Question/Answer for Assignments 6 and 7

1. In talking about problem 6.6, you suggested that HFI could perhaps provide adequate protection of Macklin Mortgage’s security interest by granting a “replacement lien” on other unencumbered property HFI owned. Would it be a violation of the automatic stay or a preference for Macklin Mortgage to take that security interest? Wouldn’t taking a replacement lien violate § 362(a)(4), because it would be an act to create a lien against property of the estate?

No. We’ll talk about preferences, and the trustee’s power to set aside preferential transfers, later in the course. The short answer is that this couldn't be a preference because the replacement lien wouldn't have occurred prior to bankruptcy. A transfer can only be a preference if it occurred prior to bankruptcy. So the preference rules in § 547 wouldn’t apply.

There also wouldn’t be a violation of the automatic stay in the problem — assuming that Macklin Mortgage filed a motion for relief from stay and the replacement lien is granted as part of a court order resolving that motion. If Macklin files a motion for relief from stay, so that the issue is resolved by the bankruptcy court, then Macklin has done what it’s supposed to do, and the court’s order — the court order would condition the continuation of the automatic stay upon the debtor’s granting a replacement lien — would mean that there was no stay violation. In other words, conduct that would otherwise have violated the stay would be OK because the creditor moved for relief and the court authorized that conduct.

In contrast, Macklin couldn’t just strike a deal separately with HFI, outside the auspices of the court, without filing a motion for relief from the stay or getting court approval. If it did that — and if HFI granted a replacement lien without the approval of the bankruptcy court — then its taking of a replacement lien WOULD violate the automatic stay under § 362(a)(4), because Macklin didn’t first get relief from the stay in order to do that.

2. What happens if a foreclosure sale happens a few minutes after the debtor filed for bankruptcy, but the secured party conducting the sale and the buyer buying the property at the sale didn't know? Is that a violation of the stay, or can the buyer claim to be a bona fide purchaser?

Assuming that the debtor can prove it filed the bankruptcy petition prior to the sale — which should be easy, since the petition will be date and time stamped by the bankruptcy court clerk — then the sale is a violation of the automatic stay. It wouldn't be a wilfull violation of the stay if the secured party didn't know, so the secured party wouldn't be subject to a risk having to pay actual or punitive damages. But it is still a violation of the stay, because the stay by operation of law enjoins any act to enforce a lien against property of the estate, and that prevents any foreclosure sale.

An action in violation of the stay is generally viewed as void. Thus, it doesn't matter that the buyer didn't know. Buyer can't be a bona fide purchaser, and doesn't get to keep the property. Because the sale was void, it didn't pass any title to the buyer.

So would the buyer get its money back?

Yes, the buyer would be entitled to recover whatever amount it paid the secured party at the sale, since it didn't get title to the collateral. Alternatively, the buyer could just "step into the shoes" of the secured party by way of subrogation, and could assert the secured party's rights in the debtor's bankruptcy. But typically, the buyer would want its money back (and thus wouldn't try to assert the secured party's rights by subrogation, unless perhaps the secured party had already spent the money and didn't have it to return).

3. Suppose that Debtor was involved in meth trafficking, and the state busts him and brings a civil forfeiture action to get his home (where he was cooking meth) and his vehicles (which he was using to sell meth). Debtor then files for bankruptcy before the state can file the forfeiture action. Would a civil forfeiture action be covered by the "police power" exception to the stay? Would the state be able to proceed, or would it first have to get relief from the stay?

The weight of current authority is that a civil forfeiture action would fall within the "police power" exception. Until 1998, the "police power" exception only applied to allow actions that would have been otherwise stayed by § 362(a)(1), which stays "the commencement or continuation ... of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced" before the petition date. Thus, if an action would have been stayed by that section, the "police power" exception would have permitted a government to enforce its police or regulatory powers despite § 362(a)(1). The police power exception did not refer to conduct that would have been stayed under § 362(a)(3), which stays "any act to obtain possession of property of the estate." Thus, under the pre-1998 Bankruptcy Code, the weight of authority was that a civil forfeiture action was an action to obtain possession of property of the estate, that such a civil forfeiture was stayed by § 362(a)(3), and did not fall under the "police power" exception under § 362(b)(4).

