IN RE: Robert E GERKE (2021)

ORDER ALLOWING USE OF CASH COLLATERAL IN PART AND DISALLOWING IT IN PART

THIS MATTER is before the Court following an evidentiary hearing on the Debtor's Motion to Use Cash Collateral and the Objection of Bankwest of Kansas (the “Bank”), the Debtor's primary secured lender. In exchange for their use of cash collateral, the Debtors have offered the Bank adequate protection in the form of replacement liens on future cash, crops, and livestock. The Bank urges this Court to hold that this offer is insufficient as a matter of law and, alternatively, under the facts and circumstances of this case. To resolve this dispute, the Court must explore the purpose and contour of adequate protection.

I. BACKGROUND

The Debtors filed a chapter 12 petition on August 11, 2021. Farming and ranching have been the businesses of not only these debtors, but of past generations of both their families. Currently, they raise cattle and crops of wheat, alfalfa, and millet in the Burlington, Colorado area. They live on the farm and they do the vast majority of the work themselves, only contracting out some custom planting. Mr. Gerke also contracts out his services for custom swathing and bailing to local farmers and receives in exchange a combination of cattle feed and cash payments. Together these Debtors devote at least eight to ten hours per day, seven days a week, toward their farming and ranching operations (referred to collectively as “farming” hereafter).

But hard work and dedication do not guarantee success every year in farming. Severe weather conditions, disease, other natural disasters, low commodity prices, high interest rates, declining land values, rising costs of production, unstable markets, and inconsistent governmental policies all beset this industry. In the past two years, these Debtors have had to endure a severe drought in the area. In addition to its direct impact on crop yields and cattle grazing, drought stress can cause both pasture forages and weeds to accumulate toxic levels of nitrates. One day, Ms. Richardson drove the cattle onto a different area to pasture. When she checked on them at day's end, she found the cattle were dying. They had eaten “pigweed,” which they later discovered had unusually high nitrate concentrations. She immediately called her husband who was out of town, he told her to move the cattle immediately, and she did so. But the damage was done. The Debtors lost approximately twenty-five percent of the herd to poisoning. It killed mature cows, caused many bred cows to abort, and produced a high mortality rate among the young calves.

At trial, the Bank first cast doubt on whether the Debtors’ cattle actually died, implying the Debtors may have sold them “out of trust.” But the Court finds these allegations were completely unfounded. Mr. Gerke testified that the Bank never even bothered to come inspect the fields to see their rotting carcasses and bones. Then the Bank claimed that these losses were attributable to “poor husbandry” practices of the Debtors. The only evidence they offered in support was the testimony of their expert, Mr. John Norwood, a retired banker who specialized in lending and portfolio management of big agri-business loans for First National Bank of Omaha and other regional banks. He testified to the methods used by big agri-business borrowers, such as futures contracts to hedge against changes in commodity prices, to protect against risk of loss. But then he strayed outside his field of expertise to opine that the Debtors were negligent in not preventing the growth of pigweed. Mr. Norwood has a small family farm himself, in which he raises wheat, millet, milo, and corn. But he demonstrated no expertise in raising cattle, animal husbandry, horticulture, or plant science. In fact, the longer he testified, the clearer it became that Mr. Norwood was willing to say anything to support the Bank's position, thereby losing his credibility with the Court.

The Court finds that the Debtors are experienced, honest, hard-working farmers, who have suffered losses due directly and indirectly to a severe drought. Before the drought hit, they had never been late on any loan payments to the Bank, despite the many years they have had loans with this Bank. The Bank was willing to work with the Debtors through the first year of the drought, but when it realized the loan had become undersecured, it embarked on a new approach.

The Bank has let the Court know that the Debtors have unencumbered assets, other sources of income, and family resources from which it believes the Debtors could and should turn this ordinary farm loan into a more risk-free loan. Mr. Gerke owns a business, known as Gerke Trucking, LLC, for which he drives a truck hauling freight (mostly cattle and farm products) approximately three days per week. His business has been successful and produces additional income for the Debtors. Apparently, the Bank had a lending relationship with Gerke Trucking in the past, but it paid off its loan in full. The Bank would now like to obtain a lien on the assets of this business to ensure full repayment of its otherwise undersecured farm loan. The income the Debtors receive from Gerke Trucking and their interest in the company are property of this chapter 12 estate, but Gerke Trucking's assets are not. In addition, Ms. Richardson is one of three adult siblings, who are each beneficiaries of a family trust that owns substantial farmland. And finally, the Debtors own their residence free of any encumbrances.

Whether the Debtors will need to tap any or all these resources in order to confirm a plan is a question for another day. The focus of the present inquiry is only whether the Bank's undersecured loan is threatened with further erosion due to the Debtors’ proposed use and sale of the Bank's collateral during a four-month period before they propose their plan. At present, the case is already two months into this four-month period, as the Court has authorized the interim use of cash collateral, leaving only the remaining two months at issue.

II. THE CONCEPT OF ADEQUATE PROTECTION

The Bankruptcy Code does not define its use of the phrase “adequate protection.” Undoubtedly, this was intentional. By leaving it undefined, Congress has signaled that it is intended to be a flexible concept. See H.R. Rep. No. 95-595, at 339 (1978). So flexible in fact that courts can interpret it or adapt it to meet the needs and competing interests of both the debtor and other parties with an interest in the debtor's property—most commonly the debtor's secured creditors.¹ And a flexible approach allows it to adapt to future changes in financial relationships and commerce in general. Its purpose is to balance the interests of both debtor and secured creditors in order to promote chances for reorganization but not by placing secured creditors at further risk of loss. The evolution of this concept over time, both in the various statutory enactments and court interpretations of them, lends additional insight into its nature.

