Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-cand-3_06-cv-05401/USCOURTS-cand-3_06-cv-05401-4/pdf.json

Nature of Suit Code: 422
Nature of Suit: Bankruptcy Appeals Rule 28 USC 158
Cause of Action: 28:0158 Notice of Appeal re Bankruptcy Matter (BAP)

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United States District Court

For the Northern District of California

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IN THE UNITED STATES DISTRICT COURT

FOR THE NORTHERN DISTRICT OF CALIFORNIA

QMECT, INC.,

Appellant,

 v.

BURLINGAME CAPITAL PARTNERS II,

L.P., and ELECTROCHEM FUNDING, LLC,

Appellees. /

BURLINGAME CAPITAL PARTNERS II,

L.P., and ELECTROCHEM FUNDING, LLC,

Cross-Appellants, 

 v.

QMECT, INC., 

Cross-Appellee.

_____________________________________/

No. C 06-05401 WHA

Consolidated with:

No. C 06-05402 WHA

ORDER AFFIRMING DECISION

OF BANKRUPTCY COURT ON

APPEAL AND AFFIRMING

DECISION OF BANKRUPTCY

COURT ON CROSS-APPEAL

INTRODUCTION

In this bankruptcy appeal and cross-appeal, the trustee of debtor Qmect, Inc.’s Chapter

VII bankruptcy estate attempts to set aside decisions of the bankruptcy court. Appellant

bankruptcy trustee John T. Kendall wishes to reverse the bankruptcy court’s final order and

have this action remanded to the bankruptcy court for a valuation determination regarding the

post-petition cash assets of the estate. The bankruptcy court did not err in holding that Qmect’s

post-petition accounts receivable were proceeds of collateral. Appellees and cross-appellants

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Burlingame Capital Partners II, L.P., and Electrochemical Funding, LLC, wish to lift the

automatic stay on secured creditors’ rights to foreclose on the estate’s adequate protection funds

and blanket lien that were granted to secured creditors as part of the cash collateral orders. The

bankruptcy court correctly held that secured creditors would have to demonstrate that their

collateral had diminished in value before foreclosing on the blanket lien and receiving the

adequate protection funds. Accordingly, the decision of the bankruptcy court on appeal is

AFFIRMED, and the decision of the bankruptcy court on cross-appeal is AFFIRMED. 

STATEMENT

Appellant and cross-appellee John T. Kendall, bankruptcy trustee, brings this appeal on

behalf of the Chapter 7 bankruptcy estate of debtor Qmect, Inc. Debtor was in the business of

electroplating and anodizing electrical connectors and technical parts and equipment for metal

fabricators and equipment manufacturers in industries such as medical devices and

biotechnology instrumentation. It is currently operated by Burlingame or a company related

thereto through foreclosure proceedings. 

Qmect filed a voluntary petition under Chapter 11 of the Bankruptcy Code on February

27, 2004 (ER 91). At that time, the company had $34,291 in a deposit account, net accounts

receivable of $742,839, and inventory of $55,016, for a total of $832,146 (Trustee’s ER Exh. 3

at 2). 

As of the petition, Qmect had the following four outstanding loans payable to

Electrochem Funding: (1) a variable rate installment note, with outstanding principal of

$187,500 and prepetition interest of $1,696.31; (2) a note secured by deed of trust (“DOT

note”), with outstanding principal of $537,816.96 and prepetition interest of $5,052.51; (3)

amended and restated note secured by deed of trust (“additional DOT note”), with outstanding

principal of $894,737.22 and prepetition interest of $8,948.32; and (4) master revolving note

with outstanding principal of $900,000 and prepetition interest of $7,850.60 (ER 36–37). The

variable rate installment note and the revolving note were secured by senior priority liens all of

Qmect’s property except for certain leased equipment if the bankruptcy court found that they

were “true leases,” prepetition deposit accounts, and grid flooring and other fixtures in which

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Electrochem’s lien was junior to that of another creditor (ER 37). The DOT note and the

additional DOT note were secured by senior priority liens on debtor’s real property and fixtures

at the company’s facility, and all rents, issues, and profits generated therefrom (ibid.). 

