Often times, Debtors are involved in accidents where personal property is totaled or unsalvageable. Many times these accidents occur while a bankruptcy is pending and the Debtor still owes a secured lender for the property. I must note the strategy detailed below is really only relevant to Chapter 13 and Chapter 11 cases. What is substitution of collateral? What the Debtor is generally looking to do is use the insurance proceeds from the accident, apply them to new property, and essentially substitute the newly acquired property as the former secured lender’s collateral.
You may be asking, what benefit is there to doing this? Well, it may allow a Debtor to purchase a new vehicle outright without new financing terms. It’s likely the Debtor will benefit from not having to pay off a secured creditor in full and worry about being able to afford a new vehicle. If the insurance proceeds are less than what is owed on the vehicle, this strategy will not work. You see this scenario most often with work vehicles. However, the issue is also very common in Chapter 11 business cases where business equipment is damaged and needs to be replaced.
Unfortunately, the strategy does not always work smoothly and the creditor may resist the motion to substitute collateral. The good creditor attorneys, who understand the law, will not object. Generally, the insurance adjuster will not release the insurance proceeds without the title being surrendered by the secured lender. This may put the Debtor in an even tougher situation financially especially if the Debtor is relying on a new piece of property for work purposes. Most Debtors cannot afford to wait months for the litigation to get resolved. Arguably, a creditor’s failure to release the title to the insurance company is a violation of the automatic stay (assuming no stay relief has been ordered).
There is case law that holds that the creditor is entitled to adequate protection of its collateral especially when the creditor seeks stay relief but the debtor objects. Forms of adequate protection can vary. An example of providing adequate protection is making sure the secured property is being insured and if there is equity in the collateral, the creditor is deemed to have adequate protection. If the debtor offers a replacement lien (essentially what the motion to substitute collateral looks to accomplish), the creditor is deemed to be provided adequate protection.
How is this applied? Let’s say a Debtor is paying on a vehicle in a Chapter 13 plan and the monthly payment attributed to the vehicle is $300.00 and $10,000.00 is still owed on the vehicle. The Debtor then gets in an accident and the vehicle is totaled. Say the Debtor is scheduled to receive $15,000.00 in insurance proceeds. The motion to substitute collateral allows the debtor to purchase a new vehicle with the insurance proceeds and the secured lender takes a lien on the new collateral for the amount owed. The Debtor would continue to pay the $300.00 per month in the plan even though it is for a totally different vehicle. Should the Debtor miss payments, the creditor could look to get stay relief to enforce its state court remedies.
If you have questions about this topic or other bankruptcy matters, speak with an experienced bankruptcy attorney.