Auto parts supplier First Brands’ highly contentious Chapter 11 case continues to face roadblocks from Evolution Credit Partners, which has been unwilling to go quietly after its adequate protection-based objections were given short shrift at the bankruptcy court level. Evolution asserts a first priority secured lien on certain of the First Brands debtors’ receivables and recently won an order from a district court remanding adequate protection issues back to the bankruptcy court for further consideration – and limiting what the bankruptcy court may consider at that hearing.

In this article, the Debtwire legal analyst team reviews the ruling and why secured lenders (and their counsel) may want to keep this one in their back pocket for future Chapter 11 cases filed in the Southern District of Texas.

Disputed liens and adequate protection rights

Before discussing the dispute and related rulings, we first discuss the nature of the parties’ relationship. Between November 2023 and March 2024, Evolution provided structured inventory financing facilities to certain First Brands debtors (i.e., receivables sellers).[1] In doing so, Evolution purchased receivables owed to the receivables sellers by their customers at a discount from the invoice amount, based on a formula set on a per transaction basis. According to Evolution, it provided approximately USD 60m to the receivable sellers in exchange for a first priority lien on all of the sellers’ assets – including most notably the factored receivables. As of the bankruptcy filing, Evolution asserted a first lien security interest on approximately USD 60.5m worth of the First Brands’ receivables.[2]

First Brands disputes that Evolution has a USD 60m lien on the receivables held in the segregated account. By way of background, in its factoring receivables motion, First Brands explained that its financial advisor found instances where invoices provided by the receivables sellers to their third-party factors were fabricated, inflated, or provided to multiple factors, and this created the potential for more than one factor to assert a claim to the same invoice. The debtor also asserted that although various First Brands entities factored approximately USD 3bn of invoices, the debtors’ forensic analysis has been unable to match approximately USD 2.5bn to actual invoices for inventory sold to customers, “either because there is no record of a particular invoice or the actual matched invoice number has amounts that have been substantially altered.” In short, First Brands asserted that its advisors’ concluded that, of the USD 105.9m of funds that came into the segregated account, only USD 4.4m match to invoices purchased by third-party factors and thus were actually properly factored. According to First Brands’ forensic expert, the USD 60.5m claim of unpaid factored receivables asserted by Evolution does not match to any valid invoices in First Brands’ records. The debtor thus contends that Evolution did not hold a lien on the funds held in the account.[3]

To begin sorting through this mess, First Brands segregated and held all funds received from customers since the petition date (other than funds received on account of postpetition sales) in a factored receivables account. In his cash management order, Judge Christopher Lopez of the US Bankruptcy Court for the Southern District of Texas prohibited First Brands from accessing or disbursing funds held in the account without prior court authorization. In December, First Brands sought the Bankruptcy Court’s permission to, among other things, use funds held in the account that it determined were not factored after providing notice to, and an opportunity to be heard by, its factors. According to First Brands, the funds constitute property of the estate and the estate was in dire need of accessing them.

Evolution and other factoring parties objected to the factoring motion. Evolution argued that it holds a first priority security interest in the funds in the account. It took issue with the fact that there had not yet been any evidence presented to the court concerning the valuation of the assets and argued that it was the only party holding a lien on those assets. As such, it argued that allowing the debtors to access that collateral as proposed in the factoring motion would violate Evolution’s rights as a secured lender – i.e., by not providing it with adequate protection. Evolution argued that keeping the USD 60m in the segregated account would serve as its adequate protection, and therefore the funds should not be released to the debtors.

Evolution also contends that it is the only party with a security interest in the funds.[4] As the parties dispute whether Evolution has a lien on the funds held in the receivables account, Evolution argued that any determination of the validity of Evolution’s lien must be made in the context of an adversary proceeding with full evidence, as opposed to in connection with a motion – i.e., First Brands’ factoring receivables motion. Evolution thus commenced an adversary proceeding against certain debtors seeking a declaratory judgment in that regard.[5]

As if this weren’t complex enough, enter First Brands’ ABL, term loan, and DIP lenders.

