Ninth Circuit holds that Postpetition Payments Received by Debtor Are Not Proceeds of “Payments to Become Due.”

Contributed by David G. Litvack
We at the Bankruptcy Blog have blogged time and time again regarding the importance of carefully structuring deals and related security agreements.  A recent decision in LID Acquisition, LLC v. Lake at Las Vegas Joint Venture, LLC (In re Lake at Las Vegas Joint Venture, LLC) provides yet another reminder for practitioners.  In Lake at Las Vegas, the United States Court of Appeals for the Ninth Circuit affirmed the lower courts’ rulings that, pursuant to section 552(a) of the Bankruptcy Code, a prepetition security agreement that gives a lender a security interest in “payments” or “future payments” does not give a lender a security interest in postpetition payments.
Prior to the debtors’ bankruptcy filing, the debtors were the owners and developers of the Lake at Las Vegas Resort, a 3,592-acre residential development and resort community.  Pursuant to certain “Acquisition Agreements,” the City of Henderson, Nevada agreed to purchase portions of the infrastructure as they were completed.  To finance the initial stages of the development, the debtors borrowed approximately $16 million and entered into security agreements to secure their obligations under the loan.  Specifically, to secure the loan for a certain portion of the property (the “T-12 District”), the debtors granted the lender a security interest in “[a]ll payments for the purchase of public improvements and all other payments, proceeds and amounts . . .due or to become due under or in connection with the [T-12] Acquisition Agreement between Borrower and the City . . . .”  Notably, the lender did not obtain a lien or security interest in the underlying land of the T-12 District.
After the debtors filed for bankruptcy protection, the creditors’ committee filed a complaint against the lender pursuant to section 552(a) of the Bankruptcy Code for a declaratory judgment that, among other things, the lender had no security interest in any of the postpetition payments made in connection with the T-12 Acquisition Agreement.  Section 552(a) of the Bankruptcy Code provides that a prepetition security interest in property of a debtor does not extend to property acquired by a debtor postpetition, except as provided in section 552(b).  Thus, section 552(a) has the effect of nullifying so-called “after-acquired property” clauses in security agreements.
The lender countered that the payments to be made in connection with the T-12 Acquisition Agreement were not property acquired by the estate postpetition (i.e., “after-acquired property”), but rather “proceeds” of the lender’s prepetition security interest.  Relying on section 552(b)(1) of the Bankruptcy Code, the lender cited the general rule that the “proceeds” of prepetition collateral are subject to any prepetition security interest in such prepetition collateral.  Section 552(b)(1) provides, in pertinent part, that:

[I]f the debtor and an entity entered into a security agreement before the commencement of the case and if the security interest created by such security agreement extends to property of the debtor acquired before the commencement of the case and to proceeds, products, offspring, or profits of such property, then such security interest extends to such proceeds, products, offspring, or profits acquired by the estate after the commencement of the case to the extent provided by such security agreement and by applicable nonbankruptcy law . . . .

11 U.S.C. § 552(b)(1) (emphasis added).  Relying on Nevada state law, the lender argued that “proceeds” include “whatever is collected on, or distributed on account of, collateral.”  The lender contended that because the future payments under the T-12 Acquisition Agreement were collected on account of the collateral described in the T-12 Security Agreement (i.e., “all payments . . . due or to become due . . .”) the lender was entitled to such postpetition “proceeds.”
The debtors, however, pointed out the tortured nature of this argument – how can future payments that might come due be the proceeds of payments to become due?  The debtors also noted that “[w]hether after-acquired property constitutes ‘proceeds’ of prepetition collateral depends on the nature of the collateral in existence at the moment of bankruptcy and whether that pre-bankruptcy collateral had to be depleted or disposed of in order to obtain the after-acquired property at issue.”  The debtors argued that “[e]ach of the excepted types of property enumerated in section 552(b) is derivative, [which] necessarily derives from the sale, exchange or other dispensation of other encumbered property . . . .”  The debtors argued that in this case, the future payments were the proceeds of (and derivative of) the underlying real estate.
The bankruptcy court, district court, and Ninth Circuit ultimately agreed with the debtors’ arguments finding that, pursuant to section 552(a), the debtor’s bankruptcy “cut off” the lender’s rights to the postpetition payments.  As the lender only took a security interest in payments made in connection with the T-12 Acquisition Agreement (not in the underlying real estate), the T-12 Security Agreement did not give the lender a security interest in postpetition payments as such “after-acquired property” is not “proceeds” of prepetition property.
The bankruptcy court noted that had the security agreement been drafted “appropriately,” the outcome would have been different.  For instance, if the lender had taken a security interest in the T-12 Acquisition Agreement or the underlying real estate, the court suggested it would have granted the lender a security interest in the postpetition payments pursuant to section 552(b).  Although this decision does not change the landscape of cases dealing with section 552(b) and “after-acquired property” clauses generally, the decision reminds us of the limits to section 552(b) and of the importance of carefully structuring deals.