As of the petition, Qmect also had an outstanding loan payable to Burlingame. The

principal was $2,000,000 with prepetition interest of $1,043,635.01 and prepetition collection

costs of $357,998,59. Qmect owed $3,401,633.60 in total on the loan from Burlingame as of

the petition, secured by a junior priority lien on all collateral that secured the loans from

Electrochem, and a first priority lien on all of Qmect’s remaining property, except for

prepetition deposit accounts (ibid.). Appellees and cross-appellants are collectively referred to

as secured lenders. 

The estate filed two emergency motions on March 1, 2004 — a motion to obtain a postpetition loan and a motion to use cash collateral (ER 91). The motion to obtain a post-petition

loan was granted, and the estate obtained a loan of approximately $150,000 from an individual

named Brian Fitzpatrick. The bankruptcy court later found that those funds went to pay

Qmect’s prepetition obligations (ER 91–92). 

The motion to use cash collateral was also granted (ibid.). Burlingame and Electrochem

were granted replacement liens as adequate protections of their interests. The order for the

replacement lien was as follows (ER 2–3):

(a) As and for adequate protection of Burlingame’s interest in the

Debtor’s assets, each of BCP and [Electrochem] Funding is

hereby granted a replacement lien (the “Adequate Protection

Liens”) on and in the types of assets identified in the prepetition

loan documents executed by the Debtor in favor of BCP or

[Electrochem] Funding or their predecessors in interest (the

“Adequate Protection Collateral”) . . . . The Adequate Protection

Liens shall be fully perfected, first priority liens as to parties other

than Burlingame without the necessity of further action by or on

behalf of Burlingame; shall have the same priority as existed prior

to the commencement of the Debtor’s chapter 11 case; and shall

attach to all Adequate Protection Collateral whether now owned

or hereafter acquired. 

(b) The Adequate Protection Collateral shall also include of the

Debtor’s right, title and interest in cash and deposit and

investment accounts including proceeds of borrowings made by

the Debtor in this Chapter 11 case. 

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Other orders issued by the bankruptcy court required the estate to make payments to

Burlingame and Electrochem’s attorneys into a trust account as further adequate protection (ER

8–9, 11, 26, 29). 

A contested evidentiary hearing was held on December 19, 2005, regarding Qmect’s

continued use of cash collateral. The bankruptcy court issued a decision that found that secured

lenders between them held a blanket lien on all of Qmect’s assets (ER 17–19). It also found

that the value of the business had decreased by over one million dollars since debtor since

debtor had filed for bankruptcy. 

Secured lenders filed a motion for relief from the automatic stay to foreclose on the

security interests. Qmect conceded that the automatic stay could be lifted to allow foreclosure

on secured lenders’ collateral in existence at the time the bankruptcy petition was filed, such as

Qmect’s real property, fixed assets, and inventory (ER 48–49). The estate objected to the

petition to foreclose on its cash assets generated after the petition date. On March 24, 2006, the

bankruptcy court issued an order granting the secured lenders relief from the automatic stay to

foreclose on their security interests in existence at the time of the petition. They were denied

relief to foreclose on the assets generated post-petition (ibid.). Burlingame obtained a receiver

over the cash collateral assets. 

An additional hearing regarding relief from the automatic stay to foreclose on the

remaining assets was scheduled for May 24, 2006. The bankruptcy court issued a memorandum

on issues raised in parties’ trial briefs, in which it stated that it was inclined to agree that the

replacement liens extended on debtor’s post-petition assets were blanket liens, and as such, the

remaining assets were proceeds of collateral regardless of whether the value of post-petition

collateral increased after the petition date (ER 54–55). The estate argued that because it had

obtained a post-petition loan, not all of the assets acquired post-petition were proceeds of

secured lenders’ collateral. As such, the secured lenders would only be entitled to the portion of

Qmect’s post-petition assets that could be traced to prepetition collateral (ER 74–76). 

