Best Practices: Understanding Cash Collateral in Bankruptcy

One of the most important bankruptcy concepts that a lender needs to understand is so-called “cash collateral.” The term cash collateral has a specific meaning in bankruptcy and there are Bankruptcy Code provisions that govern the parties’ respective rights in that collateral. Understanding what cash collateral is and how it is treated in bankruptcy can help a lender maximize its leverage and shore up any deficiencies that may affect the lender’s SBA guaranty. This article focuses on the leverage a lender can exploit when it has a security interest in the debtor’s accounts receivable.

The cash collateral concept arises in bankruptcy when a lender has a valid, perfected security interest in the debtor’s “accounts.” In most commercial loans, a lender’s security interest in “accounts” extends to the debtor’s accounts receivable.

If a lender has a valid security interest in the debtor’s accounts prior to the bankruptcy filing, the lender has tremendous leverage over the debtor. The Bankruptcy Code prohibits a debtor from using “cash collateral” unless the secured party consents or the bankruptcy court approves such use. Cash collateral is defined in the Bankruptcy Code to include the debtor’s accounts receivable. Since almost all SBA loans are cash flow driven, the debtor’s ability to use its operating revenue to fund continued operations is vital.

Since the Bankruptcy Code prohibits a debtor from using encumbered operating revenue without permission, a Chapter 11 debtor typically files a motion with the Bankruptcy Court seeking permission to use the revenue generated from accounts receivable to fund on-going operations.

The Bankruptcy Court typically holds an initial hearing on such motions very quickly. The Court usually will approve the interim use of cash collateral until it can schedule and hold a final hearing on the use of the cash collateral. In most instances, the Court will require the debtor to operate within a weekly budget in order to continue using cash collateral until the final hearing.

Each hearing on the use of cash collateral presents the secured lender with an opportunity to be heard by the Bankruptcy Court. The secured lender can limit its exposure by successfully arguing that the debtor’s proposed budget needs to be more restrictive or by arguing that the debtor lacks any feasible ability to return to profitability.

For an SBA lender, each cash collateral hearing also presents the lender with a unique opportunity to shore up its SBA guaranty. The SBA lender can condition the debtor’s use of cash collateral on the debtor correcting deficiencies in the loan file. For example, if the SBA lender failed to obtain a Form 912 or Form 1919 for all appropriate parties, it would be fatal to the lender’s SBA guaranty. In bankruptcy, however, the SBA lender can condition the debtor’s use of its cash collateral on providing the missing documents. The Court typically will include such conditions in its order approving the use of cash collateral, so the SBA lender is assured that any deficiencies in its guaranty purchase package will be rectified.

For more information on leveraging cash collateral in the context of bankruptcy, contact us at 215-542-7070 or via email at info@starfieldsmith.com