A. Statutory Enactments

1. Pre-Code

Initially, America's bankruptcy system focused only on involuntary filings aimed at liquidation. It was not until the Bankruptcy Act of 1867 that Congress introduced the concept of reorganization, known then as a “composition agreement.” But nothing in the 1867 Act required adequate protection. In fact, this concept did not surface until Congress passed the Chandler Act in 1938 during the Great Depression. It first required adequate protection, but only as a means of protecting the dissenting creditors who had objected to confirmation of the plan. See Andrew N. Karlen, “Adequate Protection Under the Bankruptcy Code, Its Role in Business Reorganization, 2 Pace L. Rev. 1, 3 (1982). It bore no relationship to the debtor's use of estate property pre-confirmation.

Thus, in pre-Code cases, without a statutory anchor of “adequate protection” in a pre-confirmation context, courts struggled to balance the reorganizational interests of the debtor and the public, on the one hand, with the interests of secured creditors in depreciating assets, on the other hand. In Fruehauf Corp. v. Yale Express System, Inc. (In re Yale Express System, Inc.), 384 F.2d 990 (2d Cir. 1967), the secured creditor held the equivalent of a purchase money security interest in the debtor's vehicles. After defaulting on its loan, the debtor filed a reorganization petition. Its lender responded with a reclamation proceeding to recover the vehicles. The court allowed the debtor's use of the collateral. The Second Circuit, however, remanded the case for a determination of whether “the equities” favored the debtor's continued use of the vehicles in its business and, if so, whether there were any protections that the court could afford the secured creditor, such as a requirement of rental payments. On remand, the court refused to impose rental payment protection and found that use of the vehicles was critical to reorganization, reorganization was reasonably possible and, if the secured creditor was harmed by the collateral's use, then the plan could grant it an administrative priority in compensation.

This case received biting criticism. Karlen, supra, at 5 (citing Murphy, Use of Collateral in Business Rehabilitations: A Suggested Redrafting of Section 7-203 of the Bankruptcy Reform Act, 63 Cal. L. Rev. 1483, 1494 (1975)). It was a virtual certainty that the value of the vehicles would depreciate with continued use and, given only the speculative hope of special treatment under a future plan, the secured lender's fifth amendment property rights may well have been violated. Id. Perhaps in response to such criticisms, a few years later in the case of In re Bermec Corp., 445 F.2d 367 (2d Cir. 1971), the Second Circuit conditioned the debtor's continued use of vehicles in its business on the payment of “an amount equal to the economic depreciation of the collateral during the use period.” Karlen, supra, at 6.

2. The Code

a) Section 361

With the Bankruptcy Reform Act of 1978, Congress introduced the pre-confirmation concept of adequate protection to the Bankruptcy Code in § 361.² As mentioned, it does not define adequate protection but offers three illustrations of the most common methods of providing it. These are periodic cash payments, additional or replacement liens, and “such other relief ․ as will result in the realization by [the secured lender] of the indubitable equivalent of [that lender's] interest in such property.” 11 U.S.C. § 361(3). This list is not intended to be exclusive. The preamble begins with a reference to “[w]hen adequate protection is required ․ [it] may be provided by.” Id. § 361 (emphasis added). The mandatory nature of “when required” juxtaposed against the permissive “may be provided by” indicates that the three methods listed are merely illustrative.

Perhaps of greater importance in § 361’s preamble is its tethering of the requirement of adequate protection to three specific things. It states: “[w]hen adequate protection is required under section 362, 363, or 364.” Id. (emphasis added). Subsections (1) and (2) echo this sentiment with their illustrations of adequate protection. Subsection (1) refers to the use of periodic cash payments “to the extent that the stay under section 362 of this title, use, sale, or lease under section 363 of this title, or any grant of a lien under section 364 of this title results in a decrease in the value of [the secured lender's] interest in such property.” Id. Subsection (2) refers to the provision of an additional or replacement lien “to the extent that such stay, use, sale, lease, or grant results in a decrease in the value of [the secured lender's] interest in such property.” Id.

What can be gleaned from this language? First, adequate protection is not required simply because the secured lender enters the bankruptcy case in an undersecured position. While “insecurity” may be a trigger under the loan documents to declare a default and invoke the lender's remedies, it is not grounds for adequate protection under the Code. Section 361 only requires adequate protection when it is the continuation of the stay, the use/sale/lease of the property, or the granting of a priming lien under § 364(d)(1) that threatens to erode the secured lender's interest in its collateral.

Second, adequate protection rights are not triggered merely because the secured lender has suffered or may suffer any sort of postpetition loss. Since this sounds contradictory of the Court's last statement, it requires further explanation. The clearest illustration of this is found in the reference to the use, sale, or lease of collateral. Adequate protection is required when the use, sale, or lease itself will result in a decrease in the collateral's value. Assume the debtor is a farmer with a new combine harvester. He files bankruptcy in the fall, after harvesting his crops. At the time of the bankruptcy filing, the combine is stored inside a structure, protected from ordinary weather, and will not be in use until the next harvest. During this time period, the debtor is not using, selling, or leasing the combine and therefore the combine will not suffer a decrease in value due to the debtor's use, sale, or lease. Market conditions could cause a deterioration of the combine's value. A tornado could suddenly descend on the farm and destroy the combine. But market conditions and Acts of God are not attributable to the debtor's use, sale, or lease of the combine. Section 361 does not protect the secured lender from market conditions or Acts of God.

If the debtor acquires postpetition financing and in exchange grants the postpetition lender a lien on his farm that “primes” or supersedes the prepetition secured creditor's lien on the farm under § 364(d), then the prepetition lender will be entitled to adequate protection but only to the extent that the priming lien decreases its interest in the farm. If the debtor enjoys a large enough equity cushion in the farm's value to more than cover both the priming and prepetition lenders’ interests, then no adequate protection beyond this equity cushion will be required.

