Qmect, Inc.

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UNITED STATES BANKRUPTCY COURT
NORTHERN DISTRICT OF CALIFORNIA
In re 	No. 04-41044 T
Chapter 11
QMECT, INC., etc.,
Debtor-in-Possession.
__________________________________/
MEMORANDUM OF DECISION RE PROCEEDS ISSUE
The Court scheduled a final evidentiary hearing on the motion of
Burlingame Capital Partners II, L.P. (“Burlingame”) and Electrochem
Funding, 	LLC 	(“Burlingame 	Funding”)(collectively 	“Lenders”) 	for
relief from the automatic stay for May 24, 2006. 	The Lenders filed
a 	trial 	brief 	prior 	to 	the 	scheduled 	hearing 	in 	which 	they 	argued
that, 	notwithstanding 	11 	U.S.C. 	§ 	552, 	their 	security 	was 	not 	“cut
off” 	as 	of 	the 	petition 	date. 	Although 	the 	orders 	granting 	the
debtor 	(“Qmect”) 	the 	right 	to 	use 	the 	Lenders’ 	cash 	collateral
granted them replacement liens in assets acquired or created by Qmect
post-petition, according to the Lenders, they were not limited to the
interest created by the replacement liens. 	Since all of the assets
acquired or created by Qmect post-petition were acquired or created
Signed: June 02, 2006
________________________________________
LESLIE TCHAIKOVSKY
U.S. Bankruptcy Judge
________________________________________
Entered on Docket
June 02, 2006
GLORIA L. FRANKLIN, CLERK
U.S BANKRUPTCY COURT
NORTHERN DISTRICT OF CALIFORNIA
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1The Lenders apparently misunderstood the purpose of the
briefing schedule. 	Instead of tailoring their arguments to the
“proceeds” issue as the Court directed, they reiterated their
arguments concerning their rights pursuant to the Court’s cash
collateral orders. 	The Court has previously indicated that, if
that the Lenders are relying on those orders as to their rights in
the post-petition assets, it will require the presentation of
valuation evidence. 	The Court deferred the presentation of that
evidence because, if the Lenders “proceeds” theory were persuasive,
no valuation would be necessary.
2
with 	their 	pre-petition 	collateral, 	all 	of 	the 	assets 	acquired 	or
created post-petition constituted the proceeds of their collateral.
As the Court noted in a prior memorandum, this argument assumed
that 	the 	value 	of 	the 	collateral 	was 	less 	than 	the 	amount 	of 	the
Lenders’ claims. 	This assumption could not be relied upon until the
Court 	resolved 	the 	claim 	asserted 	by 	the 	Official 	Creditors’
Committee 	(the 	“Committee”) 	that 	the 	Lenders 	had 	violated 	the
regulations 	governing 	their 	license 	as 	finance 	lenders 	and 	as 	a
result had lost their exemption from the usury laws. 	If not, their
claims might be less than the value of the collateral. 	As discussed
in 	a 	separate 	memorandum, 	the 	Court 	has 	concluded 	that 	the
Committee’s usury claim fails.
Qmect 	requested 	an 	opportunity 	to 	brief 	the 	“proceeds” 	issue,
and 	the 	Court 	granted 	the 	request. 	The 	parties 	have 	filed 	their
briefs, and the Court has reviewed them. 	The Court’s conclusions are
set forth below. 1
DISCUSSION
Section 552(a) of the Bankruptcy Code provides that:
Except as provided in subsection (b)...,property
acquired 	by 	the 	estate 	or 	by 	the 	debtor 	after
the 	commencement 	of 	the 	case 	is 	not 	subject 	to
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3
any 	lien 	resulting 	from 	any 	security 	agreement
entered 	into 	by 	the 	debtor 	before 	the
commencement of the case.
Section 552(b)(1) provides, in pertinent part, that:
...[I]f the debtor and an entity entered into a
security 	agreement 	before 	the 	commencement 	of
the case and if the security interest created by
such 	security 	agreement 	extends 	to 	property 	of
the 	debtor 	acquired 	before 	the 	commencement 	of
the 	case 	and 	to 	proceeds...of 	such 	property,
then 	such 	security 	interest 	extends 	to 	such
proceeds...acquired 	by 	the 	estate 	after 	the
commencement of the case to the extent provided
by 	such 	security 	agreement 	and 	by 	applicable
nonbankruptcy law, except to any extent that the
court, 	after 	notice 	and 	a 	hearing 	and 	based 	on
the equities of the case, orders otherwise.
