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Lenders Beware -- Liens Don't Float In Bankruptcy, But Are Frozen on the Petition Date

June 5, 2019

By: Elizabeth Amandus Baker

Introduction.

This article examines the effect on “floating liens” that results when a borrower seeks bankruptcy protection under Title 11 of the United States Code (the “Bankruptcy Code”). Because the “floating” nature of a floating lien terminates on the date the borrower files a bankruptcy petition, this article includes a general discussion of strategies available to a lender to protect its interests in the collateral it retains post-petition.

What Is a Floating Lien?

Lenders routinely obtain liens on a borrower’s inventory or accounts to secure repayment of a debt. These liens are called “floating liens” because they typically encompass not only all inventory and/or accounts as of a specific date, but all inventory and equipment acquired after that date (commonly referred to as “after acquired collateral”).[1] Such liens on inventory and/or accounts are referred to as “floating” because the collateral changes at a rapid, fluid pace in business, with new inventory and accounts constantly replacing the old. As the collateral constantly changes like a flowing stream, the lien floats on the surface of the collateral stream.[2]

For a borrower to obtain such a floating lien, (i) the lender and borrower must execute a security agreement in which the borrower grants the floating lien to the lender and (ii) the borrower must perfect its security interest by filing a UCC financing statement with the secretary of state’s office to put other parties on notice of the lender’s floating lien.

Floating Liens in Bankruptcy.

Lenders should be aware that even properly created and perfected floating liens immediately stop “floating” when the borrower files for bankruptcy. On the date the borrower files a bankruptcy petition (the “Petition Date”), the lender’s floating lien on inventory and/or accounts becomes fixed and is limited to only the inventory and/or accounts existing on the Petition Date and proceeds of that collateral. This is because the Bankruptcy Code provides that inventory and receivables acquired by the debtor’s estate after the Petition Date belong to the debtor’s estate. Specifically, Bankruptcy Code Section 552(a) provides:

Except as provided in subsection (b) of this section,[3] property acquired by the estate or by the debtor after the commencement of the case is not subject to any lien resulting from any security agreement entered into by the debtor before the commencement of the case.

This phenomenon becomes particularly significant in Chapter 7 or Chapter 11 bankruptcy cases where the debtor (or a Chapter 7 or Chapter 11 Trustee) continues to operate its business after the Petition Date. In these circumstances, the lender’s lien will not include any new inventory obtained after the Petition Date, and the pre-petition inventory will be sold in the course of normal business operations. “Since the operation of the business will consume the existing inventory, the secured party with the floating lien must utilize the devices available [under the Bankruptcy Code] to protect itself from the use or disposition of its collateral.”[4]

Strategies and Considerations for Lenders with Floating Liens.

What can a lender do to protect itself? From a preventative perspective, it is important for lenders to be aware of this bankruptcy concept when making loans and assessing the sufficiency of the collateral offered for the loan. Because of the risk that a lender’s floating lien might become fixed on the Petition Date if the borrower seeks bankruptcy protection, lenders should consider whether additional sources of collateral should be required of certain borrowers or for certain loans in order to sufficiently secure repayment.

A lender can also utilize strategies in a bankruptcy case to protect its interests where it has a floating lien on inventory and/or accounts. The lender can file a motion to lift the automatic stay of 11 U.S.C. § 362(d) to recover possession of its collateral (i.e., the Petition Date inventory and/or accounts and cash proceeds of that collateral received after the Petition Date, also known as “cash collateral”) where the debtor has failed to provide adequate protection to the lender for its use of the collateral. The lender can also, or alternatively, demand that the debtor provide adequate protection to the lender for its use or sale of the lender’s collateral. The Bankruptcy Code requires debtors to provide adequate protection to creditors to use or sell property subject to a creditor’s lien or interest (see 11 U.S.C. § 363(e)), which can include both monetary payments and granting replacement liens (see 11 U.S.C. § 361). Lenders can also protect their interests where the debtor has liquidated inventory subject to its floating liens. The proceeds of such inventory become the lender’s cash collateral, and the Bankruptcy Code prohibits debtors from using cash collateral unless it obtains either the consent of the entities having an interest in the cash collateral or court authority to use the cash collateral over the interested party’s objection. See 11 U.S.C. § 363(c)(2). The debtor is also required by the Bankruptcy Code to segregate cash collateral from other cash and account for it separately. See 11 U.S.C. § 363(c)(4).

While the floating lien is limited in bankruptcy, through these efforts, or a combination of them, lenders can potentially recover the Petition Date collateral or the value of its Petition Date collateral or negotiate a settlement providing the lender a replacement lien on the debtor’s post-petition inventory in exchange for granting its consent for the debtor to use its collateral and cash collateral.

[1] Section 9-204(1) of the Uniform Commercial Code, which has been enacted in most states, validates after acquired collateral clauses. Additionally, Section 9-203(3) and 9-306 of the Uniform Commercial Code provide that security interests attach automatically to proceeds of collateral.

[2] Bankruptcy law and floating liens—Floating liens and post-petition property, 2 Sec. Interests in Pers. Prop. § 34:33.

[3] Subsection (b) addresses that, except in limited circumstances, the Lender’s lien on Petition Date inventory and/or accounts will extend to post-petition “proceeds, products, offspring, and profits” of the Petition Date inventory and/or accounts.

[4] Bankruptcy law and floating liens—Floating liens and post-petition property, 2 Sec. Interests in Pers. Prop. § 34:37.

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