What is a secured creditor?
So, you’re a secured creditor—what could possibly go wrong? A secured creditor is — at the very basic level — a creditor that has lent assets that are backed by collateral.
In bankruptcy cases, being a secured creditor comes with lots of privileges not reserved for the great unwashed general unsecured creditors. But are you actually secured? And if so, are you fully, over, or under secured?
Check your loan documents carefully. Many creditors initially feel secured but then find out too late that they failed to properly perfect their security interest. In bankruptcy, unperfected means unsecured, full stop.
Types of security
What is your security (meaning your collateral)? If it’s something the debtor turns into cash or cash equivalents, then you have rights in cash collateral. The debtor must either get your consent for the use of cash collateral by way of an agreed order — or seek authorization from the court. For example, if the debtor owns an office building that is your collateral, then the rents received can only be used by the debtor after entry of a court order authorizing the use of cash collateral pursuant to an approved budget.
Generally, the debtor’s operating expenses will be authorized, but tax payments and debt payments can be delayed until a plan is confirmed, giving the debtor the “breathing spell” to formulate a plan of reorganization.
By virtue of an order authorizing the debtor’s use of cash collateral, secured lenders are able to lock down many issues that may not be reconsidered later. Things such as the amount of pre-petition indebtedness, the sanctity of its security interest and perfection, recovery of interest (contractual rate/default rate) and attorney’s fees, lender’s expenses, etc. The most important, however, is usually the grant of a super-priority administrative expense and automatically perfected liens in post-petition assets/collateral.
The collateral value
The collateral value will determine whether you are fully, over, or under-secured. In addition to the entitlement to post-petition interest and attorney’s fees for an over-secured creditor, valuation of collateral will play a major role in a secured creditor’s request for relief from the automatic stay to allow for foreclosure of its lien on collateral. An under-secured creditor will garner greater sympathy from a court than an over-secured creditor whose “equity cushion” will theoretically preserve ultimate payment on its debt in full. The finding of an equity cushion will generally allow the debtor more time before it is required to begin making payments to an over-secured creditor.
When it comes to valuing collateral, the general rule is: “What is the fair market value of the collateral at a given point in time?” Fair market value is generally defined as: “What a willing buyer will pay a willing seller with no compulsion on either party to buy or sell?” Note that valuation methodologies usually require expert testimony which can become expensive and cumbersome.
The key takeaway for secured creditors
In conclusion, confirm that you are a properly perfected secured creditor with sufficient collateral value when entering into this role. By understanding the intricacies and potential scenarios in the event of bankruptcy, you’ll be able to sleep well knowing you’ve protected your assets appropriately.