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What Is Cash Collateral?

Cash collateral refers to cash and its equivalents that are kept aside for creditors during Chapter 11 bankruptcy. Cash and cash equivalents include negotiable instruments, documents of title, securities, and deposit accounts. As assets are sold off during the bankruptcy period, the cash received is placed in a cash collateral account, separate from other assets.

Key Takeaways:

Cash collateral consists of cash and equivalents held for creditors' benefit during Chapter 11 bankruptcy proceedings.

Assets sold during bankruptcy are converted into cash and held in a separate cash collateral account.

The use of cash collateral by a debtor requires creditor consent or a court order.

Cash equivalents in cash collateral may include securities, deposit accounts, and negotiable instruments.

Debtors can continue operations in bankruptcy by pledging cash collateral, ensuring adequate protection for creditors.

How Cash Collateral Works in Financial Transactions

Collateral in the normal sense is property pledged to secure a loan; the lender then has a lien on that property. For instance, a homebuyer uses their house as collateral to secure a mortgage loan from a bank.

When a bank or other lender provides a business loan, the business may have to pledge its inventory and accounts receivable as collateral to secure the loan. Unlike a house, accounts receivable and inventory changes every day: inventory is used, sold, and replaced. Accounts receivable changes as products sell and new accounts open, especially when inventory is sold on credit.

According to 11 U.S. Code Section 363(a), the full definition of cash collateral is "cash, negotiable instruments, documents of title, securities, deposit accounts or other cash equivalents, whenever acquired, in which the estate and an entity other than the estate have an interest and includes the proceeds, products, offspring, rents, or profits of property and the fees, charges, accounts or other payments for the use or occupancy of rooms and other public facilities in hotels, motel, or other lodging properties subject to a security interest as provided in section 552(b) [of this title] whether existing or after the commencement of a case under this title."

Pledging cash collateral allows a business to operate without repaying the whole loan each time it sells inventory or collects accounts receivable.

Role of Cash Collateral in Bankruptcy Proceedings

In the context of bankruptcy, when a creditor such as a bank or a supplier has a claim on a company's assets, any cash collected or generated from the sale of assets is considered cash collateral. Money from accounts receivable, remaining inventory sales, or selling property and equipment goes into the cash collateral account.

The cash cannot be used by the debtor without the creditor's consent or by court order. In practice, creditors might allow debtors to use cash to keep operations running and ease financial stress. However, if a new piece of equipment is purchased with the cash, for example, the equipment takes the place of the cash as collateral. This type of substitution is governed by Section 361 of the Bankruptcy Code, which requires "adequate protection" for a secured creditor to "ensure against the decline of the value of its collateral." A debtor may be instructed by the court to provide a replacement lien, as in the preceding illustration, or make periodic cash payments if the value of the overall cash collateral account begins to decline.

The Bottom Line

Cash collateral is cash and cash equivalents maintained for the benefit of creditors during Chapter 11 bankruptcy proceedings. It includes negotiable instruments, documents of title, securities, and deposit accounts. Cash collateral is kept separate from other assets to protect it for creditors. It cannot be used by the person in bankruptcy without the creditor's consent or a court order. In addition, substitutions of collateral, such as replacing cash with new equipment, require adequate protection for creditors.