Cash collateral is a term you often hear in connection with a business bankruptcy, such as a reorganization or restructuring under Chapter 11 bankruptcy. Read on to find out what cash collateral is and how it is different from other types of collateral.
What Is Collateral?
Generally, collateral is property you pledged to secure a loan. The lender has a "lien" on the property. Examples include:
- the house that secures your mortgage
- the car that secures your auto loan, and
- the jewelry that secures the loan you received from a pawn broker.
When you pay back a secured loan, the lender releases the lien on your property because you no longer owe the lender anything. If you default on the loan and don’t pay it back, the lender can take the property (called repossession in the case of non-real estate and foreclosure in the case of your home), sell it, and use the proceeds to recover the money you owe on the loan.
Home loans, car loans and pawn shop loans all involve collateral that exists at the time the loan is given and remains the same throughout the life of the loan. You might put a new roof on your house or have work done on your car, but you don’t sell or trade the home or property unless you pay off the loan.
What Is Cash Collateral?
When a bank or other lender gives a business loan, it often requires that the business pledge its inventory and accounts receivable as collateral to secure the loan. Unlike the house that secures a mortgage or the car that secures an auto loan, business inventory and accounts change every day. For example, businesses
- sell inventory and replace it with new inventory
- collect accounts receivable, and
- create new accounts by selling inventory on credit.
Under the bankruptcy law, cash collateral includes cash, negotiable instruments, documents of title, securities, deposit accounts, or other cash equivalents as well as proceeds, products, offspring, and rents. This includes money collected on accounts receivable as well as money received or new accounts created from the sale of inventory.
Why do businesses pledge cash collateral for loans? Pledging cash collateral as additional security for a business loan allows a business to continue to operate without having to pay off the entire loan every time it sells inventory or collects an account receivable.
How is cash collateral different from other collateral? Cash collateral is different from a house or a car because it often changes and can include cash or accounts that did not exist at the time the original loan was given.
Using Cash Collateral in Bankruptcy
Outside of bankruptcy, as long as the business makes its loan payments pursuant to the agreement with the lender, the business can continue to operate -- selling the pledged inventory, collecting its accounts, and using all or part of the collections to replenish the inventory and otherwise conduct business without interruption. This is because the lien securing the loan shifts from the inventory to the proceeds from the sale of inventory, and then to the new inventory and accounts.
When a business reorganizes in bankruptcy, it continues to operate. When it comes to using cash collateral during the bankruptcy, however, the business must take an additional step. A business in Chapter 11 bankruptcy must get permission from the court in order to use cash collateral during the bankruptcy proceeding. This is because the bankruptcy laws prohibit an agreement made before the bankruptcy from creating a lien on income generated or assets acquired after the bankruptcy is filed.
Providing Adequate Protection to the Lender in Bankruptcy
Generally, you will have to provide the secured creditor with "adequate protection" in order for the court to approve your use of cash collateral in bankruptcy. To supply the lender with adequate protection, you'll have to provide some safeguard so the value of the lender's security interest does not decrease (usually due to the sale of inventory and collection of accounts receivable). You can do this in a variety of ways, such as:
- giving the creditor a replacement lien on the proceeds from the sale of inventory and on new accounts (this continues the practice that was in place before you filed for bankruptcy)
- maintaining a cash collateral bank account separate from the general operating account of the business
- making cash payments to the lender, and
- agreeing to a budget setting out how the business can use cash collateral and how much it can use.