as collateral per the lending agreement. In effect, senior prepetition lines of credit are secured by basically all the liquid assets of the borrower, such as accounts receivable, inventory, and cash & cash equivalents.
Section 363 Definition
Use, Sale, or Lease of Property Under Section 363 (Source: Legal Information Institute)
Contested Hearings: Creditor Refusal & Adequate Protection
Under Chapter 11, the debtor in possession may use, sell, or lease property of the estate in the ordinary course of a business unless prior approval is received from the Court.
Likewise, a debtor cannot use its cash without consent beforehand from the creditor holding the lien or formal authorization by the Court – otherwise, legal disputes could arise.
To reiterate, Bankruptcy Code §363 states “cash collateral” can only be used if the debtor obtained:
- Consent from the Creditor (or)
- Court Order Approval
In the latter, a contested hearing would be required as the creditor has refused to give consent.
The two conflicting sides of the argument in a contested hearing are:
- The prepetition lender must make the case that the interest it holds in the cash has validity and priority
- The debtor has the burden of establishing that the prepetition lender is “adequately protected”
The topic of “adequate protection” is the main prerequisite in receiving Court approval for the motion.
Briefly put, the debtor must show that the value of the specific creditor’s interest in the asset being used is under sufficient protection. In the event the value of the collateral decreases, the value of the claim held by the creditor would still retain its value.
The Bankruptcy Code defines “adequate protection” as being inclusive of:
- Cash Payments – E.g., Post-Petition Interest
- Providing a Replacement or Additional Lien
- “Indubitable Equivalent” (i.e., Exchange Equal in Value).
Adequate Protection Under Section 361 (Source: Legal Information Institute)
Each of the various types of adequate protection must sufficiently compensate the secured lender for the loss in collateral value caused by its usage by the debtor.
The purpose of the provision is arranged in an effort to reduce the concern that the value of the collateral will decrease from usage by the debtor. If that were to occur, the recoveries by the creditors would subsequently decline, which the provision protects against.
Often these contested hearings, due to the urgent nature of the request, tend to be expedited with a bit of a bias towards supporting the debtor.
For many reasons, negotiated cash-collateral usage can be fairly common in Chapter 11.
- First, the preservation of the debtor’s value is mandatory for both sides to achieve their goals – therefore, it is in the best interests of all parties for the debtor to remain operating on a “going-concern” value
- Next, filing for Chapter 11 implies a turnaround is possible, but the restriction of being able to use cash would only serve as an impediment and be a “lose, lose” situation that creates conflict between the debtor and creditors
- Lastly, the Court cannot force a positive outcome, but it strives to provide time and other beneficial protective measures to the debtor, and the rejection of the motion would be divisive from the start and impede one of the debtor’s main reasons for needing financial restructuring in the first place – i.e., the lack of liquidity and inability to raise capital
Non-Consensual Cash Collateral Usage
If a debtor proceeds to use the cash without the approval of the relevant creditors or the Court, the debtor should expect to suffer significant repercussions.
In situations of non-consensual cash collateral usage, the Chapter 11 process can be put in jeopardy and the debtor can be penalized with substantial fees for its non-compliance with the Bankruptcy Code.
But the most concerning effect is actually the decline in trust from creditors, which tends to have a domino effect.
The misuse of the cash was not an accidental lapse in judgment, but rather a decision made while fully aware of the consequences.
In a reorganization, the debtor still remains in charge of running operations (and the assets/estate); thereby, it is called the “debtor in possession”.
But on the other end of the bargain, the debtor has the legal responsibility to NOT use cash collateral without the consent of the secured creditors or a Court order. The failure of the debtor to hold up its end of the bargain leads to a rapid diminishment in trust – making future negotiations for the plan of reorganization (POR) more challenging.
While there are numerous other requirements the debtor must uphold, the breach of any of them becomes a significant issue due to the potential impact it has on the relationship among the bankruptcy participants.
From the perspective of the creditors, the debtor made a choice that suggests it places its personal desires above the interests of the creditors and even the rules set by the Court.
Said differently, the unauthorized use of the cash by the debtor could be viewed as a breach of its fiduciary duty – a severe offense in Chapter 11 proceedings. One potential outcome could be the appointee of a Chapter 11 Trustee to take over the responsibilities of the old management – a leadership hand-off that the U.S. Trustee would oversee.
Chapter 11 Conversion to Chapter 7
The misuse of cash collateral is a serious offense that could lead to the Chapter 11 bankruptcy undergoing conversion into Chapter 7 liquidation.
A violation can particularly be damaging if the breach was done for the personal benefit of the debtor at the expense of creditors.
Given the responsibility of the debtor to protect the interests of senior creditors, it would be reasonable for creditors to then lose trust in the debtor.
In the worst-case outcome, the poor choice made by the debtor can result in:
- Termination of Chapter 11 Reorganization
- Conversion into Chapter 7 Liquidation
The Court can rule that the debtor is precluded from accessing the cash, which basically restricts its ability to continue operating and pushes the debtor towards Chapter 7 liquidation as its financial health and credit metrics deteriorate.
Chapter 11 restructurings have the end goal of benefiting the debtor and helping it emerge as an economically viable entity, which can make the Court reluctant to cut off its access to much-needed cash. Nonetheless, there was a clear breach of trust in which the debtor is completely at fault – furthermore, the violation cannot (and likely will not) simply be looked past by creditors.
Despite all the protective measures afforded to the debtor as part of filing for Chapter 11 bankruptcy, the trust among the management team, creditors, and the Court has dissipated and all future action taken by the debtor will be viewed under the light of suspicion.
Considering the severe consequences of cash collateral misuse, debtors are urged to spend the cash only if approval is granted by the senior creditors and/or by order of the Court.
Once trust is lost from creditors, the majority of bankruptcies tend to transition into a liquidation as the collective mistrust in the debtor can be very difficult to recover from.