11 U.S.C. § 552(a),(b)(1).
The 	Court 	has 	previously 	concluded 	that, 	between 	them, 	at 	the
time the bankruptcy case was filed, the Lenders held a “blanket lien”
on 	all 	of 	Qmect’s 	pre-petition 	assets 	with 	the 	exception 	of 	two 	or
three 	trucks 	used 	in 	the 	operation 	of 	the 	business, 	referred 	to
hereafter 	as 	the 	“Trucks”. 	Based 	on 	the 	Court’s 	findings 	and
conclusions, 	as 	set 	forth 	in 	other 	memoranda, 	it 	is 	clear 	that, 	at
the 	time 	the 	chapter 	11 	case 	was 	filed, 	the 	value 	of 	the 	Lender’s
collateral 	was 	less 	than 	the 	combined 	amount 	of 	their 	claims.
Moreover, 	it 	does 	not 	appear 	to 	be 	disputed 	that 	the 	Lenders’
security 	interests, 	by 	their 	terms, 	extend 	to 	the 	proceeds 	of 	the
Lenders’ collateral.
Based 	on 	the 	foregoing, 	the 	Lenders 	contend 	that 	all 	of 	the
accounts 	receivable 	generated 	by 	Qmect 	post-petition 	and 	the 	funds
collected 	from 	those 	accounts 	receivable 	are 	the 	proceeds 	of 	their
pre-petition collateral. 	As a result, they contend it is unnecessary
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4
to 	value 	their 	collateral 	at 	the 	time 	of 	the 	filing 	and 	would 	be
improper 	to 	limit 	their 	interest 	in 	the 	funds 	on 	hand 	now 	to 	that
value. 	In support of this contention, they cite In re Bumper Sales,
Inc., 907 F.2d 1430, 1439 (4 th Cir. 1990).
In Bumper Sales, a secured creditor with a pre-petition lien in
all 	of 	the 	debtor’s 	assets 	consented 	to 	the 	use 	of 	its 	cash
collateral without obtaining a replacement lien. 	It was undisputed
that 	all 	of 	the 	new 	inventory 	and 	accounts 	receivable 	generated 	by
the debtor post-petition was created through the use of the secured
creditor’s cash collateral: i.e., that the debtor “did not borrow any
outside 	funds 	or 	incur 	any 	outside 	debt....” 	Id. 	at 	1433. 	The
debtor 	contended 	that, 	based 	on 	11 	U.S.C. 	§ 	552(a), 	the 	secured
creditor’s 	pre-petition 	lien 	did 	not 	extend 	to 	the 	inventory 	and
accounts 	receivable 	created 	post-petition. 	The 	secured 	creditor
disagreed, arguing that these post-petition assets were the proceeds
of 	its 	pre-petition 	collateral 	and 	thus 	subject 	to 	its 	security
interest 	pursuant 	to 	11 	U.S.C. 	§ 	552(b). 	The 	Bumper 	Sales 	court
ruled for the secured creditor, relying on the applicable state law
definition of the term “proceeds.” 	Id. at 1435-41.
Qmect notes that Bumper Sales is not binding authority in this
Circuit. 	In 	any 	event, 	it 	argues 	that 	Bumper 	Sales 	is
distinguishable 	on 	its 	facts. 	As 	noted 	above, 	in 	Bumper 	Sales, 	it
was 	stipulated 	that 	all 	of 	the 	post-petition 	assets 	were 	created
through 	the 	use 	of 	the 	secured 	creditor’s 	collateral 	and 	that 	the
debtor 	neither 	borrowed 	money 	from 	anyone 	else 	nor 	incurred 	other
debt 	post-petition. 	In 	the 	instant 	case, 	Qmect 	reminds 	the 	Court
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5
that, 	shortly 	after 	its 	chapter 	11 	case 	was 	filed, 	a 	third 	party
loaned 	Qmect 	$150,000 	to 	make 	payroll. 	In 	addition, 	it 	notes 	that
the Trucks, which were unencumbered, contributed to the value created
post-petition.
Qmect 	contends 	that 	the 	more 	relevant 	authorities 	are 	In 	re
Skagit 	Pacific 	Corp., 	316 	B.R. 	330 	(Bankr. 	9 th 	Cir. 	2004), 	In 	re
Cafeteria Operations, 299 B.R. 400 (Bankr. N.D. Tex. 2003), and In re
Photo Promotion Associates, 61 B.R. 936 (Bankr. S.D.N.Y. 1986).