The more troublesome aspect involves § 361’s reference to the automatic stay. In other cases, undersecured creditors have argued that they are entitled to adequate protection merely because the automatic stay prevents them from immediately realizing the value of their collateral through foreclosure or other means of collection. See, e.g., United Savings Ass'n of Texas v. Timbers of Inwood Forest Assocs., Ltd., 484 U.S. 365, 108 S.Ct. 626, 98 L.Ed.2d 740 (1988). They rely on the language in subsection (1) that references “to the extent that the stay under section 362 ․ results in a decrease in the value of [the secured lender's] interest in such property.” 11 U.S.C. § 361(1).³ These creditors claim that any postponement of their receipt of the collateral's value results in a decrease in the value of their “property interest” because, with the immediate receipt of the collateral's proceeds, they could reinvest the funds in a new venture. Thus, their lost opportunity costs should be compensated. As later discussed, the Supreme Court has expressly rejected this argument. Timbers of Inwood, 484 U.S. at 372-73, 108 S.Ct. 626.

Similarly, one could argue that any postpetition loss, regardless of its cause, triggers the need for adequate protection, merely because the stay was in place to prevent the undersecured creditor from liquidating its position before the loss occurred. However, this interpretation renders superfluous language in 361's preamble. It prefaces the need for adequate protection: “when [it] is required under section 362.” 11 U.S.C. § 361. The only part of § 362 that addresses the need for adequate protection is § 362(d)(1). The context presented by that subsection is a motion for relief from the automatic stay in which the movant has asserted that it lacks adequate protection of its interest in property. Once the movant has made this assertion, then § 362(d)’s preamble states that the court “shall” grant some form of relief. Id. § 362. The stay will continue unaffected pending a final hearing only if the court finds “a reasonable likelihood that the party opposing relief from such stay will prevail at the conclusion of such final hearing.” Id. § 362(e)(1). At the final hearing, the party opposing relief, usually the debtor, bears the burden of proof on the issue of adequate protection. Id. § 362(g)(2). But before § 362 triggers this procedure and mandatory relief, it first requires the filing of a motion for stay relief premised, at least in part, on an alleged lack of adequate protection. Thus, it is not the imposition of the automatic stay but the continuation of the stay, despite the lender's request for relief, that entitles the lender to adequate protection. For example, the lender might file the motion claiming lack of adequate protection because of failing market prices. At that point, the continuation of the stay may threaten to erode the value of the property, thereby entitling the lender to relief.

As a final observation on § 361’s language, Congress’ use of the phrase “indubitable equivalent” in subsection (3) bears special mention. The legislative history indicates that Congress intended this phrase to be a flexible concept adaptable to many different circumstances. H.R. Rep. No. 95-595, at 340 (1978). Its origin comes from a pre-Code case, Metropolitan Life Ins. Co. v. Murel Holding Corp. (In re Murel Holding Corp.), 75 F.2d 941 (2d Cir. 1935), in which the court stated:

It is plain that “adequate protection” must be completely compensatory; and that payment ten years hence is not generally the equivalent of payment now. Interest is indeed the common measure of the difference, but a creditor who fears the safety of his principal will scarcely be content with that; he wishes to get his money or at least the property. We see no reason to suppose that the statute was intended to deprive him of that in the interest of junior holders, unless by a substitute of the most indubitable equivalence.

Id. at 942 (emphasis added).

The court made these statements in the context of a contested confirmation hearing, when pre-Code law only required adequate protection of dissenting creditors’ treatment under the plan. What is of interest to the present dispute is the evolution of this phrase. In Murel Holding, the court referred to the “most” indubitable equivalence. When Congress employed the phrase in § 361, it dropped the reference to “most,” making it a “mere” indubitable equivalent requirement. Synonyms for “indubitably” are “obviously,” “undeniably,” and “unquestionably.” Indubitably, Merriam Webster Thesaurus, https://www.merriam-webster.com/thesaurus/indubitably. Without the superlative of “most,” Congress left room for the substitution of any other means that would be unquestionably equivalent to the existing property or collateral package. Not necessarily a better, more risk-free substitution, but one that was of equivalent value or equivalent risk as the existing collateral.

Secured creditors have argued that the phrase “indubitable equivalence” means “all to which the creditor would be entitled under the contract at issue.” Karlen, supra, at 32. They based their argument on the legislative history of § 361 that referred to the secured creditor's entitlement to the “benefit of his bargain.” Karlen, supra, at n.186. But as discussed further below, this argument was roundly rejected by the Supreme Court in United Savings Ass'n of Texas v. Timbers of Inwood Forest Assocs., Ltd., 484 U.S. 365, 380-81, 108 S.Ct. 626, 98 L.Ed.2d 740 (1988).

b) Section 1205

In the late 1970s and early 1980s, the farming industry was on the brink of financial disaster. Falling crop prices, a drop in farmland values of between twenty and eighty-five percent, and high inflation and interest rates all took a toll. Diana Ryan, The Changing Standards of Adequate Protection in Farm Bankruptcy Reorganizations, 37 Drake L. Rev. 323, 323-24 (1987). Congress responded in 1986 by enacting the Bankruptcy Judges, United States Trustees and Farmer Act of 1986. It created a new chapter 12 for “family farmers.” “To the extent that the prior [bankruptcy] laws impeded the ability of farmers to restructure their debt, changes were made.” Id. at 336. One of these changes was the replacement of § 361’s standards of adequate protection with chapter 12's own version in § 1205.

