Decline in Value of Cash Collateral Subordinates DIP Loan Lien Rights

07/23/2019 / Alexander Beeby

In Welty v. Callidus Capital Corp. (In re Midwest Asphalt), Adv. No. 18-04022 (Bankr. D. Minn. Mar. 29, 2019), the bankruptcy court held that the plaintiff successfully preserved his debtor-in-possession loan lien rights in assets sold in an 11 U.S.C. § 363 sale. However, the court found that the debtor’s cash collateral declined in value enough that the plaintiffs’ lien rights were subordinate to those of the secured creditor and purchaser of those assets.The defendant had a pre-petition security interest in various assets, including the debtor’s cash collateral (cash, inventory, and accounts receivable). Over the course of the debtor’s Chapter 11 case, the plaintiff provided just over $1.7 million in DIP financing secured by various assets, including the debtor’s cash collateral, subordinate only to any interest of the defendant in cash collateral. While additional collateral also played a role, this effectively meant that the plaintiff would have a first-position interest in the value of cash collateral above the petition-date value of the cash collateral.

The court approved a “free and clear” sale of substantially all of the debtor’s assets, including cash collateral, to the defendant for a credit bid. The plaintiff objected to the sale free and clear of the plaintiff’s interest, but the parties stipulated to preservation of this objection on the basis that the objection “was not ripe” because any change in value of the cash collateral could not be determined until the sale closed. The plaintiff filed an adversary action to assert his claim after the sale closed.

After determining at summary judgment that the filings preserving the plaintiff’s interests were vague as to which interests were preserved, the case proceeded to trial on two primary issues: (1) whether the plaintiff’s security interest in cash collateral and related assets were preserved through the sale and (2) the value of the plaintiff’s security interest as determined by the change in value of the debtor’s cash collateral.

As a preliminary matter, the bankruptcy court rejected the defendant’s argument that the court lacked subject matter jurisdiction to hear a dispute between two non-debtors involving property that was no longer part of the estate because it had been sold. The court held it had “related to” jurisdiction under the Eighth Circuit’s “conceivable effect” test because resolution of the dispute would affect the amount of the plaintiff’s superpriority administrative expense claim that had to be paid before general unsecured creditors.

The court rejected the defendant’s argument that the 363 sale effected transfer of the relevant assets to the defendant free and clear of any interests of the plaintiff. The court determined that the defendant failed to provide any evidence to resolve the ambiguity the court found in the prior filings. In contrast, the court credited the plaintiff with language in the purchase agreement preserving the interest and, to a lesser degree, testimony from plaintiff’s witnesses regarding the intent of the filings.

The court then agreed with the defendants that the cash collateral declined in value—effectively rendering the plaintiff’s security interest subordinate to that of the defendant and without value. The court found the defendant’s expert, with nearly 40 years of expertise, more credible than the plaintiff’s expert, the debtor’s former CFO.

Based on the expert witness testimony, the court rejected the plaintiff’s argument that bond and lien rights impaired the value of accounts receivable because the debtor only receives the net of the receivable less the amount due to subcontractors. Instead, the court agreed with the defendant’s expert that the reduction in liabilities to subcontractors constitutes an equivalent value to the debtor.

In valuing cash, the defendant’s expert testified that the value of cash as collateral is determined by the “checkbook” value according to general rules of accounting—i.e. outstanding checks reduce the value of cash in the debtor’s account. The plaintiff argued that In re Pratt, 486 F.3d 423, 427 (8th Cir. 2007), controls valuation of cash as a matter of law by holding that all funds in a debtor’s account are the debtor’s funds without regard to outstanding checks. The court relied solely on the defendant’s expert’s testimony in rejecting, without discussion, the plaintiff’s legal argument.

Because the court found that the debtor’s cash collateral had sufficiently declined in value, the court held that the plaintiff did not possess a first-position interest in any of the defendant’s assets.