In Photo Promotion, a secured creditor had a blanket lien on all
of 	the 	assets 	of 	the 	debtor 	which 	provided 	photographic 	portrait
services in shopping malls and department stores. 	When the debtor’s
chapter 	11 	case 	was 	converted 	to 	chapter 	7, 	the 	trustee 	obtained
authorization 	to 	borrow 	funds 	from 	someone 	other 	than 	the 	secured
creditor. 	Nevertheless, 	the 	secured 	creditor 	claimed 	the 	payments
for 	the 	portraits 	as 	the 	proceeds 	of 	its 	collateral. 	It 	had
liquidated its other assets and still had a substantial deficiency.
Id. at 937-38.
The 	Photo 	Promotion 	court 	accepted 	the 	contention 	that 	the
payments 	were 	the 	proceeds 	of 	the 	secured 	creditor’s 	collateral.
However, it observed that, if the orders had not been completed and
completed 	promptly, 	they 	would 	have 	been 	of 	little 	or 	no 	value.
Consequently, based on the equities of the case, it held that all of
the 	proceeds 	should 	be 	treated 	as 	unencumbered 	property 	of 	the
estate. 	Id. at 938-40.
Thus, 	Photo 	Promotion 	stands 	at 	the 	other 	end 	of 	the 	spectrum
from Bumper Sales. 	In Bumper Sales, by stipulation, only the secured
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2The Cafeteria Operators court recognized that the debtors’
fixtures and equipment also contributed to the production of the
revenues. 	However, it concluded that restaurant revenues could not
qualify as the “proceeds” of this type of asset. 	Id. at 408.
3The Court notes that there is no discussion in Cafeteria
Operators of whether the debtors borrowed money post-petition from
any outside source or incurred unsecured debt to third parties
6
creditor’s collateral was used to produce the post-petition asset; in
Photo 	Promotion, 	the 	only 	portion 	of 	the 	secured 	creditor’s
collateral used to produce the post-petition asset was found to be of
little or no value. 	The facts of the instant case bring it somewhere
between these two extremes.
In 	Cafeteria 	Operators, 	the 	debtors 	operated 	family 	style
restaurants in several states. 	The debtors did not dispute that the
secured creditor held a “blanket security” interest in the debtors’
assets 	which 	extended 	to 	the 	proceeds 	of 	its 	collateral. 	Id. 	at
408. 	However, 	the 	debtors 	contended 	that 	the 	revenues 	of 	its 	food
sales 	did 	not 	constitute 	the 	proceeds 	of 	the 	secured 	creditors’
collateral because the revenues were primarily generated by services:
i.e., 	the 	value 	of 	the 	food 	component 	of 	a 	meal 	was 	less 	than 	one-
third of the price of the meal. 	Id. at 408.
The 	Cafeteria 	Operators 	court 	adopted 	a 	middle 	ground. 	It
concluded 	that, 	because 	a 	portion 	of 	the 	value 	of 	the 	revenues 	was
produced 	by 	the 	secured 	creditor’s 	collateral–-i.e., 	the 	food
component–-the revenues were the proceeds of the secured creditor’s
collataral. 	However, based on the equities, it limited the value of
the secured creditor’s interest in the revenues to the value of its
inventory. 	Id. at 410. 2 	This is the approach argued for by Qmect. 3
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during the chapter 11 case.
4As to those assets, the secured creditor took possession of
the certificates of title but failed to perfect its security
interest by having its name placed on title. 	Id. at 333, 340-42.
7
The final case to be examined is Skagit Pacific, the only case
cited 	from 	this 	jurisdiction. 	In 	Skagit 	Pacific, 	the 	debtor
manufactured 	and 	sold 	modular 	offices 	and 	trailers. 	The 	parties
agreed 	that 	the 	secured 	creditor 	had 	a 	perfected 	security 	interest
that 	extended 	to 	the 	proceeds 	in 	all 	of 	the 	debtor’s 	assets 	except
the 	vehicle and trailer inventory. 4 	After filing for chapter 11, the
debtor obtained a contract to build four modular trailers. 	Shortly
after completing the project and before receiving payment, the case
was converted to chapter 7. 	The secured creditor claimed the payment
as the proceeds of its collateral. 	Id. at 332-34.