Except for adding a new illustration of adequate protection to include rental payments for farmland, § 1205's provisions essentially mirror those in § 361. However, in § 1205, Congress replaced the language that some courts had misinterpreted in § 361. Instead of repeatedly using § 361’s phrase “the value of such entity's interest in the property” to describe the object being protected, § 1205 replaced it with “the value of property securing a claim or of an entity's ownership interest in property.” 11 U.S.C. § 1205(b)(1). This change made it clear that adequate protection guarded only against a drop in the property's value attributable to the continued stay, the use/sale/lease of property, or due to the grant of a priming lien. “Congress recognized that one of the most devastating obstacles to many farm reorganizations was the requirement of adequate protection as it was interpreted by some courts [under § 361] to protect a creditor from lost opportunity costs.” Ryan, supra, at 336-37.

The new statute also dropped any reference to “indubitable equivalence.” Section 1205 still included a catch-all category for “granting such other relief,” but it replaced “indubitable equivalent” with “as will adequately protect the value of property securing a claim or of such entity's ownership interest in property.” 11 U.S.C. § 1205(b)(4). This substitution also directed courts to focus on the changes in property values tied to the bankruptcy rather than on the creditor's original “benefit of its bargain,” as many courts had misconstrued the meaning of “indubitable equivalent.”

It is a wonder why Congress did not make these changes to § 361, rather than adding § 1205, which only applies to family farmers. Two years after the enactment of chapter 12, the Supreme Court interpreted § 361 to correct these same misinterpretations. Therefore, today the provisions of § 361 and § 1205 are closely aligned.

B. The Supreme Court's Interpretation

In United Savings Ass'n of Texas v. Timbers of Inwood Forest Assocs., Ltd., 484 U.S. 365, 108 S.Ct. 626, 98 L.Ed.2d 740 (1988), the Supreme Court laid to rest the debate about the type of protection granted to undersecured creditors in § 361. The debtor owned an “underwater” apartment project. After filing chapter 11, the debtor offered the bank adequate protection in the form of remittance of the tenant's rental payments, minus expenses. The creditor moved for stay relief under § 362(d)(1), asserting a lack of adequate protection. It sought either the property or additional amounts that would compensate it for the delay in its ability to foreclose and realize the value of its collateral. The bankruptcy court, and the district court on appeal, agreed with the bank that § 361 required compensation for lost opportunity costs. The Fifth Circuit sitting en banc reversed and it was affirmed by the Supreme Court.

In defining the “interest in property” entitled to adequate protection under § 361, the Supreme Court acknowledged that the language of § 361, read in isolation, could include the immediate right to foreclose and apply the proceeds from the collateral to the repayment of the debt, thereby necessitating compensation to the undersecured creditor for the delay. But it looked at the overall treatment of secured creditors in the Code and held that § 506, in particular, did not permit undersecured creditors to claim pre-confirmation interest on their debts. “If the Code had meant to give the undersecured creditor, who is thus denied interest on his claim, interest on the value of his collateral, surely this is where that disposition would have been set forth, and not obscured within the ‘adequate protection’ provision of § 362(d)(1).” Id. at 373, 108 S.Ct. 626 (emphasis in original).

It also refused to entertain the bank's argument that § 361’s reference to the indubitable equivalent should be given the same meaning that it is given in § 1129(b)(2)(A)(iii)’s confirmation requirement. The Court held that the undersecured creditor's right to interest under a plan stems not from § 1129's use of “indubitable equivalent” but from § 1129(b)(2)(A)(i)(II)’s concept of present value, which it imparts through the phrase “deferred cash payments totaling at least the allowed amount of [the secured portion of its claim], of a value, as of the effective date of the plan ․” Id. at 377, 108 S.Ct. 626 (emphasis added). Thus, with a confirmed plan that will repay the creditor the value of its collateral in deferred payments, the undersecured creditor is entitled to receive post-confirmation interest on its claim. But § 361 does not provide for interest payments attributable to the debtor's pre-confirmation use of the property.

C. The Tenth Circuit's Approach to Adequate Protection

In In re O'Connor, 808 F.2d 1393 (10th Cir. 1987), married debtors filed a chapter 11 petition and sought court approval to use approximately $700,000 of the bank's cash collateral. Mr. O'Connor was the general partner of an oil and gas limited partnership. He wanted to use the funds to drill three new wells. He offered the bank replacement liens on the new well's proceeds as well as payments from another source of income. The bank opposed, asserting the value of the replacement liens were too speculative. After all, what could be more speculative than drilling for oil? But the debtors’ witness testified that the new drilling sites were located close to other wells the partnership had successfully drilled and, therefore, the risk of a dry hole was greatly reduced. The court accepted this testimony and rejected the bank's evidence, ultimately finding that the replacement liens provided sufficient adequate protection. On appeal, the district court reversed, holding that the value of the replacement liens was too speculative.

In reversing the district court, the primary thrust of the Tenth Circuit's decision was that the district court had erred by applying the wrong standard of review. It held that a determination of the sufficiency of adequate protection is a factual finding, subject to the clearly erroneous standard on appeal. The district court had substituted its view of the evidence rather than evaluating whether the bankruptcy court's finding was supported by the evidentiary record.

Whether considered dicta or not, the Tenth Circuit made additional observations relevant to the present dispute. It recognized that the type of protection a secured creditor must receive under a plan differs from that which it is afforded under § 361, especially in the early stages of a bankruptcy case.

In this case, Debtors, in the midst of a Chapter 11 proceeding, have proposed to deal with cash collateral for the purpose of enhancing the prospects of reorganization. This quest is the ultimate goal of Chapter 11. Hence, the Debtors’ efforts are not only to be encouraged, but also their efforts during the administration of the proceeding are to be measured in light of that quest. Because the ultimate benefit to be achieved by a successful reorganization inures to all the creditors of the estate, a fair opportunity must be given to the Debtors to achieve that end. Thus, while interests of the secured creditor whose property rights are of concern to the court, the interests of all other creditors also have bearing upon the question of whether use of cash collateral shall be permitted during the early stages of administration.