A first memorandum of decision by the bankruptcy court held that secured creditors

could claim proceeds of post-petition accounts receivable if they could properly trace the funds

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using the lowest intermediate balance methodology (ER 87–91). The secured lenders filed a

memorandum regarding the tracing of funds to pre-petition collateral along with declarations

and supporting documentation. The estate did not dispute this evidence. 

A second memorandum of decision, issued on June 27, 2006, held that Qmect used the

proceeds from the post-petition loan to pay pre-petition obligations. The estate had the burden

to show that the loan proceeds were used to produce post-petition assets, but failed to carry the

burden (ER 103). The bankruptcy court then concluded that all remaining assets and adequate

protection funds were proceeds from the secured lenders’ pre-petition collateral and that the

security interests could increase in value during the bankruptcy. The secured lenders were

granted relief from the automatic stay to foreclose on the post-petition assets (ibid.). A final

order to this effect was entered on July 14, 2006. 

The estate moved the bankruptcy court for a stay of the final order pending appeal. In

an order dated August 3, 2006, the bankruptcy court determined that the final order was

immediately enforceable except for secured lenders’ rights to foreclose on the adequate

protection funds, totaling $345,885.31, and required that the secured lenders deposit $392,902

with the adequate protection funds if Qmect’s real property was foreclosed upon. That amount

constitutes the disputed cash in this appeal. 

Both parties filed notices of appeal from the bankruptcy court’s decisions on September

1, 2006. The bankruptcy case was converted from a Chapter 11 proceeding to a Chapter 7

proceeding by an order dated October 6, 2006. Appellant John T. Kendall was appointed as

trustee. At some time thereafter, parties submitted a compromise for approval by the

bankruptcy court. Briefing in this appeal was delayed pending its resolution. The bankruptcy

court denied approval of the compromise on February 13, 2007. 

ANALYSIS

The bankruptcy court’s findings of fact are reviewed under a clearly erroneous standard,

while conclusions of law are reviewed de novo. In re Jan Weilert RV, Inc., 315 F.3d 1192,

1196 (9th Cir. 2003). This means that the bankruptcy court’s findings of fact must be accepted

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unless this Court is “left with a definite and firm conviction that a mistake has been committed.” 

Ibid. 

1. ISSUES ON APPEAL.

The following issues are presented on appeal: (1) whether the bankruptcy court abused

its discretion in entering the final order granting relief from the automatic stay so the secured

lenders could foreclose on their collateral; (2) whether the bankruptcy court’s findings that

Qmect’s post-petition assets were generated from the use of the secured lenders’ collateral were

clearly erroneous; (3) whether the bankruptcy court erred in holding that secured lenders’ liens

extended to the disputed cash and proceeds of their collateral; and (4) whether the bankruptcy

court erred in concluding that secured lenders were entitled to foreclose on the proceeds of

collateral that accumulated during the failed reorganization attempt. 

A. Relationship Between Post-Petition Assets and Collateral.

Decisions to grant relief from an automatic stay are reviewed for abuse of discretion. In

re Cybernetic Servs., 252 F.3d 1039, 1045 (9th Cir. 2001). Section 552(b) of the Bankruptcy

Code governs the relationship between security interests and post-petition assets. It states:

[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, order otherwise. 

11 U.S.C. 552(b)(1). State law governs whether or not a particular item of collateral constitutes

proceeds of the lien. Butner v. United States, 440 U.S. 48, 57 (1979). The Ninth Circuit adopts

a broad definition of the term “proceeds.” Fifteenth RMA Partners, L.P. v. Pacific/West

Communs. Group, Inc. (In re Pacific/West Communs. Group Inc.), 301 F.3d 1150, 1153 (9th

Cir. 2002). 

