Daily Development for
Friday, October 24, 1997

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

The Reporter for today's case is Jim Stillman of Murphy, Weir & Butler of Los Angeles.

The Reporter has contributed a particularly strongly worded comment at the end of the report.

BANKRUPTCY; POSTPETITION INTEREST; VALUATION: Court may revalue creditor's claim during pendency of case to determine whether application of revenues to debt have made claim "oversecured," thus entitling the creditor to postpetition interest under 506(b) pre-confirmation interest.

In re T-H New Orleans Limited Partnership, ___ F.3d___ (5th Cir. 1997).

At time of petition, the court valued the debtor's property - a hotel - at $13 million and the debt at $18 million. During pendency of the bankruptcy, however, the debtor applied the revenues from operations of the hotel to satisfaction of the debt. Further, there was some evidence that the hotel increased in value. The creditor thus sought recognition of the fact that it had become oversecured. The creditor sought interest as an oversecured creditor from the time of the petition. The debtor argued that, as the creditor was in fact undersecured at that time, it was not entitled to interest at all.

The court first noted the preliminary question of whether there should be one fixed point in the course of a bankruptcy when the valuation question should be resolved to determine the undersecured/oversecured status of a creditor's claim. It indicated that this was a question of first impression among federal circuit courts. It rejected the reasoning of the few district court cases it cited, and held that the determination would be "flexible" i.e., the creditor could petition for a revaluation when it felt that it had become oversecured. The oversecured creditor would be entitled to have interest accrue from the moment of such determination, and not retroactively to the moment the petition was filed.

The court further ruled that although interest might accrue to the oversecured creditor during the case, it should be ordered paid only at the end of the case, so that the bankruptcy court can verify that interest does not exceed the value of the creditor's interest in the collateral, per section 506(b).

Reporter's Comment: Not discussed in this case, apparently conceded by the creditor, is the manner in which post petition cash collateral was applied to the claim: rents and revenues from the hotel reduced the principal amount of the creditor's claim by $4,675,945 during the pendency of the case. This incorrect interpretation of section 506 results in the collateral "cannibalizing" itself--i.e., the better the hotel performed--the longer the debtor stayed in bankruptcy, the smaller the claim got. Compare, for the correct view, In re Ambanc La Mesa Limited Partnership, ___ F,.3d _____ (9th Cir. 1997) (post-petition proceeds of collateral * added to* value of undersecured claim for purposes of section 506).

Comment 2: As readers know from this Reporter's many comments on the subject, the Reporter is appalled by "claim cannibalization" through misapplication of sections 506(a) and 506(b) in bankruptcy cases.

Cannibalization results when a claim secured by income (rent) producing collateral is found, early in the case, to be undersecured (see 506(a)). Since the rents (income) are nonetheless collateral under 552, the court almost always gives them to the creditor sooner or later; but since, as an undersecured claimant under 506(b), the creditor is apparently not entitled to post-petition intereest, the court applies the rent to reduce the principal portion of the creditor's claim -- until such time, according to this thought process, that outstanding principal drops below collateral value; then and after, section 506(b) will allow the rents to be applied to interest.

The reporter insists that this is a bastardization of bankruptcy law. It has been the law since at least Sexton v. Dreyfus, 219 U.S. 339 (1911), that income produced by collateral does NOT reduce principal. The result is the same under the code, since the moment the rents come into existence, the lender's collateral pool increases in value, and under section 506(a) the secured portion of the claim INCREASES to the extent of the additional collateral. Once we get past, as we must, the notion that the receipt of additional collateral decreases the amount of the claim, we are left with a somewhat more nuanced debate: Do the rents satisfy additional (undersecured) principal or do they from the outset pay post-petition interest, notwithstanding section 506(b). Sexton says, INCOME from COLLATERAL always pays INTEREST in bankruptcy ...

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