The first effort of the court must be to insure the value of the collateral will be preserved. Yet, prior to confirmation of a plan of reorganization, the test of that protection is not by the same measurements applied to the treatment of a secured creditor in a proposed plan. In order to encourage the Debtors’ efforts in the formative period prior to the proposal of a reorganization, the court must be flexible in applying the adequate protection standard. In doing so, however, care must be exercised to insure that the vested property rights of the secured creditor and the values and risks bargained for by that creditor prior to bankruptcy are not detrimentally affected.

Id. at 1397-98 (internal citations omitted).

III. APPLICATION

A. The Limited Scope of the Hearing and of the Evidentiary Record

Following the Tenth Circuit's direction and guidance, the Court must now apply the evidence it received to make its determination of whether the grant of replacement liens in future cash, cattle, and crops will adequately protect the Bank over the next two months while the Debtors sell crops and cattle and reinvest the cash proceeds in new crops and cattle. As discussed, the primary focus must be on the value of the property at issue and whether the Debtors’ proposed use of it threatens to erode the Bank's existing collateral package. But cash collateral battles, when they occur, usually happen at the early stages of a case–often before the parties have their appraisals ready to go. Such is the case here. Both parties asked the Court to set aside any consideration of the value of the real estate and equipment, even though those assets comprise about two-thirds of the Bank's collateral package.

Instead they focused only on the livestock, crops, and cash proceeds. But even limiting the focus to those assets, there was a dearth of evidence presented as to the assets’ values. The Debtors prepared two exhibits—Exs. 16 and 17B—that listed the asserted values of all the Bank's collateral on the petition date (August 11, 2021) and at the end of the four-month period (January 1, 2022). While Debtors’ counsel used these exhibits when examining Mr. Gerke, the exhibits were never offered or admitted into evidence. Debtors’ counsel also used similar demonstrative exhibits in his closing argument and attached them to a post-trial brief. However, the arguments of counsel are not evidence. The Bank offered no valuation evidence of its own. It merely attempted to test the assumptions in the Debtors’ valuations.

Thus, the Court had to ascertain asset values through a piecemeal fashion. The following chart is compiled from several sources. The Debtors’ values for cattle on both dates are taken from Ex. 13, the summary of John Wright's expert opinion, which was admitted at trial. In addition, Mr. Gerke testified extensively about the cattle inventory and its value. As for Debtors’ cash, Mr. Gerke testified that he believed their cash position on January 1 will be in excess of $51,000. The Debtors’ cash position on the petition date is taken from the schedules.

That leaves the values of the crops and feed. The petition date value for those assets is taken from admitted Ex. 14, as well as Mr. Gerke's testimony. The projected value of crops and feed on January 1, 2022 is not listed in any admitted exhibit. The Debtors used Ex. 15B, which shows these values, when examining Mr. Gerke. However, while Mr. Gerke testified generally that Ex. 15B was accurate, Ex. 15B was not offered or admitted at trial. Thus, the Court has arrived at the value of the crops and feed by simple mathematics. Mr. Gerke testified that he believed the total value of all the Bank's collateral on the petition date was $1,306,737, including the real estate and equipment. Mr. Gerke did not specify in his testimony what the total value of the collateral would be on January 1, 2022. However, he indicated that the real estate and equipment would not change in value during this four-month period, but that the value of the other assets would increase by approximately $40,000. That means the total value on January 1, 2022 for the cattle, crops, and cash, in Mr. Gerke's estimation, would be approximately $419,142 (the petition date amount of $379,142 + $40,000). If you subtract from that total, the January 1, 2022 values of the cattle ($305,963) and cash ($51,000), that leaves only $62,180 for the value of the crops and feed. Thus, the chart below plugs in this combined value for the crops and feed, without any breakdown as to the types of crops and feed.

1. Cattle

Beginning with the livestock, this chart reflects no change in value with any of the bulls. The Bank did not dispute this. What the Debtors anticipate will change, and which the Bank disputes, is the quantity and weight of the heifers and steers. The first type of cattle listed are the stocker calves. A stocker calf is a steer or heifer that is roughly six to nine months of age. The Debtors believe that, at most, they will lose only one of these animals during this four-month period. Mr. Wright and Mr. Gerke both testified that a five percent mortality rate among cattle is the industry norm. This would mean that over the course of a full year, the Debtors could expect to lose three to four out of seventy-three stocker calves, which equates to one per quarter. The Bank asserted that, given the Debtors’ poor husbandry practices, they should expect to lose twenty-five percent. But the Court attributes the prior high loss rate to drought conditions only. The Court received no evidence that the Debtors suffered high loss rates in prior years.

The anticipated increase in the stocker calves’ value is due to weight gain, which this industry ties to the cattle's value. The Debtors will have grazed these cattle from the petition date until winter sets in around Thanksgiving. Grazing will be relatively expense-free. With winter, the Debtors will need to supplement their feed. They will do so from their inventory of bales of cornstalk, straw, oats, and alfalfa, and the purchase of some store-bought feed. Based on this feeding, the Debtors expect the stocker calves to experience a daily weight gain average of between one to one and one-half pounds. The Bank questioned whether these cows would gain more than one pound per day, but it offered no contrary evidence.

