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).