Creditors that hold debts secured by depreciating personal property, such loans secured by cars and boats, are entitled to receive “adequate protection” payments while a debtor undergoes the bankruptcy process. The underlying theme of adequate protection is designed to protect an entity from a decrease in value of its interest in property of the estate resulting from the imposition of the automatic stay or other provisions under the U.S. Bankruptcy Code.

Creditor concerns

A secured creditor or other party with an interest in property of the debtor’s estate may have concern that the value of its interest will diminish during the pendency of the bankruptcy. To guard against such loss, the Bankruptcy Code requires that, upon motion by the creditor or interested party, the interest be adequately protected during the bankruptcy process during the following cases:

(i)                 while the automatic stay remains in force; or

(ii)               when the property is to be used, sold, or leased; or

(iii)             when a new lien threatens the value of the interest.

Judicial determination

The Bankruptcy Code provides that a Bankruptcy Judge determine whether an interest in property is adequately protected and, if not, for adequate protection against any decline in value caused by continuation of the bankruptcy process. Each bankruptcy court handles adequate protection payments on a case-by-case basis. A Court will typically impose the amount of the required adequate protection payment based on the value of the collateral and the amount of the monthly loan payment.

If a court determines that a secured creditor or other party entitled to protection is not adequately protected against diminution in value of its interest, the Bankruptcy Code sets forth three possible methods to provide compensating value: First, the holder of the protected interest may be awarded a cash payment or periodic cash payments to make up for a decline in value. Second, adequate protection may take the form of a grant of additional or replacement liens to the holder of an otherwise inadequately protected interest. Finally, adequate protection may take other forms to protect the party’s interest.

Policy

The purpose adequate protection in a Chapter 13 case is to ensure “that the secured creditor receives the value for which he bargained.” This is a double-edged sword. On the one hand, there may be occasions where a creditor cannot maintain an interest without placing an undue hardship on the estate and efforts to utilize the bankruptcy to maximize value for the benefit of all stakeholders. As a result, the Bankruptcy Code recognizes and provides for alternate means of providing the value of what the creditor essentially bargained for in lieu of receiving the bargain in kind

Before a court will order protection, a secured creditor bears the initial burden proving the amount of its lien. Once the secured creditor’s lien has been established, the burden shifts to the debtor to demonstrate that the property in question will be adequately protected.

Valuation

After the bankruptcy court determined the creditor’s interest in the collateral, it must then select a methodology for valuing the creditor’s interest. Keep in mind that valuation can, and often does, change throughout the course of a case.

In a 1997 bankruptcy case called Associates Commercial Corp. v. Rash, the United States Supreme Court addressed the issue of proper valuation methodology for a Chapter 13 bankruptcy. In that case, the debtors sought to retain possession and use of a truck that was encumbered by a  lien. In the meantime, the debtor sought to provide payments to the secured creditor under the chapter 13 plan in the amount of the present value of the creditor’s allowed secured claim, without modification. The proper determination of the value of the truck was of great significance because it would determine the amount of the creditor’s allowed secured claim, which, in turn, would determine the amount that the debtors had to pay in order to confirm their chapter 13 plan.

At issue in that case was the determination of whether the value of the collateral that a chapter 13 debtor sought to retain should be measured by: (1) what the secured creditor could obtain through foreclosure sale of the property, the “foreclosure-value” standard; or (2) by what the debtor would have to pay for comparable property, the “replacement-value” standard; or (3) the midpoint between these two measurements. The Supreme ruled that under the circumstances of that case the replacement value standard should apply because the debtors used the property to create an income stream, so the issue was what would be the cost to replace the collateral.

If you are experiencing debt problems, contact the law firm of Melanie Tavare, an experienced consumer bankruptcy attorney.