Another type of cattle reflected here are the “cull cows.” Typically, these are cows that have less productive value. They may be poor mothers or poor breeders. They may have physical or emotional defects. They might be of advanced age. For these and other reasons, the rancher will choose at some point to “cull” them from the herd. To achieve the greatest value from cull cows, the rancher must use his or her best judgment as to when to give up on any cows before they begin to decline in sale value. Here, the Debtors have placed twenty-nine cows into this category. They plan to sell them. The Bank took no issue with the Debtors’ plans to sell but did object to their intention to use $17,000 of the proceeds to replace them with new cows.

With the remainder of the cattle listed in the above chart, it is a bit confusing to trace the expected changes. Cattle are bred twice a year, spring and fall. At any given point in the year, some will be pregnant (the “bred cows”). After they deliver a healthy calf, for several months they will be considered a “pair” because the calves have not yet been weaned from their mothers. Obviously, as the calves are weaned and grow in weight, they will increase in value. The transition from cow to bred cow and from pairs to weaned calves also generally increases their value. The figures in this chart reflect the Debtors belief as to how these cows will shift from one category to another, with corresponding values, from the beginning of the subject time period to the end.

The Bank questioned the Debtors’ assumptions as to mortality rates, which the Court has already dismissed. It also pointed out that the Debtors had not yet “preg tested” the herd to accurately ascertain the number of bred cows. But Mr. Gerke explained that, if done too early, “preg testing” may cause a heifer to abort. The Bank's counsel further asserted that, when a bred cow delivers her calf, the calf's value increases but the now “open” cow decreases in value. The Bank offered no evidence to support this assertion. Moreover, it did not point out any discrepancy based on it in the Debtors’ projections of value. In other words, it did not demonstrate that the Debtors’ values failed to take this change into account.

Overall, the Court found the Debtors’ projections as to the quantity and value of the herd by January 1, 2022 to be credible and reliable. It reflects an overall increase in cattle value during the four-month period of $62,988. If the Court does not permit the Debtors to buy cows for $17,000 to replace the cull cows in November, then the increase will be only $45,988 ($62,988 - $17,000).

2. Crops & Cash

Some of the increased cattle value will correspond with a decrease in the Debtors’ inventory of crops and feed. When winter conditions set in around Thanksgiving, the Debtors will have to use some of their stored bales of cornstalks, oats, alfalfa, and straw to supplement cattle feed. The Bank contends that the Debtors will incur greater costs to feed the cattle than projected. It claimed that they will have to start “winter feeding” in September because the grasses will stop growing by then. The Bank offered no evidence to support this claim and the Court finds Mr. Gerke's testimony that they will not need to supplement feed until about Thanksgiving to be credible.

Over these four months, the Debtors expect the crop and feed inventory to decrease by $73,599. Most of this amount will be due to anticipated sales of their wheat, alfalfa, and millet crops. During the interim use period, they will have already sold crops for $95,429.73. The only remaining crop sale during this period will be in fulfillment of a contract to sell wheat at an above market rate in December for $54,600.

As a result of the crop and cattle sales, the Debtors’ cash position, after payment of farm, cattle, and crop expenses, will increase from the petition date amount of $388 to approximately $51,000. If the Court does not permit immediate replacement of the cull cows, then it will improve by additional $17,000 to $68,000.

Overall, the Court found the Debtors’ projections to be credible and reliable. They show an aggregate increase in cattle, crops, and cash of $40,000 by the end of the four-month period. If the Debtors do not buy replacement cows in November, then the increase would be closer to $60,000.

B. The Bank's Objections

The Bank objected to the Debtors’ use of cash collateral on two grounds. First, it asserts that these Debtors are either incompetent or dishonest farmers. Therefore, their ability to raise future crops and cattle is too speculative and their willingness to safeguard the Bank's collateral position is too tenuous. Second, it claims that replacement liens in crops and cattle are too speculative to serve as adequate protection as a matter of law and is tantamount to “double dipping.”

1. Whether Replacement Liens are too Speculative Under the Facts of this Case

a) Alleged Incompetency

There were three bases on which the Bank based its claim of incompetency. The Court has already dismissed the assertion that the pigweed poisoning reflected poor husbandry practices. The second was a recent alfalfa crop circle that failed to “take a stand.” The drought cannot be to blame for this crop failure because it was planted in an irrigated circle. Therefore, the Bank contends it reflects the Debtors’ inability to properly plant crops. The Debtors did not address this matter. But without more, the Court is unwilling to leap to this conclusion. After all, they have planted crops for years and this Bank has continued to accept liens on the future crops to secure their loans for many years. And they have projected sales of alfalfa in one month, from which they expect to realize $23,070. Thus, it was not a total failure of their alfalfa crop, only a partial loss in a particular area.

Finally, the Bank claims that these Debtors have never been profitable at farming. In support, the Bank introduced the Debtors’ tax returns for the years 2017 through 2020. The following chart reflects the relevant portions of the Debtors’ returns for these four years. Columns 6 and 7 do not appear in the tax returns but show the net income without the deduction of depreciation and without the deduction of depreciation and debt service, respectively.

*Based on Mr. Gerke's testimony and page 12 of Exh. QQ.

** Based on Mr. Gerke's testimony and page 13 of Exh. RR.

In making its claim that the Debtors have never been profitable, the Bank relied solely on the figures in column 3. The Court agrees with the Debtors that this column does not provide an accurate picture of their profitability. Column 7 is a better indicator of their ability to generate a profit and service their debts.