Evolution argued that none of these lenders have an interest in its collateral. As for the prepetition lenders, Evolution asserted that its collateral falls within the definition of excluded assets that are expressly not within the collateral securing the debtors’ obligations under the ABL facility or the term loans. Similarly, Evolution argued that the bankruptcy court’s order approving the DIP financing granted the DIP lenders a first priority lien on all property of the debtors that was unencumbered on or as of the petition date. Accordingly, Evolution argued that the DIP lenders cannot have a lien on its collateral because that collateral was not unencumbered.

First Brands disagreed, contending that the prepetition credit agreements (and the relevant security documentation related thereto) did not provide a carve-out that placed Evolution’s asserted lien ahead of the company’s prepetition secured lenders’ liens. First Brands noted that, as of the petition date, the debtors held approximately USD 188m of prepetition account receivables related to the Evolution sellers, in the aggregate – but it also has approximately USD 6bn in prepetition senior secured debt that is secured by a lien on collateral that Evolution asserts a right in. First Brands contends that the prepetition lenders’ liens are senior in priority to any alleged liens held by Evolution, and therefore any lien that Evolution may have would be fifth in priority. Given how junior Evolution’s lien is in the company’s debt stack, First Brands argues that Evolution’s entitlement to adequate protection is minimal at best. Accordingly, it argued that Evolution was adequately protected because it would be (i) permitted to recover any funds that should not have been released from the segregated account, and (ii) entitled to assert a superpriority administrative expense claim under section 507(b) of the Bankruptcy Code. First Brands also argued that Evolution failed to perfect its purported security interest in various receivables as of the petition date, and therefore it was primed by the DIP liens pursuant to order approving the DIP financing on a final basis.

Bank of America, NA, as administrative agent and collateral agent under the debtors’ ABL facility, Wilmington Savings Fund Society, FSB, as administrative and collateral agent under the debtors’ first and second lien term loans, and GLAS USA as administrative and collateral agent for certain side car loan lenders each dispute Evolution’s asserted liens, arguing among other things that the loan documents did not permit Evolution’s liens or the inventory transfers underlying them. The agents also contend that for Evolution to have acquired liens on the collateral, actual, proper transfers from the First Brands debtors to the SPV debtors that participated in the factoring would have been necessary and that Evolution asserts liens on replenished inventory for which there are no purchase orders or agreements. Bank of America also makes the first in time, first in right argument. More specifically, it argues that Evolution alleges that, in 2023, it acquired liens over certain inventory collateral and that its liens have priority over liens on that same inventory collateral owned by the prepetition secured ABL lenders that were created five years earlier.

Judge Lopez heard oral arguments on the factoring motion on 22 December and ultimately allowed First Brands to use USD 60m of the funds, finding that the issue at that stage was not the lien priority, but adequate protection. Although Judge Lopez issued an order, the order did not make any findings with respect to Evolution’s asserted lien, lay out any analysis underlying his ruling, or contain any findings or requirements with respect to adequate protection. At the hearing, however, Judge Lopez stated that whoever held the priority interest in the collateral, and assuming (but doubting) that Evolution held such interest, that interest was adequately protected.

Asserting adequate protection rights when secured status is disputed

Evolution appealed Judge Lopez’s order to the US District Court for the Southern District of Texas. The issue on appeal was whether Evolution’s assumed interest in USD 60.5m was adequately protected. Given the disputed nature of Evolution’s security interest, however, the appellate court ruling yielded several rulings on a more complicated question; namely – how a bankruptcy court should determine whether a secured lender’s interest in collateral is adequately protected when the lender does not consent to the use of its collateral and the debtor denies that the lender has a lien on the collateral?

Bankruptcy Code section 363(e) provides that on request of a party that has an interest in property that a debtor proposes to use, the court must prohibit or condition such use “as is necessary to provide adequate protection of such interest.” In any such hearing, the debtor bears the burden of proving that a secured lender’s interests are adequately protected. Section 361 of the Bankruptcy Code provides examples of how a debtor can provide “adequate protection,” including by making periodic interest payments and providing any other relief that will allow the secured party to receive “the indubitable equivalent” (an undefined phrase) of its interest in the collateral.

In determining whether a secured party’s interest in its collateral is adequately protected, courts consider the allowed amount of the secured claim as determined by, among other things, the value of the collateral.[6] Determining adequate protection by considering the allowed secured claim amount and the collateral value is especially difficult when the parties’ dispute the validity and extent of Evolution’s secured status.

