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If You Liked It Then You Shoulda Put a Lien on It — The Importance of Security for Creditors

Editor’s note: this blog post was recently published in Law360.

The Advantages of Security

Security has many advantages for creditors.  Four important advantages are listed below, followed by a discussion of the results of a recent empirical study showing that creditors recognize the benefits of obtaining security from their borrowers.

     Advantage 1: A Secured Creditor Will Rarely Walk Away Empty-Handed

When a debtor files a bankruptcy petition, there is often not enough money to go around.  Equity holders may be completely wiped out, receiving zero cents on the dollar.  Unsecured creditors are slightly better-positioned, occasionally receiving a dividend, but this dividend is often less—sometimes much less—than 100 cents on the dollar.

However, secured creditors, while never thrilled to learn about a borrower’s bankruptcy, can at least take solace in the fact that they will retain their interest in their collateral.  This interest may be subject to a trustee’s surcharge, discussed below, but even after this surcharge, the security interest will often have value.

Further, secured creditors are protected against a decline in value of their collateral.  This protection, known as “adequate protection” under the Bankruptcy Code, most frequently comes in the form of cash payments or in the form of additional or replacement liens.  11 U.S.C. § 361.

     Advantage 2: Secured Claims Ride Through Bankruptcy

A secured creditor need not participate in a debtor’s bankruptcy at all, and many secured creditors do not.  Pursuant to Section 506(d), a secured creditor’s lien will ride through the bankruptcy, allowing the secured creditor to recover from the collateral, if necessary, after the bankruptcy is over.

Alternatively, a secured creditor may participate in a bankruptcy case by filing a proof of claim.  If, during the course of the bankruptcy, the secured creditor receives payment in full on its secured claim, then the secured creditor must relinquish its lien.

     Advantage 3: Secured Creditors Go to the Front of the Line in Bankruptcy

Secured creditors are entitled to an important bankruptcy priority: the claim of a secured creditor is satisfied first out of the secured creditor’s collateral.  This means that if the collateral is sold during the bankruptcy, the proceeds are paid first to the secured creditor, with any remaining proceeds to be paid out to other creditors.

The only exception to this rule is that the bankruptcy trustee may collect a “surcharge” to recover “the reasonable, necessary costs and expenses” of liquidating the property, and this surcharge is satisfied before the secured creditor’s claim is satisfied.  11 U.S.C. § 506(c).  However, it is common for secured creditors to negotiate for a waiver of this surcharge in exchange for offering financing to the debtor-in-possession (known as “DIP financing”) or access to the secured creditor’s cash collateral.

     Advantage 4: Oversecured Creditors Continue to Earn Interest in Bankruptcy

If the value of a creditor’s interest in the collateral is less than the creditor’s claim, then that creditor is said to be “undersecured.”  Such a creditor has a secured claim up to the value of the collateral and an unsecured claim for the remaining amount owed.   11 U.S.C. § 506.

If, however, the value of the collateral is greater than the amount of a secured creditor’s claim, then the creditor is said to be “oversecured.”  Such a creditor may continue to earn interest while the debtor is in bankruptcy.  11 U.S.C. § 506 (b).

Consider a bank with a claim for $500,000 that is secured by a piece of real property worth $700,000.  The bank would have a secured claim of $500,000.  The remaining $200,000 is available to satisfy other claims against the bankruptcy estate.  It is important to note that in this scenario, the bank is better positioned than unsecured creditors.  Because the bank is oversecured, the bank continues to earn interest while the debtor is bankrupt.  The money that goes to pay this interest is money that otherwise would have gone to unsecured creditors in bankruptcy.

If, however, the bank’s claim for $500,000 were secured by real property worth only $300,000, then—subject to certain exceptions in some Chapter 11 cases—the bank would have a secured claim of $300,000 and an unsecured claim of $200,000.  Because the bank would be unsecured, the bank would not receive post-petition interest.

An Empirical Analysis Suggests that Creditors Recognize the Advantages of Security

Andrew Wood, an attorney in the Orange County office of Severson & Werson, recently performed an empirical study and published a useful article in the American Bankruptcy Law Journal called The Decline of Unsecured Creditor and Shareholder Recoveries in Large Public Company Bankruptcies.  85 Am. Bankr. L.J. 429 (2011).  Wood’s article observes that recoveries by unsecured creditors and equity holders have fallen in recent years, and Wood posits that the reason for this phenomenon is that creditors are demanding more security now than in the past.  These secured creditors are recovering money that otherwise would have gone to unsecured creditors and equity holders.

Wood’s article suggests that creditors have recognized the many advantages, including the four listed above, to obtaining security for their loans.  While Wood’s article only examines recoveries for creditors and equity holders of large public companies, there is no obvious reason to believe that the outcome would be different for creditors and equity holders of small- or mid-sized companies.

So the lesson here is that creditors should obtain security (to paraphrase Beyoncé, “put a lien on it”), if they want to protect their investments, especially when a borrower is at risk of going bankrupt.