The Bank also attempted to discredit the positive net income in 2020, column 2, by pointing out that the Debtors received a large government subsidy in that year. The tax returns also show the following subsidies the Debtors received in each of these four years:

The suggestion that the government subsidies should be deducted from the net income figure to arrive at a true picture of profitability betrays an understanding of the nature of these payments. Nothing on the tax returns themselves indicates why the Debtors received these payments. But farm subsidies have taken many different forms and served varying purposes since Congress first implemented them in the 1920s. See Galen E. Boerema, Turning Straw into Gold: Federal Securitization of Agricultural Commodities, 83 N.C. L. Rev. 691, 695 (2005). Those purposes include providing a safety net for farmers, keeping the general populace fed, national security, and maintaining global parity in agricultural markets. Id. Most recently, subsidies have fallen into three major categories, often referred to as the “farm safety net” -- crop insurance, commodity programs, and the marketing loan program. See Trevor J. Smith, Corn, Cows, and Climate Change: How Federal Agricultural Subsidies Enable Factory Farming and Exacerbate U.S. Greenhouse Gas Emissions, 9 Wash. J. Env'tl. L. & Pol'y 26 (2019). Our government wants to keep farmers farming despite severe weather conditions and other catastrophic conditions. Sometimes they pay farmers not to produce certain crops in order to keep prices high. There could be any number of reasons for the payments, but a farmer's receipt of them does not signal poor farming practices or the inability to turn a profit as a farmer. Moreover, the Bank continued to lend to the Debtors for many years before this drought and it seems unlikely it would have done so if the Debtors were never profitable. And, of course, the Debtors never missed a payment to the Bank until this recent drought hit.

Based on this evidence, the Court finds that the Debtors have been profitable farmers and, until the drought hit, they have faithfully made their payments to the Bank.

b) Alleged Dishonesty

What has changed to make the Bank suddenly unwilling to accept the Debtors as borrowers is their contention that the Debtors misled them to believe they were fully secured creditors. They base this claim on a 2019 Balance Sheet, Ex. UU. It reflects total assets of $5,570,659, total liabilities of $4,208,693, leaving a positive net worth of $1,361,966. It includes the Bank's debt in the liabilities but does not indicate which of the assets are pledged to the Bank. Nor does it break out the farming assets from the trucking business assets. The Bank failed to point out to the Court how, if at all, the values of its collateral have changed from the values represented on the Balance Sheet. The Bank simply relies on the fact that it shows a net worth of over $1.3 million and yet somehow in 2021 the Bank's collateral is now worth less than the amount of its debt. This is not an apples-to-apples comparison.

Moreover, Mr. Gerke testified that he did not type one line or one number on Ex. UU. Neither he nor his wife know how to use Excel and have never created a balance sheet. Mr. Gerke said that Mr. Dean Graber, his loan officer at the Bank, prepared it without their input and then just handed it to them to sign. Mr. Gerke did not look at it closely and had no idea where the numbers came from. According to Mr. Gerke, Mr. Graber had submitted other Balance Sheets to the Debtors to sign in the past in the same manner.

The Court found Mr. Gerke's testimony on this aspect very credible. Mr. Graber was present in the courtroom throughout this evidentiary hearing and the Bank did not call him to refute Mr. Gerke's testimony. While it has no evidence to this effect, the Court surmises that no one at the Bank was concerned about this loan until the Debtors stopped making loan payments. It seems likely that Mr. Graber and the Debtors simply went through perfunctory motions each year to keep paperwork up to date in the loan file.

Based on the evidence received, the Court finds no cause for concern as to the Debtors’ fitness to be a fiduciary in safeguarding the Bank's collateral.

2. Replacement Liens on Future Crops are Per Se Too Speculative to Serve as Adequate Protection

a) The Speculative Nature of Future Crops & Cattle

The Bank contends that a replacement lien on future crops is per se too speculative to serve as adequate protection. It has cited several cases on which it relies for this proposition. These cases, however, went to great lengths to examine the factual circumstances of each case, as the case on which most of them rely, In re Martin, 761 F.2d 472 (8th Cir.1985), counselled. They did not erect a blanket prohibition against replacement liens on crops. See, e.g., In re Feather River Orchards, 56 B.R. 972, 974 (Bankr. E.D. Cal. 1986). And most of them pre-date the Supreme Court's decision in Timbers of Inwood Forest.

Admittedly, the Bank has provided more recent cases that also refused to allow a replacement lien on future crops or livestock as adequate protection. For example, in In re Kloubec, 2000 WL 150837 (Bankr. N.D. Iowa 2000), the chapter 12 debtor raised fish. It offered the bank a replacement lien on future fish. The court denied the cash collateral motion because future fish were too speculative. However, the court also noted:

In this case, Debtors propose to use up to $36,000 in cash over the next unspecified period of time for unspecified purposes and without a written budget. To adequately protect this constitutional interest, Debtors propose a substitute lien on fish in ponds who existence cannot be verified. Alternatively, Debtors have equity in other assets which could support additional liens or mortgages. However, Debtors have not chosen to offer liens or mortgages in those assets. If the Court were to approve Debtors’ proposal of adequate protection, Debtors would be free to use up to the total amount of the cash collateral presently in the DIP account for almost any purpose, including the proposed purpose of paying personal obligations, over an unlimited period of time, with no possibility of review since there is no proposed budget against which to measure the appropriateness of the expenditures. Approval of this motion would have the effect of transferring all risk of this venture to the Bank. If the fish offered as protection fail to materialize, the Bank would absorb the loss while Debtors retain their equity.

Id. at *5.

