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What happens to collateral in a business bankruptcy?

One of the most complex issues faced by both bankruptcy debtors and their creditors in New York and elsewhere is the fate of collateral that provides security for one or more of the debtor's liabilities. The automatic stay under Section 362 stops all efforts to levy on the asset that provides collateral for a debt, but the disposition of the claim and the collateral must await further developments in the bankruptcy proceeding.

All assets that provide security for debts become part of the bankrupt estate. The stay continues to block any effort by a creditor to take possession of or liquidate the collateral until the asset has been abandoned, the bankruptcy proceeding is dismissed, a discharge of the debt is granted or relief from the stay is granted by the court.

Upon motion of a creditor, a debtor can be required to provide "adequate protection" for all collateral as long as it remains in the bankruptcy estate. A motion for adequate protection is usually combined with a motion for relief from the automatic stay. Adequate protection may take one of several forms, including additional periodic payments by the debtor, additional liens to compensate the creditor for a decline in value of the collateral. The nature of the adequate protection will depend upon the financial condition of the debtor and the nature of the asset in question.

Valid liens that have not been disallowed or voided by the bankruptcy court will emerge from the bankruptcy case unaffected. Creditors will want to carefully review any plan of reorganization to ensure that the liens and value of the collateral have not been adversely affected.

This summary has necessarily omitted many details about the handling of secured obligations and collateral in a bankruptcy proceeding. Different types of assets may be handled differently under other provisions of the bankruptcy code. The advice of an experienced business bankruptcy attorney is the best way to fully understand how a bankruptcy proceeding will affect specific secured lending transactions.

Source: FindLaw, "Bankruptcy and the Secured Creditor," accessed on Feb. 5, 2018

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