In 1998, the Bankrutpcy Code was amended, and the police power exception in § 362(b)(4) was changed to read as it currently reads: "under paragraph (1), (2), (3), or (6) of subsection (a) of this section ...." As a result of this change, the "police power" exception would now cover an act that would otherwise have been stayed under § 362(a)(3). And as a result, the weight of authority now concludes that a civil forfeiture action (which would be an in rem action against the assets sought to be forfeited) falls within the police power exception. The leading case is In re James, 940 F.2d 46 (3d Cir. 2001). Under that view, the government could pursue a civil forfeiture action against the debtor's property without having to first obtain relief from the automatic stay. One can argue that this is the correct result, since the government is not really trying to collect a debt, and is instead seeking to vindicate or protect a public policy discouraging the trafficking of illegal drugs.

There are some decisions going the other way, however, and concluding that a civil forfeiture action is still subject to the automatic stay, so the final answer may depend on the prevailing view in the jurisdiction where the case arises.

4. I have a question about § 502(b)(2) disallowing a claim for "unmatured interest." The slides suggested that allowing post-bankruptcy interest wouldn't make sense because it would just increase the size of the claims of creditors, meaning that the creditors would just get smaller percentages. But isn't it likely that creditors would be entitled to collect interest at different rates? Some might have had contracts or claims that didn't provide for interest at all; some might have had interest at 10%, and others at 20%. So even if bankruptcy allowed post-bankruptcy interest, every creditor wouldn't end up in the same place; those with higher interest rates would get fractionally more than creditors with lower rates. So why disallow post-bankruptcy interest altogether for unsecured creditors?

Additional explanations/justifications for Section 502(b)(2) might include the following:

Okay, so if it makes sense not to allow unsecured creditors not to be able to accrue interest on their claims, why does bankruptcy allow oversecured creditors to accrue interest on their claims? Why not just say that all creditors are treated the same, secured or otherwise?

The answer is that if an unsecured creditor (or an undersecured creditor) is paid interest, the money to pay that interest has to come from property of the estate that would otherwise be distributed to unsecured creditors pro rata. By contrast, for the oversecured creditor, because of Section 506(b), that interest can accrue only out of the "equity cushion" — i.e., only from the collateral itself — and it thus isn't coming out of the pockets of the unsecured creditors. Congress thought that this result was appropriate because the oversecured creditor had bargained for an "equity cushion" that could better protect the creditor against the risk of nonpayment, and that unsecured creditors aren't harmed as long as that accrual of interest comes only from the collateral.

It should be apparent that this is just a policy argument/justification for that result. One could also argue that bankruptcy policy should require all creditors to be treated similarly, and that unsecured creditors are harmed by allowing interest to accrue on oversecured claims — after all, every penny that goes to an oversecured creditor in interest would otherwise have been available to be distributed to unsecured creditors. But Section 506(b) reflects the policy judgnent that Congress chose.

5. How does an oversecured creditor's right to interest relate to the concept of adequate protection? Take the example of Problem 7.3, where the secured party was owed $360,400 on the petition date and the collateral (equipment) was worth $400,000. The creditor is oversecured, so the creditor is entitled to accrue interest on Section 506(b). But if the collateral is equipment, won't it be depreciating, and thus shouldn't the creditor get adequate protection payments? How is all this accounted for?

You are correct — we talked about the right to interest and adequate protection separately, but in a real case, both of these issues could arise. If the creditor demands adequate protection, the debtor may try to argue that the "equity cushion" alone provides adequate protection, but the equity cushion here is pretty small (less than $40,000, or 10%), so even a small percentage depreciation in the value of the collateral could render the creditor undersecured. In that context, many courts would say that the equity cushion alone is not large enough to provide adequate protection by itself, and would require some adequate protection payments so as to preserve the creditor's relatively small equity cushion. [There is no "magic number" as to when the equity cushion is large enough to provide adequate protection by itself. Courts resolve this on a case-by-case basis, on the facts of each case.]

But adequate protection payments are NOT equivalent to interest. They are specifically payments that reduce the principal amount of the debt, in order to protect the secured creditor's overall secured position relative to the amount of the debt. So if the court orders the debtor to pay the secured creditor $3,000 per month for adequate protection payments, those payments have to get applied to reduce the debt, and thus they would reduce the amount of the creditor's secured claim.

As long as the creditor's secured claim is oversecured, however, the creditor is entitled to interest on its claim under section 506(b), so the oversecured creditor accrues pendency interest even if it is also getting adequate protection payments to account for depreciation in the value of the collateral. And because these payments are truly interest, they would NOT be applied to reduce the principal amount of the debt (like an adequate protection payment would be).