Under California law, “the attachment of a security interest in collateral gives the

secured party the rights to the proceeds provided by Section 9315 and is also a security interest

in a supporting obligation for the collateral.” Cal. Comm. Code § 9203(f). Proceeds are

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defined as “(a) whatever is acquired upon the sale, lease, license, exchange or other disposition

of collateral, (b) whatever is collected on, or distributed on account of, collateral; (c) rights

arising out of collateral.” Cal. Comm. Code § 9102(64). Additionally, proceeds to which a

security interest attaches are included in the definition of collateral. Cal. Comm. Code §

9102(12). Furthermore, “a security interest attaches to any identifiable proceeds of collateral.” 

Cal. Comm. Code § 9315(a)(2) (emphasis added). 

Appellant first contends that the bankruptcy court erred in determining that all of the

post-petition assets derived from the secured lenders’ collateral under the blanket lien. 

Appellants do not dispute that the secured lenders held a security interest in nearly all of

Qmect’s assets. They instead argue that the proceeds from the continued post-petition operation

of Qmect were not derived from those assets. Essentially, they argue, something should cut off

the secured lenders’ right to proceeds from collateral since the cash collateral eventually

appreciated from $742,837 to $1,570,000. 

In determining that all the post-petition assets were proceeds of collateral, the

bankruptcy court adopted the approach used in In re Skagit Pacific Corp., 316 B.R. 330 (9th

Cir. B.A.P. 2004). The panel in Skagit Pacific first noted that post-petition accounts receivable

are not automatically proceeds. Revenue that was generated solely from services rendered was

not proceeds of a secured creditor’s pre-petition security interest in accounts receivable. Id. at

336. A secured creditor could, however, claim proceeds from post-petition accounts receivable

if it could trace the proceeds to pre-petition collateral. Id. at 337. If the secured creditor’s

funds were commingled with funds from another source, then the secured creditor would have

to present detailed evidence tracing the funds to the pre-petition collateral. In Skagit Pacific,

the panel found that the secured creditor had failed to meet its burden on the tracing issue. Id.

at 338. The panel endorsed using the lowest intermediate balance rule, which assumes that the

proceeds are the last funds withdrawn from a commingled account. If the funds are withdrawn

and spent, the security interest disappears, so it is calculated from the lowest balance in the

account during the period in question. Id. at 338–340. 

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The bankruptcy court initially determined that the secured lenders were required to trace

the funds to their pre-petition security interest (AR 88–89). It also determined that any other

funds in the estate’s accounts were spent to satisfy pre-petition debts, not to generate postpetition accounts receivable. Thus, the post-petition accounts receivable were proceeds of

secured lenders’ collateral. The bankruptcy court’s factual findings that all post-petition assets

were generated from secured lenders’ collateral are not clearly erroneous. The only other

source of post-petition funding the estate had was the loan from an individual, and there was

ample evidence that those funds went to pay pre-petition debts. 

B. Increase in Value of Collateral.

The bankruptcy court also found that secured lenders’ pre-petition collateral could

increase in value and the increase could inure to their benefit. In In re 1441 Veteran Street,

144, F.3d 1288, 1291 (9th Cir. 1998), the Ninth Circuit held that a secured creditor’s security

interest could attach to rents from the property produced post-petition, even though those rents

represented an increase in the value of the collateral. 

Qmect contends that this situation is distinguishable from 1441 Veteran Street because it

involved rents generated from a property which were directly traceable to the collateral itself. 

The rents in 1441 Veteran Street were not used to generate further funds. Appellant urges that

this case is more like In re Skagit Pacific, in which the panel noted that Section 552(a) cuts off

security interests in property acquired after the petition. 316 B.R. at 335. This decision is

distinguishable from the present facts because there was no blanket lien; the lender in Skagit

Pacific only had a security interest in certain trucks and inventory of the debtor. The facts here

are more like 1441 Veteran Street. There, the secured lender held an interest in an entire

property, here, Electrochem and Burlingame held an interest in substantially all of Qmect’s

assets. Furthermore, 11 U.S.C. 522(b)(1) and (2) provide for parallel treatment of rents and

proceeds from collateral, so the trustee’s attempt to distinguish rents from proceeds fails. The

Ninth Circuit held further that under Section 552(b) “secured creditors shall enjoy the same

rights to postpetition rents and proceeds that they would have under state law.” In re 1441

Veteran Street, 344 F.3d at 1290–91. 