While debtors have the burden of proving adequate protection, parties asserting a lien on a debtor’s property have the burden of proof on the issue of the validity, priority, or extent of such interest.[7] That dispute cannot be resolved in connection with First Brands factoring receivables motion, because Rule 7001(b) of the Federal Rules of Bankruptcy Procedure mandates that an adversary proceeding must be commenced to determine the validity, priority, or extent of a lien or other interest in property. Unlike a motion, an adversary proceeding requires the filing of a complaint, an answer to the complaint (or a motion to dismiss or for summary judgment) discovery, and if factual disputes remain, a trial. As such, adversary proceedings take considerably longer than motions. Thus the bankruptcy court was put in the position of balancing First Brands’ imminent need for access to the funds against Evolution’s right to an adversary proceeding and its disputed right to adequate protection.

At the bankruptcy court hearing, Judge Lopez explained that he was not convinced that Evolution’s purported lien had priority over First Brands’ other secured creditors’ liens and authorized the release of the funds because he found that, assuming Evolution had a lien, it was adequately protected. He noted that if First Brands drew up to the amount permitted by the order, approximately USD 49m would remain in the receivables account.

Evolution argued on appeal that Judge Lopez erred in not making his determinations through an adversary proceeding and because he failed to apply the correct standard for finding adequate protection.

The District Court ruled that an adversary proceeding was not necessary for Judge Lopez to allow First Brands access to the funds. He explained that bankruptcy courts may conduct preliminary hearings on the use of cash collateral rather than conducting a full adversary proceeding when an asserted lien is disputed. However, under these circumstances, courts may authorize the use of only that amount of cash collateral that is necessary to avoid immediate and irreparable harm to the estate pending a final hearing. The District Court found that Judge Lopez erred in this regard because he did not characterize his authorization as “interim” – i.e., subject to a final hearing. He further erred, the District Court ruled, because he did not make any findings that allowing First Brands to use the funds in the account was necessary to avoid immediate and irreparable harm pending a final hearing.

The District Court went on to explain that when ruling on a motion under section 363(e), bankruptcy courts may conduct some examination of lien validity without having to engage in a full adversary proceeding. However, it held that in the absence of an adversary proceeding, bankruptcy courts addressing requests for relief that raise questions about an asserted property interest should assess only whether the party asserting the lien has made a prima facie showing of the validity and scope of its lien. As in Evolution’s case, when a party with a disputed interest in collateral asserts a right to adequate protection, courts may consider whether there is evidence that clearly refutes the asserted security interest – but – “the substantive consideration of such evidence should stop as soon as it appears that the party asserting the property interest has a ‘colorable claim’ to the property in question.” The District Court explained that permitting a broader or deeper inquiry into the validity of an asserted property interest at a preliminary hearing on the use of cash collateral would run afoul of Bankruptcy Rule 7001(b)’s general requirement that parties must challenge lien validity through an adversary proceeding, not an adequate protection hearing.

In short, the District Court ruled that weighing Evolution’s likelihood of success on the merits of establishing its lien against the likelihood of success in showing that it was adequately protected, as the bankruptcy court did, crossed the line into what may not be considered in the context of a motion versus an adversary proceeding. Thus, absent clear evidence or legal precedent that refutes a claimant’s right to an asserted property interest, when a claimant has established a colorable claim to its asserted lien, it is entitled to adequate protection until an adversary proceeding determines the validity, extent, and priority of the asserted property interest.

Back to the Bankruptcy Court

The District Court held that without a firmer determination on the validity of Evolution’s asserted first priority lien – or at least adherence to the procedures for the preliminary use of cash collateral or a ruling that Evolution failed to make a prima facie showing of its first priority interest – Evolution is entitled to adequate protection. The Court went on to say that, at the time Evolution appealed, its interest was not adequately protected because the receivables account did not include enough to cover Evolution’s USD 60.5m interest. In providing further guidance to the Bankruptcy Court, the District Court stated that in determining whether Evolution is adequately protected, Judge Lopez may consider the amount of funds remaining in the segregated account, the likelihood that additional funds may enter the account, and other potential sources of recovery for Evolution. In what could be considered a warning (or a reprimand given the lack of findings in Judge Lopez’s order granting First Brands’ factoring receivables motion), the District Court explained that, if Judge Lopez subsequently finds that Evolution is adequately protected, he must state specifically what funds or other property, whether currently in the estate or projected to be in the estate (and on what basis), adequately protect Evolution. This potentially could give Evolution additional grounds for seeking updated relief in the event that any such funds disappear or fail to materialize.