The Kloubec court placed a great deal of emphasis on the fact that the debtors were not required to reinvest these proceeds in assets on which the bank would have lien rights. Thus, their use of cash collateral could very well result in a decrease in the bank's collateral values. By way of contrast, the Debtors in the present case have agreed to restrict their use of cash collateral to the items in the budget. And as noted further below, the Court will restrict their use of cash collateral further to only expenditures that should protect or increase the Bank's prepetition collateral package. And in this case, the budget only extends over the next two months.

b) Double Dipping

The Bank claims that the promise of replacement liens on new cattle and crops is illusory and constitutes “double dipping.” After all, the Bank already has a lien on the offspring and crops and, therefore, the Debtors’ offer of a replacement lien does not given the Bank any added value. This argument misunderstands the purpose of adequate protection. It is not necessarily to add more collateral to the Bank's package. It is about ensuring that the Bank's collateral package will not erode due to the Debtors’ intended use and sale of collateral. If the metamorphosis of the Bank's collateral from cattle to cash and from crops to cash, and then from cash back into cattle and crops, will result in erosion of its position, then the Bank will need additional protection. But if this metamorphosis leaves the Bank in the same or a slightly better position, then additional protection is not needed. So perhaps it is technically more accurate to state that the Bank is not receiving replacement liens; its existing liens merely continue to protect its prebankruptcy status and that no “adequate protection” is needed to maintain the status quo.

But the Bank cries out, “future cows and crops are no substitute for cold, hard cash.” There are risks inherent in farming and few risks with cash. While true, this does not take into account that the cash position on the petition date was only $388. Only through the Debtors’ postpetition efforts will it increase to $51,000 (or $68,000 if no new cows are purchased). On the petition date, the Bank had only seeds planted in the ground and cows who had not yet been impregnated or given birth. This is somewhat of an oversimplification, but the point is that its cash collateral at the outset of the case was almost nonexistent. And $22,500 of the available cash will come from Mr. Gerke's custom swathing and bailing. Under § 552(a), the Bank has no lien on these proceeds. What the Court must determine is whether the continued farming operations, in accordance with a restricted budget, carry any different or additional risks that threaten to erode the Bank's prepetition position. The Court finds that continued operations are unlikely to do so in the next two months—as to the crops, cattle, and cash assets.

C. Limited Grant of Use of Cash Collateral

Nevertheless, the Court holds that the budget should be restricted to only those expenditures that will either maintain the status quo or improve the Bank's position. What this means over the next two months is the expenditures from the Bank's proceeds will be limited to the following:

• The Debtors must delay their purchase of new cattle until after the four-month period. If the Debtors are not able to formulate a plan that has reasonable prospects of confirmation within a reasonable period of time, then liquidating their assets will be simplified by having less cattle to sell and their expenses will decrease with less cattle to feed over the winter;

• No household expenses will be permitted from the Bank's proceeds;

• The farming expenses in the Budget, Ex. 1A, will be limited to actual costs of repairs up to $5,000 per month, the listed farm insurance payments, and the addition of their combined monthly salary of $3,000. Payments to equipment lenders will be suspended for these two months;

• The cattle expenses will be limited to actual expenses up to the projected $2,160 per month; and

• There are no expected crop expenses in these two months, other than $3,000 per month for fuel. The Court surmises that this is attributable to the costs that Mr. Gerke will incur when he does custom bailing for local farmers in November, from which he will generate $15,000 in income. Therefore, the Court allows the actual costs of fuel attributable to farming, up to $3,000 per month.

As the Court acknowledged at the outset, farming is a risky business. Many factors, such as weather, disease, market conditions, and the like, are outside the Debtors’ control. Any farmer could have a twenty-year track record of success and still suffer a bad year. They can insure some crops, such as wheat, but not others, like alfalfa and millet. “Family farmers,” as defined by the Bankruptcy Code, are not suitable candidates for purchasing hedging contracts, in the same way that big agri-business does. But the Bank did not require such protections when it loaned the Debtors money. It did not require sufficient real estate collateral to cover its loan balance, or personal guarantees from the Debtors. It did not require liquid assets, such as a certificate of deposit. It was content to rely on a combination of real estate, equipment, livestock, and crops. It knew that the crops and cattle would turn over and that its liens on them would transfer first to proceeds and then onto future crops and cattle, however speculative those might be.

What the Bank is demanding through the guise of adequate protection is to turn its farm loan into a more risk-free loan, such as a real estate loan. This is far beyond maintaining the benefit of its bargain. This would not be the “indubitable” or unquestionable equivalent form of collateral; it would be a far greater substitution. Although, as farmers saw in the late 1970s and early 1980s, even farmland values can diminish greatly.

Is there a certainty that the value of the Bank's crop, cattle, and cash collateral will increase or even maintain their value over the next two months? No. But if § 1205 requires certainty, Congress did not do a very good job of expressing that. Nor did the Tenth Circuit require certainty when it reversed the district court in O'Connor. Drilling oil wells seems to this Court to be far riskier than farming. Yet this form of collateral was what the O'Connor lender bargained for originally. The Bank in this case bargained for crops and cattle to be part of its collateral package, knowing that their cash proceeds would be reinvested in more crops and cattle over time.

Based on the evidence received, and the Debtors’ adherence to the permissible expenditures, the Court does not find any shortfall is likely to occur in the next two months. Thus, providing the Bank with “replacement liens” or merely continuing their existing liens in crops, cattle, and cash should not threaten the status quo. It will also foster the Debtors’ efforts at reorganization, which may benefit all creditors. It is simply too early in this case to deny the Debtors any chance at reorganization.

IV. CONCLUSION

For the reasons stated, the Debtors’ motion to use cash collateral is GRANTED in part and DENIED in part. They are permitted to use cash proceeds in accordance with the Budget, Exh. 1A, with the modifications set forth herein.

FOOTNOTES

1.   Hereafter the Court will refer only to secured creditors, but adequate protection is not limited to secured creditors. Lessors, co-owners, and other parties that hold an interest in the property are also entitled to be protected.

2.   All references to “section” or “§” hereafter are to Title 11, United States Code, except as expressly stated otherwise.

3.   Subsection 361(2)’s language substantially parrots this language.

Elizabeth E. Brown, Bankruptcy