Cash Collateral

Cash collateral refers to cash or cash equivalents that a debtor grants a creditor as security for a loan or debt. The purpose of cash collateral is to protect the interests of creditors who have extended credit to the debtor company.

In Chapter 11 bankruptcy, the debtor may use cash collateral only with the creditor's consent or court approval. The creditor has the right to take possession of the cash collateral if the debtor defaults on their obligations. This helps to prevent the debtor company from using its cash and other liquid assets without the court's approval, which could harm the creditors' ability to recover their debts.

Cash collateral guarantees repayment to the creditors of a business entity, such as suppliers or banks, in case the debtor or borrower goes bankrupt or dissolves the incorporation. To obtain a business loan or credit, a company pledges its inventory, accounts receivable, negotiable instruments, bank balance, and other assets as collateral. However, the debtor can only use, lease, or sell the underlying asset, property, or estate for regular business activities.

Under USC section 363(c), the debtor in possession is restricted from using, selling, or leasing the asset or property for any purpose other than day-to-day business operations. To do so, the debtor must file a motion of use with the bankruptcy court and state the purpose. The cash collateral budget, released by the court as Exhibit 1 with the cash collateral order, outlines the permissible uses of the collateral. The budget can be amended within the boundaries of the collateral order, and parties can file their disagreement within seven days of the amendment. If there is no disagreement, the amended budget becomes applicable.

When a company purchases new equipment or assets for cash, these assets may be considered collateral under Section 361 of the Bankruptcy Code. If the company declares bankruptcy, its current assets, such as inventory, accounts receivable, negotiable instruments, and securities, are sold. The proceeds are transferred to a cash collateral account managed by an administrative agent. The debtor cannot use this fund without the creditor's permission or the bankruptcy court's approval. Additionally, if the value of the collateral depreciates, the debtor must either make regular cash payments to the creditor or provide a replacement lien.

let's look into some examples for a better understanding of the concept

Example #1

Suppose ABC Enterprises avail a business loan of $50,000 from XYZ bank against its inventory worth $10,000, accounts receivable worth $30,000, and bank balance of $10,000. The debtor (ABC Enterprises) later bought equipment for $7000 and paid through its bank account. Thus, it has to keep this equipment as collateral with the creditor (XYZ bank).

However, after a few months, ABC Enterprises became bankrupt, and therefore a collateral account was opened. The firm sold its equipment and inventory for $15,000 and encashed accounts receivable of $30,000. Thus, $45,000 sales proceeds were deposited in the collateral account.

Example #2

Suppose company A is struggling with its financials and is at default risk on its business loan from bank B. To secure its loan and ensure repayment, bank B demands that company A provides cash security through its inventory and accounts receivable. Company A agrees to these terms and deposits the value of its inventory and accounts receivable into a collateral account managed by bank B.

Unfortunately, company A still goes bankrupt despite these efforts and cannot repay its loan. In this case, bank B would use the funds in the collateral account to recover as much of its loan as possible. However, if the value of the collateral is insufficient to cover the full amount of the loan, bank B may pursue legal action to recover the remaining balance.