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Moreover, here the bankruptcy court found that there were, in effect, no sources to

which the post-petition accounts receivable could be traced other than the secured lenders’

collateral. Nothing other than secured lenders’ collateral could have generated revenue, so all

proceeds, even the increase in value, were proceeds of secured lenders’ collateral. 

Appellants also argue that the secured lenders’ interpretation of Section 552 is

inconsistent with other provisions, specifically Section 547(c)(5), which states that creditors

with security interests in a floating mass like inventory or accounts receivable are subject to

preference attack to the extent they improve their position. This section is not implicated in the

issues presented on appeal here. Moreover, the secured lenders did not improve their

positions — before and after the petition they held the same blanket lien. Accordingly the

bankruptcy court correctly found that the secured lenders had a security interest in the proceeds

of the collateral. Based on this finding, the bankruptcy court gave the secured lenders relief

from the automatic stay to foreclose on their liens. This finding also was not in error. The

bankruptcy court’s decision on appeal is AFFIRMED. 

2. ISSUES ON CROSS-APPEAL.

The following issues are presented on cross-appeal: (1) whether the bankruptcy court

should have allowed secured lenders to enforce the replacement liens granted for Qmect’s use

of cash collateral without first requiring them to present evidence establishing a diminution in

value of their collateral; and (2) whether the bankruptcy court should have allowed the secured

lenders to obtain the adequate protection funds without first requiring secured lenders to present

evidence that established a diminution in value of collateral or tracing the adequate protection

funds to proceeds of collateral. 

A. Adequate Protection and Cash Collateral Orders.

Secured lenders contend that the replacement liens granted to them should have

enforceable absent any other action by them or by the bankruptcy court. They should not have

been required to prove diminution in the value of their collateral before collecting on the liens,

or so the argument goes. This argument was not well-developed in the record, and the secured

lenders do a very poor job of pointing out where this decision was made. An order issued from

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the bankruptcy court on March 24, 2006, granting the secured lenders relief from the automatic

stay and allowing them to foreclose on substantially all of Qmect’s pre-petition assets and all

inventory regardless of when generated. The automatic stay still applied, however, to assets

acquired or generated post-petition, including cash, deposit accounts, security deposits, and the

adequate protection funds (AR 49). 

Under 11 U.S.C. 363(e), “on request of an entity that has an interest in property used,

sold, or leased . . . by the trustee, the court, with or without a hearing, shall prohibit or condition

such use, sale, or lease as is necessary to provide adequate protection of such an interest.” 

Where adequate protection is requested or required: 

such adequate protection may be provided by– (1) requiring the

trustee to make a cash payment or periodic cash payments to such

entity, to the extent that . . . use, sale, or lease under section 363

of this title . . . results in a decrease in the value of such entity’s

interest in such property; (2) providing to such entity an

additional or replacement lien to the extent that such stay, use,

sale, lease, or grant results in a decrease in the value of such

entity’s interest in such property; or (3) granting such other relief,

other than entitling such entity to compensation allowable under

section 503(b)(1) of this title as an administrative expense, as will

result in the realization by such entity of the indubitable

equivalent of such entity’s interest in such property. 

11 U.S.C. 361. 

Pursuant to the cash collateral orders, the secured lenders were granted a replacement

lien on all of the secured lenders’ pre-petition collateral, as well as in Qmect’s cash and deposit

accounts. The secured lenders argue that the cash collateral orders granted fully perfected, firstpriority replacement liens to the secured lenders, so secured lenders are arguing that by

requiring them to show diminution in the value of the collateral, the bankruptcy court

effectively rewrote the cash collateral orders. 