After the District Court’s ruling, Evolution filed a motion contending that it is an oversecured creditor entitled to adequate protection. Evolution noted its current need for adequate protection given that its collateral is still intermingled with other funds in the factoring receivables account, which was depleted by Judge Lopez’s earlier ruling. Evolution has also argued that even if additional funds do enter the account, any additional cash in which it already has an interest is not adequate protection for the “improper taking” of its cash collateral. Evolution has asked the Bankruptcy Court to order the debtors to segregate unencumbered cash (or the “indubitable equivalent” of unencumbered cash) exclusively for Evolution in the amount of its claim, plus the fees and interest. First Brands has opposed the request arguing, among other things, that Evolution’s purported first priority claim is adequately protected by over USD 146.8m in current cash in the segregated account or prepetition accounts receivables that are past due, and that the debtors have no unencumbered cash. As of 11 February, First Brands stated in its opposition to Evolution’s adequate protection motion that USD 42.8m in funds were in the account.

In ruling on Evolution’s motion, Judge Lopez must first determine whether Evolution has a colorable claim to its purported security interest. Given the documentation supporting the receivables purchasing agreement between the parties, we would expect that Evolution will have has made a prima facie showing of with respect to the asserted USD 60m lien.

Judge Lopez must then determine the amount of the funds to be released from the account by finding an amount that is necessary to avoid immediate and irreparable harm to the estate. Moreover, such finding must be made pending a final hearing.

Last but not least, Judge Lopez must then determine what would leave Evolution’s asserted security interest adequately protected, and he must include this in his order.

What Judge Lopez may not do, however, is balance the likelihood of Evolution’s success in the adversary proceeding against the estate’s need to use the funds in the account, as the District Court explained that such inquiry would run afoul of the Bankruptcy Rules. In determining whether a purportedly secured lender has made a prima facie showing of its security interest, a bankruptcy court may may consider whether there is evidence that clearly refutes a creditor’s claim to the property, but the inquiry should not go beyond that.

Lender friendly ruling

The District Court’s ruling as to how courts must handle adequate protection issues when presented with a disputed property interest (e.g., a lien) was a practical construction of the relevant Bankruptcy Code section and rules. It would not make sense to make a debtor await an adversary proceeding’s conclusion before allowing it much needed access to cash collateral, even over a secured lender’s objection. As long as a lender establishes a colorable claim to a security interest, that should be sufficient for entitlement to adequate protection, on an interim basis, while the pending adversary proceeding plays out.

Secured lenders now have a district court ruling that lays out their entitlements when asserting a lien on property that a debtor disputes and related adequate protection rights. They also have a ruling that prohibits bankruptcy courts from engaging in certain inquiries when determining whether to allow debtors to use cash collateral under these circumstances without the lender’s consent.

Lenders whose borrower’s commence Chapter 11 cases in the Southern District of Texas now know that asserting a colorable claim to a security interest is sufficient for entitlement to adequate protection when their liens are disputed, pending resolution of an adversary proceeding for a determination of its property rights. Lenders also now know that any order permitting a debtor to use cash collateral under these circumstances must (i) be interim and subject to a final determination when the adversary proceeding is resolved, and (ii) plainly list what the lender will be entitled to in the form of adequate protection. To this last point, we note that First Brands argued that Evolution is adequately protected because there is USD 146.8m in current cash in the segregated account or prepetition accounts receivables that are past due. First Brands did not say that there is USD 146.8m in the account – but that the debtors are owed receivables that, combined with funds in the account (which amount would not be static as new receivables come in) total that amount. If Judge Lopez rules that Evolution is protected by funds expected to come into the account, it will be interesting to see what will happen if those funds do not materialize before the adversary proceeding is resolved, and whether Evolution’s adequate protection package would need to be modified.