The 	secured 	creditor 	contended 	that 	the 	proceeds 	of 	its
collataral 	had 	been 	used 	to 	produce 	the 	trailers 	for 	which 	the
disputed 	payment 	was 	made. 	The 	bankruptcy 	court 	conducted 	an
evidentiary hearing at which the secured creditor presented evidence
regarding 	the 	deposits 	and 	withdrawals 	from 	the 	debtor’s 	accounts.
Based on the evidence presented, the bankruptcy court granted relief
as to approximately one-half of the payment. 	Id. at 334. 	On appeal,
the bankruptcy appellate panel reversed.
The 	Skagit 	Pacific 	panel 	noted 	that 	the 	proceeds 	of 	post-
petition 	accounts 	receivable 	do 	not 	automatically 	constitute 	the
proceeds 	of 	a 	secured 	creditor’s 	pre-petition 	security 	interest 	in
accounts receivable. 	It noted further that revenue generated solely
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by 	services 	do 	not 	constitute 	the 	proceeds 	of 	a 	secured 	creditor’s
pre-petition security interest in accounts receivable. 	Id. at 336.
The panel acknowledged that a secured creditor could claim the
proceeds of a post-petition account receivable if it could properly
trace 	the 	proceeds 	to 	its 	pre-petition 	collateral. 	Id. 	at 	337.
However, 	if 	the 	proceeds 	of 	the 	pre-petition 	collateral 	were
commingled 	with 	funds 	obtained 	from 	some 	other 	source, 	the 	secured
creditor must present detailed evidence tracing the funds claimed as
proceeds. 	The panel concluded that the secured creditor had failed
to do this.
Traditionally, 	tracing 	is 	done 	using 	the 	lowest 	intermediate
balance 	rule. 	Id. 	at 	338. 	This 	rule 	assumes 	that 	the 	traced
proceeds 	are 	the 	last 	funds 	withdrawn 	from 	the 	commingled 	account.
However, 	once 	the 	traced 	proceeds 	are 	withdrawn 	and 	spent, 	the
security 	interest 	disappears. 	The 	security 	interest 	does 	not
reappear 	or 	increase 	if 	additional 	funds 	from 	another 	source 	are
later 	deposited 	into 	the 	account. 	Thus, 	the 	security 	interest 	is
limited 	to 	the 	lowest 	balance 	in 	the 	account 	during 	the 	period 	in
question. 	Id. at 338-40.
The Court will adopt the approach set forth in Skagit Pacific,
which 	is 	the 	most 	authoritative 	case 	in 	this 	jurisdiction 	and 	the
rationale 	of 	which 	appears 	sound. 	Like 	the 	Cafeteria 	Operators
court, 	the 	Court 	does 	not 	believe 	fact 	that 	the 	Lenders’ 	lack 	of 	a
security interest in the Trucks diminishes their right to claim the
post-petition assets as their proceeds. 	However, if the proceeds of
the 	pre-petition 	accounts 	receivable 	were 	commingled 	with 	the
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5The Court does not mean to imply that, if the Lenders are
unable to trace their pre-petition security interest into the post-
petition assets, they may not rely on their rights pursuant to the
cash collateral orders. 	Similarly, the Lenders may be able to
supplement rights established under one theory with rights
established under another. 	However, as discussed above, if the
Lenders wish to rely on the cash collateral orders to any extent,
valuation evidence must be presented.
9
$150,000 	loan 	made 	by 	a 	third 	party 	post-petition, 	the 	secured
creditor 	will 	be 	required 	to 	trace 	its 	security 	interest 	in 	the
proceeds 	of 	the 	pre-petition 	accounts 	receivable 	into 	the 	post-
petition assets using the lowest intermediate balance rule. 5
The 	Court 	does 	not 	believe 	oral 	argument 	is 	necessary 	with
respect 	to 	this 	issue. 	However, 	the 	Court 	directs 	the 	parties 	to
appear by telephone for a status conference on Monday June 5, 2006 at
3:00 p.m. to discuss how best to proceed with respect to this issue.
The 	parties 	are 	directed 	to 	coordinate 	their 	appearance 	for 	this
purpose with the judge’s calendar clerk.
END OF DOCUMENT
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COURT SERVICE LIST
Paul E. Manasian
Manasian & Rougeau, LLP
400 Montgomery St., Ste. 1000
San Francisco, CA 94104
Robert R. Moore
Allen Matkins Leck Gamble & Mallory LLP
Three Embarcadero Center, 12 th Floor
San Francisco, CA 94111
Philip J. Nicholsen
Law Offices of Philip J. Nicholsen
221 Main St., #740
San Francisco, CA 94105
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