First, they point out that the cash collateral orders were final and were subject to

immediate appeal on their entry by the bankruptcy court. Because of the possibility of

irreparable harm to the creditor if cash collateral is used, “an order granting a debtor use over

funds alleged to be cash collateral requires immediate appellate review.” Watson Pacific

Ventures v. Valley Fed. Sav. & Loan, 2 F.3d 967, 969 (9th Cir. 1993). The estate did not appeal

the cash collateral orders, so they then became final. This much is clear. Next, secured lenders

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contend that the replacement liens and cash collateral orders themselves dictated that secured

lenders needed to pursue no further action to collect the cash collateral and foreclose on the

replacement liens. 

B. Diminution in Value of Collateral.

Adequate protection is made available to protect creditors from the diminution of

collateral during the pendency of the bankruptcy petition; not to compensate creditors for delay

in being able to foreclose on collateral. See In re Timbers of Inwood Forest Assocs., Ltd., 484

U.S. 365, 377 (1988). The principle that adequate protection under 11 U.S.C. 363 is intended to

compensate lenders for diminution of their collateral was reaffirmed by a Bankruptcy Appellate

Panel of the Ninth Circuit. In re Weinstein, 227 B.R. 284, 296 (9th Cir. 1998). Bankruptcy

courts have held that lenders are not entitled to foreclose on replacement liens absent proof that

collateral has diminished in value as a result of the automatic stay or the collateral’s use during

the pendency of a bankruptcy petition. In re Sun Valley Ranches, Inc., 38 B.R. 595, 598 (Br. Id.

1984) (Young, J.). Accordingly, the purpose of adequate protection is to protect lenders from

diminution in the value of their collateral, so the bankruptcy court did not err in requiring

secured lenders from proving that their collateral had diminished in value. 

Secured lenders argue that the replacement liens were granted to them to ensure that

they had a security interest in the collateral on which they already had liens, but also any other

identified types of collateral that Qmect acquired during the bankruptcy. They further argue

that this was a sign that the bankruptcy court intended to preserve secured lenders’ rights in the

collateral as their rights existed before the petition, including rights in the proceeds. Here, the

basis for secured lenders’ assertion is unclear. This argument also neglects the purpose of

adequate protection as stated by the statute — to compensate lenders in the event their collateral

decreases in value. Furthermore, the bankruptcy court twice noted that secured lenders would

have to present valuation evidence showing that the value of their collateral had decreased

before taking any action on the replacement liens. 

“Adequate protection payments are intended to compensate the creditor for a decline in

the value of the collateral.” 3 Collier on Bankruptcy § 36103[2][a]. Secured lenders present

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similar arguments regarding the adequate protection payments. Specifically, they argue that

since the funds were paid into a trust account, that indicated that the adequate protection

payments were necessarily there for the secured lenders’ benefit. Also, they argued that the

cash collateral orders did not condition the secured lenders’ right to obtain the funds on proving

diminution in the value of their collateral. As with the replacement liens, secured lenders’

arguments are contrary to the purpose, as defined by statute, of adequate protection funds. In

return for giving permission to use the cash collateral, the secured lenders got adequate

protection payments to guard against diminution in the value of cash collateral and other assets. 

The bankruptcy court also found that the adequate protection payments were not

proceeds of collateral. Pursuant to the cash collateral orders, the adequate protection payments

were paid into a separate account and were for a different purpose. Accordingly, the

bankruptcy court did not err when deciding that secured lenders had to prove diminution in the

value of their collateral before getting the adequate protection payments. The bankruptcy

court’s decision on cross-appeal is AFFIRMED. 

CONCLUSION

For all of the above-stated reasons, the bankrtupcy’s courts decisions on appeal and

cross-appeal are AFFIRMED. 

IT IS SO ORDERED.

Dated: August 15, 2007. WILLIAM ALSUP

UNITED STATES DISTRICT JUDGE

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