At a status conference held today (23 February), upon Evolution’s request, Judge Lopez scheduled a 9 March hearing to consider Evolution’s adequate protection motion.

Related Links:

Factoring Receivables Motion
Evolution’s Objection to Factoring Receivables Motion
Bankruptcy Court Order Granting Factoring Receivables Motion
District Court Order
Evolution’s Adequate Protection Motion
First Brands Case Profile
Debtwire Dockets: First Brands Group
Debtwire Dockets: First Brands Group, LLC v. Sealed Defendants
Debtwire Restructuring Database: First Brands Group

Prior to joining Debtwire, Sara was a law clerk to two judges in the United States Bankruptcy Court, S.D.N.Y. and practiced in the Financial Restructuring Group at Clifford Chance, where she represented financial institutions (as secured and unsecured creditors, defendants in adversary proceedings, and participants in DIP financings) in high-profile restructurings. She also represented foreign representatives in Chapter 15 cross-border cases.

This report should not be relied upon to make investment decisions. Furthermore, this report is not intended and should not be construed as legal advice. ION Analytics does not provide any legal advice, and clients should consult with their own legal counsel for matters requiring legal advice. All information is sourced from either the public domain, ION Analytics data or intelligence, and ION Analytics cannot and does not verify or guarantee the adequacy, accuracy or completeness of any source document. No representation is made that it is current, complete or accurate. The information herein is not intended to be used as a basis for investing and does not constitute an offer to buy or sell any securities or investment strategy. The information herein is for informational purposes only and ION Analytics accepts no liability whatsoever for any direct or consequential loss arising from any use of the information contained herein.

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[1] According to Evolution, the First Brands receivables sellers include: (i) Strongarm, LLC, (ii) Carter Fuel Systems, LLC, (iii) Trico Products Corporation, (iv) ASC Industries, Inc., (v) Fram Group Operations LLC, (vi) Brake Parts Inc. LLC, (vii) First Brands Group, LLC, and (viii) Champion Laboratories, Inc..

[2] For reasons beyond the scope of this article, Evolution asserts liens on not only the receivables concerning the receivables sellers it entered into the factoring arrangements with, but also on all factored receivables.

[3] Evolution relies on a provision of its receivables purchase agreement that provides that if any purchased receivables are not characterized as a true sale, each receivables seller is deemed to have granted Evolution a first priority lien on any and all present and future purchased receivables and the proceeds thereof to secure all obligations of such seller arising in connection with the receivables purchase agreement. First Brands argued that Evolution has no such security interests because they were not properly perfected. According to First Brands, Evolution filed UCC financing statements against each receivables seller, which provided notice that Evolution holds a lien on receivables transferred or purported to be transferred to it pursuant to the governing documents. However, according to First Brands, the UCC-1 filings make no reference to lien on all of the receivables sellers’ receivables or any receivables that were not transferred or purported to be transferred.

[4] See First Brands’ factoring receivables motion, at ¶ 3. Evolution also made a basic fairness argument in its objection. It noted that the debtors were asking the court to bless an exacting receivables-matching process that would penalize Evolution and other factors for the debtors’ own errors and failures. Specifically, under the debtors’ proposed procedures, any receipts that” do not perfectly match their own system-generated invoice records will be handed over to the [d]ebtors. These procedures do not guard the interests of any of the Third-Party Factors, much less the interests of Evolution which holds a first-priority security interest in all Receivables of the Receivable Sellers.” See Evolution objection, at ¶ 4.

[5] In addition to various debtors, Evolution also named the prepetition agents as defendants. Aequum Capital Financial II, as administrative agent under the debtors’ revolving credit facility moved to intervene in the adversary proceeding. In the adversary proceeding, among other things, Evolution seeks a declaration that it has a perfected, first-priority security interest in the collateral, free and clear of any liens in favor of the agents. On 29 January, Bank of America, GLAS USA and Wilmington Savings Fund Society moved to dismiss the adversary proceeding, and the First Brands debtors filed a joinder to Bank of America’s dismissal motion. On 19 February, Evolution filed an opposition to the dismissal motions.

[6] For example, whereas an oversecured creditor may be adequately protected by its equity cushion, and undersecured creditor may require less adequate protection given the small amount of its interest.

[7] See 11 U.S.C. § 363(p).